This document contains forward-looking statements that describe the objectives,
expectations, estimates, and assessments of the Federal Home Loan Bank of
Cincinnati (FHLBank). These statements use words such as "anticipates,"
"expects," "believes," "could," "estimates," "may," and "should." By their
nature, forward-looking statements relate to matters involving risks or
uncertainties, some of which we may not be able to know, control, or completely
manage. Actual future results could differ materially from those expressed or
implied in forward-looking statements or could affect the extent to which we are
able to realize an objective, expectation, estimate, or assessment. Some of the
risks and uncertainties that could affect our forward-looking statements include
the following:
? the effects of economic, financial, credit, market, and member conditions
on our financial condition and results of operations, including changes in
economic growth, general liquidity conditions, inflation and deflation,
interest rates, interest rate spreads, interest rate volatility, mortgage
originations, prepayment activity, housing prices, asset delinquencies,
and members' mergers and consolidations, deposit flows, liquidity needs,
and loan demand;
? political events, including legislative, regulatory, federal government,
judicial or other developments that could affect us, our members, our
counterparties, other FHLBanks and other government-sponsored enterprises
(GSEs), and/or investors in the Federal Home Loan Bank System's (FHLBank
System) debt securities, which are called Consolidated Obligations or
Obligations;
? competitive forces, including those related to other sources of funding
available to members, to purchases of mortgage loans, and to our issuance
of Consolidated Obligations;
? the financial results and actions of other FHLBanks that could affect our
ability, in relation to the FHLBank System's joint and several liability
for Consolidated Obligations, to access the capital markets on favorable
terms or preserve our profitability, or could alter the regulations and
legislation to which we are subject;
? changes in ratings assigned to FHLBank System Obligations or our FHLBank
that could raise our funding cost;
? changes in investor demand for Obligations;
? the volatility of market prices, interest rates, credit quality, and other
indices that could affect the value of investments and collateral we hold as security for member obligations and/or for counterparty obligations;
? the ability to attract and retain skilled management and other key employees;
? the ability to develop and support technology and information systems that
effectively manage the risks we face;
? the ability to successfully manage new products and services; and
? the risk of loss arising from litigation filed against us or one or more
other FHLBanks.
We do not undertake any obligation to update any forward-looking statements made
in this document.
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EXECUTIVE OVERVIEW
Financial Highlights
The following table presents selected Statement of Condition information,
Statement of Income data and financial ratios for the periods indicated.
(Dollars in millions)
June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 June 30, 2011
STATEMENT OF CONDITION DATA AT
QUARTER END:
Total assets $ 67,466 $ 61,976 $ 60,397 $ 66,921 $ 66,618
Advances 35,095 27,177 28,424 30,345 29,173
Mortgage loans held for
portfolio 8,114 8,237 7,871 7,889 7,561
Allowance for credit losses on
mortgage loans 20 21 21 15 15
Investments (1) 23,359 26,419 21,941 26,054 27,940
Consolidated Obligations, net:
Discount Notes 30,539 27,076 26,136 33,339 32,916
Bonds 31,319 29,317 28,855 27,511 28,052
Total Consolidated Obligations,
net 61,858 56,393 54,991 60,850 60,968
Mandatorily redeemable capital
stock 265 270 275 331 324
Capital:
Capital stock - putable 3,259 3,141 3,126 3,106 3,113
Retained earnings 488 467 444 436 448
Accumulated other comprehensive
loss (9 ) (10 ) (11 ) (8 ) (7 )
Total capital 3,738 3,598 3,559 3,534 3,554
STATEMENT OF INCOME DATA FOR THE
QUARTER:
Net interest income $ 53 $ 81 $ 68 $ 44 $ 66
Provision for credit losses - 1 7 2 1
Other income (loss) 22 (1 ) (2 ) (6 ) -
Other expenses 14 14 14 15 13
Assessments 6 7 5 2 14
Net income $ 55 $ 58 $ 40 $ 19 $ 38
Dividend payout ratio (2) 60 % 61 % 79 % 167 % 91 %
Weighted average dividend rate
(3) 4.25 % 4.50 % 4.00 % 4.00 % 4.50 %
Return on average equity 6.03 6.50 4.44 2.07 4.28
Return on average assets 0.34 0.37 0.25 0.11 0.22
Net interest margin (4) 0.33 0.52 0.42 0.27 0.39
Average equity to average assets 5.61 5.68 5.57 5.36 5.23
Regulatory capital ratio (5) 5.95 6.26 6.37 5.79 5.83
Operating expense to average
assets 0.068 0.076 0.065 0.072 0.065
(1) Investments include interest bearing deposits in banks, securities
purchased under agreements to resell, Federal funds sold, trading
securities, available-for-sale securities, and held-to-maturity
securities.
(2) Dividend payout ratio is dividends declared in the period as a percentage
of net income.
(3) Weighted average dividend rates are dividends paid in stock and cash
divided by the average number of shares of capital stock eligible for
dividends.
(4) Net interest margin is net interest income before provision for credit
losses as a percentage of average earning assets.
(5) Regulatory capital ratio is period-end regulatory capital (capital stock,
mandatorily redeemable capital stock and retained earnings) as a
percentage of period-end total assets.
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Financial Condition
Mission Asset Activity
The following table summarizes our financial condition.
Ending Balances Average Balances
Year Ended
June 30, December 31, Six Months Ended June 30, December 31,
(In millions) 2012 2011 2011 2012 2011 2011
Total Assets $ 67,466 $ 66,618 $ 60,397 $ 63,872 $ 69,415 $ 67,288
Mission Asset Activity:
Advances (principal) 34,602 28,578 27,839 28,983 28,223 28,635
Mortgage Purchase Program:
Mortgage loans held for
portfolio (principal) 7,955 7,473 7,752 7,925 7,499 7,610
Mandatory Delivery Contracts
(notional) 236 361 431 366 205 268
Total Mortgage Purchase
Program 8,191 7,834 8,183 8,291 7,704 7,878
Letters of Credit (notional) 3,997 5,302 4,838 4,321 5,801 5,219
Total Mission Asset Activity $ 46,790$ 41,714 $ 40,860 $ 41,595 $ 41,728$ 41,732
The FHLBank continued to fulfill its mission by providing readily available and
competitively priced wholesale funding to its member financial institutions,
supporting its commitment to affordable housing, and paying stockholders a
competitive dividend return on their capital investment. The first six months of
2012 continued the overall trends in our financial condition experienced since
Mission Asset Activity peaked in the fourth quarter of 2008. Our business is
cyclical and Mission Asset Activity normally stabilizes or declines in periods
of difficult macro-economic conditions, when financial institutions have ample
liquidity, or when there is significant growth in the money supply. All these
conditions continue to exist.
Total assets at June 30, 2012 increased $7.1 billion (12 percent) from year-end
2011, led by growth in Advances. By contrast, average asset balances in the
first two quarters were $5.5 billion (eight percent) lower compared to the same
period of 2011, mostly due to lower liquidity investment balances.
The balance of Mission Asset Activity - comprising Advances, Letters of Credit,
and the Mortgage Purchase Program - was $46.8 billion at June 30, 2012, an
increase of $5.9 billion (15 percent) from year-end 2011. The increase was led
by a $6.8 billion increase in the principal balance of Advances. Most of the
Advance growth ($5.6 billion) was due to borrowings by two large-asset members.
Average Advance principal balances in the first six months of 2012 increased
$0.8 billion (three percent) from the same period of 2011.
The principal balance of mortgage loans held for portfolio (the Mortgage
Purchase Program) rose $0.2 billion (three percent) from year-end 2011. During
the first six months of 2012, the FHLBank purchased $1.4 billion of mortgage
loans, while principal paydowns totaled $1.2 billion.
As of June 30, 2012, members funded on average 3.3 percent of their assets with
Advances, and the penetration rate was relatively stable with almost 75 percent
of members holding Mission Asset Activity. These ratios were similar to those of
2011. The number of active sellers and participants, and member interest, in the
Mortgage Purchase Program remained at strong levels.
Based on our earnings during the first two quarters of 2012, we contributed $13
million to the Affordable Housing Program pool of funds to be awarded to members
in 2013. This continued a trend of adding to the available funds each quarter
since the inception of the program in 1990.
Other Assets
The balance of investments at June 30, 2012 was $23.4 billion, an increase of
$1.4 billion (six percent) from year-end 2011. Average investment balances were
$26.1 billion in the first six months of 2012, a decrease of $6.7 billion (20
percent) from the same period in 2011. The changes in ending and average
balances reflected normal periodic variation in holdings, particularly of
short-term liquidity investments. The reduction in average investment balances
was due to the normal periodic variation, as well as to narrower spreads
available and fewer eligible counterparties for liquidity investments that met
our unsecured credit risk criteria. Despite the decline in average liquidity
investments, we believe we continued to maintain an adequate amount of asset
liquidity.
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The investment balance at the end of the quarter included $10.9 billion of
mortgage-backed securities and $12.5 billion of other investments, which are
mostly short-term liquidity instruments. All of our mortgage-backed securities
held at June 30, 2012 were issued and guaranteed by Fannie Mae, Freddie Mac or a
U.S. agency.
Capital
Capital adequacy continued to be strong in the first six months of 2012,
exceeding all minimum regulatory capital requirements. The GAAP
capital-to-assets ratio at June 30, 2012 was 5.54 percent, while the regulatory
capital-to-assets ratio was 5.95 percent. Both ratios were well above the
regulatory required minimum of 4.00 percent. Regulatory capital includes
mandatorily redeemable capital stock accounted for as a liability under GAAP.
The dollar amounts of GAAP and regulatory capital increased five percent and
four percent, respectively, between year-end 2011 and the end of the second
quarter.
Total retained earnings were $488 million at June 30, 2012, an increase of $44
million (ten percent) from year-end 2011. Total retained earnings were comprised
of $454 million unrestricted and $34 million restricted.
Results of Operations
The table below summarizes our results of operations.
Year Ended December
Three Months Ended June 30, Six Months Ended June 30, 31,
(Dollars in millions) 2012 2011 2012 2011 2011
Net income $ 55 $ 38 $ 112 $ 80 $ 138
Affordable Housing Program accrual 6 5 13 10 17
Return on average equity (ROE) 6.03 % 4.28 % 6.26 % 4.53 % 3.89 %
Return on average assets 0.34 0.22 0.35 0.23 0.21
Weighted average dividend rate 4.25 4.50 4.38 4.50 4.25
Average 3-month LIBOR 0.47 0.26 0.49 0.29 0.34
Average overnight Federal funds
effective rate 0.15 0.09 0.13 0.12 0.10
ROE spread to 3-month LIBOR 5.56 4.02 5.77 4.24 3.55
Dividend rate spread to 3-month
LIBOR 3.78 4.24 3.89 4.21 3.91
ROE spread to Federal funds
effective rate 5.88 4.19 6.13 4.41 3.79
Dividend rate spread to Federal
funds effective rate 4.10 4.41 4.25 4.38 4.15
The spreads between ROE and short-term interest rates, for which we use as a
proxy 3-month LIBOR and Federal funds, are market benchmarks we believe
stockholders use to assess the competitiveness of return on their capital
investment in our company. Earnings continued to be sufficient to provide
competitive returns to stockholders' capital investment. Consistent with
experience over the last several years, ROE was significantly above short-term
rates, resulting in the ROE spreads being wider than the historical average
spreads.
We estimate, using our current balance sheet and operating expense structure,
that the long-term average ROE in a stable market and interest rate environment
would be in the range of 2.50 to 3.50 percentage points above short-term
interest rates. The factors determining the current elevated level of ROE spread
to market interest rates, compared to the long-term historical range, include
the extremely low level of short-term rates, an ability to retire a large amount
of high-cost Consolidated Obligation Bonds before their final maturities, muted
acceleration of mortgage prepayment speeds, and relatively wider spreads to
funding costs on new mortgage assets.
The increase in operating results and profitability in the first six months of
2012 compared to the same period of 2011 resulted primarily from the following
favorable factors, which more than offset the combined effect of several smaller
unfavorable factors.
? An increase in realized gains ($23 million in both the three- and six-month
comparisons) from the sales of certain mortgage-backed securities. Each of
the securities sold had less than 15 percent of the original acquired
principal remaining and were sold under our periodic clean-up process.
? The FHLBank System's REFCORP obligation was satisfied at the end of the
second quarter of 2011. REFCORP, which had been recorded as a reduction to
net income, was replaced with an allocation of 20 percent of net income to a
separate
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restricted retained earnings account under the Joint Capital Enhancement
Agreement (the "Capital Agreement"). This change had a favorable impact to net
income of $9 million and $19 million in the three- and six-month comparisons,
respectively.
? We called a significant amount of high-cost Consolidated Bonds before their
final maturities throughout 2011 and the first two quarters of 2012 and
replaced them with new Consolidated Obligations at substantially lower rates.
The resulting savings in interest expense exceeded the decrease in interest
income from paydowns of high-yielding mortgage loans, which were reinvested
into new mortgage assets also at lower yields.
? Average spreads between LIBOR-indexed assets (mostly Advances) and short-term
Discount Note debt were wider in the last quarter of 2011 and first two
quarters of 2012 because of, among other reasons, concerns over the ongoing
economic and financial conditions in Europe which has increased the rates at
which financial institutions are willing to lend to one another as indicated
by LIBOR. We use Discount Notes to fund a large amount of LIBOR-indexed
assets.
The primary unfavorable factor that partially offset the favorable factors was a
sharp increase in net amortization expense of purchase premiums on mortgage
assets and of premiums/discounts and concession costs on Consolidated
Obligations. This amortization expense increased $20 million and $23 million in
the three- and six-month comparisons, respectively, mainly due to mortgage
amortization. Recognition of net amortization has been large during periods when
mortgage rates trended downward, including the first six months of 2012.
Update on Business Outlook, Risk Factors, and Risk Exposures
This section summarizes and updates from our 2011 Form 10-K filing our major
current risk exposures and current business outlook. "Quantitative and
Qualitative Disclosures About Risk Management" provides details on current risk
exposures.
Business Outlook--Strategic/Business Risk
Advances. We cannot predict the future trend of Mission Asset Activity because
it depends on, among other things, the state of the economy, conditions in the
housing markets, the government's liquidity programs, the willingness and
ability of financial institutions to expand lending, and regulatory initiatives
that could affect demand for our Mission Asset Activity. We would expect to see
an increase in Advance demand across the broad membership base when one or more
of the following occur: the economy experiences a sustained improvement; the
Federal Reserve System's monetary policy tightens; or the government's liquidity
programs wind down. Additionally, there is a substantial amount ($4.7 billion)
of Advances held by former members that will pay down over the next several
years.
Two national financial institutions became members in 2012, and one had Advance
borrowings at June 30 totaling $4 billion. The addition of these new
members may, over time, result in further increases to Advance balances that
also may change the composition of our largest Advance borrowers.
We continue to be concerned about several regulatory initiatives that could
affect Advance demand over time. One rule already implemented increased FDIC
assessments for large financial institutions that utilize Advances, effectively
raising the cost of borrowing from an FHLBank for certain members. Although we
cannot determine whether this rule has impacted Advance balances to date (due in
part to members' already subdued demand for Advances), it could adversely affect
Advance demand over time to the extent the changes in assessments increase the
cost of Advances for affected members.
Potential statutory and regulatory changes, or implementation of statutory and
regulatory actions being promulgated, that could affect our business include:
limitations on Advance lending to large financial institutions; prohibition
under Basel III for institutions to incorporate unused FHLBank System borrowing
capacity as sources of liquidity; development of a covered bond market; and
members' implementation of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.
Mortgage Purchase Program. Our strategy for the Mortgage Purchase Program
continues to emphasize moderate growth and a prudent limit on the Program's size
relative to capital. This strategy will help ensure that our exposure to market
and credit risk remains consistent with our conservative risk management
principles, cooperative business model, and status as a government-sponsored
enterprise. We will continue to emphasize recruiting community financial
institution members to the Program and increasing the number of regular sellers.
Moderate growth may result in the intermediate term based on the low levels of
mortgage rates that promote mortgage refinancing activity, continued additions
to the number of regular sellers, several new mid-sized sellers joining the
Program, and continued activity with our two largest sellers. However, higher
mortgage rates would likely slow growth.
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The primary regulation currently affecting growth of balances in the Mortgage
Purchase Program is that if our purchases in a calendar year exceed $2.5
billion, we are required by regulation to enact affordable housing goals for the
Program. We believe these would be operationally costly to administer and could
harm the Program's credit risk exposure and increase reputational risk. As a
result, we currently plan to limit our calendar year purchases to less than $2.5
billion.
Legislative and Regulatory Risk
The legislative and regulatory environment in which we operate continues to
undergo rapid change driven principally by reforms under the Housing and
Economic Reform Act of 2008 (HERA) and the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (the Dodd-Frank Act). Legislative and regulatory
actions for the first six months of 2012 that we believe could significantly
impact our company are summarized below.
Regulation on Asset Classification. In April 2012, the Finance Agency issued
Advisory Bulletin 2012-02, Framework for Adversely Classifying Loans, Other Real
Estate Owned, and Other Assets and Listing Assets for Special Mention, that
establishes guidance that is generally consistent with the Uniform Retail Credit
Classification and Account Management Policy issued by federal banking
regulators in June 2000. We have not yet determined when we will implement this
guidance or the effect, if any, that this guidance will have on our results of
operations or financial condition.
Supervision and Regulation of Nonbank Financial Companies. In April, 2012, the
Financial Stability Oversight Council (the Oversight Council) issued a final
rule to be effective May 11, 2012 and guidance on the standards and procedures
the Oversight Council will follow in determining whether to designate a nonbank
financial company for supervision by the Federal Reserve Board (the Federal
Reserve) and to be subject to certain heightened prudential standards. The final
rule provides that, in making its determinations, the Oversight Council will
consider as one factor whether a nonbank financial company is subject to
oversight by a primary financial regulatory agency (for the FHLBank, the Finance
Agency). We would be designated a nonbank financial company pursuant to a
separate rule that has been proposed by the Federal Reserve. If we are
designated by the Oversight Council for supervision by the Federal Reserve and
subject to additional prudential standards, our operations and business could be
adversely impacted by resulting additional regulatory costs and potential
restrictions on our business activities.
Regulation on Prudential Management and Operations Standards. In June, 2012, the
Finance Agency issued a final rule, as required by HERA and effective August 7,
2012, regarding prudential standards for the management and operations of the
FHLBanks. If the Finance Agency determines that the FHLBank has failed to meet
one or more of the standards, the rule states that the FHLBank may be required
to file a corrective action plan. In this case, the Finance Agency is required
to notify the FHLBank in writing that a plan is required, and the FHLBank
generally has 30 calendar days to comply with such requirement. If an acceptable
corrective action plan is not submitted by the deadline or the terms of such a
plan are not complied with, the Director of the Finance Agency can impose
sanctions, such as limits on asset growth, increases in the level of retained
earnings, and prohibitions on dividends or the redemption or repurchase of
capital stock.
Dodd-Frank Act Developments. Together with the other FHLBanks, we continue to
monitor rulemakings pursuant to implementing the derivatives reform under the
Dodd-Frank Act. We also continue to implement the processes and documentation
necessary to comply with the Dodd-Frank Act as we currently understand the
requirements, many of which are still being promulgated. The following major
regulatory actions related to the Dodd-Frank Act were issued in the first six
months of 2012.
In April 2012, a joint regulatory ruling determined that the FHLBanks will not
be required to register as either major swap participants or as swap dealers
because the derivative transactions the FHLBanks transact are for the purposes
of hedging and managing market risk exposure or intermediating for our member
institutions.
Based on final regulatory rules and accompanying interpretive regulatory
guidance issued in July 2012, call and put options in certain Advances to our
members will not be treated as "swaps" as long as the optionality relates solely
to the interest rate on the Advance and does not result in enhanced or inverse
performance or other risks unrelated to the interest rate. Accordingly, our
ability to offer these types of Advances to members should be unaffected by the
regulation.
The U.S. Commodity Futures Trading Commission (CFTC) is expected to issue
proposals in the third quarter of 2012 regarding which swaps will be subject to
mandatory clearing requirements. At this time, we do not expect any of our swaps
will be subject to the new clearing and trading requirements until the beginning
of 2013, at the earliest.
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Market Risk and Profitability
Market risk exposure was moderate in the first six months of 2012, well within
policy limits, and below long-term historical average exposure. The
below-average market risk exposure was due to distortions in the measurements
caused by the exceptionally low level of interest rates (including the reduction
in long-term rates in 2012) and elevated prices of mortgage assets. When
mortgage rates rise 0.50 percentage points or more, we would expect market risk
exposure to further rate increases to return to levels more consistent with
historical positioning. Based on the totality of our market risk analysis, we
expect that profitability, defined as the level of ROE compared with short-term
market rates, will remain competitive unless interest rates would change by
extremely large amounts in a short period of time.
Credit Risk
In the first six months of 2012, we continued to experience limited overall
credit risk exposure from offering Advances, making investments, and executing
derivative transactions; and a moderate amount of credit risk exposure related
to credit losses in the Mortgage Purchase Program. Consistent with previous
years, the FHLBank required no loss reserve for Advances and considered no
investments to be other-than-temporarily impaired at June 30, 2012. We believe
policies and procedures related to credit underwriting, Advance collateral
management, and transactions with investment and derivative counterparties
continue to mitigate these risks.
The allowance for credit losses in the Mortgage Purchase Program was $20 million
and $21 million at June 30, 2012 and December 31, 2011, respectively. We believe
the portfolio's credit risk will remain moderate and manageable. However, in an
adverse scenario of further large reductions in home prices, sustained elevated
levels of unemployment, or failure of one or more mortgage insurance providers,
credit losses experienced in the portfolio net of credit enhancements could
increase significantly.
Funding and Liquidity Risk
Our liquidity position remained ample and strong during the first six months of
2012, as did our overall ability to fund operations through Consolidated
Obligation issuances at acceptable terms, availability, and interest costs.
While there can be no assurances, the possibility of a funding or liquidity
crisis in the FHLBank System that would impair our FHLBank's ability to access
the capital markets, service debt or pay competitive dividends is considered to
be remote. The System has continued to experience uninterrupted access on
acceptable terms to the capital markets for its debt issuance and funding needs.
Spreads on the System's longer-term Consolidated Obligations to U.S. Treasury
rates and LIBOR have not changed materially.
Capital Adequacy
We have always maintained compliance with our capital requirements. We believe
that the amount of retained earnings is sufficient to protect against impairment
risk of capital stock and to provide the opportunity to stabilize dividends when
earnings may be exceptionally volatile. Our Capital Plan has safeguards to
prevent financial leverage from increasing beyond regulatory minimums or safe
levels. We believe members continue to place a high value on their capital
investment in our company.
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CONDITIONS IN THE ECONOMY AND FINANCIAL MARKETS
Effect of Economy and Financial Markets on Mission Asset Activity
The primary external factors that affect our Mission Asset Activity and earnings
are the general state and trends of the economy and financial institutions,
especially in our Fifth District; conditions in the financial, credit, mortgage,
and housing markets; interest rates; and competitive alternatives to our
products, such as retail deposits and other sources of wholesale funding.
The relatively weak economy and continued housing and mortgage market stresses
have resulted in slow growth in consumer, mortgage and commercial loans, which
has limited members' demand for Advances and wholesale funding in general. From
March 31, 2011 to March 31, 2012 (the most recent data period available), Fifth
District depository institutions' aggregate loan portfolios grew only $24.8
billion (4.6 percent) while their aggregate deposit balances rose $42.0 billion
(6.7 percent). We have no reason to believe that these trends changed materially
during the second quarter of 2012, although we have seen indications of
potential stabilization of Advance demand across the broad membership.
Also continuing to negatively impact demand for our credit services is the
substantial liquidity still being made available to depository institutions by
the federal government in an attempt to stimulate economic growth, extending a
practice that began in late 2008. The government's activities are being led by
the Federal Reserve System and its quantitative easing programs, which have
resulted in an historic expansion of its balance sheet and in the banking system
holding extremely large and unprecedented levels of excess reserves instead of
using the liquidity to expand lending.
Interest Rates
Trends in market interest rates affect members' demand for Mission Asset
Activity, earnings, spreads on assets, funding costs and decisions in managing
the tradeoffs in our market risk/return profile. The following table presents
key market interest rates (obtained from Bloomberg L.P.).
Six
Months Ended June 30,
Quarter 2 2012 Quarter 1 2012 2012 2011 Year 2011
Average Ending Average Ending Average Average Average Ending
Federal funds target 0-0.25% 0-0.25% 0-0.25% 0-0.25% 0-0.25% 0-0.25% 0-0.25% 0-0.25%
Federal funds
effective 0.15 0.09 0.10 0.09 0.13 0.12 0.10 0.04
3-month LIBOR 0.47 0.46 0.51 0.47 0.49 0.29 0.34 0.58
2-year LIBOR 0.59 0.55 0.59 0.57 0.59 0.82 0.72 0.72
5-year LIBOR 1.09 0.96 1.17 1.27 1.13 2.20 1.79 1.23
10-year LIBOR 1.95 1.78 2.12 2.29 2.03 3.41 2.90 2.04
2-year U.S. Treasury 0.28 0.30 0.28 0.33 0.28 0.61 0.44 0.24
5-year U.S. Treasury 0.78 0.72 0.89 1.04 0.83 1.97 1.51 0.83
10-year U.S.
Treasury 1.80 1.65 2.02 2.21 1.91 3.31 2.76 1.88
15-year mortgage
current coupon (1) 1.77 1.63 1.92 2.04 1.85 3.30 2.83 2.05
30-year mortgage
current coupon (1) 2.78 2.60 2.90 3.10 2.84 4.16 3.74 2.92
15-year mortgage
note rate (2) 3.04 2.94 3.19 3.23 3.12 3.98 3.68 3.24
30-year mortgage
note rate (2) 3.79 3.66 3.92 3.99 3.86 4.75 4.45 3.95
(1) Simple average of current coupon rates of Fannie Mae and Freddie Mac par
mortgage-backed security indications.
(2) Simple weekly average of 125 national lenders' mortgage rates for prime
borrowers having a 20 percent down payment as surveyed and published by
Freddie Mac.
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Short-term rates remained at historic lows in the first six months of 2012. The
Federal Reserve maintained the overnight Federal funds target and effective
rates between zero and 0.25 percent, with other short-term rates generally
consistent with their historical relationships to Federal funds.
The spread between short-term LIBOR (especially LIBOR with three-month resets)
and our Discount Note funding costs continued to be wider than historical
averages as discussed in the "Executive Overview" and "Results of Operations."
This benefited our earnings because we fund a significant amount of
adjustable-rate LIBOR-indexed assets with Discount Notes.
Average and ending intermediate- and long-term rates were relatively stable, or
even increased modestly, in the first quarter compared to year-end 2011. These
rates then declined in the second quarter on both an average- and ending basis,
and were substantially lower than compared to the same period of 2011.
The trends in interest rates had several impacts on our results of operations in
the first six months of 2012, as discussed in detail in the "Executive Overview"
and the "Results of Operations." The Federal Reserve has indicated that it
currently plans to hold certain short-term rates at or near zero until 2014 or
beyond. This projection could change if its forecast of slow economic growth and
subdued inflation changes. The evolution of long-term rates is more difficult to
predict since the Federal Reserve has less control over these rates. As
discussed in the "Executive Overview" and "Market Risk" section of "Quantitative
and Qualitative Disclosures About Risk Management," we believe our market risk
profile is positioned to remain moderate and our profitability competitive,
across a wide range of interest rate environments.
Despite the continued trend of declining intermediate- and long-term rates
during the first six months of 2012, the interest rate environment remained
favorable for our FHLBank's results of operations in terms of the longer-term
trend level of profitability (ROE) compared to the levels of interest rates.
This difference, or spread, averaged 5.77 percentage points (relative to
three-month LIBOR) in the first six months of 2012 and 4.24 percentage points in
the same period of 2011. In the ten years prior to 2011, this spread averaged
3.18 percentage points.
In general, when interest rates decline, our profitability relative to
short-term interest rates widens. The rate environment has been a net benefit to
our profitability relative to interest rate levels, for several reasons:
? Reductions in market interest rates raise ROE compared to market rates to the
extent we fund a portion of long-term assets with shorter-term debt.
? The lower intermediate- and long-term rates have provided us the opportunity
to retire many Consolidated Bonds before their final maturities and replace
them with lower cost Obligations, at a pace exceeding mortgage paydowns.
? Earnings generated from funding assets with interest-free capital have not
decreased as much as the reduction in overall interest rates because
long-term assets do not reprice immediately to the lower rates.
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ANALYSIS OF FINANCIAL CONDITION
Credit Services
Credit Activity and Advance Composition
The table below shows trends in Advance balances by major programs and in the
notional amount of Letters of Credit.
(Dollars in millions) June 30, 2012 March 31, 2012 December 31, 2011
Balance Percent(1) Balance Percent(1) Balance Percent(1)
Adjustable/Variable Rate Indexed:
LIBOR $ 13,641 39 % $ 9,659 36 % $ 9,649 35 %
Other 263 1 155 1 229 1
Total 13,904 40 9,814 37 9,878 36
Fixed-Rate:
REPO 6,126 18 2,322 9 3,085 11
Regular Fixed Rate 7,983 23 4,940 19 5,013 18
Putable (2) 2,832 8 5,992 22 6,204 22
Convertible (2) 1,143 3 1,174 4 1,178 4
Amortizing/Mortgage Matched 2,315 7 2,209 8 2,232 8
Other 299 1 213 1 249 1
Total 20,698 60 16,850 63 17,961 64
Other Advances - - - - - -
Total Advances Principal $ 34,602 100 % $ 26,664 100 % $ 27,839 100 %
Letters of Credit (notional) $ 3,997 $ 4,218 $ 4,838
(1) As a percentage of total Advances principal.
(2) Excludes Putable/Convertible Advances where the related put/conversion
options have expired. Such Advances are classified based on their current
terms.
The increase in Advance balances in the second quarter of 2012 compared to the
first quarter and the end of 2011 occurred mostly from borrowings by a small
number of large-asset institutions. Advance growth was comprised almost entirely
of short-term REPO Advances (mostly having overnight maturities) and
adjustable-rate LIBOR. The higher amount of Regular Fixed-Rate Advances
represented the reclassification of $3.2 billion of Putable Advances for which
the last put option has expired; $3.0 billion of which matured in July 2012.
We do not know if the increase in second-quarter Advance balances will continue
or develop into broad-based Advance usage by the overall membership base. We
believe Advance demand continues to be affected by the weak economy, the
extremely low levels of interest rates, and the Federal Reserve's ongoing
actions to provide an extraordinary amount of liquidity to financial
institutions. An additional factor putting downward pressure on Advance balances
is that former members hold $4.7 billion (14 percent), of which approximately 65
percent are scheduled to mature by the end of 2013. These will pay down without
opportunity for replacement with new Advances by former members. "Executive
Overview" and "Conditions in the Economy and Financial Markets" above provide
more detail on trends in Advance balances.
Members reduced their available lines in the Letters of Credit program by $0.8
billion in the first six months of 2012 over year-end 2011. The lines fell
principally because of decreased activity from a few large members who heavily
use Letters of Credit and whose usage can be volatile. We earn fees on Letters
of Credit based on the actual notional amount of the Letters utilized, which
normally is less than the available lines.
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The following tables present principal balances for our top five Advance
borrowers.
(Dollars in
millions)
June 30, 2012 December 31, 2011
Percent of Percent of
Total Par Total Par
Par Value of Value of Par Value of Value of
Name Advances Advances Name Advances Advances
U.S. Bank, N.A. $ 7,314 21 % U.S. Bank, N.A. $ 7,314 26 %
Fifth Third Bank 4,158 12 PNC Bank, N.A. (1) 3,996 14
JPMorgan Chase
Bank, N.A. 4,000 12 Fifth Third Bank 2,533 9
Protective Life
PNC Bank, N.A. (1) 3,994 12 Insurance Company 1,000 4
Protective Life Republic Bank &
Insurance Company 1,152 3 Trust Company 935 4
Total of Top 5 $ 20,618 60 % Total of Top 5 $ 15,778 57 %
(1)Former member.
The concentration ratio of the top five borrowers has fluctuated in the range of
50 to 65 percent in the last several years, with a moderate upward trend. The
top five borrowers at June 30 included a new member, JPMorgan Chase Bank, N.A.
We believe that having large financial institutions who actively use our Mission
Asset Activity augments the value of membership to all members because it
improves operating efficiency, increases financial leverage and earnings, and
enables us to possibly obtain more favorable funding costs and maintain
competitively priced Mission Asset Activity.
The following table shows the unweighted average ratio of each member's Advance
balance to its most-recently available figures for total assets. Each member's
Advances are counted the same in these ratios.
June 30, 2012 March 31, 2012 December 31, 2011
Average Advances-to-Assets for Members
Assets less than $1.0 billion (679 members) 3.29 % 3.43 % 3.69 %
Assets over $1.0 billion (66 members) 3.04 % 2.80 % 3.04 %
All members 3.27 % 3.37 % 3.63 %
Advance usage ratios continued to decline in the first six months of 2012 from
the end of 2011, at the same approximate pace as in 2011. However, the measure
showed signs of beginning to stabilize in the second quarter and grew for larger
members with assets over $1.0 billion. Despite the difficult economic
environment and significant levels of financial institution liquidity, our
membership still funded over three percent of their assets with Advances.
Mortgage Purchase Program (Mortgage Loans Held for Portfolio)
The table below shows principal paydowns and purchases of loans in the Mortgage
Purchase Program for the first six months of 2012.
(In millions)
Mortgage Purchase Program Principal
Balance at December 31, 2011 $ 7,752
Principal purchases 1,444
Principal paydowns (1,241 )
Balance at June 30, 2012 $ 7,955
The principal loan balance grew moderately (three percent) in this period. The
purchases reflected activity with the largest seller in the Program, as well as
ongoing sales by over 70 community-based financial institutions and a continuing
trend of increases in the number of regular sellers. The decline in mortgage
rates in the first six months of the year also prompted an increase in net loan
refinancings among our sellers.
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We closely track the refinancing incentives of our mortgage assets because the
option for homeowners to change their principal payments normally represents
almost all of our market risk exposure. Principal paydowns in the first six
months of 2012 equated to a 25 percent annual constant prepayment rate,
moderately higher than the 20 percent rate for all of 2011.
The Program's composition of balances by loan type and original final maturity
did not change materially. Similar to Advances, the Program's balances are
concentrated among several members, with our top five sellers providing 73
percent of balances at June 30, 2012. Yields earned during the first two
quarters, relative to funding costs, continued in the aggregate to offer
acceptable risk-adjusted returns, despite substantial fluctuations in mortgage
premium amortization detailed in "Results of Operations." For discussion of net
amortization, see the "Net Interest Income" section of "Results of Operations."
Our focus for the Program continues to be recruiting community-based members to
sell us mortgage loans and increasing the number of regular sellers. A number of
members either are actively interested in joining the Program or are in the
process of joining.
Investments
We hold investments in order to provide liquidity, enhance earnings, and help
manage market risk. We hold both shorter-term investments, which we refer to as
"liquidity investments" because most of them serve to augment asset liquidity,
and longer-term mortgage-backed securities. The table below presents the ending
and average balances of our investments.
Six Months Ended Year Ended
(In millions) June 30, 2012 December 31, 2011
Ending Balance Average Balance Ending Balance Average Balance
Liquidity investments $ 12,475 $ 14,820 $ 10,737 $ 18,411
Mortgage-backed securities 10,884 10,811 11,204 11,100
Other investments (1) - 456 - 469
Total investments $ 23,359 $ 26,087 $ 21,941 $ 29,980
(1) The average balance includes the rights or obligations to cash collateral,
which are included in the fair value of derivative assets or derivative
liabilities on the Statements of Condition at period end.
The changes in both ending and average liquidity investment balances for the
periods shown reflected normal periodic variation. The $3.6 billion decrease in
the average balance of liquidity investments from the full year of 2011 to the
first six months 2012 was due to the normal periodic variation, as well as
narrower spreads available and fewer eligible counterparties for these types of
investments that met our unsecured credit risk criteria. Despite the decline in
average liquidity investments, we believe we continued to maintain an adequate
amount of asset liquidity.
Our overarching strategy for mortgage-backed securities is to maximize their
holdings close to the regulatory maximum of three times capital, subject to the
availability of securities that we believe provide favorable risk/return
tradeoffs. The balance of mortgage-backed securities at June 30, 2012
represented a 2.71 multiple of regulatory capital and consisted of $9.5 billion
of securities issued by Fannie Mae or Freddie Mac (of which $1.9 billion were
floating-rate securities) and $1.4 billion of floating-rate securities issued by
the National Credit Union Administration. We held no private-label mortgage
backed securities at the end of the quarter.
The table below shows principal purchases, paydowns and sales of our
mortgage-backed securities for the first six months of 2012.
(In millions)
Mortgage-backed Securities Principal
Balance at December 31, 2011 $ 11,163
Principal purchases 1,819
Principal paydowns (1,646 )
Principal sales (478 )
Balance at June 30, 2012 $ 10,858
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Principal paydowns in this period equated to a 26 percent annual constant
prepayment rate, almost the same as the 28 percent rate for all of 2011.
Purchases during the period were concentrated in fixed-rate securities, driven
by our assessment that these types of securities had more favorable risk/return
tradeoffs compared to floating-rate securities. The principal sales were
comprised of securities that had less than 15 percent of the original acquired
principal outstanding at the time of the sale. Yields earned during the first
two quarters on new mortgage-backed securities, relative to funding costs,
offered acceptable risk-adjusted returns.
Consolidated Obligations
The table below presents the ending and average balances of our participations
in Consolidated Obligations.
Six Months Ended Year Ended
(In millions) June 30, 2012 December 31, 2011
Ending Balance Average Balance Ending Balance Average Balance
Consolidated Discount Notes:
Par $ 30,542 $ 27,761 $ 26,138 $ 32,295
Discount (3 ) (3 ) (2 ) (3 )
Total Consolidated Discount Notes 30,539 27,758 26,136 32,292
Consolidated Bonds:
Unswapped fixed-rate 18,588 18,725 18,882 20,123
Unswapped adjustable-rate 2,040 1,586 1,440 681
Swapped fixed-rate 10,565 9,693 8,404 7,904
Total par Consolidated Bonds 31,193 30,004 28,726 28,708
Other items (1) 126 128 129 140
Total Consolidated Bonds 31,319 30,132 28,855 28,848Total Consolidated Obligations (2) $ 61,858 $ 57,890
$ 54,991 $ 61,140
(1) Includes unamortized premiums/discounts, fair value option valuation
adjustments, hedging and other basis adjustments.
(2) The 12 FHLBanks have joint and several liability for the par amount of all
of the Consolidated Obligations issued on their behalves. The par amount
of the outstanding Consolidated Obligations of all 12 FHLBanks was (in
millions) $685,195 and $691,868 at June 30, 2012 and December 31, 2011,
respectively.
Balances and composition of Consolidated Obligations fluctuate with changes in
the amount and composition of total assets. We fund short-term and
adjustable-rate Advances, Advances hedged with interest rate swaps, and most
liquidity investments with a combination of Discount Notes, unswapped
adjustable-rate Bonds, and swapped fixed-rate Bonds (which effectively create
short-term funding). We fund long-term assets principally with unswapped
fixed-rate Bonds, in order to effectively reduce market risk exposure.
The $6.9 billion increase in the total ending balance of Consolidated
Obligations from year-end 2011 to June 30, 2012 corresponded to the increase in
total assets (primarily Advances) and the relatively stable amount of deposits
and capital. All of the growth was in short-term Discount Notes, unswapped
adjustable-rate, and swapped fixed-rate Obligations. The short-term and
adjustable-rate terms of the funding corresponded to the growth in short-term
REPO and adjustable-rate LIBOR Advances.
Long-term Consolidated Obligation Bonds normally have an interest cost at a
spread above U.S. Treasury securities and below LIBOR. The level of spreads and
amounts of volatility in the first six months of 2012 were at levels comparable
to historical averages. For discussion of the cost of Discount Note funding
relative to LIBOR, see the "Net Interest Income" section of "Results of
Operations."
Deposits
Members' deposits with us are normally a relatively minor source of low-cost
funding. Total interest bearing deposits at June 30, 2012 were $1.1 billion, an
increase of $0.1 billion (five percent) from year-end 2011. The average balance
of total interest bearing deposits in the first six months of 2012 was $1.2
billion, a decrease of $0.1 billion (11 percent) from the average balance in the
same period of 2011.
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Derivatives Hedging Activity and Liquidity
Our use of and accounting for derivatives is discussed in the "Effect of the Use
of Derivatives on Net Interest Income" section in "Results of Operations."
Liquidity is discussed in the "Liquidity Risk" section in "Quantitative and
Qualitative Disclosures About Risk Management." We did not change our strategy
of using derivatives solely to manage market risk exposure in the first six
months of 2012.
Capital Resources
The following tables present capital amounts and capital-to-assets ratios, on
both a GAAP and regulatory basis.
GAAP and Regulatory Capital Six Months Ended Year Ended
June 30, 2012 December 31, 2011
(In millions) Period End Average Period End Average
GAAP Capital Stock $ 3,259 $ 3,138 $ 3,126 $ 3,109
Mandatorily Redeemable Capital Stock 265 271 275 327
Regulatory Capital Stock 3,524 3,409 3,401 3,436
Retained Earnings 488 476 444 455
Regulatory Capital $ 4,012 $ 3,885 $ 3,845 $ 3,891
GAAP and Regulatory
Capital-to-Assets Ratio Six Months Ended Year Ended
June 30, 2012 December 31, 2011
Period End Average Period End Average
GAAP 5.54 % 5.64 % 5.89 % 5.29 %
Regulatory 5.95 6.08 6.37 5.78
Both the GAAP and regulatory capital-to-assets ratios were well above the
regulatory required minimum of 4.00 percent.
We consider the regulatory ratio to be a better representation of financial
leverage than the GAAP ratio because, although the latter ratio treats
mandatorily redeemable capital stock as a liability, it provides the same
function as GAAP capital stock and retained earnings in protecting investors in
our debt.
The $167 million increase in regulatory capital (net of $27 million of
redemptions and repurchases) from year-end 2011 to June 30, 2012 was due mostly
to membership and activity stock purchases from two large, national financial
institutions that became members in 2012. The moderate reductions in the period
end capital-to-asset ratios, and the corresponding growth in financial leverage,
in the first six months of 2012, was due primarily to the growth in Advance
balances.
For the same reason, the amount of excess capital stock declined by $216 million
in first six months of 2012, and at June 30 it stood at $1.1 billion. A Finance
Agency Regulation prohibits us from paying stock dividends if the amount of our
regulatory excess stock (as defined by the Finance Agency) exceeds one percent
of our total assets on a dividend payment date. Since the end of 2008, this
regulatory threshold has been exceeded and, therefore, we have been required to
pay cash dividends.
At June 30, 2012, retained earnings were comprised of $454 million unrestricted
(an increase of $22 million from year-end 2011) and $34 million restricted (also
an increase of $22 million), which are not permitted to be distributed as
dividends. We believe that the amount of retained earnings is sufficient to
protect against impairment risk of capital stock and to provide the opportunity
to stabilize dividends when earnings may be exceptionally volatile.
Membership and Stockholders
During the first six months of 2012, we added ten new member stockholders and
lost six, ending the second quarter at 745. The new members were comprised of
three insurance companies, two commercial banks, and five credit unions.
Regarding the six institutions that are no longer members, two merged with
another member in our district, three were closed by the Tennessee Department of
Financial Institutions, and one had its charter closed by its parent company.
The impact on our earnings and mission asset activity from membership changes in
the first two quarters was negligible. We will continue to recruit institutions
eligible for membership in order to maintain and expand our customer base, with
a continuing focus on insurance companies.
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RESULTS OF OPERATIONS
Components of Earnings and Return on Equity
The following table is a summary income statement for the three and six months
ended June 30, 2012 and 2011. Each ROE percentage is computed by dividing income
or expense for the category by the average amount of stockholders' equity for
the period.
Three Months Ended June 30, Six Months Ended June 30,
(Dollars in millions) 2012 2011 2012 2011
Amount ROE (a) Amount ROE (a) Amount ROE (a) Amount ROE (a)
Net interest income $ 53 5.80 % $ 66 7.50 % $ 133 7.45 % $ 137 7.77 %
Provision for credit
losses - - (1 ) (0.13 ) (1 ) (0.08 ) (4 ) (0.21 )
Net interest income
after provision for
credit losses 53 5.80 65 7.37 132 7.37 133 7.56
Net gains on derivatives
and hedging activities 3 0.35 - 0.01 7 0.39 5 0.29
Other non-interest
income (loss) 19 2.10 - (0.03 ) 14 0.81 (1 ) (0.08 )
Total non-interest
income 22 2.45 - (0.02 ) 21 1.20 4 0.21
Total revenue 75 8.25 65 7.35 153 8.57 137 7.77
Total other expense (14 ) (1.52 ) (13 ) (1.52 ) (28 ) (1.58 ) (28 ) (1.57 )
Assessments (6 ) (0.70 ) (14 ) (1.55 ) (13 ) (0.73 ) (29 ) (1.67 )
Net income $ 55 6.03 % $ 38 4.28 % $ 112 6.26 % $ 80 4.53 %
(a) The ROE amounts have been computed using dollars in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions) in
this table may produce nominally different results.
The most significant individual contributors to the higher net income in the
first six months of 2012 were 1) satisfying the FHLBank's REFCORP obligation at
the end of June 2011; 2) realized gains in sales of certain mortgage-backed
securities (which are included in the "other non-interest income (loss)"
account); 3) calling Bonds and replacing them at lower rates; and 4) a wider
spread between LIBOR-indexed assets and Discount Note funding costs.
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Net Interest Income
Components of Net Interest Income
The following table shows the major components of net interest income. Reasons
for the variance in net interest income between the comparison periods are
discussed below.
Three Months Ended June 30, Six Months Ended June 30,
(Dollars in millions) 2012 2011 2012 2011
Pct of Pct of Pct of Pct of
Earning Earning Earning Earning
Amount Assets Amount Assets Amount Assets Amount AssetsComponents of net
interest rate spread:
Other components of net
interest rate spread $ 68 0.42 % $ 61 0.36 % $ 138 0.44 % $ 120 0.35 %
Net
(amortization)/accretion
(1) (2) (29 ) (0.17 ) (9 ) (0.05 ) (34 ) (0.11 ) (11 ) (0.03 )
Prepayment fees on
Advances, net (2) 2 0.01 1 - 5 0.02 1 -
Total net interest rate
spread 41 0.26 53 0.31 109 0.35 110 0.32
Earnings from funding
assets with interest-free
capital 12 0.07 13 0.08 24 0.07 27 0.08
Total net interest
income/net interest
margin (3) $ 53 0.33 % $ 66 0.39 % $ 133 0.42 % $ 137 0.40 %
(1) Includes (amortization)/accretion of premiums/discounts on mortgage
assets and Consolidated Obligations and deferred transaction costs
(concession fees) for Consolidated Obligations.
(2) These components of net interest rate spread have been segregated here to
display their relative impact.
(3) Net interest margin is net interest income before provision for credit
losses as a percentage of average total interest earning assets.
Earnings From Capital. The earnings from capital fell slightly in each of the
two comparison periods. Although market interest rates, especially long-term
rates, continued their downward trends of the last four years, the reduction in
overall average rates of assets and liabilities was not significant between the
two comparison periods, as shown in the "Average Balance Sheet and Rates" table
below.
Net Amortization/Accretion. Net amortization/accretion (generally referred to as
"amortization") includes recognition of premiums and discounts paid on purchases
of mortgage assets (which include loans in the Mortgage Purchase Program and
investments in mortgage-backed securities) and premiums, discounts and
concessions paid on most Consolidated Obligations.
We have historically purchased most loans in the Mortgage Purchase Program at
premium prices (and earning above-market coupons) while we have purchased
mortgage-backed securities at overall lower net premiums. In the first six
months of 2012, conditions prevailing in the mortgage markets limited the
availability and risk-return attractiveness of loans in the Program with prices
close to par or at discounts. Premium prices on loans in the Program have
continued to be elevated in the first six months of the year, while we have been
able to purchase mortgage-backed securities at prices near par or in some cases
at slight discounts. At June 30, 2012, the net premium balance of mortgage
assets totaled $184 million - of which $158 million was in the Program -
compared to $161 million at the end of 2011. The increase in the net premium
balance occurred primarily because we purchased loans in the Program at higher
prices than the loans that paid down.
Premiums/discounts on mortgage assets are deferred and amortized/accreted to net
interest income using the constant effective (level) yield method. The amount of
periodic net amortization for mortgage assets can be very sensitive to
comparatively moderate changes in actual and projected prepayments, because we
adjust net amortization on a periodic (monthly) basis as if the current actual
and projected prepayments were known at the beginning of the assets' lives.
Periodic amortization adjustments do not necessarily indicate a trend in
economic return over the entire life of mortgage assets, although amortization
over the entire lives is one component of lifetime economic returns.
Similar to other periods in the last several years, the amount of net
amortization was significant (as reflected in the table above) for both the
three- and six-months ended June 30, 2012, in both absolute terms and relative
to the same periods in 2011. The increases in net amortization in 2012 over the
same periods in 2011 reflected the large premium balance and an acceleration in
actual and projected prepayment speeds due to the continued downward trends in
mortgage rates for most months of 2012.
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Despite the large amount of, and volatility in, recent periodic net
amortization, we believe based on our analyses that the economic profitability
of current premium mortgage assets and of new premium assets in the Program has
and will continue to offer acceptable compensation for the risks of unprofitable
or volatile returns that could occur under extremely unfavorable stressed
interest rate scenarios.
The amount of amortization in the second quarter of 2012 included approximately
a $6 million reduction (which improved earnings) resulting from enhancements to
our modeling estimate of future mortgage rates applied in our market risk and
prepayment models. The enhancements were designed to make our modeling of
mortgage rates more consistent with observed trends and patterns in the
relationships among primary mortgage rates, secondary market mortgage rates and
benchmark LIBOR and U.S. Treasury rates; and to incorporate the dynamics of the
recent unique interest rate and housing markets. As related to amortization, the
enhancements had the effect of modestly slowing projected prepayment speeds in
the current interest rate environment.
Prepayment Fees on Advances. Fees for members' early repayment of certain
Advances are designed to make us economically indifferent to whether members
hold Advances to maturity or repay them before maturity. Although Advance
prepayment fees can be, and in the past have been, significant, they were
relatively modest in each of the periods presented.
Other Components of Net Interest Rate Spread. Excluding net amortization and
prepayment fees, the other components of the net interest rate spread increased
by $7 million (11 percent) in the three-months comparison and $18 million (16
percent) in the six-months comparison. Several factors, discussed below in
estimated approximate order of impact from largest to smallest, were primarily
responsible for the changes in the net interest rate spread due to other
components.
Six-Months Comparison
? Re-issuing called Consolidated Bonds at lower debt costs-Favorable: In the
last six months of 2011 and the first six months of 2012, we called $6.4
billion unswapped Bonds before their final maturities and replaced them
with new Consolidated Obligations at substantially lower rates than the
Bonds called. Most of the Bonds called funded mortgage assets. By
contrast, there were fewer principal paydowns ($5.9 billion) of mortgage
assets, which we reinvested in new mortgage assets with lower yields
corresponding to the general trend of declining mortgage rates. In
addition, on average, the called Bonds were replaced at lower rates
compared to the reduction in yields from reinvesting mortgage asset paydowns into new mortgage assets. We estimate this component increased
net interest income by approximately $10-12 million.
? Wider portfolio spreads on LIBOR-indexed assets-Favorable: We normally use
short-term Discount Notes to fund a substantial amount of LIBOR-indexed
assets. The current amount of such funding is approximately $15 billion.
In the first six months of 2012, the average portfolio spread between
LIBOR and Discount Notes was between five and 30 basis points wider than
in the same period of 2011 (depending on the interest reset period). The wider spreads were due primarily to concerns over the ongoing economic and
financial conditions in Europe, which raised the rates at which financial
institutions are willing to lend to one another as indicated by LIBOR. We
estimate this component increased interest income by approximately $5
million.
? Trading securities-Favorable: In the first two quarters of 2012, we held a
portion of our investment portfolio in short-term trading securities
(including instruments of the U.S. Treasury and government-sponsored
enterprises) in order to enhance asset liquidity and manage counterparty
credit risk. Many of the trading securities were purchased with
above-market coupon rates, which resulted in an estimated $8 million
increase in net interest income in the first six months of 2012 compared
to the same period of 2011. However, this was offset by earnings
reductions in other non-interest income (specifically, net unrealized
market value losses on trading securities), with the resulting combined
earnings from the trading securities reflecting at-market rates. See
"Non-Interest Income and Non-Interest Expense" below for a discussion of
the net losses on trading securities.
? Lower overall market risk exposure-Unfavorable: Average market risk
exposure was lower in the first six months of 2012 than in the same period
of 2011. A primary indicator of the reduction in market risk exposure was
the amount of longer-term mortgage assets funded with shorter-term
Consolidated Obligations. Because of the steep yield curve, the reduced
market risk exposure decreased earnings, by an estimate of $5 million.
Three-Months Comparison
For the three-months comparison, the same factors generally affected the other
components of net interest rate spread as in the six-months comparison and in
approximately the same relative magnitude. However, the favorable impacts of
wider portfolio spreads on LIBOR-indexed assets and income from trading
securities was lower in the three-month comparison period than in the six-month
comparison period. The former was because the spread between LIBOR to Discount
Notes narrowed back towards historical averages in the second quarter of 2012,
and the average amount of trading securities decreased in the three-months
comparison.
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Average Balance Sheet and Rates
The following tables provide average rates and average balances for major
balance sheet accounts, which determine the changes in the net interest rate
spread. All data include the impact of interest rate swaps, which we allocate to
each asset and liability category according to their designated hedging
relationship. The changes in the net interest rate spread and net interest
margin for the three-month and six-month comparisons occurred mostly from the
net impact of the factors discussed above in "Components of Net Interest
Income."
(Dollars in millions) Three Months Ended Three Months Ended
June 30, 2012 June 30, 2011
Average Average Average Average
Balance Interest Rate (1) Balance Interest Rate (1)
Assets
Advances $ 30,686 $ 60 0.78 % $ 28,531 $ 59 0.82 %
Mortgage loans held for portfolio
(2) 8,158 69 3.41 7,549 85 4.53
Federal funds sold and securities
purchased under resale agreements 7,024 3 0.15 7,132 2 0.08
Interest-bearing deposits in banks
(3) (4) (5) 2,782 1 0.17 4,682 2 0.20
Mortgage-backed securities 10,459 66 2.53 11,204 103 3.69
Other investments (4) 5,616 13 0.94 8,772 12 0.55
Loans to other FHLBanks 1 - - 8 - 0.10
Total earning assets 64,726 212 1.32 67,878 263 1.55
Less: allowance for credit losses on
mortgage loans 21 14
Other assets 193 236
Total assets $ 64,898 $ 68,100
Liabilities and Capital
Term deposits $ 119 - 0.22 $ 175 - 0.20
Other interest bearing deposits (5) 1,051 - 0.01 1,040 - 0.02
Short-term borrowings 28,211 7 0.10 32,835 6 0.08
Unswapped fixed-rate Consolidated
Bonds 18,892 143 3.04 20,591 182 3.54
Unswapped adjustable-rate
Consolidated Bonds 1,731 1 0.26 93 - 0.14
Swapped Consolidated Bonds 10,080 5 0.21 8,467 5 0.21
Mandatorily redeemable capital stock 267 3 3.99 329 4 4.50
Other borrowings - - - - - -
Total interest-bearing liabilities 60,351 159 1.06 63,530 197 1.24
Non-interest bearing deposits 18 13
Other liabilities 890 997
Total capital 3,639 3,560
Total liabilities and capital $ 64,898 $ 68,100
Net interest rate spread 0.26 % 0.31 %
Net interest income and net interest
margin (6) $ 53 0.33 % $ 66 0.39 %
Average interest-earning assets to
interest-bearing liabilities 107.25 % 106.84 %
(1 ) Amounts used to calculate average rates are based on dollars in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions) may
not produce the same results.
(2 ) Non-accrual loans are included in average balances used to determine average
rate.
(3 ) Includes certificates of deposit and bank notes that are classified as
available-for-sale securities.
(4 ) Includes available-for-sale securities based on their amortized costs. The
yield information does not give effect to changes in fair value that are
reflected as a component of stockholders' equity for available-for-sale
securities.
(5 ) The average balance amounts include the rights or obligations to cash
collateral, which are included in the fair value of derivative assets or
derivative liabilities on the Statements of Condition at period end.
(6 ) Net interest margin is net interest income before provision for credit
losses as a percentage of average total interest earning assets.
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(Dollars in millions) Six Months Ended Six Months Ended
June 30, 2012 June 30, 2011
Average Average Average Average
Balance Interest Rate (1) Balance Interest Rate (1)
Assets
Advances $ 29,530 $ 123 0.84 % $ 28,842 $ 120 0.84 %
Mortgage loans held for portfolio
(2) 8,072 158 3.93 7,582 176 4.69
Federal funds sold and securities
purchased under resale agreements 6,545 4 0.13 7,689 5 0.12
Interest-bearing deposits in banks
(3) (4) (5) 3,456 3 0.17 5,290 6 0.22
Mortgage-backed securities 10,811 146 2.72 11,301 212 3.78
Other investments (4) 5,275 24 0.92 8,494 21 0.51
Loans to other FHLBanks 2 - 0.10 6 - 0.11
Total earning assets 63,691 458 1.45 69,204 540 1.57
Less: allowance for credit losses on
mortgage loans 21 14
Other assets 202 225
Total assets $ 63,872 $ 69,415
Liabilities and Capital
Term deposits $ 108 - 0.23 $ 208 - 0.24
Other interest bearing deposits (5) 1,059 - 0.01 1,108 - 0.03
Short-term borrowings 27,758 11 0.08 33,257 18 0.11
Unswapped fixed-rate Consolidated
Bonds 18,781 294 3.14 20,685 367 3.57
Unswapped adjustable-rate
Consolidated Bonds 1,586 2 0.28 47 - 0.14
Swapped Consolidated Bonds 9,765 12 0.24 9,201 10 0.22
Mandatorily redeemable capital stock 271 6 4.54 334 8 4.78
Other borrowings 1 - 0.37 - - -
Total interest-bearing liabilities 59,329 325 1.10 64,840 403 1.25
Non-interest bearing deposits 17 13
Other liabilities 923 1,011
Total capital 3,603 3,551
Total liabilities and capital $ 63,872 $ 69,415
Net interest rate spread 0.35 % 0.32 %
Net interest income and net interest
margin (6) $ 133 0.42 % $ 137 0.40 %
Average interest-earning assets to
interest-bearing liabilities 107.35 % 106.73 %
(1 ) Amounts used to calculate average rates are based on dollars in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions) may
not produce the same results.
(2 ) Non-accrual loans are included in average balances used to determine average
rate.
(3 ) Includes certificates of deposit and bank notes that are classified as
available-for-sale securities.
(4 ) Includes available-for-sale securities based on their amortized costs. The
yield information does not give effect to changes in fair value that are
reflected as a component of stockholders' equity for available-for-sale
securities.
(5 ) The average balance amounts include the rights or obligations to cash
collateral, which are included in the fair value of derivative assets or
derivative liabilities on the Statements of Condition at period end.
(6 ) Net interest margin is net interest income before provision for credit
losses as a percentage of average total interest earning assets.
For both comparison periods, the decline in the average rate on total earning
assets resulted mostly from the lower rates on mortgage loans held for portfolio
and mortgage-backed securities. Rates on these asset categories decreased due to
the cumulative runoff of higher yielding mortgage assets and their replacement
with new mortgage assets at lower yields and due to the increase in net
amortization. The decline in the average rate on total interest-bearing
liabilities resulted mostly from the
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lower rates on unswapped fixed-rate Consolidated Bonds, as many of these Bonds
with high rates matured or were called and replaced with new Bonds at lower
rates.
Combining all factors, the net interest margin declined 0.06 percentage points
in the three-months comparison period and rose 0.02 percentage points in the
six-months comparison period. There were several reasons that the margin was
lower in the second quarter of 2012 than the first six months of 2012 and that
the margin narrowed in the three-month period (i.e., the second quarter)
compared to its increase in the six month period:
? The change in net amortization was greater in the three-month period.
? The amount of principal runoff of high-yielding mortgages was larger in the
three-month period.
? The LIBOR to Discount Note spread began to revert down towards historical
levels in the second quarter.
? Average Advance rates were lower, and declined more, in the second quarter.
? Advance prepayment fees rose less in the three-months comparison period.
Volume/Rate Analysis
Changes in both average balances (volume) and interest rates influence changes
in net interest income. The following table summarizes these changes and trends
in interest income and interest expense.
Three Months Ended Six Months Ended
(In millions) June 30, 2012 over 2011 June 30, 2012 over 2011
Volume (1)(3) Rate (2)(3) Total Volume (1)(3) Rate (2)(3) Total
Increase (decrease) in
interest income
Advances $ 4 $ (3 ) $ 1 $ 3 $ - $ 3
Mortgage loans held for
portfolio 7 (23 ) (16 ) 11 (29 ) (18 )
Federal funds sold and
securities purchased under
resale agreements - 1 1 (1 ) - (1 )
Interest-bearing deposits
in banks (1 ) - (1 ) (2 ) (1 ) (3 )
Mortgage-backed securities (6 ) (31 ) (37 ) (9 ) (57 ) (66 )
Other investments (5 ) 6 1 (10 ) 13 3
Loans to other FHLBanks - - - - - -
Total (1 ) (50 ) (51 ) (8 ) (74 ) (82 )
Increase (decrease) in
interest expense
Term deposits - - - - - -
Other interest-bearing
deposits - - - - - -
Short-term borrowings (1 ) 2 1 (3 ) (4 ) (7 )
Unswapped fixed-rate
Consolidated Bonds (14 ) (25 ) (39 ) (32 ) (41 ) (73 )
Unswapped adjustable-rate
Consolidated Bonds 1 - 1 2 - 2
Swapped Consolidated Bonds - - - 1 1 2
Mandatorily redeemable
capital stock - (1 ) (1 ) (1 ) (1 ) (2 )
Other borrowings - - - - - -
Total (14 ) (24 ) (38 ) (33 ) (45 ) (78 )
Increase (decrease) in net
interest income $ 13 $ (26 ) $ (13 ) $ 25 $ (29 ) $ (4 )
(1) Volume changes are calculated as the change in volume multiplied by the
prior year rate.
(2) Rate changes are calculated as the change in rate multiplied by the prior
year average balance.
(3) Changes that are not identifiable as either volume-related or
rate-related, but rather are equally attributable to both volume and rate
changes, have been allocated to the volume and rate categories based upon
the proportion of the absolute value of the volume and rate changes.
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Effect of the Use of Derivatives on Net Interest Income
The following table shows the effect of using derivatives on net interest
income. The table does not show the effect on earnings from the non-interest
components of derivatives related to market value adjustments; this is provided
in the next section "Non-Interest Income and Non-Interest Expense."
Three Months Ended June 30, Six Months Ended June 30,
(In millions) 2012 2011 2012 2011
Advances:
Amortization/accretion of hedging
activities in net interest income $ (1 ) $ - $ (1 ) $ (1 )
Net interest settlements included
in net interest income (77 ) (93 ) (158 ) (186 )
Mortgage loans:
Amortization of derivative fair
value adjustments in net interest
income (2 ) - (3 ) -
Consolidated Obligation Bonds:
Net interest settlements included
in net interest income 9 19 18 40
Decrease to net interest income $ (71 ) $ (74 ) $ (144 ) $ (147 )
Most of our derivatives synthetically convert the intermediate- and long-term
fixed interest rates on certain Advances and Consolidated Obligation Bonds to
adjustable-coupon rates tied to short-term LIBOR (mostly three-month). These
adjustable-rate coupons normally carry lower interest rates than the fixed
rates. The use of derivatives lowered net interest income in the three and six
months of both 2012 and 2011 primarily because the Advances that were swapped to
short-term LIBOR had higher fixed interest rates than the Bonds that were
swapped to short-term LIBOR. This reduction in earnings was acceptable because
it enabled us, as designed, to significantly lower market risk exposure by
resulting in a much closer match of actual cash flows between assets and
liabilities than would occur otherwise.
Provision for Credit Losses
In the first six months of 2012, we recorded a $1.4 million provision for credit
losses in the Program compared to $3.7 million in the same period of 2011. There
was no provision in the three-months ended June 30, 2012, compared to $1.1
million in the same period of 2011. The decreases were based on our assessment
that incurred losses stabilized in 2012. Further information is in the "Credit
Risk - Mortgage Purchase Program" section in "Quantitative and Qualitative
Disclosures About Risk Management" and Note 9 of the Notes to Unaudited
Financial Statements.
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Non-Interest Income and Non-Interest Expense
The following table presents non-interest income and non-interest expense for
the three and six months ended June 30, 2012 and 2011.
(Dollars in millions) Three Months Ended June 30,
Six Months Ended June 30,
2012 2011 2012 2011
Other Income
Net gains on held-to-maturity
securities $ 29 $ 6 $ 29 $ 6
Net gains on derivatives and hedging
activities 3 - 7 5
Other non-interest loss, net (10 ) (6 ) (15 ) (7 )
Total other income $ 22 $ - $ 21 $ 4
Other Expense
Compensation and benefits $ 8 $ 8 $ 16 $ 16
Other operating expense 3 3 7 7
Finance Agency 1 1 3 2
Office of Finance 1 1 2 2
Other 1 - - 1
Total other expense $ 14 $ 13 $ 28 $ 28
Average total assets $ 64,898 $ 68,100 $ 63,872 $ 69,415
Average regulatory capital 3,916 3,896 3,885 3,892
Total other expense to average total
assets (1) 0.09 % 0.08 % 0.09 % 0.08 %
Total other expense to average
regulatory capital (1) 1.41 1.39 1.46 1.43
(1) Amounts used to calculate percentages are based on dollars in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions)
may not produce the same results.
The net gains on held-to-maturity securities occurred from the sales of $478
million of mortgage-backed securities. Each of the securities sold had less than
15 percent of the original acquired principal remaining and were sold under the
FHLBank's periodic clean-up process. The gains represent future lost income from
the high-yielding securities sold.
The greater other non-interest loss was mostly due to higher losses on trading
securities, which were partially offset by $3 million more unrealized gains on
Bonds held at fair value during the six-month comparison periods. As discussed
above in "Components of Net Interest Income," the losses on the trading
securities were because these securities were purchased at above-market coupon
rates and, therefore, at prices above par. The related premiums paid are
reflected as mark-to-market losses to the securities as their fair values
approach par at maturity.
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Effect of Derivatives and Hedging Activities
(In millions) Three Months Ended June 30, Six Months Ended June 30,
2012 2011 2012 2011
Net gains on derivatives and hedging
activities
Advances:
Gains on fair value hedges $ 3 $ 2 $ 7 $ 8
Losses on derivatives not receiving
hedge accounting (2 ) (3 ) (2 ) (3 )
Mortgage loans:
Gains (losses) on derivatives not
receiving hedge accounting 1 - (2 ) (4 )
Consolidated Obligation Bonds:
Gains on derivatives not receiving
hedge accounting 1 1 4 4
Total net gains on derivatives and
hedging activities 3 - 7 5
Net gains on financial instruments
held at fair value (1) - - 2 -
Total net effect of derivatives and
hedging activities $ 3 $ - $ 9 $ 5
(1) Includes only those gains or losses on financial instruments held at fair
value that have an economic derivative "assigned."
The changes in net gains on derivatives and hedging activities represented
unrealized market value adjustments, which resulted principally from lower
intermediate- and long-term interest rates at June 30, 2012 than June 30, 2011
and, secondarily, from amortization of certain market value gains. The amount of
income volatility in derivatives and hedging activities in the period presented
was modest, well within the range of normal historical fluctuation relative to
the notional amount of derivatives, and consistent with the close hedging
relationships of our derivative transactions. In each of the periods shown, the
market value adjustment, as a percentage of notional derivatives principal, was
less than 0.05 percentage points.
REFCORP and Affordable Housing Program Assessments
Until the third quarter of 2011, assessments against earnings had included both
a REFCORP obligation and expenses for the Affordable Housing Program. The
FHLBank System's REFCORP obligation was satisfied at the end of the second
quarter of 2011. Under the Capital Agreement among all 12 FHLBanks, REFCORP,
which had been recorded as reduction to net income, was replaced with a 20
percent allocation of net income to restricted retained earnings. The restricted
retained earnings are not recorded in the income statement and are not available
to be distributed as dividends to stockholders. This change resulted in a $19
million increase in the first six months of 2012's net income and a
corresponding reduction in assessments. There has been no change in our
Affordable Housing Program.
In the first six months of 2012, assessments totaled $13 million and lowered ROE
by 0.73 percentage points. In the first six months of 2011, assessments totaled
$29 million and lowered ROE by 1.67 percentage points. The smaller impact of
assessments on ROE in the first six months of 2012 was due to the satisfaction
of the REFCORP obligation.
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Segment Information
Note 17 of the Notes to Unaudited Financial Statements presents information on
our two operating business segments. We manage financial operations and market
risk exposure primarily at the level, and within the context, of the entire
balance sheet, rather than exclusively at the level of individual segments.
Under this approach, the market risk/return profile of each segment may not
match, or possibly even have the same trends as, what would occur if we managed
each segment on a stand-alone basis. The tables below summarize each segment's
operating results for the periods shown.
(Dollars in millions) Traditional Member
Mortgage Purchase
Finance Program Total
Three Months Ended June 30, 2012
Net interest income after provision for
credit losses $ 41 $ 12 $ 53
Net income $ 45 $ 10 $ 55
Average assets $ 56,727 $ 8,171 $ 64,898
Assumed average capital allocation $ 3,181 $ 458 $ 3,639
Return on Average Assets (1) 0.32 % 0.49 % 0.34 %
Return on Average Equity (1) 5.63 % 8.80 % 6.03 %
Three Months Ended June 30, 2011
Net interest income after provision for
credit losses $ 47 $ 18 $ 65
Net income $ 26 $ 12 $ 38
Average assets $ 60,530 $ 7,570 $ 68,100
Assumed average capital allocation $ 3,164 $ 396 $ 3,560
Return on Average Assets (1) 0.17 % 0.63 % 0.22 %
Return on Average Equity (1) 3.30 % 12.06 % 4.28 %
(1) Amounts used to calculate returns are based on numbers in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions)
may not produce the same results.
(Dollars in millions) Traditional Member Mortgage Purchase
Finance Program Total
Six Months Ended June 30, 2012
Net interest income after provision for
credit losses $ 92 $ 40 $ 132
Net income $ 81 $ 31 $ 112
Average assets $ 55,787 $ 8,085 $ 63,872
Assumed average capital allocation $ 3,147 $ 456 $ 3,603
Return on Average Assets (1) 0.29 % 0.76 % 0.35 %
Return on Average Equity (1) 5.21 % 13.53 % 6.26 %
Six Months Ended June 30, 2011
Net interest income after provision for
credit losses $ 91 $ 42 $ 133
Net income $ 54 $ 26 $ 80
Average assets $ 61,812 $ 7,603 $ 69,415
Assumed average capital allocation $ 3,162 $ 389 $ 3,551
Return on Average Assets (1) 0.18 % 0.68 % 0.23 %
Return on Average Equity (1) 3.47 % 13.20 % 4.53 %
(1) Amounts used to calculate returns are based on numbers in thousands.
Accordingly, recalculations based upon the disclosed amounts (millions)
may not produce the same results.
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Traditional Member Finance Segment
The increase in net income and ROE in both the three- and six-months comparison
periods reflected primarily the following factors, each of which is discussed in
more detail above: the ending of the REFCORP obligation; the sales of
mortgage-backed securities; replacing calls of high-cost Consolidated Bonds with
new Obligations at lower rates; a wider average LIBOR to Discount Note spread;
and Advance prepayment fees. These favorable factors were partially offset by
increased net amortization for mortgage-backed securities and a reduction in
market risk exposure.
Mortgage Purchase Program Segment
The profitability of the Mortgage Purchase Program continued to be at a
substantial level over market interest rates, with a moderate amount of market
risk and credit risk. In the first six months of 2012, the Program averaged 13
percent of total average assets but accounted for 27 percent of earnings. The
segment's ROE for both the first six months of 2012 and 2011 was consistent with
its historical average ROE (after adjustment for the REFCORP obligation).
The decrease in the Program's net income and ROE for the three-months comparison
reflected the increase in net amortization and the cumulative runoff of higher
yielding mortgages, which were replaced with new mortgages at lower yields.
These factors were partially offset by satisfaction of the REFCORP obligation
and replacing calls of high-cost Consolidated Bonds with new Obligations at
lower rates.
The increase in the Program's net income and ROE for the six-months comparison
reflected the satisfaction of the REFCORP obligation; replacing called high-cost
Consolidated Bonds with new Obligations at lower rates; and comparatively
smaller increase in net amortization on an annualized basis compared to the
three-month comparison. These favorable factors were partially offset by the
cumulative runoff of higher-yielding mortgages.
Compared to the Traditional Member Finance segment, the Mortgage Purchase
Program segment can exhibit more earnings volatility relative to short-term
interest rates and more credit risk exposure, but also provides the opportunity
for enhancing risk-adjusted returns which normally augments earnings. As
discussed elsewhere, although mortgage assets are the largest source of our
market risk, we believe that we have historically managed the risk prudently and
that these assets do not excessively elevate the balance sheet's overall market
risk exposure.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT RISK MANAGEMENT
Market Risk
Market Value of Equity and Duration of Equity - Entire Balance Sheet
Market risk exposure is the risk that net income and the value of stockholders'
capital investment in the FHLBank may decrease, and that profitability may be
uncompetitive, as a result of changes and volatility in the market environment
and business conditions. Along with business/strategic risk, market risk is
normally one of our largest residual risks. We attempt to minimize market risk
exposure within a prudent range while earning a competitive return on members'
capital stock investment.
Two key measures of long-term market risk exposure are the sensitivities of the
market value of equity and the duration of equity to changes in interest rates
and other variables, as presented in the following tables for various
instantaneous and permanent interest rate shocks. Average results are compiled
using data for each month end. Given the very low level of rates, the down rate
shocks are nonparallel scenarios, with short-term rates decreased less than
long-term rates so that no rate falls below zero.
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Market Value of Equity
(Dollars in millions) Down 300 Down 200 Down 100 Flat Rates Up 100 Up 200 Up 300
Average Results
2012 Year-to-Date
Market Value of Equity $ 4,044 $ 4,046 $ 4,073 $ 4,156 $ 4,241 $ 4,138 $ 3,930
% Change from Flat Case (2.7 )% (2.6 )% (2.0 )% - 2.0 % (0.4 )% (5.4 )%
2011 Full Year
Market Value of Equity $ 3,944 $ 3,972 $ 4,026 $ 4,108 $ 4,075 $ 3,904 $ 3,692
% Change from Flat Case (4.0 )% (3.3 )% (2.0 )% - (0.8 )% (5.0 )% (10.1 )%
Month-End Results
June 30, 2012
Market Value of Equity $ 4,140 $ 4,143 $ 4,169 $ 4,225 $ 4,278 $ 4,151 $ 3,920
% Change from Flat Case (2.0 )% (1.9 )% (1.3 )% - 1.3 % (1.8 )% (7.2 )%
December 31, 2011
Market Value of Equity $ 3,958 $ 3,964 $ 3,996 $ 4,090 $ 4,191 $ 4,102 $ 3,915
% Change from Flat Case (3.2 )% (3.1 )% (2.3 )% - 2.5 % 0.3 % (4.3 )%
Duration of Equity
(In years) Down 300 Down 200 Down 100 Flat Rates Up 100 Up 200 Up 300
Average Results
2012 Year-to-Date 1.4 0.7 (0.4 ) (3.2 ) 0.7 4.2 6.0
2011 Full Year (0.2 ) (0.8 ) (1.4 ) (1.1 ) 3.2 5.3 6.0
Month-End Results
June 30, 2012 1.5 1.0 - (1.8 ) 1.2 4.7 6.5
December 31, 2011 0.5 (0.3 ) (1.2 ) (3.8 ) 0.5 3.7 5.5
In the first six months of 2012, the average market risk exposure to both higher
and lower interest rates was moderate, well within policy limits, and below
long-term historical average exposure. The extremely low level of interest rates
elevates the importance of analyzing numerous measures of market risk exposure.
The recent levels of market value sensitivity and duration of equity being below
long-term historical average exposure was due to distortions in the measurements
caused by the exceptionally low level of interest rates (including the reduction
in long-term rates in 2012) and elevated prices of mortgage assets. When
mortgage rates rise 0.50 percentage points or more, we would expect market risk
exposure to further rate increases to return to levels more consistent with
historical positioning.
Based on the totality of our market risk analysis, we expect that profitability,
defined as the level of ROE compared with short-term market rates, would remain
competitive unless interest rates would change by extremely large amounts in a
short period of time. Decreases in long-term interest rates even up to 2.00
percentage points (which would put fixed-rate mortgages at two percent or less)
would still result in ROE being above market interest rates. However, sharp
reductions in long-term rates could result in an immediate, one-time large
amount of amortization of mortgage purchase premiums, which could negatively
impact our results of operations for one quarter. Although declines in mortgage
rates would accelerate mortgage prepayment speeds and require reinvestment of
asset principal paydowns at lower yields, the effect on ongoing earnings would
be significantly offset by the ability to call high-cost Consolidated Bonds
before their final maturities and replace them with lower rate debt.
We believe that profitability would not become uncompetitive unless long-term
rates were to permanently increase in a short period of time by 4.00 percentage
points or more combined with short-term rates increasing to at least seven
percent. Such large changes in interest rates would not result in negative
earnings, unless these rate environments occurred quickly, lasted for a long
period of time, and were coupled with very unfavorable changes in other market
and business variables or our business model. We believe such a scenario is
extremely unlikely to occur.
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In the last several years, we and our model vendors have made numerous changes
to the market risk and prepayment models we utilize, in order to adapt them to
the constantly evolving and unprecedented conditions in the mortgage and housing
markets. The modeling enhancements implemented effective on June 30, 2012 and
referenced in the "Net Interest Income" section of "Results of Operations" tend
to modestly slow prepayment speeds in most rate environments and reduce the
sensitivity of the market risk measures to rate changes. Overall, the impact on
market risk exposure of this modeling change is expected to be moderate.
As a matter of best modeling practices, we expect to continue implementing
additional model enhancements to adapt to the recent and current conditions in
the mortgage and housing markets. We believe that the current pipeline of model
enhancements we are considering will not have a material impact on measured
market risk exposure.
Market Capitalization Ratio
The following table presents the market capitalization ratios for the interest
rate environments for which we have policy limits, as described above.
June 30, 2012 December 31, 2011
Market Value of Equity to Par Value of Regulatory
Capital Stock 120 % 120 %
Market Value of Equity to Par Value of Regulatory
Capital Stock - Down Shock of 200 bps 118
118
Market Value of Capital to Par Value of
Regulatory Capital Stock - Up Shock of 200 bps 118
121
In the first six months of 2012, the market capitalization ratios in the
scenarios indicated continued to be well above 100 percent and in compliance
with policy limits. Currently the ratios are at favorable (high) levels due to
the combination of 1) the fact that retained earnings currently comprise 14
percent of regulatory capital stock, 2) we have maintained market risk exposure
at moderate levels, and 3) the anomaly that market prices of mortgage assets are
at elevated levels compared to prices of our Consolidated Bonds. These measures
provide additional support for our assessment that we have a moderate amount of
overall market risk exposure.
Market Risk Exposure of the Mortgage Assets Portfolio
The mortgage assets portfolio accounts for almost all of our market risk
exposure because of prepayment volatility that we cannot completely hedge while
maintaining positive net spreads. Sensitivities of the market value of equity
allocated to the mortgage assets portfolio under interest rate shocks (in basis
points) are shown below. Average results are compiled using data for each
month-end. The market value sensitivities are one measure of the portfolio's
estimated market risk exposure.
% Change in Market Value of Equity-Mortgage Assets Portfolio
Down 300 Down 200 Down 100 Flat Rates Up 100 Up 200 Up 300
Average Results
2012 Year-to-Date (15.6 )% (14.0 )% (9.6 )% - 9.7 % 3.5 % (11.9 )%
2011 Full Year (20.1 )% (15.8 )% (9.2 )% - (1.0 )% (14.6 )% (32.1 )%
Month-End Results
June 30, 2012 (11.5 )% (10.4 )% (6.6 )% - 5.9 % (1.8 )% (17.6 )%
December 31, 2011 (17.1 )% (15.2 )% (10.3 )% - 10.3 %
4.2 % (10.6 )%
At June 30, 2012 the mortgage assets portfolio had an assumed par-value equity
(capital) allocation equaling the entire balance sheet's regulatory
capital-to-assets ratio, which for our portfolio was $1.2 billion. The
sensitivities indicate that the market risk exposure of the portfolio had
similar trends across interest rate shocks as those of the entire balance sheet.
The dollar amount of exposure for any individual rate shock can be obtained by
multiplying the percentage change by the equity allocation. We believe that the
mortgage assets portfolio continues to have a moderate amount of market risk
exposure relative to the inherent market risks of owning mortgages and relative
to their actual and expected profitability. We believe this exposure is
consistent with our conservative risk philosophy and cooperative business model.
Use of Derivatives in Market Risk Management
In addition to issuing long-term Consolidated Bonds, an important way that we
manage and hedge market risk exposure is by engaging in derivatives
transactions, primarily interest rate swaps. Our hedging and risk management
strategies in using
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derivatives did not change in the first six months of 2012 compared to
historical strategies, nor were there changes in the accounting treatment of new
or existing derivative hedge transactions that materially impacted our results
of operations.
Capital Adequacy
Capital Leverage
Prudent risk management dictates that we maintain effective financial leverage
to minimize risk to our capital stock while preserving profitability and that we
hold an adequate amount of retained earnings. We have always complied with each
capital requirement. The regulatory capital-to-assets ratio at June 30, 2012 was
5.95 percent, which means that, given the amount of regulatory capital, total
assets could increase by at least $32 billion before the capital-to-assets ratio
would fall to 4.00 percent. This amount of growth in assets is unlikely to occur
and, if it did, we would require additional amounts of capital under our Capital
Plan before the 4.00 percent policy limit on capitalization would be reached.
See the "Capital Resources" section of "Analysis of Financial Condition" and
Note 14 of the Notes to Unaudited Financial Statements for more information on
our capital adequacy.
Retained Earnings
Our Retained Earnings Policy sets forth a range for the amount of retained
earnings we believe is needed to mitigate impairment risk and augment dividend
stability in light of the risks we face. In 2011, the Board of Directors
approved a minimum retained earnings requirement of $350 million, based on
mitigating all of our combined risks under stress scenarios to at least a 99
percent confidence level. Given the recent financial and regulatory environment,
we have been carrying a greater amount of retained earnings in the last several
years than required by the Policy. As discussed elsewhere, we will continue to
bolster capital adequacy over time by allocating a portion of earnings to a
separate restricted retained earnings account in accordance with the FHLBank
System's Capital Agreement.
Credit Risk
Overview
We assume a substantial amount of inherent credit risk exposure in our dealings
with members, purchases of investments, and transactions of derivatives. For the
reasons detailed below, we believe we have a minimal overall amount of residual
credit risk exposure related to our Credit Services, purchases of investments,
and transactions in derivatives and a moderate amount of legacy credit risk
exposure related to the Mortgage Purchase Program.
Credit Services
Overview. We have policies and practices to manage credit risk exposure from our
secured lending activities, which include Advances and Letters of Credit. The
objective of our credit risk management is to equalize risk exposure across
members and counterparties to a zero level of expected losses, consistent with
our risk appetite of desiring no residual credit risk related to member
borrowings. Despite continued effects from the deterioration over the last five
years in the credit conditions of many of our members and in the value of some
pledged collateral, we believe that credit risk exposure in our secured lending
activities continued to be minimal in the first six months of 2012. We base this
assessment on the following factors:
? a conservative approach to collateralizing credit services that results in
significant over-collateralization;
? close monitoring of members' financial conditions and repayment capacities;
? a risk-focused process for reviewing and verifying the quality,
documentation, and administration of pledged loan collateral;
? significant upward adjustments on collateral margins assigned to almost
all of the subprime and nontraditional mortgages pledged as collateral;
and
? a history of never experiencing a credit loss or delinquency on any Advance.
Because of these factors, we have never established a loan loss reserve for
Advances. We expect to collect all amounts due according to the contractual
terms of Advances and Letters of Credit.
Collateral. We require each member to provide us a security interest in eligible
collateral before it can undertake any secured borrowing. At June 30, 2012, our
policy on over-collateralization resulted in total collateral pledged of $167.8
billion with total borrowing capacity of $112.4 billion. Lower borrowing
capacity results because we apply Collateral Maintenance
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Requirements (CMRs) to discount the value of pledged collateral in order to
recognize market, credit, and liquidity risks that may affect the collateral's
realizable value in the event we must liquidate it. Over-collateralization by
one member is not applied to another member.
The table below shows the total pledged collateral (unadjusted for CMRs) on
June 30, 2012 and December 31, 2011.
June 30, 2012
December 31, 2011
Percent of Total Collateral Amount Percent of Total Collateral Amount
Pledged Collateral ($ Billions) Pledged Collateral ($ Billions)
Single family loans 61 % $ 102.4 62 % $ 97.0
Home equity loans/lines
of credit 15 25.1 17 26.2
Commercial real estate 10 17.4 11 17.1
Bond securities 8 13.2 8 13.5
Multi-family loans 6 9.2 2 2.6
Farm real estate (a) 0.5 (a) 0.4
Total 100 % $ 167.8 100 % $ 156.8
(a) Less than one percent of total pledged collateral.
At June 30, 2012, 76 percent of collateral was related to residential mortgage
lending in single family loans and home equity lines. The only substantial
change in collateral composition was in multi-family loans, which increased
between these two periods due to the pledge of this type of collateral by a
large member.
We assign each member one of four levels of collateral status-Blanket,
Securities, Listing, and Physical Delivery-
based in part on our internal credit rating model that reflects our view of the
member's current financial condition, capitalization, level of problem assets,
and other risk factors. Blanket collateral status, which we assign to
approximately 85 percent of members and borrowing nonmembers (or former
members), is the least restrictive status and is available for lower risk
institutions. Over 90 percent of single family mortgage loan collateral and
commercial real estate collateral and almost all home equity loan collateral are
under the blanket status. We monitor eligible collateral pledged under Blanket
status using quarterly regulatory financial reports or periodic collateral
"Certification" documents submitted by all significant borrowers.
Under Listing collateral status, a member pledges and provides us detailed
information on specifically identified individual loans and securities that meet
certain minimum qualifications. Physical Delivery is the most restrictive
collateral status, which we assign to members experiencing significant financial
difficulties, insurance companies pledging loans, and newly chartered
institutions. We require borrowers assigned to Physical Delivery to deliver into
our possession securities and/or original notes, mortgages or deeds of trust.
Some members may pledge bond securities, which we hold in physical delivery
collateral status. We regularly estimate market values of collateral under
Listing and Physical status using detailed information on the collateral and a
third-party pricing service.
Borrowing Capacity/Lendable Value. We determine borrowing capacity against
pledged collateral by applying CMRs. CMRs are intended to capture market,
credit, liquidity, and prepayment risks that may affect the realizable value of
each pledged asset in the event we must liquidate collateral. CMRs are
percentage adjustments (i.e., discounts) determined by statistical analysis and
certain management assumptions applied to the estimated market value of pledged
collateral, and therefore their application results in borrowing capacity that
is less than the amount of pledged collateral. The discounts are determined by
dividing one by the CMR; for example, a CMR of 150 percent translates into a
discount of 66.7 percent, which means that 66.7 percent of the value is eligible
for borrowing. Members and collateral with a higher risk profile, more risky
credit quality, and/or less favorable performance are generally assigned higher
CMRs.
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The table below indicates the range of lendable values remaining after the
application of CMRs for each major collateral type pledged at June 30, 2012.
Lending Values
Applied to
Collateral
Blanket Status
1-4 family loans 67-83%
Multi-family loans 41-53%
Home equity loans/lines of credit 37-63%
Commercial real estate loans 44-56%
Farm real estate loans 51-69%
Listing Status/Physical Delivery
Cash/U.S. Government/U.S. Treasury/U.S. agency securities 93-100%
U.S. agency MBS/CMOs
90-96%
Private-label MBS/CMOs 65-87%
Commercial mortgage-backed securities 48-83%
Small Business Administration certificates 91%
1-4 family loans 70-83%
Multi-family loans 49-63%
Home equity loans/lines of credit 53-69%
Commercial real estate loans 53-67%
The ranges of lendable values are expressed as percentages of collateral market
value and exclude subprime and nontraditional mortgage loan collateral. Loans
pledged under a Blanket status generally are haircut more aggressively than
loans on which we have detailed loan structure and underwriting information.
The FHLBank periodically evaluates the CMRs applied by completing internal
evaluations or engaging third-party specialists. Beginning in June, we engaged a
market-recognized vendor to perform this regular update to the CMRs. The first
update addressed collateral comprised of multi-family loans because the amount
of that collateral type grew materially in June. The result of the update was to
lower the CMRs, and consequently was to increase the lendable values by
approximately 20 to 33 percent, for this type of collateral pledged by members
to whom we assign strong internal credit ratings and who elect to deliver
collateral under listing status. This change in CMRs was informed by the
stabilization in the credit environment generally and specifically for
multi-family collateral. Although the borrowing capacity has increased for these
members pledging this type of collateral, we believe that the updated CMRs
maintain a rigorous amount of credit protection consistent with our risk
appetite of accepting no residual credit risk related to member borrowings. This
change in CMR was implemented in mid-July; CMRs for other collateral types will
be updated in the remainder of 2012.
Subprime and Nontraditional Mortgage Loan Collateral. Based on our collateral
reviews, we estimate that approximately 20 to 25 percent of pledged residential
loan collateral has one or more subprime characteristics and that approximately
five to seven percent of pledged collateral meets the industry definition of
"nontraditional." These percentages have increased slightly over the last
several years. We apply significantly higher adjustments to the standard CMRs on
almost all collateral identified as subprime and/or nontraditional mortgages. No
security known to have more than one-third subprime collateral is eligible for
pledge to support additional credit borrowings.
Internal Credit Ratings. We assign all members and nonmember borrowers an
internal credit rating, based on a combination of internal credit analysis and
consideration of available credit ratings from independent credit rating
organizations. The analysis focuses on asset quality, financial performance,
earnings quality, liquidity, and capital adequacy. The credit ratings are used
in conjunction with other measures of the credit risk posed by members and
pledged collateral, as described above, in managing credit risk exposure of
Advances. A lower internal credit rating can cause us to 1) decrease the
institution's borrowing capacity via higher CMRs, 2) require the institution to
provide an increased level of detail on pledged collateral, 3) require it to
deliver collateral into our custody, and/or 4) prompt us to more closely and/or
frequently monitor the institution using several established processes.
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The following tables show the distribution of internal credit ratings we
assigned to member and nonmember borrowers, which we use to help manage credit
risk exposure. The lower the numerical rating, the higher our assessment of the
member's credit quality.
(Dollars in billions)
June 30, 2012December 31, 2011
All Members and Borrowing
Nonmembers All Members and Borrowing Nonmembers
Collateral-Based Collateral-Based
Credit Borrowing Credit Borrowing
Rating Number Capacity Rating Number Capacity
1-3 457 $ 63.4 1-3 420 $ 57.0
4 141 43.8 4 181 41.0
5 82 2.7 5 72 2.0
6 35 1.1 6 34 0.7
7 42 1.4 7 46 1.8
Total 757 $ 112.4 Total 753 $ 102.5
A "4" rating is our assessment of the lowest level of satisfactory performance.
Many members continue to be adversely affected by the last recession, the weak
economic recovery, and the continued distress in the housing market, although at
a diminished overall level compared to trends in 2008-2011. As of June 30, 2012,
159 members and borrowing nonmembers (21 percent of the total) had credit
ratings of 5 through 7, a net increase of 7 from the end of 2011. These members
had $5.2 billion of borrowing capacity at June 30. However, there was a net
decrease of 40 members who had a 4 credit rating and a net increase of 37
members with credit ratings of 1, 2, or 3. These trends could indicate a general
stabilization in the overall financial condition of our members.
Member Failures, Closures, and Receiverships. There were three member failures
during the first six months of 2012. These institutions had no Advances
outstanding with us.
Mortgage Purchase Program
Overview. We believe that the residual amount of credit risk exposure to loans
in the Mortgage Purchase Program is moderate, an assessment made based on the
following factors:
? various credit enhancements for conventional loans, which are designed to
protect us against credit losses;
? conservative underwriting and loan characteristics consistent with
favorable expected credit performance;
? a relatively moderate overall amount of delinquencies and defaults
experienced when compared to national averages;
? only $2.7 million of year-to-date and $8.1 million of program-to-date
charge-offs through June 30, 2012; and
? in addition to the program-to-date charge-offs, financial analysis
suggesting that future credit losses will not harm capital adequacy and
will not significantly affect profitability except under the most extreme
and unlikely credit conditions.
Portfolio Loan Characteristics. The following table shows Fair Isaac and Company
(FICO®) credit scores of homeowners at origination dates for the conventional
loan portfolio.
FICO® Score (1) June 30, 2012 December 31, 2011
< 620 - % - %
620 to < 660 3 4
660 to < 700 9 10
700 to < 740 18 18
>= 740 70 68
Weighted Average 757 754
(1) Represents the original FICO® score.
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There was little change in the FICO® score distribution in the first six months
of 2012 compared with prior periods. We believe the distribution of FICO® scores
is one indication of the portfolio's overall favorable credit quality: 70
percent of the portfolio had scores above an excellent level of 740 or above and
88 percent had scores above 700 which is a threshold generally considered
indicative of homeowners' good credit quality.
A high loan-to-value ratio, in which a homeowner has little or no equity at
stake, is a key driver in many mortgage delinquencies and defaults. The
following tables show loan-to-value ratios for conventional loans based on
values estimated at the origination dates and current values estimated at the
noted periods. The estimated current ratios are based on original loan values,
principal paydowns that have occurred since origination, and a third-party
estimate of changes in historical home prices for the metropolitan statistical
area in which each loan resides. Both measures are weighted by current unpaid
principal.
Based on Estimated Origination Value Based On Estimated Current Value
Loan-to-Value June 30, 2012 December 31, 2011 Loan-to-Value June 30, 2012 December 31, 2011
<= 60% 21 % 21 % <= 60% 26 % 26 %
> 60% to 70% 19 18 > 60% to 70% 19 17
> 70% to 80% 51 52 > 70% to 80% 33 29
> 80% to 90% 6 6 > 80% to 90% 11 14
> 90% 3 3 > 90% to 100% 5 6
> 100% 6 8
Weighted Average 70 % 70 % Weighted Average 70 % 72 %
Overall loan-to-value ratios of the current portfolio of loans deteriorated
moderately since origination. At June 30, 2012, 22 percent of loans were
estimated to have current loan-to-value ratios above 80 percent, up from nine
percent at origination. We believe this trend represents an overall acceptable
credit quality of the portfolio, in light of the significant deterioration in
national average housing prices in recent years. In the first six months of
2012, the loan-to-value ratios improved modestly: the percentage of loans having
estimated current loan-to-value ratios above 80 percent declined by six percent.
Based on the available data, we believe we have little exposure to loans in the
Program considered to have characteristics of "subprime" or
"alternative/nontraditional" loans. Further, we do not knowingly purchase any
loan that violates the terms of our Anti-Predatory Lending Policy.
Lender Risk Account. Conventional mortgage loans are supported against credit
losses by various combinations of primary mortgage insurance (PMI), supplemental
mortgage insurance (SMI) and the Lender Risk Account. The Lender Risk Account is
a purchase-price holdback that PFIs may receive back from us, starting five
years from the loan purchase date, for managing credit risk to pre-defined
acceptable levels of exposure on loan pools they sell to us. The Lender Risk
Account is funded by the FHLBank as a portion of the purchase proceeds to cover
expected credit losses for a specific pool of loans. As a result, some pools of
loans may have sufficient credit enhancements to recapture all losses while
other pools of loans may not have enough credit enhancements to recapture all
losses. The amount of loss claims against the Lender Risk Account in the first
six months of 2012 was approximately $2 million. The Account had balances of $91
million and $69 million at June 30, 2012 and December 31, 2011, respectively.
For more information, see Note 9 of the Notes to Unaudited Financial Statements.
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Credit Performance. The table below provides an analysis of conventional loans
delinquent or in foreclosure, along with the national average serious
delinquency rate.
Conventional Loan Delinquencies
(Dollars in millions) June 30, 2012 December 31, 2011
Early stage delinquencies - unpaid principal balance (1) $ 65 $ 82
Serious delinquencies - unpaid principal balance (2) 88 91
Early stage delinquency rate (3) 1.0 % 1.3 %
Serious delinquency rate (4) 1.3 1.4
National average serious delinquency rate (5) 4.0 4.1
(1) Includes conventional loans 30 to 89 days delinquent and not in foreclosure.
(2) Includes conventional loans that are 90 days or more past due or where the
decision of foreclosure or a similar alternative such as pursuit of
deed-in-lieu has been reported.
(3) Early stage delinquencies expressed as a percentage of the total
conventional loan portfolio.
(4) Serious delinquencies expressed as a percentage of the total conventional
loan portfolio.
(5) National average number of fixed-rate prime conventional loans that are 90
days or more past due or in the process of foreclosure is based on the
most recent national delinquency data available. The June 30, 2012 rate is
based on March 31, 2012 data.
The Mortgage Purchase Program has experienced a moderate amount of delinquencies
and foreclosures. The rates continued to be well below national averages and we
expect this to continue to be the case. Delinquency rates for both the early
stage and serious categories declined in the first six months of 2012. It is too
soon to determine whether these data indicate a sustainable trend of a subsiding
of stresses in the housing market or a respite based on a slower rate at which
financial institutions are initiating the foreclosure process.
We consider a high risk loan as having a current loan-to-value ratio above 100
percent. At June 30, 2012, high risk loans had experienced relatively moderate
serious delinquencies (i.e., delinquencies that are 90 days or more past due or
in the process of foreclosure). For example, of the $390 million of conventional
principal balances with current estimated loan-to-values above 100 percent, only
$33 million (eight percent) were seriously delinquent. We believe these data
further support our view that the overall portfolio is comprised of high quality
loans.
Credit Losses. The following table shows the effects of credit enhancements on
the determination of the allowance for credit losses at the noted periods:
(In millions)
June 30, 2012 December 31, 2011
Estimated incurred credit losses, before
credit enhancements $ (62 ) $ (64 )
Estimated amounts to be covered by:
Primary mortgage insurance 5 5
Supplemental mortgage insurance 28 30
Lender Risk Account 9 8
Allowance for credit losses, after credit
enhancements $ (20 ) $ (21 )
The data presented above are aggregated, which provide useful information on the
health of the overall portfolio. Credit risk exposure depends on the actual and
potential credit performance of the loans in each pool compared to the pool's
equity (on individual loans) and credit enhancements, including PMI (for
individual loans), the Lender Risk Account, and SMI.
The slight reduction in the allowance for credit losses in the first two
quarters of 2012 compared to year-end 2011 was based on stabilization or even
slight growth in home prices, losses given default ("loss severities"), and the
number of loans assessed to have incurred losses. It is too soon for us to
determine whether these favorable trends will continue. We cannot predict the
future course of factors that determine incurred credit losses, including home
prices, macro-economic conditions such as unemployment rates, estimated loss
severities, the health of mortgage insurance providers, and regulatory or
accounting guidance.
In addition to the credit loss allowance, we regularly analyze, using recognized
third-party credit and prepayment models, potential ranges of lifetime credit
risk exposure for the loans in the Program. Even under adverse scenarios for
either home prices or unemployment rates (and assuming the two SMI providers
continue to pay claims), we do not expect further credit
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losses to significantly decrease our overall annual profitability or dividends
payable to members, or to materially affect our capital adequacy. For example,
for an additional 20 percent decline in all home prices over the next two years,
we estimate that our lifetime credit losses could increase by approximately $60
million, which would decrease annual ROE by 0.35 percentage points over the next
five years (most of the losses are estimated to occur in the next five years).
Credit Risk Exposure to Insurance Providers.
Primary Mortgage Insurance
Some of our conventional loans carry PMI as a credit enhancement feature. Based
on the guidelines of the Mortgage Purchase Program, we have assessed that we do
not have any credit risk exposure to the primary mortgage insurance providers.
Supplemental Mortgage Insurance
Another credit enhancement feature is SMI purchased from Genworth and MGIC.
Beginning February 1, 2011, we discontinued use of SMI as a credit enhancement
for new loan purchases; instead, we augment credit enhancements with a greater
amount of the purchase proceeds added to the Lender Risk Account. However, we
have $4.1 billion of conventional loans purchased prior to February 2011 with
outstanding SMI coverage through Genworth and MGIC.
We subject both SMI providers to a standard credit underwriting analysis. Both
providers have experienced weakened financial conditions in the last several
years. Currently, the lowest credit rating from NRSROs is B- for MGIC and B for
Genworth, with both on negative outlook. Our exposure to these providers is that
they may be unable to fulfill their contractual coverage on loss claims. In a
scenario in which home prices do not change and both providers fail to fulfill
any of their insurance coverage on defaulting loans (with an assumption that we
would obtain a limited recovery rate), we estimate exposure at June 30, 2012 to
the providers over the life of the loans to be approximately $19 million. In an
adverse scenario in which home prices decline an additional 20 percent over the
next two years and both providers fail to pay claims (with the same limited
recovery rate assumption), we estimate exposure to be approximately $30 million.
Based on our most-recent analysis and that of a third-party rating agency, we do
not expect either of the providers to fail to fulfill their insurance contracts.
Over time, as existing business in the Mortgage Purchase Program pays off and is
replaced with new business which does not rely on SMI, the amount of exposure
will diminish.
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Investments
Liquidity Investments. The following table presents the carrying value of
liquidity investments outstanding in relation to the counterparties' lowest
long-term credit ratings provided by Standard & Poor's, Moody's, and/or Fitch
Advisory Services.
(In millions) June 30, 2012
Long-Term Rating
AAA AA A Total
Unsecured Liquidity Investments
Federal funds sold $ - $ 2,410 $ 1,300 $ 3,710
Certificates of deposit - 400 400 800
Total unsecured liquidity investments - 2,810 1,700
4,510
Guaranteed/Secured Liquidity Investments
Securities purchased under agreements to resell - 3,200 -
3,200
U.S. Treasury obligations - 301 -
301
Government-sponsored enterprises (1) - 2,653 -
2,653
TLGP (2) - 1,811 -
1,811
Total guaranteed/secured liquidity investments - 7,965 -
7,965
Total liquidity investments $ - $ 10,775 $ 1,700 $ 12,475
December 31, 2011
Long-Term Rating
AAA AA A Total
Unsecured Liquidity Investments
Federal funds sold $ - $ 540 $ 1,730 $ 2,270
Certificates of deposit - 2,329 1,625 3,954
Other (3) 217 - - 217
Total unsecured liquidity investments 217 2,869 3,355 6,441
Guaranteed/Secured Liquidity Investments
U.S. Treasury obligations - 331 -
331
Government-sponsored enterprises (1) - 2,554 -
2,554
TLGP (2) - 1,411 -
1,411
Total guaranteed/secured liquidity investments - 4,296 -
4,296
Total liquidity investments $ 217 $ 7,165 $ 3,355 $ 10,737
(1) Consists of securities that are issued and effectively guaranteed by
Fannie Mae and/or Freddie Mac, which have the backing of the U.S.
government, although they are not obligations of the U.S. government.
(2) Represents corporate debentures issued or guaranteed by the Federal
Deposit Insurance Corporation (FDIC) under the Temporary Liquidity
Guarantee Program (TLGP).
(3) Consists of debt securities issued by International Bank for
Reconstruction and Development.
We believe these investments were purchased from counterparties that have a
strong ability to repay principal and interest. We currently limit such
investments to counterparties with credit ratings at time of purchase at
single-A or above, are aggressive in restricting maturities, reducing dollar
exposure, and suspending new investments with counterparties we deem to
represent elevated credit risk. We currently tend to invest only in overnight
Federal funds (due to their lack of marketability) and certificates of deposit
which are negotiable and held in available-for-sale accounts.
At June 30, 2012, a majority (64 percent) of our liquidity investments were
purchased from counterparties that provide explicit guarantees from the U.S.
government (Treasuries and TLGP securities), that are effectively guaranteed
(government-sponsored enterprises), or that are secured with collateral
(securities purchased under agreements to resell). We believe the guaranteed and
secured investments continue to represent no credit risk exposure to us.
We actively monitor our credit exposure and the credit quality of all of our
counterparties. This includes ongoing assessments of each counterparty's
financial condition, performance, and capital adequacy, sovereign support, the
market's current perceptions of the counterparty's market presence and
activities, and general macro-economic, political, and market conditions.
Since 2007, we have discretionarily suspended many otherwise eligible
counterparties and reduced maturity limits.
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The following table presents credit ratings of our unsecured investment credit
exposures by the domicile of the counterparty or the domicile of the
counterparty's parent for U.S. branches and agency offices of foreign commercial
banks.
(In millions) June 30, 2012
Counterparty Rating (1)
Sovereign
Rating
Domicile of Counterparty (1) AA A Total
Domestic AA+ $ 775 $ 1,350 $ 2,125
U.S. branches and agency offices
of foreign commercial banks:
Canada AAA 795 - 795
Finland AAA 545 - 545
Netherlands AAA 545 - 545
Austria AA+ - 350 350
Australia AAA 150 - 150
Total U.S. branches and agency
offices of foreign commercial
banks 2,035 350 2,385
Total unsecured investment credit
exposure $ 2,810 $ 1,700 $ 4,510
(1) Represents the lowest long-term credit ratings provided by Standard &
Poor's, Moody's, and/or Fitch Advisory Services.
The following table presents the remaining contractual maturity of our unsecured
investment credit exposure by the domicile of the counterparty or the domicile
of the counterparty's parent for U.S. branches and agency offices of foreign
commercial banks.
(In millions) June 30, 2012
Due 2 days through Due 31 days
Domicile of Counterparty Overnight 30 days through 90 days Total
Domestic $ 1,725 $ 125 $ 275 $ 2,125
U.S. branches and agency offices
of foreign commercial banks:
Canada 545 250 - 795
Finland 545 - - 545
Netherlands 545 - - 545
Austria 350 - - 350
Australia - 150 - 150
Total U.S. branches and agency
offices of foreign commercial
banks 1,985 400 - 2,385
Total unsecured investment credit
exposure $ 3,710 $ 525 $ 275 $ 4,510
At June 30, 2012, all of the $4.5 billion of unsecured liquidity exposure was to
counterparties with holding companies domiciled in countries receiving between
triple-A and double-A long-term sovereign ratings, and 82 percent of the amount
had overnight maturities. By Finance Agency Regulations, all counterparties
exposed to non-U.S. countries are domestic U.S. branches of foreign
counterparties. We believe we face minimal exposure in our unsecured investments
to counterparties and countries that could have significant direct or indirect
exposure to European sovereign debt, especially to those countries currently
experiencing financial distress; and we are aggressive in limiting exposure to
such counterparties. The exposure to non-U.S. countries at June 30, 2012 was
comprised of lending to six institutions.
Mortgage-Backed SecuritiesGSE Mortgage-Backed Securities. Historically, almost all of our mortgage-backed
securities have been residential GSE securities issued by Fannie Mae and Freddie
Mac, which provide credit safeguards by guaranteeing either timely or ultimate
payments of principal and interest, and agency securities issued by Ginnie Mae,
which the federal government guarantees. We believe that the conservatorships of
Fannie Mae and Freddie Mac lower the chance that they would not be able to
fulfill their credit guarantees; we believe the securities issued by these two
GSEs are effectively government guaranteed. In addition, based
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on the data available to us and on our purchase practices, we believe that most
of the mortgage loans backing our GSE mortgage-backed securities are of high
quality with strong credit performance.
Mortgage-Backed Securities Issued by Other Government Agencies. Beginning in the
fourth quarter of 2010, we invested in mortgage-backed securities issued and
guaranteed by the National Credit Union Administration. These securities have
floating rate coupons tied to one-month LIBOR with interest rate caps ranging
from seven to eight percent. The strength of the issuer's guarantee and backing
by the full faith and credit of the U.S. government is sufficient to protect us
against credit losses on these securities.
Private Label Mortgage-Backed Securities. The FHLBank did not hold any
private-label mortgage-backed securities at June 30, 2012.
Derivatives
Credit Risk Exposure. The table below presents the gross credit risk exposure
(i.e., the market value) and net exposure of derivatives outstanding at June 30,
2012. Based on both the gross and net exposures, we had a minimal amount of
residual credit risk exposure throughout the first six months of 2012. Gross
exposure would likely increase if interest rates rise and could increase if the
composition of our derivatives change; however, contractual collateral
provisions would limit our exposure to acceptable levels.
(In millions)
Credit Exposure
Gross Credit Net of Cash
Credit Rating (1) Total Notional Exposure Cash Collateral Held Collateral Held
Aaa/AAA $ - $ - $ - $ -
Aa/AA 1,585 4 - 4
A 13,871 3 (2 ) 1
Baa/BBB 4,373 - - -
Member institutions (2) 236 2 - 2
Total $ 20,065 $ 9 $ (2 ) $ 7
(1) Each category includes the related plus (+) and minus (-) ratings (i.e.,
"A" includes "A+" and "A-" ratings).
(2) Represents Mandatory Delivery Contracts.
The following table presents counterparties that provided 10 percent or more of
the total notional amount of interest rate swap derivatives outstanding.
(In millions)
June 30, 2012 December
31, 2011
Credit Rating Notional Net Unsecured Credit Rating Notional Net Unsecured
Counterparty Category Principal Exposure Counterparty Category Principal Exposure
BNP Paribas A $ 3,771 $ - Barclays Bank PLC A $ 3,596 $ -
Barclays Bank
PLC A 3,552 - BNP Paribas A 2,830 -
Citigroup
Financial
Products Inc. Baa/BBB 2,254 - Deutsche Bank AG A 2,116 -
Morgan Stanley Royal Bank of
Capital Services Baa/BBB 2,119 - Scotland PLC A 1,981 -
All others
(10 All
others
counterparties) A to Aa/AA 8,043 5 (9 counterparties) A to Aa/AA 8,230 3
Total $ 19,739 $ 5 Total $ 18,753 $ 3
Although we cannot predict if we will realize credit risk losses from any of our
derivatives counterparties, we continue to have no reason to believe any of them
will be unable to continue making timely interest payments or, more generally,
to continue to satisfy the terms and conditions of their derivative contracts
with us. As of June 30, 2012, we had no unsecured credit risk exposure to
members. We did, however, have $1.3 billion of notional principal under interest
rate swaps outstanding to our member JPMorgan Chase Bank, N.A., whom we also had
outstanding credit services with. Due to market value amounts, we
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had no outstanding credit exposure to this counterparty at June 30, 2012.
Lehman Brothers Derivatives. On September 15, 2008, Lehman Brothers Holdings,
Inc. ("Lehman Brothers") filed a petition for bankruptcy protection under
Chapter 11 of the U.S. Bankruptcy Code. We had 87 derivative transactions
(interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman
Brothers Special Financing, Inc. ("LBSF"), with a total notional principal
amount of $5.7 billion. Under the provisions of our master agreement with LBSF,
all of these swaps automatically terminated immediately prior to the bankruptcy
filing by Lehman Brothers. The close-out provisions of the Agreement required us
to pay LBSF a net fee of approximately $189 million, which represented the
swaps' total estimated market value at the close of business on Friday,
September 12, 2008. We paid LBSF approximately $14 million to settle all of the
transactions, comprised of the $189 million market value fee minus the value of
collateral we had delivered previously and other interest and expenses. On
Tuesday, September 16, 2008, we replaced these swaps with new swaps transacted
with other counterparties. The new swaps had the same terms and conditions as
the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee
of approximately $232 million to enter into these transactions based on the
estimated market values at the time we replaced the swaps.
The $43 million difference between the settlement amount we paid Lehman and the
market value fee we received on the replacement swaps represented an economic
gain to us based on changes in the interest rate environment between the
termination date and the replacement date. Although the difference was a gain to
us in this instance, because it represented exposure from terminating and
replacing derivatives, it could have been a loss if the interest rate
environment had been different. We are amortizing the gain into earnings
according to the swaps' final maturities, most of which will occur by the end of
2012.
In early March 2010, representatives of the Lehman bankruptcy estate advised us
that they believed that we had been unjustly enriched and that the bankruptcy
estate was entitled to the $43 million difference between the settlement amount
we paid Lehman and the market value fee we received on the replacement swaps. In
early May 2010, we received a Derivatives Alternative Dispute Resolution notice
from the Lehman bankruptcy estate with a settlement demand of $65.8 million,
plus interest accruing primarily at LIBOR plus 14.5 percent since the bankruptcy
filing, based on their view of how the settlement amount should have been
calculated. In accordance with the Alternative Dispute Resolution Order of the
Bankruptcy Court administering the Lehman estate, senior management participated
in a non-binding mediation in New York in August 2010, and our legal counsel
continued discussions with the court-appointed mediator for several weeks
thereafter. The mediation concluded in October 2010 without a settlement of the
claims asserted by the Lehman bankruptcy estate. We believe that we correctly
calculated, and fully satisfied, our obligation to Lehman in September 2008, and
we intend to vigorously dispute any claim for additional amounts.
Liquidity Risk
Liquidity Overview
Our principal long-term source of funding and liquidity is through cost
effective access to the capital markets for participation in the issuance of
FHLBank System debt securities (Consolidated Obligations) and for execution of
derivative transactions. We also raise liquidity via our liquidity investment
portfolio and the ability to sell certain investments without significant
accounting consequences. As shown on the Statements of Cash Flows, in the first
six months of 2012, our share of participations in debt issuances totaled $125.7
billion for Discount Notes and $10.0 billion for Consolidated Bonds. The
System's favorable debt ratings, the implicit U.S. government backing of our
debt, and our effective funding management were, and continue to be,
instrumental in ensuring satisfactory access to the capital markets.
Our liquidity position remained strong during the first two quarters of 2012 and
our overall ability to fund our operations through debt issuance at acceptable
interest costs remained sufficient. Although we can make no assurances, we
expect this to continue to be the case, and we believe the possibility of a
liquidity or funding crisis in the FHLBank System that would impair our
FHLBank's ability to participate in issuances of new debt, service outstanding
debt, maintain adequate capitalization, or pay competitive dividends is remote.
We must meet both operational and contingency liquidity requirements. We
satisfied the operational liquidity requirement both as a function of meeting
the contingency liquidity requirement and because we were able to adequately
access the capital markets to issue Obligations. In addition, Finance Agency
guidance requires us to target at least 15 consecutive days of positive
liquidity based on specific assumptions. In practice, we tend to hold over 20
days of positive liquidity. The amount of liquidity per the Finance Agency
guidance and our internal operational liquidity measures tended to be in the
range of $4 billion to $8 billion during the first six months of 2012.
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Contingency Liquidity Requirement
Contingency liquidity risk is the potential inability to meet liquidity needs
because our access to the capital markets to issue Consolidated Obligations is
restricted or suspended for a period of time due to a market disruption,
operational failure, or real or perceived credit quality problems. We continued
to hold an ample amount of liquidity reserves to protect against contingency
liquidity risk.
Contingency Liquidity Requirement (in millions) June 30, 2012 December 31, 2011
Total Contingency Liquidity Reserves (1) $ 26,513 $
23,599
Total Requirement (2) (16,360 ) (6,669 )
Excess Contingency Liquidity Available $ 10,153 $
16,930
(1) Includes, among others, cash, overnight Federal funds, overnight deposits,
self-liquidating term Federal funds, 95 percent of the market value of
available-for-sale negotiable securities, and 75 percent of the market
value of certain held-to-maturity obligations, including obligations of
the United States, U.S. government agency obligations and mortgage-backed
securities.
(2) Includes maturing net liabilities in the next seven business days, assets
traded not yet settled, Advance commitments outstanding, Advances maturing
in the next seven business days, and a three percent hypothetical increase
in Advances.
Deposit Reserve Requirement
To support our member deposits, we also must meet a statutory deposit reserve
requirement. The sum of our investments in obligations of the United States,
deposits in eligible banks or trust companies, and Advances with a final
maturity not exceeding five years must equal or exceed the current amount of
member deposits. The following table presents the components of this liquidity
requirement.
Deposit Reserve Requirement (in millions) June 30, 2012 December 31, 2011
Total Eligible Deposit Reserves $ 41,434 $ 33,733
Total Member Deposits (1,124 ) (1,067 )
Excess Deposit Reserves $ 40,310 $ 32,666
Contractual Obligations
The following table summarizes our contractual obligations at June 30, 2012. The
allocations according to the expiration terms and payment due dates of these
obligations were not materially different from those at the end of 2011. Changes
reflected normal business variations. We believe that, as in the past, we will
continue to have sufficient liquidity, including from access to the debt markets
to issue Consolidated Obligations, to satisfy these obligations timely.
(In millions) < 1 year 1<3 years 3<5 years > 5 years Total
Contractual Obligations
Long-term debt (Consolidated Bonds)
- par (1) $ 14,075 $ 8,588 $ 3,781 $ 4,749 $ 31,193
Operating leases (include premises
and equipment) 1 2 - - 3
Mandatorily redeemable capital stock 3 262 - - 265
Commitments to fund mortgage loans 236 - - - 236
Pension and other postretirement
benefit obligations 2 4 4 20 30
Total Contractual Obligations $ 14,317$ 8,856$ 3,785$ 4,769$ 31,727
(1) Does not include Discount Notes and contractual interest payments related
to Consolidated Bonds. Total is based on contractual maturities; the
actual timing of payments could be affected by factors affecting
redemptions.
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