ITEM 1. BUSINESS
General
The Federal Home Loan Bank of Boston is a federally chartered corporation organized by the U.S. Congress (Congress) in 1932 pursuant to the Federal Home Loan Bank Act of 1932 (as amended, the FHLBank Act) and is a government-sponsored enterprise (GSE). Unless otherwise indicated or unless the context requires otherwise, all references in this discussion to “the Bank,” "we," "us," "our," or similar references mean the Federal Home Loan Bank of Boston. Our primary regulator is the Federal Housing Finance Agency (the FHFA).
We are privately capitalized, and our mission is to provide highly reliable wholesale funding, liquidity, and a competitive return on investment to our members. We develop and deliver competitively priced financial products, services, and expertise that support housing finance, community development, and economic growth, including programs targeted to lower-income households. We serve the residential-mortgage and community-development lending activities of our members and certain nonmember institutions (referred to as housing associates) located in our district. Our district is comprised of Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont. There are 11 district Federal Home Loan Banks (the FHLBanks or the FHLBank System) located across the United States (the U.S.), each supporting the lending activities of its members within their districts. Each FHLBank is a separate entity with its own board of directors, management, and employees.
We are exempt from ordinary federal, state, and local taxation except for local real estate tax. However, we set aside funds at a 10 percent rate on our income for our Affordable Housing Program (AHP). For additional information, see - AHP Assessment. We also have put in place certain subsidized advance programs including our Jobs for New England program and our Helping to House New England program. For additional information, see - Targeted Housing and Community Investment Programs.
We are managed with the primary objectives of enhancing the value of our membership and fulfilling our public purpose. In pursuit of our primary objectives, we have adopted long-term strategic priorities in our strategic business plan, which are to:
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position the Bank to compete effectively in the wholesale funding market and support members' and housing associates’ efforts to address the affordable housing and economic needs of their communities;
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maintain an appropriate and efficient capital structure considering our risk profile through proactive capital stock management and dividend strategies;
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advocate stakeholder interests in policy matters, and effectively monitor and respond to pending GSE reform and other legislative and regulatory initiatives;
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acquire, develop and retain the talent required to meet our current and future needs;
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leverage the advantages of a diverse and inclusive organization in all aspects of our efforts; and
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continue to evolve as a strong and agile organization that responds quickly and effectively to emerging risks and opportunities while upholding our commitment to efficient and effective operations.
We combine private capital and public sponsorship in a way that is intended to enable our members and housing associates to assure the flow of credit and other services for housing and community development. We serve the public through our members and housing associates by providing these institutions with a readily available, low-cost source of funds, called advances, as well as other products and services that are intended to support the availability of residential-mortgage and community-investment credit. In addition, we provide liquidity by enabling members to sell mortgage loans through a mortgage loan purchase program. Under this program, we offer participating financial institutions the opportunity to originate mortgage loans for sale to us or to designated third-party investors. Our primary sources of income come from interest on invested capital as well as the spread between interest-earning assets and interest-bearing liabilities. We are generally able to borrow funds at favorable rates due to our GSE status.
Our members and housing associates are comprised of institutions located throughout our district. Institutions eligible for membership include thrift institutions (savings banks, savings and loan associations, and cooperative banks), commercial banks, credit unions, qualified community development financial institutions (CDFIs), and insurance companies that are active in housing finance. We are also authorized to lend to housing associates such as state housing-finance agencies located in New England. Members are required to purchase and hold our capital stock as a condition of membership and for advances and certain other activities transacted with us. Our capital stock is not publicly traded on any stock exchange. We are capitalized by the capital stock purchased by our members and by retained earnings. Members may receive dividends, which are determined
by our board of directors, and may request redemption or, at our sole discretion, repurchase of their capital stock at par value subject to certain conditions, as discussed further in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital. The U.S. government does not guarantee either the member's investment in or any dividend on our stock.
Federal Housing Finance Agency
The FHFA, an independent agency in the executive branch of the U.S. government, supervises and regulates the FHLBanks. The FHFA is financed through assessments on the entities it regulates, which include the FHLBanks, as discussed under Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 1 - Summary of Significant Accounting Policies - FHFA Expenses.
The FHFA has broad supervisory authority over the FHLBanks, including, but not limited to, the power to suspend or remove any entity-affiliated party (including any director, officer, or employee) of an FHLBank who violates certain laws or commits certain other acts; to issue and serve a notice of charges upon an FHLBank or any entity-affiliated party; to obtain a cease and desist order, or a temporary cease and desist order; to stop or prevent any unsafe or unsound practice or violation of law, order, rule, regulation, or condition imposed in writing; to issue civil money penalties against an FHLBank or an entity-affiliated party; to require an FHLBank to maintain capital levels in excess of usual regulatory requirements; to require an FHLBank to take certain actions, or refrain from certain actions, under the prompt corrective action provisions that authorize or require the FHFA to take certain supervisory actions, including the appointment of a conservator or receiver for an FHLBank under certain conditions; and to require any one or more of the FHLBanks to repay the primary obligations of another FHLBank on outstanding consolidated obligations (COs).
The FHFA conducts an annual on-site examination and other periodic reviews of our operations to assess our safety and soundness as well as our compliance with statutory and regulatory requirements. In addition, we are required to submit information on our financial condition and results of operations each month to the FHFA. We are generally prohibited by FHFA regulations from disclosing the results of the FHFA's examinations and reviews. However, we do consider the information we gather from these processes in setting our business objectives and conducting our operations. Information from those examinations and reviews could become publicly available either through the FHFA or through the FHFA's Office of Inspector General, which can sometimes occur via their reports to Congress.
Additionally, we are subject to annual stress testing by the FHFA. We expect to publish the results of our annual severely adverse economic conditions stress test to our public website, www.fhlbboston.com, between November 15 and November 30.
Office of Finance
The Federal Home Loan Banks' Office of Finance (the Office of Finance) facilitates the issuing and servicing of FHLBank debt in the form of COs. The FHLBanks, through the Office of Finance as their agent, are the issuers of COs for which they are jointly and severally liable. The Office of Finance also provides the FHLBanks with credit and market data and maintains the FHLBanks' joint relationships with credit-rating agencies. The FHLBanks are charged for the costs of operating the Office of Finance, as discussed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 1 - Summary of Significant Accounting Policies - Office of Finance Expenses. The Office of Finance is governed by a board of directors that is constituted of the FHLBank presidents and five independent directors.
Available Information
Our website provides a link to the section of the Electronic Data Gathering and Reporting (EDGAR) web site, as maintained by the Securities and Exchange Commission (the SEC), containing all reports electronically filed, or furnished, including our annual report on Form 10-K, our quarterly reports on Form 10-Q, and reports on Form 8-K as well as any amendments to such reports. These reports are made available free of charge on our website as soon as reasonably practicable after electronically filing or being furnished to the SEC. These reports may also be read and copied at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. Further information about the operation of the Public Reference Room may be obtained by calling 1-800-SEC-0330. In addition, the SEC maintains a website that contains reports and other information regarding our electronic filings (located at http://www.sec.gov). The Bank's and the SEC's website addresses have been included as inactive textual references only. Information on those websites is not part of this report.
Employees
As of February 29, 2016, we had 205 full-time employees and one part-time employee.
Membership
The following table summarizes our membership, by type of institution, as of December 31, 2015, 2014, and 2013.
As of December 31, 2015, 2014, and 2013, 72.0 percent, 69.9 percent, and 68.2 percent, respectively, of our members had outstanding advances with us. These usage rates are calculated excluding housing associates and other nonmember borrowers. While eligible to borrow, housing associates are not members and, as such, cannot hold our capital stock. Other nonmember borrowers consist of institutions that are former members or that have acquired former members and assumed the advances held by those former members. These other nonmember borrowers are required to hold capital stock to support outstanding advances with us until those advances either mature or are paid off. In addition, nonmember borrowers are required to deliver all required collateral to us or our safekeeping agent until all outstanding advances either mature or are paid off. Other than housing associates, nonmember borrowers may not request new advances and are not permitted to extend or renew any advances they have assumed.
Our membership includes the majority of Federal Deposit Insurance Corporation (FDIC)-insured institutions and large credit unions in our district that are eligible to become members. We do not anticipate that a substantial number of additional FDIC-insured institutions will become members. There are a number of other institutions that are eligible for membership, such as insurance companies, smaller credit unions, and CDFIs which could become members in the future. We note that, for a variety of reasons including merger of members, we could experience a contraction in our membership that could lower overall demand for our products and services.
Economic Conditions
While our membership is limited to institutions with their principal place of business located in our district, both U.S. national and New England economic conditions, particularly in the housing market, impact our results of operations, financial condition, and future prospects. For example, demand for advances is influenced in part by factors such as the level of our members' deposits, which serve as liquidity alternatives to advances, and demand for residential mortgage loans, which members can generally use as collateral for advances. For information on some of the economic factors that have impacted us in 2015 and are expected to impact us in 2016, see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Economic Conditions.
Business Lines
Our business lines include offering credit products, such as advances, access to the Mortgage Partnership Finance® (MPF®) program, deposit and safekeeping services, and access to the AHP. We also maintain a portfolio of investments for liquidity purposes and to supplement earnings.
Advances. We serve as a source of liquidity and make advances to our members and housing associates secured by mortgage loans and other eligible collateral. We offer an array of fixed- and variable-rate advances products, with repayment terms intended to provide funding alternatives to our members in many interest-rate environments and situations. Principal repayment terms may be structured as 1) interest-only to maturity (sometimes referred to as bullet advances) or to an optional early termination date or series of dates or 2) amortizing advances, which are fixed-rate and term structures with equal monthly payments of interest and principal.
"Mortgage Partnership Finance," "MPF," "eMPF" and "MPF Xtra" are registered trademarks of the Federal Home Loan Bank of Chicago.
We price advances based on the estimated marginal cost of funding with a similar maturity profile, as well as market rates for comparable funding alternatives. In accordance with the FHLBank Act and FHFA regulations, we price our advance products in a consistent and nondiscriminatory manner to all members. However, we are permitted to price our products on a differential basis, which is based on the creditworthiness of the member, volume, or other reasonable criteria applied consistently to all members.
Our major competitors are other sources of liquidity, including deposits, investment banks, commercial banks, and, in certain instances, other FHLBanks.
We had 321 members, two housing associates, and three nonmember institutions with advances outstanding as of December 31, 2015. For information on competition and trends in demand for advances, see Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Advances Balances.
Members that have an approved line of credit with us may from time to time overdraw their demand-deposit account. These overdrawn demand-deposit accounts are reported as advances in the statements of condition. These line of credit advances are fully secured by eligible collateral pledged by the member to us. In cases where the member overdraws its demand-deposit account by an amount that exceeds its approved line of credit, we may assess a penalty fee to the member.
In addition to making advances to members, we are permitted under the FHLBank Act, to make advances to housing associates that are approved mortgagees under Title II of the National Housing Act. Housing associates must be chartered under law and have succession, be subject to inspection and supervision by a governmental agency, and lend their own funds as their principal activity in the mortgage field. Housing associates are not subject to capital stock investment requirements, however, they are subject to the same underwriting standards as members, but are more limited in the forms of collateral that they may pledge to secure advances.
Our advance products can also help members in their asset-liability management. For example, we offer advances that members can use to match the cash-flow patterns of their mortgage loans. Such advances can reduce a member's interest-rate risk associated with holding long-term, fixed-rate mortgages. As another example, we also offer advances with interest rates that vary based on changes in the yield curve. We may also offer advances that shift from fixed to floating rates or vice versa after a certain period or upon the occurrence of a certain condition.
Generally, advances may be prepaid at any time. We charge prepayment fees to make us financially indifferent to advance prepayments, except in cases where the prepayment of an advance does not have an adverse financial impact on us.
We also offer an advance restructuring program under which the prepayment fee on prepaid advances may be satisfied by the member's agreement to pay an interest rate on a new advance sufficient to amortize the prepayment fee by the maturity date of the new advance, rather than paying the fee in funds immediately available to us.
We have never experienced a credit loss on an advance.
Targeted Housing and Community Investment Programs. We offer several solutions that are targeted to meet the affordable housing or economic development needs of communities that our members serve. These programs include the AHP, the Equity Builder Program (EBP), Community Development advances (CDAs), the New England Fund (NEF), Jobs for New England (JNE), and Helping to House New England (HHNE).
The AHP provides subsidies in the form of direct grants or discounted interest rates on advances (AHP advances) to help fund affordable housing projects that are directly sponsored by members. AHP funds are required to be used for homeownership housing for households with incomes at or below 80 percent of the median income for the area, or rental housing in which 20 percent of the units are for households with incomes that do not exceed 50 percent of the median income for the area. Program funds must be used for the direct costs to purchase, construct, or rehabilitate affordable housing.
The EBP offers members grants to provide households with incomes at or below 80 percent of the area median income with down-payment, closing-cost, homebuyer counseling, and rehabilitation assistance. The EBP is funded with a portion of the AHP assessment. For further information about how AHP subsidies are funded, see AHP Assessment below.
CDAs are discounted advances offered at interest rates that are lower than our regular advances programs for the purpose of helping our members fund community development efforts, such as small business, roads and schools, and affordable housing for individuals with incomes at or below defined percentages of area median income.
NEF advances are targeted to support housing and community development initiatives that benefit moderate-income households and neighborhoods.
JNE provides advances to support small businesses in New England that are expected to create and/or retain jobs, or otherwise contribute to overall economic development activities. Examples include using funds to support the working capital, expansion, or financing needs of a small business. The JNE program provides subsidies that will be used to write down interest rates to zero percent on eligible advances that finance qualifying loans to small businesses. We plan to provide interest rate subsidies of up to $5 million per year in 2016, 2017, and 2018 under this program.
HHNE provides advances for targeted initiatives serving individuals and families who qualify for loans under the six New England housing finance agencies income guidelines for comparable loans. The HHNE program provides subsidies that will be used to write down interest rates to zero percent on eligible advances to the New England housing finance agencies for the purpose of expanding affordable rental and homeownership initiatives. Examples of uses include, but are not limited to, short-term construction lending, workforce housing, deferred loan programs for homeownership, multifamily loan refinance, and rental housing expansion, particularly in areas with job growth that exceeds the supply of rental units. We plan to provide interest rate subsidies of up to $5 million per year in 2016, 2017, and 2018 under this program.
Investments. We maintain a portfolio of investments for liquidity purposes and to supplement earnings. To better meet members' potential borrowing needs at times when access to the capital markets is unavailable (either due to requests that follow the end of daily debt issuance activities or due to a market disruption event impacting CO issuance) and in support of certain statutory and regulatory liquidity requirements, as discussed in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Investments - Investments Credit Risk, we maintain a portfolio of short-term investments issued by highly rated institutions, including federal funds and securities purchased under agreements to resell (secured by U.S. Department of the Treasury (U.S. Treasury) securities, Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae), or Federal Home Loan Mortgage Corporation (Freddie Mac) securities).
We also endeavor to effectively leverage our capital to enhance our income and further support our contingent liquidity needs and mission by maintaining a longer-term investment portfolio, which includes debentures issued or guaranteed by U.S. government agencies and instrumentalities, supranational institutions, mortgage-backed securities (MBS), and asset-backed securities (ABS) that are issued by GSE mortgage agencies or by other private-sector entities provided they are rated in at least the second highest rating category from a nationally recognized statistical rating organization (NRSRO) as of the date of purchase. Our ABS holdings are further limited to securities backed by loans secured by real estate. We have also purchased securities issued by state or local housing-finance-agencies (HFAs) that are rated in at least the second-highest rating category from an NRSRO as of the date of purchase. The long-term investment portfolio is intended to provide us with higher returns than those available in the short-term money-markets. For a discussion of developments and factors that have impacted and could continue to impact the profitability of our investments, particularly our long-term investment portfolio, see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary.
Under our regulatory authority to purchase MBS, additional investments in MBS, ABS, and certain securities issued by the Small Business Administration (SBA) are prohibited if our investments in such securities exceed 300 percent of capital. Capital for this calculation is defined as capital stock, mandatorily redeemable capital stock, and retained earnings. At December 31, 2015, and 2014, our MBS, ABS, and SBA holdings represented 242 percent and 230 percent of capital, respectively.
We conduct our investment activities so as to strive to comply with the FHFA’s core mission achievement advisory bulletin, which is described in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Legislative and Regulatory Developments.
Mortgage Loan Finance. We participate in the MPF program, which is a secondary mortgage market structure under which we either invest in or, for fees, facilitate Fannie Mae's investment in eligible mortgage loans (referred to as MPF loans) from FHLBank members. MPF loans are either conventional, residential, fixed-rate mortgage loans (conventional mortgage loans) or government mortgage fixed-rate loans that are insured or guaranteed by the Federal Housing Administration (the FHA), the U.S. Department of Veterans Affairs (the VA), the Rural Housing Service of the U.S. Department of Agriculture (RHS), or the U.S. Department of Housing and Urban Development (HUD) and are secured by one- to four-family residential properties with original maturities ranging from five years to 30 years or participations in such mortgage loans (government mortgage loans). For information on trends in the growth of the program in 2015, see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Mortgage Loans.
We have offered our members Original MPF, MPF 125, MPF Plus, MPF Government, and MPF Xtra, each being closed-loan products in which we, or a third party investor in the case of MPF Xtra, invest in MPF loans that have been acquired or have already been closed by the participating financial institutions with its own funds. In addition we have begun offering new MPF products during the period covered by this report: MPF Direct, MPF 35, and MPF Government MBS. MPF Direct and MPF Government MBS, like MPF Xtra, each facilitate the investment in MPF loans by third party investors for which we are paid fees and under which the related credit and market risks are transferred to the investors. See the MPF Product Comparison Chart below that compares the principal characteristics of these different MPF products.
The participating financial institution performs all of the traditional retail loan origination functions under all of these MPF products. We continue to offer Original MPF, MPF 35, MPF Government, MPF Direct, MPF Government MBS, and MPF Xtra. We do not currently offer our members new master commitments under either MPF 125 or MPF Plus.
The FHLBank of Chicago (in this capacity, the MPF Provider) establishes general eligibility standards under which an FHLBank member may become a participating financial institution, the structure of MPF loan products, and the eligibility rules for MPF loans. In addition, the MPF Provider manages the delivery mechanism for MPF loans and the back-office processing of MPF loans as master servicer and master custodian. The FHLBanks that participate in the MPF Program (including the Bank, the MPF Banks) pay fees to the MPF Provider for these services.
The MPF Provider has engaged Wells Fargo Bank N.A. as the vendor for master servicing and as the primary custodian for the MPF program (referred to herein as the master servicer). The MPF Provider also has contracted with other custodians meeting MPF program eligibility standards at the request of certain participating financial institutions. These other custodians are typically affiliates of participating financial institutions, and in some cases a participating financial institution may act as self-custodian.
The MPF Provider publishes and maintains the MPF Origination Guide, MPF Servicing Guide, and MPF Underwriting Guide (together, the MPF guides), which detail the requirements participating financial institutions must follow in originating, underwriting, or selling and servicing MPF loans. The MPF Provider also maintains the infrastructure through which MPF Banks may purchase MPF loans through their participating financial institutions.
For conventional mortgage loan products (MPF loan products other than government mortgage loans and products in which we do not invest such as MPF Xtra), participating financial institutions assume or retain a portion of the credit risk on the MPF loans they sell to an MPF Bank by providing credit enhancement either through a direct liability to pay credit losses up to a specified amount or through a contractual obligation to provide supplemental mortgage guaranty insurance. The participating financial institution's credit enhancement covers losses for MPF loans under a master commitment in excess of the MPF Bank's allocated portion of credit losses up to an agreed upon amount, called the first loss account. A master commitment is an agreement that provides the terms under which the participating financial institution delivers mortgage loans to an MPF Bank. Participating financial institutions are paid a credit-enhancement fee for providing credit enhancement and in some instances all or a portion of the credit-enhancement fee may be adjusted based upon the performance of loans purchased by the MPF Bank. See - MPF Products, below, for a summary of the credit-enhancement and risk-sharing arrangements for the MPF program.
Participating Financial Institution Eligibility
Members and eligible housing associates may apply to become a participating financial institution. All of the participating financial institution's obligations under the applicable agreement are secured in the same manner as the other obligations of the participating financial institution under its regular advances agreement with us. We have the right to request additional collateral to secure the participating financial institution's obligations.
Repurchases of MPF Loans
When a participating financial institution fails to comply with its representations and warranties concerning its duties and obligations described within applicable agreements, the MPF guides, applicable laws, or terms of mortgage documents, the participating financial institution may be required to repurchase the MPF loans that are impacted by such failure. Reasons that would require a participating financial institution to repurchase an MPF loan may include, but are not limited to, MPF loan ineligibility, failure to deliver documentation to an approved custodian, a servicing breach, fraud, or other misrepresentation. In such instances, we can require that the participating financial institution compensate us for any losses or costs that we incur. Additionally, subject to our approval, participating financial institutions may repurchase delinquent government mortgage loans so that they may comply with loss-mitigation requirements of the applicable government agency to preserve the insurance or guaranty coverage. The repurchase price for each such delinquent loan is equal to the current scheduled principal balance and accrued interest on the government mortgage loan.
MPF Products
A variety of MPF loan products have been developed to meet the differing needs of participating financial institutions. We have offered various MPF loan products from which participating financial institutions may have chosen. These products include Original MPF, MPF Government, MPF 125, MPF Plus, MPF 35, MPF Direct, MPF Government MBS, and MPF Xtra. The products have different credit-risk-sharing characteristics based upon the different levels for the first loss account and credit enhancement and the types of credit-enhancement fees (performance-based, fixed amount, or none). There are no first loss account, credit enhancement, or credit-enhancement fees for MPF Direct, MPF Government MBS, and MPF Xtra because the credit risk for such loans is transferred to the third-party investors. The following table provides a comparison of the MPF products.
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(1)
Future payouts of performance-based credit-enhancement fees are reduced when losses are allocated to the first loss account.
(2)
For master commitments issued prior to February 2, 2007, the participating financial institution is paid a monthly government loan fee equal to 0.02 percent (two basis points) per annum based on the month-end outstanding aggregate principal balance of the master commitment, which is in addition to the customary 0.44 percent (44 basis points) per annum servicing fee that continues to apply for master commitments issued after February 2, 2007, and that is retained by
the participating financial institution on a monthly basis based on the outstanding aggregate principal balance of the MPF Government loans.
(3)
We do not currently offer new master commitments to our members under MPF 125.
(4)
Currently, no supplemental mortgage guaranty insurance provider has the required NRSRO rating and so we do not offer new master commitments to our members under MPF Plus at this time.
MPF Servicing
The participating financial institution, or a servicer it engages, generally retains the right and responsibility for servicing MPF loans it delivers, including loan collections and remittances, default management, loss mitigation, foreclosure, and disposition of the real estate acquired through foreclosure or deed in lieu of foreclosure.
If there is a loss on a conventional mortgage loan, the loss is allocated to the master commitment and shared in accordance with the risk-sharing structure for that particular master commitment. The servicer pays any gain on sale of real-estate-owned property (REO) to the related MPF Bank, or in the case of a participation, to us and other MPF Bank(s) based upon their respective interests in the MPF loan. However, the amount of the gain is available to reduce subsequent losses incurred under the master commitment before such losses are allocated between us and the participating financial institution.
Loss Allocation
Credit losses from conventional mortgage loans that are not covered by the borrower's equity in the mortgaged property, property insurance, or primary mortgage insurance are allocated between us and the participating financial institution as follows:
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Credit losses are allocated first to us, up to an agreed-upon amount, called the first loss account determined for the MPF product as follows:
Original MPF. The first loss account starts out at zero on the day the first MPF loan under a master commitment is purchased but increases monthly over the life of the master commitment at a rate that ranges from 0.03 percent to 0.06 percent (three to six basis points) per annum based on the month-end outstanding aggregate principal balance of the master commitment. The first loss account is structured so that over time, it should cover expected losses on a master commitment, though losses early in the life of the master commitment could exceed the first loss account and be charged in part to the participating financial institution's credit enhancement.
MPF 125. The first loss account is equal to 1.00 percent (100 basis points) of the aggregate principal balance of the MPF loans funded under the master commitment. Once the master commitment is fully funded or expires, the first loss account is expected to cover expected losses on that master commitment, although we may economically recover a portion of losses incurred under the first loss account by withholding performance credit-enhancement fees payable to the participating financial institution.
MPF Plus. The first loss account is equal to an agreed-upon number of basis points of the aggregate principal balance of the MPF loans funded under the master commitment that is not less than the amount of expected losses on the master commitment. Once the master commitment is fully funded, the first loss account is expected to cover expected losses on that master commitment. We may recover a portion of losses incurred under the first loss account by withholding performance credit-enhancement fees payable to the participating financial institution.
MPF 35. The first loss account is equal to 35 basis points of the aggregate principal balance of the MPF loans funded under the master commitment. We may recover a portion of losses we absorb by withholding performance credit-enhancement fees that would otherwise be payable to the participating financial institution.
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Credit losses are allocated second to the participating financial institution under its credit-enhancement obligation for losses for each master commitment in excess of the first loss account, if any, up to the credit enhancement. The credit enhancement may consist of a direct liability of the participating financial institution to pay credit losses up to a specified amount, a contractual obligation of the participating financial institution to provide supplemental mortgage guaranty insurance, or a combination of both.
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Third, any remaining unallocated losses are absorbed by us.
We occasionally invest in participation interests in MPF loans together with other MPF Banks. For participation interests, MPF loan losses (other than those allocable to the participating financial institution) are allocated among us and the participating MPF Bank(s) pro rata based upon the respective participation interests in the related master commitment.
Other Banking Activities. We engage in other banking activities including, among others:
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offering standby letters of credit, which are financial instruments we issue for a fee under which we agree to honor payment demands made by a beneficiary in the event the primary obligor cannot fulfill its obligations; and
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acting as a correspondent for deposit, disbursement, funds transfer, and safekeeping services for which we earn a fee.
Consolidated Obligations
We fund our activities principally through the sale of debt securities referred to herein as COs. Our ability to access the money and capital markets through the sale of COs using a variety of debt structures and maturities has historically allowed us to manage our balance sheet effectively and efficiently. The FHLBanks are among the world's most active issuers of debt, issuing on a near-daily basis, including sometimes multiple issuances in a single day. The FHLBanks compete with Fannie Mae, Freddie Mac, and other GSEs for funds raised through the issuance of unsecured debt in the agency debt market.
COs, consisting of bonds and discount notes, represent our primary source of debt to fund advances, mortgage loans, and investments. All COs are issued on behalf of an FHLBank (as the primary obligor) through the Office of Finance, but all COs are the joint and several obligation of each of the FHLBanks. COs are not obligations of the U.S. government and are not guaranteed by the U.S. government or any government agency. As of February 29, 2016, Moody's Investors Service Inc. (Moody's) rated COs Aaa/P-1, and Standard & Poor’s Financial Services LLC (S&P) rated them AA+/A-1+. The GSE status of the FHLBanks and the ratings of the COs have historically provided the FHLBanks with ready capital market access. For information on the market for COs during the period covered by this report, see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Liquidity.
CO Bonds. CO bonds may have original maturities of up to 30 years (although there is no statutory or regulatory limit on maturities) and are generally issued to raise intermediate and long-term funds. CO bonds may also contain embedded options that affect the term or yield structure of the bond. Such options include call options under which we can redeem bonds prior to maturity.
CO bonds may be issued with either fixed-rate coupon-payment terms, zero-coupon terms, or variable-rate coupon-payment terms that use a variety of indices for interest-rate resets including the London Interbank Offered Rate (LIBOR), the Federal Funds (Effective) rate, and others.
In the aggregate, the FHLBanks may comprise a significant percentage of the federal funds sold market from time to time however, each FHLBank, including the Bank, manages its investment portfolio separately.
CO bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members. We frequently participate in these issuances. Each FHLBank requests funding through the Office of Finance, and the Office of Finance endeavors to issue the requested bonds and allocate proceeds in accordance with each FHLBank's requested funding. In some cases, proceeds from partially fulfilled offerings must be allocated among the requesting FHLBanks in accordance with predefined rules that apply to particular issuance programs. Conversely, under certain programs, proceeds from bond offerings that exceed aggregate FHLBank demand will be allocated to the FHLBanks in accordance with predefined rules that apply to particular issuance programs. The Office of Finance also prorates the amounts of fees paid to dealers in connection with the sale of COs to each FHLBank based upon the percentage of debt issued that is assumed by each FHLBank.
The Office of Finance has established an allocation methodology for the proceeds from the issuance of COs when COs cannot be issued in sufficient amounts to satisfy all FHLBank demand for funding during periods of financial distress and when its existing allocation processes are deemed insufficient. In general, this methodology provides that the proceeds in such circumstances will be allocated among the FHLBanks based on relative FHLBank total regulatory capital, with FHLBanks with greater total regulatory capital in absolute terms receiving greater allocations of issuance proceeds. The Office of Finance will use this method in such periods unless it determines that there is an overwhelming reason to adopt a different allocation method. As is the case during any instance of a disruption in our ability to access the capital markets, market conditions or this allocation could adversely impact our ability to finance our operations, financial condition, and results of operations.
CO Discount Notes. CO discount notes are short-term obligations issued at a discount to par with no coupon. Terms range from overnight up to one year. We generally participate in CO discount note issuance on a daily basis as a means of funding short-term assets and managing our short-term funding gaps. Each FHLBank submits commitments to issue CO discount notes in specific amounts with specific terms to the Office of Finance, which in turn, aggregates these commitments into offerings to securities dealers. Such commitments may specify yield limits that we have specified in our commitment, above which we will not accept funding. CO discount notes are sold either at auction on a scheduled basis or through a direct bidding process on an as-needed basis through a group of dealers known as the selling group, who may turn to other dealers to assist in the ultimate distribution of the securities to investors.
FHFA regulations require that each FHLBank maintain the following types of assets, free from any lien or pledge, in an amount at least equal to the amount of that FHLBank's participation in the total COs outstanding:
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cash;
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obligations of, or fully guaranteed by, the U.S. government;
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secured advances;
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mortgages, which have any guaranty, insurance, or commitment from the U.S. government or any agency of the U.S.; and
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investments described in Section 16(a) of the FHLBank Act, which, among other items, includes securities that a fiduciary or trust fund may purchase under the laws of the state in which the FHLBank is located.
The following table illustrates our compliance with this regulatory requirement:
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(1)
Investments include interest-bearing deposits, securities purchased under agreements to resell, federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
Although each FHLBank is primarily liable for the portion of COs corresponding to the proceeds received by that FHLBank, each FHLBank is also jointly and severally liable with the other FHLBanks for the payment of principal and interest on all COs. Under FHFA regulations, if the principal or interest on any CO issued on behalf of one of the FHLBanks is not paid in full when due, then the FHLBank primarily responsible for the payment may not pay dividends to, or redeem or repurchase shares of stock from, any member of such FHLBank. The FHFA, in its discretion, may require any FHLBank to make principal or interest payments due on any COs, whether or not the primary obligor FHLBank has defaulted on the payment of that obligation.
To the extent that an FHLBank makes any payment on a CO on behalf of another FHLBank, the paying FHLBank shall be entitled to reimbursement from the FHLBank otherwise responsible for the payment. However, if the FHFA determines that an FHLBank is unable to satisfy its obligations, then the FHFA may allocate the outstanding liability among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank's participation in all COs outstanding, or on any other basis the FHFA may determine.
Neither the FHFA nor any predecessor to it has ever required us to repay obligations in excess of our participation nor have they allocated to us any outstanding liability of any other FHLBank's COs.
Capital Resources
As a cooperative, we are owned by our member institutions, which are required to purchase shares of our capital stock as a condition of membership in us and to support the capital requirements for certain credit products that we provide, and for which all transfers are exchanged at a par value of $100 per share. We currently issue one class of stock, Class B, which shareholders may redeem five years after providing a written redemption request. Our equity capital also includes retained earnings.
Total Stock-Investment Requirement (TSIR). Each member is required to satisfy its TSIR at all times, which is an amount of stock equal to its activity-based stock-investment requirement plus its membership stock-investment requirement. Any stock held by a member in excess of its TSIR is referred to as excess stock. At December 31, 2015, members and nonmembers with capital stock outstanding held excess capital stock totaling $158.9 million, representing approximately 6.7 percent of total capital stock outstanding.
Membership Stock-Investment Requirement (MSIR). The MSIR is equal to 0.35 percent of the value of certain member assets eligible to secure advances subject to a current minimum balance of $10,000 and a current maximum balance of $25.0 million.
Activity-Based Stock-Investment Requirement (ABSIR). Certain activity with us has an associated ABSIR. For example, advances have an ABSIR. The ABSIR for advances varies by term with longer terms typically requiring a higher ABSIR.
Redemption of Excess Stock. Members may submit a written request for redemption of excess stock. The stock subject to the request will be redeemed at par value by us upon expiration of the stock-redemption period, which is five years for Class B stock, provided that the stock is not required to support the member's TSIR. The stock-redemption period also applies to stock held by a member that (1) gives notice of intent to withdraw from membership or (2) becomes a nonmember due to merger or acquisition, charter termination, or involuntary termination of membership. At the end of the stock-redemption period, we must comply with the redemption request unless doing so would cause us to fail to comply with our minimum regulatory capital requirements, cause the member to fail to comply with its TSIR, or violate any other applicable limitation or prohibition.
Repurchase of Excess Stock. Our capital plan provides us with the authority and discretion to repurchase excess stock from any shareholder at par value upon 15 days prior written notice to the member, unless a shorter notice period is agreed to in writing with the member, so long as the repurchase will not cause us to fail to meet any of our regulatory capital requirements or violate any other applicable limitation or prohibition. On July 24, 2015, our board of directors authorized management to implement an excess stock management program, under which we are authorized to repurchase excess stock to maintain excess stock within a targeted range between zero and $200 million. We expect to execute repurchases under the program from time to time to stay within this targeted excess stock range and to ensure a fair distribution of ownership consistent with shareholders’ total stock investment requirements in 2016. In addition, shareholders may request that we voluntarily repurchase excess stock shares at any time. In either case, we retain sole discretion over any voluntary repurchases of excess stock in accordance with our capital plan. During the year ended December 31, 2015, we repurchased $602.1 million of excess capital stock, of which $256.7 million was mandatorily redeemable capital stock.
Statutory and Regulatory Restrictions on Capital-Stock Redemption and Repurchases. In accordance with the Gramm-Leach-Bliley Act of 1999, as amended (the GLB Act), our stock is putable by the member. However, there are significant statutory and regulatory restrictions on the obligation or right to redeem outstanding stock, including the following:
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Our board of directors, or a committee of the board, may decide to suspend redemptions if it reasonably believes that continued redemptions would cause us to fail to meet any of our minimum capital requirements, prevent us from maintaining adequate capital against potential risks that are not adequately reflected in our minimum capital requirements, or otherwise prevent us from operating in a safe and sound manner.
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We may not redeem or repurchase any capital stock without the prior written approval of the FHFA if our board of directors or the FHFA determine that we have incurred or are likely to incur losses that result in or are likely to result in charges against our capital stock while such charges are continuing or expected to continue.
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If, during the period between receipt of a stock-redemption notification from a member and the actual redemption, we become insolvent and are either liquidated or forced to merge with another FHLBank, the redemption value of the stock will be established either through the market-liquidation process or through negotiation with a merger partner. In either case all senior claims must first be settled, and there are no claims which are subordinated to the rights of FHLBank stockholders.
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We can only redeem stock investments that exceed the members' TSIR.
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If we are liquidated, after payment in full to our creditors, our stockholders will be entitled to receive the par value of their capital stock as well as any retained earnings in an amount proportional to the stockholder's share of the total shares of capital stock. In the event of a merger or consolidation, our board of directors shall determine the rights and preferences of our stockholders, subject to any terms and conditions imposed by the FHFA.
Additionally, we cannot redeem or repurchase shares of capital stock from any of our members if:
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following such redemption, we would fail to satisfy our minimum capital requirements;
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we become undercapitalized or our capital would be insufficient to maintain a classification of adequately capitalized after redeeming or repurchasing shares, except, in this latter case, with the Director of the FHFA's permission;
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the principal or interest due on any CO issued through the Office of Finance on which we are the primary obligor has not been paid in full when due;
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we fail to provide to the FHFA a certain quarterly certification required by the FHFA's regulations prior to declaring or paying dividends for a quarter;
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we fail to certify in writing to the FHFA that we will remain in compliance with our liquidity requirements and will remain capable of making full and timely payment of all of our current obligations;
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we notify the FHFA that we cannot provide the required certification, project we will fail to comply with statutory or regulatory liquidity requirements, or will be unable to timely and fully meet all of our current obligations; or
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we actually fail to comply with statutory or regulatory liquidity requirements or to timely and fully meet all of our current obligations, or negotiate to enter or enter into an agreement with one or more other FHLBanks to obtain financial assistance to meet our current obligations.
In addition to possessing the authority to suspend capital-stock redemptions or repurchases, our board of directors also has a statutory obligation to review and adjust member capital stock purchase requirements to comply with our minimum capital requirements, and each member must comply promptly with any such requirement. However, a member may be able to reduce its outstanding business with us as an alternative to purchasing additional capital stock.
Mandatory Purchases of Capital Stock. Our board of directors has a right and an obligation to call for additional capital-stock purchases by our members in accordance with our capital plan, if needed to satisfy statutory and regulatory capital requirements. Our board of directors has never called for any additional capital-stock purchases by members under our capital plan.
Retained Earnings. Our current minimum retained earnings target is $700.0 million, which was selected for the reasons discussed under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Internal Capital Practices and Policies - Retained Earnings and the Minimum Retained Earnings Target.
As of December 31, 2015, our retained earnings totaled $1.1 billion. Of that amount, $194.6 million is in a restricted retained earnings account and is not available to pay dividends, as discussed under Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. We are required to allocate 20 percent of net income to this restricted retained earnings account in accordance with our capital plan and a joint capital enhancement agreement (as amended, the Joint Capital Agreement) among the FHLBanks.
Dividends. We may pay dividends from current net earnings or unrestricted retained earnings, subject to certain limitations and conditions. For additional information see Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Interest-Rate-Exchange Agreements
In general, we use interest-rate-exchange agreements (derivatives) in two ways: 1) as a fair-value or cash-flow hedge of a hedged financial instrument, firm commitment, or a forecasted transaction, or 2) as economic hedges in asset-liability management that are not designated as hedges. In addition to using interest-rate-exchange agreements to manage mismatches of interest rates between assets and liabilities, we also use interest-rate-exchange agreements to manage embedded options in assets and liabilities and to hedge the market value of existing assets, liabilities, and anticipated transactions. We may also enter into interest-rate-exchange agreements concurrently with the issuance of COs to reduce funding costs. We enter into derivatives directly with principal counterparties and also enter into centrally cleared derivatives where our counterparty is a derivatives
clearing organization (DCO). FHFA regulations require the documentation of nonspeculative use of these instruments and the establishment of limits to credit risk arising from these instruments.
AHP Assessment
Annually, the FHLBanks collectively must set aside for the AHP the greater of $100 million or 10 percent of the current year's net income before interest expense associated with mandatorily redeemable capital stock and the assessment for AHP. For the year ended December 31, 2015, our AHP assessment was $32.3 million.
If the result of the aggregate 10 percent calculation described above is less than $100 million for all FHLBanks, then each FHLBank would be required to contribute such prorated sums as may be required to assure that the aggregate contributions of the FHLBanks equals $100 million. The shortfall would be allocated among the FHLBanks based upon the ratio of each FHLBank's income before AHP to the sum of the income before AHP of the FHLBanks combined, except that the required annual AHP contribution for an FHLBank cannot exceed its net earnings for the year. Accordingly, the actual amount of each future AHP assessment is dependent upon both our net income before interest expense associated with mandatorily redeemable capital stock and the income of the other FHLBanks. Thus, future AHP assessments are not determinable.
Risk Management
We have a comprehensive risk-governance structure. We have identified the following major risk categories relevant to business activities:
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Credit risk, the risk to earnings or capital due to an obligor's failure to meet the terms of any contract with us or otherwise perform as agreed;
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Market risk, the risk to earnings or shareholder value due to adverse movements in interest rates, market prices, or interest-rate spreads;
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Liquidity risk, the risk that we may be unable to meet our funding requirements, or meet the credit needs of members, at a reasonable cost and in a timely manner;
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Leverage risk, the risk that our capital is not sufficient to support the level of assets that can result from a deterioration of our capital base, a deterioration of the assets, or from overbooking assets;
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Business risk, the risk to earnings or capital arising from adverse business decisions or improper implementation of those decisions, or from external factors as may occur in both the short- and long-run, including from legislative and regulatory developments;
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Operational risk, the risk of unexpected loss resulting from human error, fraud, vendor or third-party failure, unenforceability of legal contracts, or deficiencies in internal controls or information systems; and
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Reputation risk, the risk to earnings or capital arising from negative public opinion, which can affect our ability to establish new business relationships or maintain existing business relationships.
Credit, market, liquidity, and leverage risks are discussed in greater detail throughout Item 7 -Management's Discussion and Analysis of Financial Condition and Results of Operations and Item 7A - Quantitative and Qualitative Disclosures About Market Risk. Business, operational, and reputation risks are discussed in greater detail below.
The board of directors provides risk oversight through the review and approval of our risk- management policy. The board of directors also evaluates and approves risk tolerances and risk limits. The board of directors' Risk Committee provides additional oversight for market risk, credit risk, and operational risk. The board of directors also reviews the results of an annual risk assessment that we perform for our major business processes.
Management establishes a quantifiable connection between our desired risk profile and our risk tolerances and risk limits as expressed in our risk-management policy. Management is responsible for maintaining internal policies consistent with the risk-management policy and maintains various standing committees intended to assess and manage each of the major risk categories relevant to our business activities. Our chief risk officer is responsible for communicating material changes to these internal policies to the board of directors' Risk Committee. Management is also responsible for monitoring, measuring, and reporting risk exposures to the board of directors. Additionally, our Internal Audit department may report to the board's Audit Committee the results of internal audit work on the effectiveness of management's risk management processes and controls.
Business Risk
Management's strategies for mitigating business risk include annual and long-term strategic planning exercises; continually monitoring key economic indicators, projections, competitive threats, and our external environment; and developing contingency plans where appropriate.
Operational Risk
We are subject to operational risk, which is the risk of unexpected loss resulting from, among other possible sources, human error, fraud, unenforceability of legal contracts, or deficiencies in internal controls or information systems.
We have policies and procedures intended to mitigate operational risks. We train our employees for their roles and maintain written policies and procedures for our key functions. We maintain a system of internal controls designed to adequately segregate responsibilities and appropriately monitor and report on our activities to management and the board of directors. Our Internal Audit department, which reports directly to the Audit Committee of the board of directors, regularly monitors our adherence to established policies and procedures. Some operational risks are beyond our control, and the failure of other parties to adequately address their operational risks could adversely impact us.
Operational risk includes risk arising from breaches of our cybersecurity or other cyber incidents that could result in a failure or interruption of our information technology or other technology. We have not experienced a disruption in our information systems or other technology that has had a material adverse impact on us. However, we rely heavily on our information systems and other technology to conduct and manage our business and failures or interruptions of these information systems or other technology could have a material adverse impact on our financial condition and results of operations. We take several steps to protect our information systems and technology, including operational redundancy and supplier diversity, monitored physical and logical security controls to protect our information systems and data, and third party facilitated penetration testing.
Additionally, most of our information systems have been co-located with a third-party service provider to a site designed to host information systems with specialized environmental controls; certain power, heating and cooling system redundancies; 24-hour onsite staffing; and physical security. We rely on this service provider to continue to provide a secure location and a stable operating environment for these systems. Any failure to provide such stability or security by the third-party service provider could result in failures or interruptions in our ability to conduct business. We take several steps to mitigate the risks of our reliance on this third-party service provider, including physical and monitored logical security controls to protect our information systems and data within the co-location space along with maintaining redundancy of systems at an alternate location that we control for disaster-recovery and business continuity. Additionally, we review the provider's controls report annually and monitor and meet with the provider on a regular basis. We have a disaster-recovery site intended to provide continuity of operations in the event that our primary information systems become unavailable, but there can be no assurance that the disaster-recovery site will work as intended in the event of an actual disruption or failure. Moreover, certain of our applications vendors host their applications in a software-as-a-service framework, either on their own hardware or on third-party, cloud-based environments. We have executed contracts with these providers stipulating standards for control intended to mitigate our risks based on loss of access or security breaches. Additionally, we actively manage these service providers through our vendor management program.
Further, our AHP, MPF, and certain collateral activities rely on the secure processing, storage, and transmission of a large volume of private borrower information, such as names, residential addresses, social security numbers, credit rating data, and other consumer financial information. We take several steps to protect such data, including information technology and security, general computing controls governing access to programs and data, along with physical and logical security. Additionally, we review related third-party service providers' controls reports annually. Despite these steps, this information could be exposed in several ways, including through unauthorized access to our computer systems, computer viruses that attack our computer systems, software or networks, accidental delivery of information to an unauthorized party, and loss of encrypted media containing this information. Any of these events could result in financial losses, legal and regulatory sanctions, and reputational damage.
Disaster-Recovery/Business Continuity Provisions. We maintain a disaster-recovery/business continuity site in Massachusetts to provide continuity of operations in the event that our Boston headquarters becomes unavailable. Data for critical computer systems is backed up regularly and stored offsite to avoid disruption in the event of a computer failure. We also have a reciprocal back-up agreement in place with the FHLBank of Topeka to provide short-term advances in the event that our facilities are inoperable.
Insurance Coverage. We have insurance coverage for employee fraud, forgery, alteration, and embezzlement, as well as director and officer liability protection for, among other things, breach of duty, negligence, and acts of omission. Additionally, insurance coverage is currently in place for general liability, bankers professional liability, employment practices liability, cyber
liability, electronic data-processing equipment and software, personal property, leasehold improvements, fire, explosion, water damage, and personal injury including slander and libelous actions. We maintain additional insurance protection as deemed appropriate, which covers liability arising from automobiles, company credit cards, and business-travel accidents for both directors and staff. We use the services of an insurance consultant who periodically conducts a review of our insurance coverage levels.
Reputation Risk
We take several steps to manage reputation risk. We have established a code of ethics and business conduct and operational risk-management procedures intended to ensure ethical behavior among our staff and directors and require all employees to annually certify compliance with our code of ethics. We work to ensure that all communications are presented accurately, consistently, and in a timely way to multiple audiences and stakeholders. In particular, we regularly conduct outreach efforts with our membership and with housing and economic-development advocacy organizations throughout our district. We also cultivate relationships with government officials at the federal, state, and municipal levels; key media outlets; nonprofit housing and community-development organizations; and regional and national trade and business associations to foster awareness of our mission, activities, and value to members. We work with the Council of Federal Home Loan Banks and the Office of Finance to coordinate communications on a broader scale.
ITEM 1A.
ITEM 1A. RISK FACTORS
The following discussion summarizes some of the most important risks that we face. This discussion is not exhaustive, and there may be other risks that we face, which are not described below. The risks described below, if realized, may result in us being prohibited from paying dividends and/or repurchasing and redeeming our capital stock, and could adversely impact our business operations, financial condition, and future results of operations.
BUSINESS AND REPUTATION RISKS
Sustained low advances balances and/or limited opportunities for loan purchases at our offered pricing could adversely impact results of operations.
Our primary business is providing liquidity to our members by making advances to, and purchasing mortgage loans from, our members. Many of our competitors are not subject to the same body of regulation applicable to us. This is one factor among several that may enable our competitors to offer wholesale funding on terms that we are not able to offer and that members deem more desirable than the terms we offer on our advances.
The availability to our members of different products from alternative funding sources, with terms more attractive than the terms of products we offer, as can happen from time-to-time, may significantly decrease the demand for our advances and/or loan purchases. Further, any changes we make in the pricing of our advances in an effort to compete effectively with these competitive funding sources could decrease the profitability of advances, which could reduce earnings. More generally, a decrease in the demand for advances and/or loan purchases, or a decrease in the profitability of advances and/or mortgage loan investments, could adversely impact our financial condition and results of operations.
The loss of significant members could result in lower demand for our products and services.
At December 31, 2015, our five largest stock-holding members held 31.1 percent of our stock and our largest stock-holding member had affiliates with memberships in other FHLBanks, allowing their affiliates the flexibility of borrowing from other FHLBanks. The loss of significant members or a significant reduction in the level of business they conduct with us is likely to lower overall demand for our products and services in the future and adversely impact our performance.
Also, consolidations within the financial services industry could reduce the number of current and potential members in our district. Industry consolidation could also cause us to lose members whose business and stock investments are so substantial that their loss could threaten our viability. In turn, we might be forced to consider strategic alternatives, which could include a merger with another FHLBank.
A decrease in demand for our products and services due to the loss of significant members could adversely impact our results of operations and financial condition.
We are subject to a complex body of laws and regulations, which could change in a manner detrimental to our business operations and/or financial condition.
The FHLBanks are GSEs, organized under the authority of the FHLBank Act, and as such, are governed by federal laws and regulations promulgated, adopted, and applied by the FHFA, an independent agency in the executive branch of the federal government that regulates the FHLBanks, Fannie Mae, and Freddie Mac. Congress may amend the FHLBank Act or other statutes in ways that significantly affect (1) the rights and obligations of the FHLBanks and (2) the manner in which the FHLBanks carry out their mission and business operations. New or modified legislation enacted by Congress or regulations adopted by the FHFA or other financial services regulators could adversely impact our ability to conduct business or the cost of doing business.
For example, we note that, from time to time, Congress, the Obama administration, and various federal agencies have advanced plans to reform the federal support of U.S. housing finance, specifically targeting Fannie Mae and Freddie Mac. These plans are likely to directly and indirectly impact other GSEs that support the U.S. housing market, including the FHLBanks. Any such reforms that are implemented could adversely impact the profitability of the FHLBanks or limit future growth opportunities.
We cannot predict what additional regulations will be issued or what additional legislation will be enacted, and we cannot predict the effect of any such additional regulations or legislation on our business operations and/or financial condition. Additional changes in regulatory or statutory requirements could result in, for example, an increase in the FHLBanks' cost of funding, a change in permissible business activities, limitations on advances made to our members, or a decrease in the size, scope, or nature of the FHLBanks' lending, investment, or mortgage-financing activities, all and any of which could adversely impact our financial condition and results of operations.
Our dividend practices could decrease demand for our products that require capital stock purchases and/or result in withdrawals from membership.
Historically, our board of directors has varied dividend declarations based on our financial condition, outlook and economic environment. For example, from November 2008 until January 2011, the board of directors did not declare any dividends based on our focus on accumulating retained earnings toward our retained earnings target at the time. As our financial condition and outlook improved, the board of directors recommenced declaring dividends, and dividends have been declared each quarter since that time. Nonetheless, if our financial performance or condition were to deteriorate significantly in the future, our board of directors could determine to reduce or eliminate dividends.
Should the board of directors determine to suspend or lower dividend declarations, we could experience decreased member demand for our products requiring capital stock purchases and/or withdrawals from membership that could adversely impact our business operations and financial condition.
Limiting or ending repurchases of excess stock from members could decrease demand for advance products and increase membership withdrawals.
From December 8, 2008, until January 1, 2015, we maintained a general moratorium on excess stock repurchases although we completed several partial repurchases of excess stock during that period. We have since rescinded the moratorium, however, that period of constrained excess stock repurchases could provide an incentive for members to limit certain of their business with us to avoid associated stock purchase requirements and a disincentive to prospective members from becoming members, either of which could adversely impact our business operations and financial condition.
An NRSRO's downgrade of the U.S. federal government's credit ratings could adversely impact our funding costs and/or access to the capital markets, require us to deliver collateral to certain derivatives counterparties, and/or adversely impact demand for certain of our products.
Certain NRSROs have indicated that the credit ratings of the FHLBanks are constrained by the credit ratings of the U.S. federal government. Accordingly, a downgrade of the U.S. federal government's credit rating by an NRSRO is likely to be followed by a similar downgrade of the FHLBanks. Downgrades of the U.S. federal government (and, in turn, the FHLBanks) are possible, and any resulting downgrades to our credit ratings could adversely impact our funding costs and/or access to the capital markets. Additionally, downgrades could trigger obligations to deliver collateral (in some cases, in addition to amounts already delivered, depending on the downgrade) to certain derivatives counterparties to which we are a net obligor, as discussed under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Derivative Instruments - Derivative Instruments Credit Risk and Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 11 - Derivatives and Hedging Activities. Further, member and housing associate demand for certain of our products, such as letters of credit and standby bond purchase agreements, is influenced by our credit ratings and downgrade of our credit ratings could weaken or eliminate demand for such products. To the extent that we cannot
access funding when needed on acceptable terms to effectively manage our cost of funds or demand for our products falls, our financial condition and results of operations could be adversely impacted.
Negative information about the FHLBanks or housing GSEs in general could adversely impact our cost and availability of financing, or could limit membership growth.
Negative information about us or any other FHLBank, such as material losses or increased risk of losses, could also adversely impact our cost of funds. More broadly, negative information about housing GSEs, in general, could adversely impact us. Potential sources of negative information about the FHLBanks include NRSROs, the FHFA, and its Office of Inspector General. Further, an FHFA rule annually requires us to perform stress tests under various scenarios and make the results of a severely adverse economic conditions test publicly available. The results of the stress test, or the public’s reaction to the results, could adversely impact the Bank.
The housing GSEs Fannie Mae, Freddie Mac, and the FHLBanks issue highly rated agency debt to fund their operations. From time to time negative announcements by any of the housing GSEs concerning accounting problems, risk-management issues, and regulatory enforcement actions have created pressure on debt pricing for all GSEs, as investors have perceived such instruments as bearing increased risk.
Any such negative information or other factors could result in the FHLBanks having to pay a higher rate of interest on COs to make them attractive to investors. If we maintain our existing pricing on our advances products and other services notwithstanding increases in CO interest rates, the spreads we earn would fall and our results of operations would be adversely impacted. If, in response to this decrease in spreads, we change the pricing of our advances, the advances may be less attractive to members, and the amount of new advances and our outstanding advance balances may decrease. In either case, the increased cost of issuing COs could adversely impact our financial condition and results of operations. Moreover, such negative information could deter prospective members from becoming members and could adversely impact our financial condition and results of operations.
We could fail to meet our minimum regulatory capital requirements and/or maintain a capital classification of "adequately capitalized," which could result in prohibitions on dividends, excess stock repurchases, capital stock redemptions, and additional regulatory prohibitions.
We are required to satisfy certain minimum regulatory capital requirements, including risk-based capital requirements and certain regulatory capital and leverage ratios, and are subject to the FHFA's regulation on FHLBank capital classification and critical capital levels (the Capital Rule), as described in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital. Any failure to satisfy these requirements will result in our becoming subject to certain capital restoration requirements and being prohibited from paying dividends and redeeming or repurchasing capital stock without the prior approval of the FHFA.
The Capital Rule, among other things, establishes criteria for four capital classifications and corrective action requirements for FHLBanks that are classified in any classification other than adequately capitalized. An adequately capitalized FHLBank is one that has sufficient permanent and total capital to satisfy its risk-based and minimum capital requirements. We satisfied these requirements at December 31, 2015. However, pursuant to the Capital Rule, the FHFA has discretion to reclassify an FHLBank and modify or add to corrective action requirements for a particular capital classification. If we become classified into a capital classification other than adequately capitalized, we would be subject to the corrective action requirements for that capital classification in addition to being subject to prohibitions on declaring dividends and redeeming or repurchasing capital stock.
We could be subject to enforcement action by the FHFA that could result in prohibitions on dividends, excess stock repurchases, and capital stock redemptions and/or adversely impact our results of operations.
The FHFA is the FHLBank System's safety and soundness regulator and has broad powers to cause us to take or refrain from taking certain actions including, but not limited to, paying dividends, repurchasing excess stock, redeeming capital stock, increasing or decreasing our total assets, and curtailing our investing activities.
Our efforts to maintain adequate capital levels could impede our ability to generate asset growth including, but not limited to, meeting member advance requests.
We are mandated to maintain minimum regulatory capital thresholds including, but not limited to, a minimum regulatory capital ratio of 4.0 percent, which is a percentage equal to permanent capital divided by total assets. Moreover, we have a policy that requires us to maintain a minimum regulatory capital amount equal to 4.0 percent of total assets plus our calculated
economic capital requirement. As a condition for borrowing advances from us, members are required to invest in capital stock, permitting members to leverage their stock investment to borrow at multiples of that stock investment. In certain scenarios, members seeking to leverage their excess stock availability may be unable to borrow at the fullest capacity if overall asset growth causes our total regulatory capital ratio to fall below 4.0 percent, even after discretionary assets, including, but not limited to, short-term investments, are disposed.
We could become primarily liable for all or a portion of the COs of the other FHLBanks, which could adversely impact our financial condition and results of operations.
Each of the FHLBanks relies upon the issuance of COs as a primary source of funds. COs are the joint and several obligations of all of the FHLBanks, backed only by the financial resources of the FHLBanks. Accordingly, we are jointly and severally liable with the other FHLBanks for the COs issued by the FHLBanks through the Office of Finance, regardless of whether we receive all or any portion of the proceeds from any particular issuance of COs. The FHFA, at its discretion, may require any FHLBank to make principal or interest payments due on any COs, whether or not the primary obligor FHLBank has defaulted on the payment of that obligation (although this has never happened). Accordingly, we could incur significant liability beyond our primary obligation under COs due to the failure of other FHLBanks to meet their obligations, which could adversely impact our financial condition and results of operations.
Compliance with regulatory contingency liquidity requirements could adversely impact our results of operations.
We are required to maintain sufficient liquidity through short-term investments in an amount at least equal to our cash outflows under two different scenarios, as discussed in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources. The requirement is designed to enhance our protection against temporary disruptions in access to the capital markets resulting from a rise in capital markets volatility. To satisfy this additional requirement, we maintain balances in shorter-term investments, which could earn lower interest rates than alternate investment options and could, in turn, adversely impact net interest income. In certain circumstances, we may need to fund overnight or shorter-term advances with short-term discount notes that have maturities beyond the maturities of the related advances, thus increasing our short-term advance pricing or reducing net income through lower net interest spread. To the extent these increased prices make our advances less competitive, advance levels and, therefore, our net interest income could be adversely impacted.
MARKET AND LIQUIDITY RISKS
Prolonged, low interest rates could continue to adversely impact our financial condition and results of operations.
Like many financial institutions, we realize a significant portion of our income from the spread between interest earned on our outstanding loans and investments and interest paid on our borrowings and other liabilities, as measured by our net interest spread. A continued and prolonged low interest-rate environment could continue to adversely impact us in various ways, including lower market yields on investments and faster prepayments on our investments with associated reinvestment risk. Our investment income and, in turn, our financial condition and results of operations, could be adversely impacted to the extent that the foregoing, or similar, risks are realized.
Changes in interest rates could adversely impact our financial condition and results of operations.
Although we use various methods and procedures to monitor and manage exposures due to changes in interest rates, we could experience instances when either our interest-bearing liabilities will be more sensitive to changes in interest rates than our interest-earning assets, or vice versa. These impacts could be exacerbated by prepayment risk, which is the risk that mortgage-related assets will be refinanced and prepaid in low interest-rate environments. The realization of such risk could require us to reinvest the proceeds at lower, and possibly negative, spreads, or will remain outstanding at below-market yields when interest rates increase. Moreover, accelerated prepayments in a low interest-rate environment could result in elevated levels of premium expense recognition due to the fact that the majority of our mortgage assets were purchased at premium prices. In any case, changes in interest rates could adversely impact our financial condition and results of operations.
Any inability or curtailment of our ability to access the capital markets could adversely impact our business operations, financial condition, and results of operations.
Our primary source of funds is the sale of COs in the capital markets. Our ability to obtain funds through the sale of COs depends in part on prevailing conditions in the capital markets at that time, which are beyond our control. Accordingly, we cannot make any assurance that we will be able to obtain funding on terms acceptable to us, if at all. If we cannot access
funding when needed, our ability to support and continue our operations would be adversely impacted, which would thereby adversely impact our financial condition and results of operations.
CREDIT RISKS
We are subject to credit-risk exposures related to the loans that back our investments. Increased delinquency rates and credit losses beyond those currently expected could adversely impact the yield on or value of those investments.
We invested in private-label MBS until the third quarter of 2007. These investments are backed by prime, subprime, and/or Alt-A hybrid and pay-option adjustable-rate mortgage loans. Many of these investments have sustained and will sustain credit losses under current modeling assumptions, and have been downgraded by various NRSROs. As described under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates, other-than-temporary-impairment assessment is a subjective and complex determination by management. The assumptions we made for our other-than-temporary-impairment assessments of our private-label MBS resulted in projected future credit losses, thereby causing other-than-temporary impairment losses from certain of these securities. We incurred credit losses of $4.1 million for private-label MBS that we determined were other-than-temporarily impaired for the year ended December 31, 2015. If macroeconomic trends or collateral credit performance within our private-label MBS portfolio deteriorate further than currently anticipated, or if foreclosures or similar activity are delayed or impeded, we may use even more stressful assumptions, including, but not limited to, lower house prices, higher loan-default rates, and higher loan-loss severities in future other-than-temporary impairment assessments.
Declines in U.S. home prices or in activity in the U.S. housing market or rising delinquency or default rates on mortgage loans could result in credit losses and adversely impact our business operations and/or financial condition.
A deterioration of the U.S. housing market and national decline in home prices could adversely impact the financial condition of a number of our borrowers, particularly those whose businesses are concentrated in the mortgage industry. One or more of our borrowers may default on their obligations to us for a number of reasons, such as changes in financial condition, a reduction in liquidity, operational failures, or insolvency. In addition, the value of residential mortgage loans pledged to us as collateral may decrease. If a borrower defaults, and we are unable to obtain additional collateral to make up for the reduced value of such residential mortgage loan collateral, we could incur losses. A default by a borrower lacking sufficient collateral to cover its obligations to us could result in significant financial losses, which would adversely impact our results of operations and financial condition. Our top five advances borrowing members by par value of outstanding advances are set forth in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Advances in the table captioned “Top Five Advance-Borrowing Institutions.”
Further, as discussed in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates, our methodology for determining our allowance for loan losses is determined based on our investments in MPF loans and considers factors relevant to those investments. Important factors in determining this allowance are the delinquency rates and trends in the delinquency rates on our investments in conventional mortgage loans. If delinquency or default rates rise for these investments or other factors in determining the allowance worsen, we may determine to increase our allowance for loan losses, which would adversely impact our results of operations and financial condition.
We have geographic concentrations that could adversely impact our business operations and/or financial condition.
We, by nature of our charter and our business operations, are exposed to credit risk resultant from limited geographic diversity. Our advances business is generally limited to operations within our district. While we employ conservative credit rating and collateral practices to limit exposure, a decline in our district's economic conditions could create a credit exposure to our members' advances obligations in excess of collateral held.
We have concentrations of mortgage loans in some geographic areas based on our investments in MPF loans and private-label MBS and on our receipt of collateral pledged for advances. See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Mortgage Loans for additional information on these concentrations. To the extent that any of these geographic areas experience significant declines in the local housing markets, declining economic conditions, or a natural disaster, we could experience increased losses on our investments in the MPF loans or the related MBS or be exposed to a greater risk that the pledged collateral securing related advances would be inadequate in the event of default on such an advance.
Counterparty credit risk could adversely impact us.
We assume counterparty credit risk through our money-market and derivatives transactions. Our counterparties include major domestic and international financial institutions. The insolvency or other inability of a significant counterparty to perform its obligations under such transactions or other agreements could have an adverse impact on our financial condition and results of operations.
OPERATIONAL RISKS
The inability to retain key personnel could adversely impact our operations.
We rely on key personnel for many of our functions and have a relatively small workforce, given the size and complexity of our business. Our ability to retain such personnel is important to our ability to conduct our operations and measure and maintain risk and financial controls. Our ability to retain key personnel could be challenged as the U.S. employment market improves.
We rely heavily upon information systems and other technology and any disruption or failure of such information systems or other technology could adversely impact our reputation, financial condition, and results of operations.
We rely heavily on our information systems and other technology to conduct and manage our business. We take steps to mitigate the risks of such reliance, as discussed under Item 1 - Business - Risk Management - Operational Risk, however failures or interruptions of these information systems or other technology could have a material adverse impact on our financial condition and results of operations. Additionally, most of our information systems have been co-located with a third-party service provider on which we are reliant to provide a secure location and a stable operating environment for these systems. Any failure to provide such stability or security by the third-party service provider could result in failures or interruptions in our ability to conduct business. Further, our AHP, MPF, and certain collateral activities rely on the secure processing, storage, and transmission of a large volume of private borrower information, such as names, residential addresses, social security numbers, credit rating data, and other consumer financial information. This information could be exposed in several ways, including through unauthorized access to our computer systems, computer viruses that attack our computer systems, software or networks, accidental delivery of information to an unauthorized party, and loss of encrypted media containing this information. Any of these events could result in financial losses, legal and regulatory sanctions, and reputational damage.
We rely on third parties for certain important services and could be adversely impacted by disruptions in those services.
For example, in participating in the MPF program, we rely on the FHLBank of Chicago in its capacity as the MPF Provider. Our investments in mortgage loans through the MPF program account for 6.2 percent of our total assets as of December 31, 2015, and 21.0 percent of interest income for the year ended December 31, 2015. If the FHLBank of Chicago changes, or ceases to operate the MPF program or experiences a failure or interruption in its information systems and other technology in its operation of the MPF program, our mortgage-investment business could be adversely impacted, and we could experience a related decrease in net interest margin, financial condition, and profitability. In the same way, we could be adversely impacted if any of the FHLBank of Chicago's third-party vendors engaged in the operation of the MPF program were to experience operational or technological difficulties.
As another example, we rely on the Office of Finance for, among other things, the placement of COs, our primary source of funds. A disruption in this service would disrupt our access to these funds, as also discussed under - Market and Liquidity Risks - Any inability or curtailment of our ability to access the capital markets could adversely impact our business operations, financial condition, and results of operations.
We rely on models for many of our business operations and changes in the assumptions used could have a significant effect on our financial position, results of operations, and assessments of risk exposure.
For example, we use models to assist in our determination of the fair values of financial instruments. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that are actively traded and have quoted market prices or parameters readily available, there is little to no subjectivity in determining fair value. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility or on dealer prices or prices of similar instruments. Pricing models and their underlying changes in assumptions are based on our best estimates for discount rates, prepayments, market volatility, and other factors. These assumptions could have a significant effect on the reported fair values of assets and liabilities, including derivatives, the related income and expense, and the expected future behavior of assets and liabilities. While the models we use to value instruments and measure risk exposures are subject to periodic validation by our staff and by independent parties, rapid changes in market conditions in the interim could impact
our financial position. The use of different models and assumptions, as well as changes in market conditions, could significantly impact our financial condition and results of operations.
We use derivatives to manage our interest-rate risk, however, we could be unable to enter into effective derivative instruments on acceptable terms.
We use derivatives to manage our interest-rate risk. If, due to an absence of creditworthy swap dealers or guarantors, we are unable to manage our hedging positions properly, or we are unable to enter into hedging instruments upon acceptable terms, we could be unable to effectively manage our interest-rate and other risks without altering our business strategies, which could adversely impact our financial condition and results of operations.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We occupy approximately 54,000 rentable square feet in the Prudential Tower, 800 Boylston Street, Boston, Massachusetts 02199 that serves as our headquarters. We also maintain 9,969 square feet of leased property for an off-site back-up facility in Westborough, Massachusetts.
We believe our properties are adequate to meet our requirements for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Private-label MBS Complaint
On April 20, 2011, we filed a complaint (the original complaint) in the Superior Court Department of the Commonwealth of Massachusetts in Suffolk County, against various securities dealers, underwriters, control persons, issuers/depositors, and credit rating agencies based on our investments in certain private-label MBS issued by 115 securitization trusts for which we originally paid approximately $5.8 billion. Since the original complaint was filed, the defendants filed certain notices of removal to remove the case to the United States District Court for the District of Massachusetts. On March 9, 2012, our motion to remand the matter to state court was denied.
On June 29, 2012, we filed an amended complaint (the amended complaint) in the United States District Court for the District of Massachusetts against various securities dealers, underwriters, control persons, issuers/depositors, and credit rating agencies based on our investments in certain private-label MBS issued by 111 securitization trusts for which we originally paid approximately $5.7 billion. The amended complaint asserts, as the original complaint had asserted, claims based on untrue or misleading statements in the sale of securities, signing or circulating securities documents that contained material misrepresentations and omissions, negligent misrepresentation, unfair or deceptive trade practices, fraud by the rating agencies, and controlling person liability. We are seeking various forms of relief including rescission, recovery of damages, recovery of purchase consideration plus interest (less income received to date), and recovery of reasonable attorneys' fees and costs of suit.
On September 30, 2013, the court issued orders granting and denying motions to dismiss filed by the defendants. More specifically, the court:
•
upheld claims based on negligent misrepresentation and unfair or deceptive trade practices against non-rating agency defendants;
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upheld claims based on fraud but dismissed claims based on negligent misrepresentation and unfair or deceptive trade practices against rating agency defendants;
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upheld claims based on the Massachusetts Uniform Securities Act against underwriter and corporate seller defendants, but dismissed such claims against issuer/depositor defendants and control person defendants (with respect to claims that were premised solely on control of an issuer/depositor); and
•
dismissed the claims against DB Structured Products, Inc. that were solely premised on a claim of its successor liability.
On January 28, 2014, Moody's Investors Service, Inc., Moody's Corporation, McGraw Hill Financial, Inc. and Standard & Poor's Financial Services LLC (the credit rating agency defendants) filed renewed motions for reconsideration of their previously denied motions to dismiss the claims against these defendants based on lack of jurisdiction or, alternatively, for
leave to make an immediate appeal. We simultaneously filed a separate motion to sever and transfer the claims against the credit rating agency defendants to the U.S. District Court for the Southern District of New York.
On September 30, 2014, the court dismissed our claims against the credit rating agency defendants, based on a recent Supreme Court case. The court held that the United States District Court for the District of Massachusetts (the Massachusetts District Court) lacks personal jurisdiction over our claims against the credit rating agency defendants and declined to grant our motion to transfer those claims to another federal district court that does have personal jurisdiction. The court certified the ruling for immediate appeal. To preserve our rights with respect to a permissive appeal, on October 10, 2014, we sought permission from the United States Court of Appeals for the First Circuit to appeal. Later that same month, we filed a notice of appeal to preserve our right to appeal under a separate grant of appellate jurisdiction. Oral argument on the Bank’s appeal against Moody’s was completed on February 1, 2016, and we await a ruling.
On October 14, 2014, we also entered into tolling agreements with the credit rating agency defendants regarding the claims we had asserted against them in the Massachusetts District Court. Those agreements toll the statute of limitations for purposes of our filing a possible new action in a different jurisdiction, which we may determine is appropriate as to Moody’s if our appeal is not successful.
In addition to our appeal with respect to the dismissal of our claims against Moody’s, we continue to pursue claims in this litigation against the following and/or their affiliates and subsidiaries and/or entities under their control or controlled by affiliates or subsidiaries thereof: Barclays Capital Inc.; Credit Suisse (USA), Inc.; Morgan Stanley; Nomura Holding America, Inc.; RBS Holdings USA Inc.; and UBS Americas Inc.
During the year ended December 31, 2015, we agreed with certain defendants in our private-label MBS litigation to settle our claims against them for an aggregate amount of $184.9 million (which amount is net of legal fees and expenses).
Class Action Complaint
On May 8, 2015, we voluntarily dismissed a class action complaint we had filed against EMC Mortgage Corporation and Bear, Stearns & Co., Inc. now known as J.P. Morgan Securities, LLC, based on claims we made arising from our investment in certain private-label MBS trusts.
Other Legal Proceedings
From time to time, we are subject to various pending legal proceedings arising in the normal course of business. After consultation with legal counsel, we do not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on our financial condition or results of operations.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The par value of our capital stock is $100 per share. Our stock is not publicly traded and can be purchased only by our members at par. As of February 29, 2016, 445 members and 5 nonmembers held a total of 24.3 million shares of our Class B stock. Our capital plan provides us with the authority to issue Class A capital stock, $100 par value per share (Class A stock). However, we have not issued and do not intend to issue Class A stock at this time.
Dividends are solely within the discretion of our board of directors. The board of directors declared dividends during 2015, 2014, and 2013 as set forth in the below table. Dividend rates are quoted in the form of an interest rate, which is then applied to each stockholder's average capital-stock-balance outstanding during the preceding calendar quarter to determine the dollar amount of the dividend that each stockholder will receive. The dividend rate was based upon a spread to average short-term interest rates experienced during the quarter.
_________________________
(1)
Average capital stock amounts do not include average balances of mandatorily redeemable stock.
(2)
The dividend amounts do not include the interest expense on mandatorily redeemable stock.
On February 18, 2016, our board of directors declared a cash dividend that was equivalent to an annual yield of 3.42 percent, the approximate daily average three-month LIBOR for the fourth quarter of 2015 plus 300 basis points. The dividend amount, based on average daily balances of Class B shares outstanding for the fourth quarter of 2015 totaled $19.5 million and was paid on March 2, 2016. In declaring the dividend, the board stated that it expects to follow this formula for declaring cash dividends through 2016, though a quarterly loss or a significant adverse event or trend would cause a dividend to be reduced or suspended.
Dividends are declared and paid in accordance with a schedule adopted by the board of directors that enables our board of directors to declare each quarterly dividend after net income is known, rather than basing the dividend on estimated net income. For example, in 2015, quarterly dividends were declared in February, April, July, and October based on the immediately preceding quarter's net income and were paid on the second business day of the month that followed the month of declaration. We expect to continue this approach through 2016.
Dividends may be paid only from current net earnings or previously retained earnings. In accordance with the FHLBank Act and FHFA regulations, we may not declare a dividend if we are not in compliance with our minimum capital requirements or if we would fall below our minimum capital requirements or would not be adequately capitalized as a result of a dividend except, in this latter case, with the Director of the FHFA's permission. Further, we may not pay dividends if the principal and interest due on any CO issued through the Office of Finance on which we are the primary obligor has not been paid in full, or under certain circumstances, if we become a noncomplying FHLBank as that term is defined in FHFA regulations as a result of any inability to either comply with regulatory liquidity requirements or satisfy our current obligations.
We maintain a policy providing that when our minimum retained earnings target exceeds the level of our retained earnings, the quarterly dividend payout cannot exceed 40 percent of our earnings for the quarter. Our minimum retained earnings target was $700.0 million as of December 31, 2015, compared with $1.1 billion in retained earnings at December 31, 2015.
We may not pay dividends in the form of capital stock or issue new excess stock to members if our excess stock exceeds 1.0 percent of our total assets or if the issuance of excess stock would cause our excess stock to exceed 1.0 percent of our total assets. At December 31, 2015, we had excess stock outstanding totaling $158.9 million or 0.3 percent of our total assets.
Should we determine to issue Class A stock, dividends declared on Class A stock may differ from dividends declared on Class B stock but may not exceed dividends declared on Class B stock.
We maintain a policy establishing a minimum capital level in excess of regulatory requirements to provide further protection for our capital base. This adopted minimum capital level provides that we will maintain a minimum capital level equal to 4.0 percent of total assets plus an amount we measure as our risk exposure with 99 percent confidence using our economic capital model, an amount equal to $2.9 billion at December 31, 2015. Our permanent capital level was $3.5 billion at December 31, 2015, so we were in excess of this requirement by $617.1 million on that date. If necessary to satisfy this adopted minimum capital level, however, we will take steps to control asset growth and/or maintain capital levels, the latter of which may limit future dividends.
Our capital plan and the Joint Capital Agreement require us to allocate 20 percent of our net income to a separate restricted retained earnings account. The Joint Capital Agreement requires each FHLBank to make such contributions until the total amount in the restricted retained earnings account is at least equal to 1.0 percent of the daily average carrying value of that FHLBank's outstanding total COs (excluding fair-value adjustments) for the calendar quarter. Amounts in the restricted retained earnings account cannot be used to pay dividends. As of December 31, 2015, $194.6 million of our retained earnings are amounts in the restricted retained earnings account compared with our total contribution requirement of $530.1 million at that date. For additional information on the Joint Capital Agreement, see Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Internal Capital Practices and Policies - Restricted Retained Earnings and the Joint Capital Agreement.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
We derived the selected results of operations for the years ended December 31, 2015, 2014, and 2013, and the selected statement of condition data as of December 31, 2015 and 2014, from financial statements included elsewhere herein. We derived the selected results of operations for the years ended December 31, 2012 and 2011, and the selected statement of condition data as of December 31, 2013, 2012, and 2011, from financial statements not included herein. This selected financial data should be read in conjunction with the financial statements and the related notes appearing in this report.
_______________________
(1)
Investments include available-for-sale securities, held-to-maturity securities, trading securities, interest-bearing deposits, securities purchased under agreements to resell and federal funds sold.
(2)
The allowance for credit losses amounted to $1.0 million, $2.0 million, $2.2 million, $4.4 million, and $7.8 million for the years ended December 31, 2015, 2014, 2013, 2012, and 2011, respectively.
(3)
Capital stock is putable at the option of a member, subject to applicable restrictions.
(4)
Prior to the satisfaction of the FHLBanks' REFCorp obligation in the second quarter of 2011, each FHLBank was required to pay to REFCorp 20 percent of net income calculated in accordance with GAAP after the assessment for the AHP, but before the assessment for the REFCorp until the total amount of payments actually made was equivalent to a $300 million annual annuity whose final maturity date was April 15, 2030. The FHFA shortened or lengthened the period during which the FHLBanks made payments to REFCorp based on actual payments made relative to the referenced annuity.
(5)
Weighted-average dividend rate is the dividend amount declared divided by the average daily balance of capital stock eligible for dividends. See Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities for additional information.
(6)
Return on average equity is net income divided by the total of the average daily balance of outstanding Class B capital stock, accumulated other comprehensive loss and total retained earnings.
(7)
Net interest margin is net interest income before provision for credit losses as a percentage of average earning assets.
(8)
Total regulatory capital ratio is capital stock (including mandatorily redeemable capital stock) plus total retained earnings as a percentage of total assets. See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 15 - Capital.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
This report includes statements describing anticipated developments, projections, estimates, or future predictions of ours that are “forward-looking statements.” These statements may use forward-looking terminology such as, but not limited to, “anticipates,” “believes,” “expects,” “plans,” “intends,” “may,” “could,” “estimates,” “assumes,” “should,” “will,” “likely,” or their negatives or other variations on these terms. We caution that, by their nature, forward-looking statements are subject to a number of risks or uncertainties, including the risk factors set forth in Item 1A - Risk Factors and the risks set forth below. Accordingly, we caution that actual results could differ materially from those expressed or implied in these forward-looking statements or could impact the extent to which a particular objective, projection, estimate, or prediction is realized. As a result, you are cautioned not to place undue reliance on such statements. We do not undertake to update any forward-looking statement herein or that may be made from time to time on our behalf.
Forward-looking statements in this report may include, among others, our expectations for:
•
income, retained earnings, and dividend payouts;
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repurchases of stock in excess of a shareholder’s total stock investment requirement (excess stock);
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credit losses on advances and investments in mortgage loans and ABS, particularly private-label MBS;
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balance-sheet changes and components thereof, such as changes in advances balances and the size of our portfolio of investments in mortgage loans;
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our minimum retained earnings target; and
•
the interest-rate environment in which we do business.
Actual results may differ from forward-looking statements for many reasons, including, but not limited to:
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changes in interest rates, the rate of inflation (or deflation), housing prices, employment rates, and the general economy, including changes resulting from changes in U.S. fiscal policy or ratings of the U.S. federal government;
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changes in demand for our advances and other products;
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the willingness of our members to do business with us;
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changes in the financial health of our members;
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changes in borrower defaults on mortgage loans;
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changes in the credit performance and loss severities of our investments;
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changes in prepayment rates on advances and investments;
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the value of collateral we hold as security for obligations of our members and counterparties;
•
issues and events across the FHLBank System and in the political arena that may lead to legislative, regulatory, judicial, or other developments impacting demand for COs, our financial obligations with respect to COs, our ability to access the capital markets, our members, the manner in which we operate, or the organization and structure of the FHLBank System;
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competitive forces including, without limitation, other sources of funding available to our members, other entities borrowing funds in the capital markets, and our ability to attract and retain skilled employees;
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the pace of technological change and our ability to develop and support technology and information systems sufficient to manage the risks of our business effectively;
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the loss of members due to, among other ways, member withdrawals, mergers and acquisitions;
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changes in investor demand for COs;
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changes in the terms or availability of derivatives and other agreements we enter into in support of our business operations;
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the timing and volume of market activity;
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the volatility of reported results due to changes in the fair value of certain assets and liabilities, including, but not limited to, private-label MBS;
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our ability to introduce new (or adequately adapt current) products and services and successfully manage the risks associated with our products and services, including new types of collateral used to secure advances;
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losses arising from litigation filed against us or one or more of the other FHLBanks;
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gains resulting from legal claims we have;
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losses arising from our joint and several liability on COs;
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significant business disruptions resulting from vendor or third-party failure, natural or other disasters, cyberincidents, acts of war, or terrorism; and
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new accounting standards.
These risk factors are not exhaustive. New risk factors emerge from time to time. We cannot predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those implied by any forward-looking statements.
EXECUTIVE SUMMARY
We had a strong year in 2015. Our net income increased to $289.3 million for the year ended December 31, 2015, from $149.8 million for the year ended December 31, 2014, the highest annual net income in the Bank's history, largely due to $184.9 million in litigation settlement income related to private-label MBS for the year. In addition, advances balances grew as discussed below. Our financial condition continued to strengthen with retained earnings growing to $1.1 billion at December 31, 2015, from $901.7 million at December 31, 2014, a surplus of $428.8 million over our minimum retained earnings target, as we continue to satisfy all regulatory capital requirements as of December 31, 2015. We also provided a dividend spread of 300 basis points over the daily average three-month LIBOR. Our return on average equity was 9.54 percent for the year ended December 31, 2015, compared with 5.24 percent for the year ended December 31, 2014, an increase of 430 basis points.
Net Interest Margin
In 2015, net interest margin was flat relative to the year ended December 31, 2014, at 0.41 percent. We view this as a favorable outcome in the face of the continuing very low interest-rate environment discussed under - Economic Conditions - Interest-Rate Environment.
Advances Balances
We continue to deliver on our primary mission, supplying liquidity to our members, with advances balances growing to $36.1 billion at December 31, 2015, from $33.5 billion at December 31, 2014. The increase in advances was broadly based, with long-term advances as the most significant contributor. We cannot predict whether this trend will continue.
Investments in Private-Label MBS
The amortized cost of our total investments in private-label MBS and ABS backed by home-equity loans has declined to $1.2 billion at December 31, 2015, compared with $6.4 billion at its peak in September 30, 2007, and other-than-temporary impairment credit losses recognized in recent periods have dropped significantly from those earlier periods.
For the years ended December 31, 2015 and 2014, we recognized $38.8 million and $36.0 million, respectively, in interest income resulting from the increased accretable yields of certain private-label MBS for which we had previously recognized credit losses. For a discussion of this accounting treatment, see Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 1 - Summary of Significant Accounting Policies - Investment Securities - Other-than-Temporary Impairment - Interest Income Recognition.
Excess Stock Management Program
On July 24, 2015, our board of directors authorized management to implement an excess stock management program, under which we may repurchase excess stock to maintain aggregate excess stock within a targeted range between zero and $200 million. Repurchases of excess stock have led to reductions in our capital levels, including reductions to mandatorily redeemable capital stock from $298.6 million at December 31, 2014, to $42.0 million at December 31, 2015. Dividend payments on mandatorily redeemable capital stock are classified as interest expense, so the repurchase of this stock should lead to a reduction in interest expense, all other things being equal. For the year ended December 31, 2015, interest expense on mandatorily redeemable capital stock amounted to $1.6 million compared with $8.8 million for the year ended December 31, 2014.
Regulatory Developments
The FHFA and other regulators with authority over us or our way of doing business have issued or proposed multiple regulations during the year and into 2016, as described in - Legislative and Regulatory Developments. Such developments affect the way we conduct business and could impact the way we satisfy our mission as well as the value of our membership.
ECONOMIC CONDITIONS
Economic Environment
The U.S. economy in 2015 proved resilient. Against the backdrop of a historically severe winter and economic instability overseas, the U.S. economy continued to expand.
The labor market continued to improve, with nonfarm payroll growth averaging over 200,000 per month for the year. At five percent in December, the unemployment rate declined 0.6 percentage point since December 2014. Alternative broader gauges of unemployment also showed steady improvement. All six of the New England states continued to see unemployment rates decline between December 2014 and 2015. Over this period, the region’s unemployment rate dropped 0.7 percentage points and in December 2015 was 4.7 percent.
The gradual recovery in the housing market continued in 2015. The FHFA reported that house prices were up 5.8 percent in December 2015 compared to a year prior. Annual house price changes were positive for all nine census regions, reflecting a broad housing market recovery across the U.S. The housing market provided a significant boost to the New England economy in 2015, with rising prices and construction activity.
The U.S. and New England economies appear likely to continue to grow at a modest pace. Even though equity prices have been volatile and overseas risks appear to have heightened in early 2016, continued job gains, lower energy prices, and rising house prices look likely to support consumer spending and economic growth in 2016.
Interest-Rate Environment
Since 2010 and continuing into 2016, we generally have been operating in a historically low interest-rate environment, which has adversely impacted our results of operations.
We note that on March 16, 2016, despite having increased the targeted federal funds rate for the first time since 2006 at its December 2015 meeting, the Federal Open Market Committee (the FOMC) issued a press release providing that in light of ongoing global risks and continued low price inflation, a more accommodative stance of monetary policy remains appropriate. The statement noted that the FOMC expects economic conditions that will warrant only gradual increases in the federal funds rate.
The interest-rate environment adversely impacts our results of operations. Interest rates continue to hover close to record low levels, compressing the yields and margins that we can earn on our liquidity investments and short-term advances because our funding costs essentially have a floor of zero percent. Moreover, spreads on high-quality, interest-bearing assets in which we invest remain low relative to the yields at which we can issue comparable term debt.
The following chart illustrates the interest-rate environment.
The federal funds target rate has remained constant at zero to 0.25 percent during the time periods from the fourth quarter 2014 through the third quarter 2015. On December 17, 2015, the FOMC had raised the target range for the federal funds rate by 25 basis points, to 0.25 to 0.50 percent.
RESULTS OF OPERATIONS
Comparison of the year ended December 31, 2015, versus the year ended December 31, 2014
Net income increased to $289.3 million for the year ended December 31, 2015, from $149.8 million for the year ended December 31, 2014. The reasons for the increase are discussed under - Executive Summary.
Net Interest Income
Net interest income after provision for credit losses for the year ending December 31, 2015, was $226.0 million, compared with $213.2 million for 2014. The $12.8 million increase in net interest income after provision for credit losses was attributable to a $3.5 billion increase in average earning assets, from $51.7 billion for 2014, to $55.2 billion for 2015. The increase in average earning assets was driven by a $2.3 billion increase in average advances balances and a $1.0 billion increase in average investments balances. For additional information see - Rate and Volume Analysis. Additional increases to net interest income included a $7.2 million reduction of interest expense on mandatorily redeemable capital stock and a $2.8 million increase in accretion of discount on securities that were other-than-temporarily impaired in prior periods, but for which a significant improvement in projected cash flows has subsequently been recognized. Offsetting these increases was a $2.2 million decrease in net prepayment fees from investments and advances from $10.5 million in the year ending December 31, 2014, to $8.3 million in the year ending December 31, 2015.
Net interest spread was 0.37 percent for the year ended December 31, 2015, a one basis point increase from 2014, and net interest margin was 0.41 percent, unchanged from 2014. The increase in net interest spread reflects a two basis point decrease in the average yield on earning assets and a three basis point decrease in the average yield on interest-bearing liabilities.
The following table presents major categories of average balances, related interest income/expense, and average yields for interest-earning assets and interest-bearing liabilities. Our primary source of earnings is net interest income, which is the interest earned on advances, mortgage loans, and investments less interest paid on COs, deposits, and other sources of funds.
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(1)
The average balances of held-to-maturity securities and available-for-sale securities are reflected at amortized cost; therefore the resulting yields do not give effect to changes in fair value or the noncredit component of a previously recognized other-than-temporary impairment reflected in accumulated other comprehensive loss.
Rate and Volume Analysis
Changes in both average balances (volume) and interest rates influence changes in net interest income and net interest margin. The following table summarizes changes in interest income and interest expense for the years ended December 31, 2015 and 2014. Changes in interest income and interest expense that are not identifiable as either volume-related or rate-related, but 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.
Average Balance of Advances Outstanding
The average balance of total advances increased $2.3 billion, or 7.7 percent, for the year ended December 31, 2015, compared with the same period in 2014. We experienced a broadly based rise in advances balances during the year with long-term advances as the most significant contributor. We cannot predict whether this trend will continue. The following table summarizes average balances of advances outstanding during the years ended December 31, 2015, 2014, and 2013 by product type.
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(1)
Includes floating-rate advances that may be contractually prepaid by the borrower on a floating-rate reset date without incurring prepayment or termination fees.
In addition, the average balance of fixed-rate advances that were hedged with interest-rate swaps to yield an effective floating rate totaled $6.2 billion for the year ended December 31, 2015. Therefore, a significant portion of our advances, including overnight advances, short-term fixed-rate advances, fixed-rate putable advances, certain fixed-rate bullet advances, and variable-rate advances, either earn a short-term interest rate or are swapped to a short-term index, resulting in yields that closely follow short-term market interest-rate trends. The average balance of all such advances totaled $22.3 billion for the year ended December 31, 2015, representing 69.0 percent of the total average balance of advances outstanding during the year ended December 31, 2015. The average balance of all such advances totaled $20.1 billion for the year ended December 31, 2014, representing 66.9 percent of the total average balance of advances outstanding during the year ended December 31, 2014.
For the years ended December 31, 2015 and 2014, net prepayment fees on advances and investments were $8.3 million and $10.5 million, respectively. Prepayment-fee income is unpredictable and inconsistent from period to period, occurring only when advances and investments are prepaid prior to the scheduled maturity or repricing dates, and generally when prevailing reinvestment yields are lower than those of the prepaid advances.
Average Balance of Investments
Average short-term money-market investments, consisting of interest-bearing deposits, securities purchased under agreements to resell, and federal funds sold, increased $591.4 million, or 6.2 percent, for the year ended December 31, 2015, compared with the same period in 2014. The yield earned on short-term money-market investments is highly correlated to short-term market interest rates. These investments are used for liquidity management and to manage our leverage ratio in response to fluctuations in other asset balances. We have increased these investments principally in response to growth in our advances balances to maintain the level of our contingency liquidity. For the year ended December 31, 2015, average balances of federal funds sold increased $790.4 million and average balances of securities purchased under agreements to resell decreased $224.0 million in comparison to the year ended December 31, 2014.
Average investment-securities balances increased $450.9 million, or 5.2 percent for the year ended December 31, 2015, compared with the same period in 2014, an increase consisting primarily of a $581.3 million increase in MBS offset by a $124.9 million decline in agency and supranational institutions' debentures.
Average Balance of COs
Average CO balances increased $4.1 billion, or 8.7 percent, for the year ended December 31, 2015, compared with the same period in 2014, resulting from our increased funding needs principally due to the increase in our average advances balances and short-term money-market investment balances. This overall increase consisted of an increase of $2.5 billion in CO discount notes and an increase of $1.6 billion in CO bonds.
The average balance of CO discount notes represented approximately 49.2 percent of total average COs during the year ended December 31, 2015, compared with 48.1 percent of total average COs during the year ended December 31, 2014. The average balance of CO bonds represented 50.8 percent and 51.9 percent of total average COs outstanding during the years ended December 31, 2015 and 2014, respectively. The proportional growth in average CO discount notes was slightly higher than our short-term asset growth.
Impact of Derivatives and Hedging Activities
Net interest income includes interest accrued on interest-rate-exchange agreements that are associated with advances, investments, deposits, and debt instruments that qualify for hedge accounting. We generally use derivative instruments that qualify for hedge accounting as interest rate risk-management tools. These derivatives serve to stabilize net interest income and net interest margin when interest rates fluctuate. Accordingly, the impact of derivatives on net interest income and net interest margin should be viewed in the overall context of our risk-management strategy. The following tables show the net effect of derivatives and hedging activities on net interest income, net gains (losses) on derivatives and hedging activities, and net unrealized gains (losses) on trading securities for the years ended December 31, 2015, 2014, and 2013 (dollars in thousands).
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(1)
Represents the amortization/accretion of hedging fair-value adjustments and cash-flow hedge amortization reclassified from accumulated other comprehensive loss.
(2)
Represents interest income/expense on derivatives included in net interest income.
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(1)
Represents the amortization/accretion of hedging fair-value adjustments.
(2)
Represents interest income/expense on derivatives included in net interest income.
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(1)
Represents the amortization/accretion of hedging fair-value adjustments.
(2)
Represents interest income/expense on derivatives included in net interest income.
Net interest margin was 0.41 percent for both the years ended December 31, 2015 and 2014. If derivatives had not been used as hedges to mitigate the impact of interest-rate fluctuations, net interest margin would have been 0.60 percent and 0.63 percent, respectively.
Interest paid and received on interest-rate-exchange agreements that are economic hedges is classified as net losses on derivatives and hedging activities in other income. As shown under - Other Income (Loss) below, interest accruals on derivatives classified as economic hedges totaled a net expense of $6.9 million for each of the years ended December 31, 2015 and 2014.
Other Income (Loss)
The following table presents a summary of other income (loss) for the years ended December 31, 2015, 2014, and 2013. Additionally, detail on the components of net gains (losses) on derivatives and hedging activities is provided, indicating the source of these gains and losses by type of hedging relationship and hedge accounting treatment.
Litigation settlement income has had a dominant impact on Other Income (Loss) during the periods represented above, and is expected to decline in future years after the remainder of our claims are either settled or resolved through litigation. Apart from litigation settlement income, as evident in the Other Income (Loss) table above, accounting for derivatives and hedged items results in the potential for considerable timing differences between income recognition from assets or liabilities and income effects of hedging instruments entered into to mitigate interest-rate risk and cash-flow activity.
Changes in the fair value of trading securities are recorded in other income (loss). For the years ended December 31, 2015 and 2014, we recorded net unrealized losses on trading securities of $4.9 million and unrealized gains of $972,000, respectively. Changes in the fair value of the associated economic hedges amounted to net gains of $2.7 million and $836,000 for the years ended December 31, 2015 and 2014, respectively. In addition to the changes in fair value are interest accruals on these economic hedges, which resulted in net expenses of $7.0 million and $7.1 million for the years ended December 31, 2015 and 2014, respectively, and are included in other income (loss).
Operating Expenses
For the year ended December 31, 2015, compensation and benefits expense and other operating expenses totaled $67.0 million, representing an increase of $9.5 million from the total of $57.5 million for the year ended December 31, 2014. The increase was primarily driven by a $9.4 million increase in compensation and benefits expense which was the result of a voluntary contribution to the Pentegra Defined Benefit Plan and increases to our incentive compensation awards.
Comparison of the year ended December 31, 2014, versus the year ended December 31, 2013
Net income decreased to $149.8 million at December 31, 2014, from $212.3 million at December 31, 2013. A significant component of the decline was the difference in litigation settlements year-over-year. Our return on average equity was 5.24 percent at December 31, 2014, compared with 7.40 percent at December 31, 2013, a decline of 216 basis points, of which 110 basis points is attributable to the decline in litigation settlements. Compression in net interest margin led to the year-over-year decline in our net interest income, the other significant component of the decline in net income, although the decline in net interest income reflected a return to net interest spreads and margins that were closer to long-term historical norms.
Net Interest Income
Net interest income for the year ended December 31, 2014, decreased $42.6 million from $255.9 million in 2013 to $213.3 million in 2014. Contributing to the decrease in net interest income was a decrease in net prepayment fees of $19.2 million, as well as a narrowing of the spread between interest earned on assets and interest paid on liabilities. Partially offsetting these decreases to net interest income was an increase in interest income resulting from an increase in average earning assets of $12.4 billion from $39.3 billion for 2013, to $51.7 billion for 2014. The increase in average earning assets was driven by an increase of $8.4 billion in average advances and an increase of $4.1 billion in average investment balances. Additionally, $36.0 million of our interest income for the year ended December 31, 2014, was from the accretion of discount on securities that were other-than-temporarily impaired in prior periods, but for which a significant improvement in projected cash flows has subsequently been recognized. This represents an increase of $16.3 million from $19.7 million of accretion recorded in 2013.
In 2014, we experienced compression in net interest margin. Net interest margin fell to 0.41 percent for the year ended December 31, 2014, from 0.65 percent for the year ended December 31, 2013. The compression resulted from the run-off of higher-yielding long-term advances, investments and mortgage loans, a reduction in prepayment fee income, and the increase in our dividends paid on mandatorily-redeemable capital stock, which are classified as interest expense.
The average balance of fixed-rate advances that were hedged with interest-rate swaps to yield an effective floating rate totaled $4.4 billion for the year ended December 31, 2014. Therefore, a significant portion of our advances, including overnight advances, short-term fixed-rate advances, fixed-rate putable advances, certain fixed-rate bullet advances, and variable-rate advances, either earn a short-term interest rate or are swapped to a short-term index, resulting in yields that closely follow short-term market interest-rate trends. The average balance of all such advances totaled $20.1 billion for the year ended December 31, 2014, representing 66.9 percent of the total average balance of advances outstanding during the year ended December 31, 2014. The average balance of all such advances totaled $12.2 billion for the year ended December 31, 2013, representing 56.7 percent of the total average balance of advances outstanding during the year ended December 31, 2013.
For the years ended December 31, 2014 and 2013, net prepayment fees on advances and investments were $10.5 million and $29.7 million, respectively.
Average short-term money-market investments, consisting of interest-bearing deposits, securities purchased under agreements to resell, and federal funds sold, increased $5.1 billion, or 111.1 percent, for the year ended December 31, 2014, compared with the same period in 2013. For the year ended December 31, 2014, average balances of securities purchased under agreements to resell increased $2.2 billion and average balances of federal funds sold increased $2.8 billion in comparison to the year ended December 31, 2013.
Average investment-securities balances decreased $982.1 million, or 10.2 percent for the year ended December 31, 2014, compared with the same period in 2013, a decrease consisting primarily of a $1.3 billion decline in agency and supranational institutions' debentures offset by a $320.9 million increase in MBS.
Average CO balances increased $12.9 billion, or 37.8 percent, for the year ended December 31, 2014, compared with the same period in 2013, resulting from our increased funding needs principally due to the increase in our average advances balances and short-term money-market investment balances. This overall increase consisted of an increase of $13.6 billion in CO discount notes and a decrease of $652.9 million in CO bonds.
The average balance of CO discount notes represented approximately 48.1 percent of total average COs during the year ended December 31, 2014, as compared with 26.6 percent of total average COs during the year ended December 31, 2013. The average balance of CO bonds represented 51.9 percent and 73.4 percent of total average COs outstanding during the years ended December 31, 2014 and 2013, respectively.
Impact of Derivatives and Hedging Activities
Net interest margin for the years ended December 31, 2014 and 2013, was 0.41 percent and 0.65 percent, respectively. If derivatives had not been used as hedges to mitigate the impact of interest-rate fluctuations, net interest margin would have been 0.63 percent and 0.96 percent, respectively.
Other Income (Loss) and Operating Expenses
For the years ended December 31, 2014 and 2013, we recorded net unrealized gains on trading securities of $972,000 and unrealized losses of $13.2 million, respectively. Changes in the fair value of the associated economic hedges amounted to net gains of $836,000 and $13.9 million for the years ended December 31, 2014 and 2013, respectively. In addition to the changes
in fair value are interest accruals on these economic hedges, which resulted in a net expense of $7.1 million and $7.3 million for the years ended December 31, 2014 and 2013, respectively.
For the year ended December 31, 2014, compensation and benefits expense and other operating expenses totaled $57.5 million, representing an increase of $1.3 million from the total of $56.2 million for the year ended December 31, 2013.
FINANCIAL CONDITION
Advances
At December 31, 2015, the advances portfolio totaled $36.1 billion, an increase of $2.6 billion compared with $33.5 billion at December 31, 2014.
The following table summarizes advances outstanding by product type at December 31, 2015 and 2014.
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(1)
Includes floating-rate advances that may be contractually prepaid by the borrower on a floating-rate reset date without incurring prepayment or termination fees.
See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 8 - Advances for disclosures relating to redemption terms of the advances portfolio.
Advances Credit Risk
We endeavor to minimize credit risk on advances by monitoring the financial condition of our borrowers and by holding sufficient collateral to protect the Bank from credit losses. All pledged collateral is subject to haircuts assigned based on our opinion of the risk that such collateral presents. We are prohibited by Section 10(a) of the FHLBank Act from making advances without sufficient collateral to secure the advance. We have never experienced a credit loss on an advance.
We monitor the financial condition of all members and housing associates by reviewing available financial data, such as regulatory call reports filed by depository institution members, regulatory financial statements filed with the appropriate state insurance department by insurance company members, audited financial statements of housing associates, SEC filings, and rating-agency reports to ensure that potentially troubled members are identified as soon as possible. In addition, we have access to most members' regulatory examination reports. We analyze this information on a regular basis.
Our members continue to be challenged by economic conditions, although improvements continue. Aggregate nonperforming assets for depository institution members declined from 0.50 percent of assets as of December 31, 2014, to 0.46 percent of assets as of September 30, 2015. The aggregate ratio of tangible capital to assets among the membership increased from 9.44 percent of assets as of December 31, 2014, to 9.75 percent as of September 30, 2015. (September 30, 2015, is the date of our most recent data on our membership for this report.). There were no member failures during 2015. All of our extensions of credit to members are secured by eligible collateral as noted herein. However we could incur losses if a member were to default, if the value of the collateral pledged by the member declined to a point such that we were unable to realize sufficient value from the pledged collateral to cover the member's obligations, and we were unable to obtain additional collateral to make up for the reduction in value of such collateral. Although not expected, a default by a member with significant obligations to us could result in significant financial losses, which would adversely impact our results of operations and financial condition.
We assign each non-insurance company borrower to one of the following three credit status categories based primarily on our assessment of the borrower's overall financial condition and other factors:
•
Category-1: members that are generally in satisfactory financial condition;
•
Category-2: members that show weakening financial trends in key financial indices and/or regulatory findings; and
•
Category-3: members with financial weaknesses that present an elevated level of concern. We also place housing associates and non-member borrowers in Category-3.
We monitor the financial condition of our insurance company members quarterly. We lend to them based on our assessment of their financial condition and their pledge of sufficient amounts of eligible collateral.
Each credit status category reflects our increasing level of control over the collateral pledged by the borrower as its financial condition weakens. Category-1 borrowers retain possession of all mortgage loan collateral pledged to us, provided the borrower executes a written security agreement and agrees to hold such collateral for our benefit. Category-1 borrowers must specifically list with us all mortgage loan collateral other than loans secured by first-mortgage loans on owner-occupied one- to four-family residential property. Category-2 borrowers retain possession of eligible mortgage loan collateral, however, we require such borrowers to specifically list all mortgage loan collateral pledged to us. Category-3 borrowers are required to place physical possession of all pledged eligible collateral with us or an approved safekeeping agent, with which we have a control agreement. All securities pledged to us by our borrowers must be delivered to us, an approved safekeeping agent, or be held by the borrower's securities corporation in a custodial account with us. We have control agreements with approved safekeeping agents which are intended to give us appropriate control over the related collateral.
Our agreements with our borrowers require each borrower to have sufficient eligible collateral pledged to us to fully secure all outstanding extensions of credit, including advances, accrued interest receivable, standby letters of credit, MPF credit-enhancement obligations, and lines of credit (collectively, extensions of credit) at all times. We generally accept the following types of assets as collateral:
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fully disbursed, first-mortgage loans on improved residential property (provided that the borrower is not in arrears by two or more payments), or securities representing a whole interest in such mortgages;
•
securities issued, insured, or guaranteed by the U.S. government or any agency thereof (including without limitation, MBS issued or guaranteed by Freddie Mac, Fannie Mae, and Ginnie Mae);
•
cash or deposits in a collateral account with us; and
•
other real-estate-related collateral acceptable to us if such collateral has a readily ascertainable value and we can perfect our security interest in the collateral.
In addition, in the case of any community financial institution, as defined in accordance with the FHLBank Act, we may accept as collateral secured loans for small business and agriculture, or securities representing a whole interest in such secured loans.
To mitigate the credit risk, market risk, liquidity risk, and operational risk associated with collateral, we discount the book value or market value of pledged collateral to establish the lending value of the collateral to us. Collateral that we have determined to contain a low level of risk, such as U.S. government obligations, is discounted at a lower rate than collateral that carries a higher level of risk, such as commercial real estate mortgage loans. We periodically analyze the discounts applied to all eligible collateral types to verify that current discounts are sufficient to fully secure us against losses in the event of a borrower default. Our agreements with our members and borrowers grant us authority, in our sole discretion, to adjust the discounts applied to
collateral at any time based on our assessment of the member's financial condition, the quality of collateral pledged, or the overall volatility of the value of the collateral.
We generally require our members and housing associates to execute a security agreement that grants us a blanket lien on all assets of such borrower that consist of, among other types of collateral: fully disbursed whole first-mortgage loans and deeds of trust constituting first liens against real property; U.S. federal, state, and municipal obligations; GSE securities; corporate debt obligations; commercial paper; funds placed in deposit accounts with us; COs, such other items or property that are offered to us by the borrower as collateral; and all proceeds of all of the foregoing. In the case of insurance companies and housing associates, in some instances we establish a specific lien instead of a blanket lien subject to our receipt of additional safeguards from such members including larger haircuts on collateral. We protect our security interest in pledged assets by filing a Uniform Commercial Code (UCC) financing statement in the appropriate jurisdiction. Our employees conduct on-site reviews of collateral pledged by borrowers to confirm the existence of the pledged collateral and to determine that the pledged collateral conforms to our eligibility requirements. We may conduct an onsite collateral review at any time.
Our agreements with borrowers allow us, in our sole discretion, to refuse to make extensions of credit against any collateral, require substitution of collateral, or adjust the discounts applied to collateral at any time. We also may require members to pledge additional collateral regardless of whether the collateral would be eligible to originate a new extension of credit. Our agreements with our borrowers also afford us the right, in our sole discretion, to declare any borrower to be in default if we deem ourselves to be insecure.
Beyond our practice of taking security interests in collateral, Section 10(e) of the FHLBank Act affords any security interest granted by a federally insured depository institution member or such a member's affiliate to us priority over the claims or rights of any other party, including any receiver, conservator, trustee, or similar entity that has the rights of a lien creditor, unless these claims and rights would be entitled to priority under otherwise applicable law and are held by actual purchasers or by parties that are secured by actual perfected security interests. In this regard, the priority granted to our security interests under Section 10(e) may not apply when lending to insurance company members due to the anti-preemption provision contained in the McCarran-Ferguson Act in which Congress declared that federal law would not preempt state insurance law unless the federal law expressly regulates the business of insurance. Thus, if state law conflicts with Section 10(e) of the FHLBank Act, the protection afforded by this provision may not be available to us. However, we protect our security interests in the collateral pledged by our borrowers, including insurance company members, by filing UCC financing statements, or by taking possession or control of such collateral, or by taking other appropriate steps. We have not experienced any rehabilitation, conservatorship, receivership, liquidation or other insolvency event for an insurance company member and therefore have continuing uncertainty on the potential inapplicability of Section 10(e). Additionally, we note that the relevant state insolvency authority could take actions that could impede our ability to sell collateral that any such insolvent member has pledged to us.
The following table shows the asset quality of the one- to four-family mortgage loan portfolios held on the balance sheets of our borrowers. One- to four-family mortgage loans constitute the largest asset type pledged as collateral to us. Note that these figures include all one- to four-family mortgage loans on depository borrowers' balance sheets. The figures in this table include loans that are not pledged as collateral to us. Qualified collateral does not include loans that have been in default within the most recent 12-month period, except that whole first-mortgage collateral on one- to four-family residential property is acceptable provided no payment is overdue by more than 45 days, unless the collateral is insured or guaranteed by the U.S. or any agency thereof.
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(1)
September 30, 2015 is the most recent data available for inclusion in this table.
(2)
Includes all member assets.
(3)
Includes 1-4 family first lien mortgage loans from depository and CDFI members only.
(4)
Credit union early delinquencies are reported at 30-59 days past due and are included on this line.
(5)
Credit union non-performing loans are reported over 60 days past due. These 60+ day 1-4 family first lien mortgage loans are included on this line.
The following table provides information regarding advances outstanding with our borrowers in Category-1, Category-2, Category-3, and insurance company members, at December 31, 2015, along with their corresponding collateral balances.
The method by which a borrower pledges collateral is dependent upon the category to which it is assigned and on the type of collateral that the borrower pledges. Moreover, borrowers in Category-1 are permitted to specifically list and identify single-family residential mortgage loans at a lower discount than is allowed if the collateral is not specifically listed and identified.
Based upon the method by which borrowers pledge collateral to us, the following table shows the total potential lending value of the collateral that borrowers have pledged to us, net of our collateral valuation discounts as of December 31, 2015.
We accept nontraditional and subprime loans that are underwritten in accordance with applicable regulatory guidance as eligible collateral for our advances. However, we do not accept as eligible collateral any mortgage loan that allows for negative amortization, including, but not limited to, pay-option adjustable-rate mortgage loans. We recognize that nontraditional and subprime loans may present incremental credit risk to us. Therefore, we have monitoring and review procedures in place to measure the incremental risk presented by this collateral and to mitigate this incremental credit risk. Further, we apply baseline collateral valuation discounts to nontraditional and subprime loans secured by a mortgage on the borrower's primary residence of 35 and 40 percent of book value, respectively. These discounts reflect the incremental credit risk associated with these types of loans relative to conventional mortgage loans. Borrowers in Category-1 also have the option of providing loan level data for their subprime and nontraditional loans to potentially obtain a more favorable valuation based on the credit risk profile of the pledged loan portfolio, subject to a minimum discount of 25 percent of book value. In addition, we limit the amount of borrowing capacity that a member may derive from subprime loan collateral to the lower of two times the pledging member's most recently reported capital as determined in accordance with generally accepted accounting principles (GAAP) or one-half of its total borrowing capacity. Additionally, private-label MBS issued or acquired and residential mortgage loans originated or acquired by our members after July 10, 2007, are not eligible collateral unless it can be documented that all loans, including all loans in MBS pools, are in compliance with regulatory underwriting standards on subprime or nontraditional lending, as applicable.
At both December 31, 2015 and 2014, the amount of pledged nontraditional and subprime loan collateral was nine percent of total member discounted collateral.
We have not recorded any allowance for credit losses on credit products at December 31, 2015, and 2014, for the reasons discussed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 10 - Allowance for Credit Losses.
The following table presents the top five advance-borrowing institutions at December 31, 2015, and the interest earned on outstanding advances to such institutions for the year ended December 31, 2015.
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(1)
Weighted-average rates are based on the contract rate of each advance without taking into consideration the effects of interest-rate-exchange agreements that we may use as hedging instruments.
Investments
At December 31, 2015, investment securities and short-term money market instruments totaled $18.0 billion, compared with $16.9 billion at December 31, 2014.
Short-term money-market investments increased $1.0 billion to $8.8 billion at December 31, 2015, compared with December 31, 2014. The increase was attributable to a $1.5 billion increase in securities purchased under agreements to resell offset by a $430.0 million decrease in federal funds sold.
Investment securities increased $119.8 million to $9.2 billion at December 31, 2015, compared with December 31, 2014. The increase was attributable to a $162.9 million increase in MBS offset by a decrease of $33.5 million in agency and supranational institutions' debentures.
Held-to-Maturity Securities
The following table provides a summary of our held-to-maturity securities.
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(1)
Maturity ranges are based on the contractual final maturity of the security.
Available-for-Sale Securities
We classify certain investment securities as available-for-sale to enable liquidation at a future date or to enable the application of hedge accounting using interest-rate swaps. By classifying investments as available-for-sale, we can consider these securities to be a source of short-term liquidity, if needed. From time to time, we invest in certain securities and simultaneously enter into matched-term interest-rate swaps to achieve a LIBOR-based variable yield, particularly when we can earn a wider interest spread between the swapped yield on the investment and short-term debt instruments than we can earn between the bond's fixed yield and comparable-term fixed-rate debt. Because an interest-rate swap can only be designated as a hedge of an available-for-sale investment security, we classify these investments as available-for-sale. The following table provides a summary of our available-for-sale securities.
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(1)
MBS maturity ranges are based on the contractual final maturity of the security.
Trading Securities
We classify certain investments acquired for purposes of meeting short-term contingency liquidity needs and asset/liability management as trading securities and carry them at fair value. However, we do not participate in speculative trading practices and hold these investments indefinitely as we periodically evaluate our liquidity needs. The following table provides a summary of our trading securities.
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(1)
MBS maturity ranges are based on the contractual final maturity of the security.
Certain Investment Concentrations
At December 31, 2015, we held securities from the following issuers with total carrying values greater than 10 percent of total capital, as follows:
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(1)
Carrying value for trading securities and available-for-sale securities represents fair value.
Our MBS investment portfolio consists of the following categories of securities as of December 31, 2015 and 2014. The percentages in the table below are based on carrying value.
Investments Credit Risk
We are subject to credit risk on unsecured investments consisting primarily of short-term (meaning under one year to maturity) money-market instruments issued by high-quality financial institutions and long-term (original maturity in excess of one year) debentures issued or guaranteed by U.S. agencies, U.S government-owned corporations, GSEs, and supranational institutions. We place short-term funds with large, high-quality financial institutions with long-term credit ratings no lower than single-A (or equivalent) on an unsecured basis. Most of these placements expire within one day.
In addition to these unsecured short-term investments, we also make secured investments in the form of securities purchased under agreements to resell secured by U.S. Treasury and agency obligations, whose terms to maturity are up to 35 days. We have also invested in and are subject to secured credit risk related to MBS, ABS, and HFA securities that are directly or indirectly supported by underlying mortgage loans.
We actively monitor our investments' credit exposures and the credit quality of our counterparties, including assessments of each counterparty's financial performance, capital adequacy, and sovereign support as well as related market signals. We endeavor to reduce or suspend credit limits and/or seek to reduce existing exposures, as appropriate, as a result of these monitoring activities.
Credit ratings of our investments are provided in the following table.
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(1)
Ratings are obtained from Moody's, Fitch, Inc. (Fitch), and S&P and are each as of December 31, 2015. If there is a split rating, the lowest rating is used.
(2)
The issuer rating is used for these investments, and if a rating is on negative credit watch, the rating in the next lower rating category is used and then the lowest rating is determined.
FHFA regulations include limits on the amount of unsecured credit an individual FHLBank may extend to a counterparty or to a group of affiliated counterparties. This limit is based on a percentage of eligible regulatory capital and the counterparty's long-term unsecured credit rating. Under these regulations, the level of eligible regulatory capital is determined as the lesser of our total regulatory capital or the eligible amount of regulatory capital of the counterparty. The eligible amount of regulatory capital is then multiplied by a specified percentage for each counterparty, which product is the maximum amount of unsecured credit exposure we may extend to that counterparty. The percentage that we may offer for extensions of unsecured credit other than overnight sales of federal funds ranges from one to 15 percent based on the counterparty's credit rating. Extensions of unsecured credit other than sales of federal funds include on- and off-balance sheet and derivative transactions. See - Derivative Instruments Credit Risk for additional information related to derivatives exposure.
FHFA regulations allow additional unsecured credit for sales of federal funds. The specified percentage of eligible regulatory capital used for determining the maximum amount of unsecured credit exposure we may offer to a counterparty for overnight sales of federal funds is twice the amount that we may extend to that counterparty for extensions of credit other than overnight sales of federal funds reduced by the amount of any other unsecured credit exposure attributable to other than overnight sales of federal funds.
We are prohibited by FHFA regulations from investing in financial instruments issued by non-U.S. entities, other than those issued by U.S. branches and agency offices of foreign commercial banks. We are also prohibited by FHFA regulations from investing in financial instruments issued by foreign sovereign governments, including members of the European Union. Our unsecured credit risk to U.S. branches and agency offices of foreign commercial banks includes, among other things, the risk that, as a result of political or economic conditions in a country, the counterparty may be unable to meet their contractual repayment obligations. Notwithstanding the foregoing credit limits based on FHFA regulations, from time to time, we impose internal limits on all or specific individual counterparties that are lower than the maximum credit limits allowed by regulation.
The table below presents our short-term unsecured money-market credit exposure.
At December 31, 2015, our unsecured credit exposure related to money-market instruments and debentures, including accrued interest, was $3.0 billion to eight counterparties and issuers, of which $2.1 billion was for federal funds sold, and $840.1 million was for debentures issued by GSEs and supranational institutions. The following issuers/counterparties individually accounted for greater than 10 percent of total unsecured credit exposure as of December 31, 2015:
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(1)
Consists of federal funds sold. We sold federal funds to either the U.S. branch or agency of the named commercial bank.
Private-Label MBS
Of our $8.7 billion in par value of MBS and ABS investments at December 31, 2015, $1.5 billion in par value are private-label MBS and ABS backed by home equity loans, as set forth in the table below:
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(1)
The determination of fixed or variable rate is based upon the contractual coupon type of the security.
The following table provides additional information related to our investments in MBS issued by private trusts and ABS backed by home equity loans. The table sets forth the credit ratings and summary credit enhancements associated with our private-label MBS and ABS, stratified by year of securitization. Average current credit enhancements as of December 31, 2015, reflect the percentage of subordinated class outstanding balances as of December 31, 2015, to our senior class outstanding balances as of December 31, 2015, weighted by the par value of our respective senior class securities. Average current credit enhancements as of December 31, 2015, are indicative of the ability of subordinated classes to absorb loan collateral lost principal and interest shortfall before senior classes are impacted.
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(1)
Represents loans that are 60 days or more delinquent.
Mortgage Loans
We invest in mortgages through the MPF program. The MPF program is further described under - Mortgage Loans Credit Risk and in Item 1 - Business - Business Lines - Mortgage Loan Finance.
As of December 31, 2015, our mortgage loan investment portfolio totaled $3.6 billion, an increase of $97.8 million from December 31, 2014. We do not expect the balance of this portfolio to change significantly in 2016 as we expect continued competition from Fannie Mae and Freddie Mac for loan investment opportunities. We note further that the Director of the FHFA has delayed increases in Fannie Mae and Freddie Mac guaranty fees and certain other fees pending further study, which increases would have tended to weaken competition from Fannie Mae and Freddie Mac.
The following table presents information relating to our mortgage portfolio for the five year period ended December 31, 2015.
Mortgage Loans Credit Risk
We are subject to credit risk from the mortgage loans in which we invest due to our exposure to the credit risk of the underlying borrowers and the credit risk of the participating financial institutions when the participating financial institutions retain credit-enhancement and/or servicing obligations.
Although our mortgage loan portfolio includes loans throughout the U.S., concentrations of five percent or greater of the outstanding principal balance of our conventional mortgage loan portfolio are shown in the following table:
The following table provides a summary of certain characteristics of our investments in mortgage loans.
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(1)
Percentages are calculated based on unpaid principal balance at the end of each period.
Government mortgage loans may not exceed the loan-to-value limits set by the applicable federal agency. Conventional mortgage loans with loan-to-value ratios greater than 80 percent require certain amounts of primary mortgage insurance from a mortgage insurance company rated at least triple-B (or equivalent rating).
Allowance for Credit Losses on Mortgage Loans. The allowance for credit losses on mortgage loans was $1.0 million at December 31, 2015, compared with $2.0 million at December 31, 2014.
For information on the determination of the allowance at December 31, 2015, see Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 10 - Allowance for Credit Losses, and for information on our methodology for estimating the allowance, see - Critical Accounting Estimates - Allowance for Loan Losses.
We place conventional mortgage loans on nonaccrual status when the contractual principal or interest is 90 days or more past due. Accrued interest on nonaccrual loans is reversed against interest income. We monitor the delinquency levels of the mortgage loan portfolio on a monthly basis. Our investments in conventional mortgage loans that are delinquent and our allowance for credit losses are shown in the following table:
Although delinquent loans in our portfolio are spread throughout the U.S., delinquent loan concentrations of five percent or greater of the outstanding principal balance of our total conventional mortgage loans delinquent by more than 30 days are shown in the following table:
Higher-Risk Loans. Our portfolio includes certain higher-risk conventional mortgage loans. These include high loan-to-value ratio mortgage loans and subprime mortgage loans. The higher-risk loans represent a relatively small portion of our conventional mortgage loan portfolio (4.2 percent by outstanding principal balance), but a disproportionately higher portion of the conventional mortgage loan portfolio delinquencies (33.1 percent by outstanding principal balance). The table below shows the balance of higher-risk conventional mortgage loans and their delinquency rates as of December 31, 2015.
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(1)
Subprime loans are loans to borrowers with FICO® credit scores of 660 or lower.
(2)
High loan-to-value loans have an estimated current loan-to-value ratio greater than 100 percent based on movements in property values in the core-based statistical areas where the property securing the loan is located.
(3)
These loans are subprime and also have a current estimated loan-to-value ratio greater than 100 percent.
Our portfolio consists solely of fixed-rate conventionally amortizing first-mortgage loans. The portfolio does not include adjustable-rate mortgage loans, pay-option adjustable-rate mortgage loans, interest-only mortgage loans, junior lien mortgage loans, or loans with initial teaser rates.
Mortgage Insurance Companies. We are exposed to credit risk from mortgage insurance companies that provide credit enhancement in place of the participating financial institution and for primary mortgage insurance coverage on individual loans. As of December 31, 2015, we were the beneficiary of primary mortgage insurance coverage of $69.9 million on $278.5 million of conventional mortgage loans, and supplemental mortgage insurance coverage of $18.3 million on mortgage pools with a total unpaid principal balance of $246.4 million.
We have analyzed our potential loss exposure to all of the mortgage insurance companies and do not expect incremental losses based on these exposures at this time.
Deposits
We offer demand and overnight deposits, custodial mortgage accounts, and term deposits to our members. Deposit programs are intended to provide members a low-risk earning asset that satisfies liquidity requirements. Deposit balances depend on members' needs to place excess liquidity and can fluctuate significantly. Due to the relatively small size of our deposit base and the unpredictable nature of member demand for deposits, we do not rely on deposits as a core component of our funding. At December 31, 2015, and December 31, 2014, deposits totaled $482.6 million and $369.3 million, respectively.
Consolidated Obligations
See - Liquidity and Capital Resources for information regarding our COs.
Derivative Instruments
All derivatives are recorded on the statement of condition at fair value and classified as either derivative assets or derivative liabilities. Derivatives outstanding with counterparties with which we have an enforceable master-netting agreement are classified as assets or liabilities according to the net fair value of derivatives aggregated by each counterparty. Derivatives that have been cleared through a clearing member with a DCO are classified as assets or liabilities according to the net fair value of those derivatives that have been transacted through a particular clearing member with a particular DCO. Derivative assets' net fair value, net of cash collateral and accrued interest, totaled $40.1 million and $14.5 million as of December 31, 2015, and December 31, 2014, respectively. Derivative liabilities' net fair value, net of cash collateral and accrued interest, totaled $442.0 million and $558.9 million as of December 31, 2015, and December 31, 2014, respectively.
We offset fair-value amounts recognized for derivative instruments and fair-value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from derivatives recognized at fair value executed with the same counterparty under a master-netting arrangement as well as arising from derivatives cleared through a DCO.
We base the estimated fair values of these agreements on the cost of interest-rate-exchange agreements with similar terms or available market prices. Consequently, fair values for these instruments must be estimated using techniques such as discounted cash-flow analysis and comparison with similar instruments. Estimates developed using these methods are subjective and require judgments regarding significant matters such as the amount and timing of future cash flows and the selection of discount rates that appropriately reflect market and credit risks. We formally establish hedging relationships associated with balance-sheet items and forecasted transactions to obtain desired economic results. These hedge relationships may include fair-value and cash-flow hedges, as well as economic hedges.
We had commitments for which we were obligated to invest in mortgage loans with par values totaling $24.7 million and $26.9 million at December 31, 2015 and 2014, respectively. All commitments to invest in mortgage loans are recorded at fair value on the statement of condition as derivatives. Upon satisfaction of the commitment, the recorded fair value is then reclassified as a basis adjustment of the purchased mortgage assets.
The following table presents a summary of the notional amounts and estimated fair values of our outstanding derivatives, excluding accrued interest, and related hedged item by product and type of accounting treatment as of December 31, 2015 and 2014. The notional amount is a factor in determining periodic interest payments or cash flows received and paid. However, the notional amount does not represent actual amounts exchanged or our overall exposure to credit and market risk. The hedge designation “fair value” represents the hedge classification for transactions that qualify for hedge-accounting treatment and hedge changes in fair value attributable to changes in the designated benchmark interest rate, which is LIBOR. The hedge designation "cash flow" represents the hedge classification for transactions that qualify for hedge-accounting treatment and hedge the exposure to variability in expected future cash flows. The hedge designation “economic” represents hedge strategies that do not qualify for hedge accounting, but are acceptable hedging strategies under our risk-management policy.
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(1)
As of December 31, 2015 and 2014 embedded derivatives separated from the advance contract with notional amounts of $342.0 million and $190.5 million, respectively, and fair values of $1.2 million and $1.5 million, respectively, are not included in the table.
The following tables present our hedging strategies at December 31, 2015 and 2014.
The following tables provide a summary of our hedging relationships for fair-value hedges of advances and COs that qualify for hedge accounting by year of contractual maturity. Interest accruals on interest-rate-exchange agreements in qualifying hedge relationships are recorded as interest income on advances and interest expense on COs in the statement of operations. The notional amount of derivatives in qualifying fair-value hedge relationships of advances and COs totals $14.6 billion, representing 87.8 percent of all derivatives outstanding as of December 31, 2015. Economic hedges and cash-flow hedges are not included within the two tables below.
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(1)
Included in the advances hedged amount are $2.1 billion of putable advances, which would accelerate the termination date of the derivative and the hedged item if the put option is exercised.
(2)
The fair-value adjustment of hedged advances represents the amounts recorded for changes in the fair value attributable to changes in the designated benchmark interest rate, LIBOR.
(3)
The yield for floating-rate instruments and the floating-rate leg of interest-rate swaps is the coupon rate in effect as of December 31, 2015.
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(1)
Included in the CO bonds hedged amount are $2.2 billion of callable CO bonds, which would accelerate the termination date of the derivative and the hedged item if the call option is exercised.
(2)
The fair-value adjustment of hedged CO bonds represents the amounts recorded for changes in the fair value attributable to changes in the designated benchmark interest rate, LIBOR, plus remaining unamortized premiums or discounts on hedged CO bonds where applicable.
(3)
The yield for floating-rate instruments and the floating-rate leg of interest-rate swaps is the coupon rate in effect as of December 31, 2015.
We may engage in derivatives directly with affiliates of certain of our members that act as derivatives dealers to us. These derivatives are entered into for our own risk-management purposes and are not related to requests from our members to enter into such contracts.
Derivative Instruments Credit Risk. We are subject to credit risk on derivatives. This risk arises from the risk of counterparty default on the derivative. The amount of loss created by default is the replacement cost of the defaulted contract, net of any collateral held by us or pledged by us to counterparties (unsecured derivatives exposure). We accept both securities and cash collateral for uncleared derivatives (principal-to-principal derivatives that are not centrally cleared) from counterparties with
whom we are in a current positive fair-value position (i.e., we are in the money) by an amount that exceeds an exposure threshold (if any) defined in our master netting agreement with the counterparty. The resulting net exposure at fair value is reflected in the derivatives table below. We pledge securities and cash collateral for uncleared derivatives to counterparties with whom we are in a current negative fair-value position (i.e., we are out-of-the-money) by an amount that exceeds an exposure threshold (if any) defined in our master netting agreement with the counterparty. From time to time, due to timing differences or derivatives valuation differences between our calculated derivatives values and those of our counterparties, and to the contractual haircuts applied to securities, we receive from counterparties cash or securities collateral whose fair value is less than the current positive fair-value positions with them adjusted for any applicable exposure threshold. We pledge only cash collateral, including initial and variation margin, for cleared derivatives, but may also pledge securities for initial margin as allowed by the applicable DCO and clearing member. From time to time, due to timing differences or derivatives valuation differences between our calculated derivatives values and those of our counterparties, and to the contractual haircuts applied to securities, we pledge to counterparties cash or securities collateral whose fair value exceeds the current negative fair-value positions with them adjusted for any applicable exposures. The table below details our counterparty credit exposure as of December 31, 2015.
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(1)
Uncleared derivatives counterparty ratings are obtained from Moody's, Fitch, and S&P. Each rating classification includes all rating levels within that category. If there is a split rating, the lowest rating is used. In the case where the obligations are unconditionally and irrevocably guaranteed, the rating of the guarantor is used.
(2)
Total fair-value exposures related to commitments to invest in mortgage loans are offset by certain pair-off fees. Commitments to invest in mortgage loans are reflected as derivatives. We do not collateralize these commitments. However, should the participating financial institution fail to deliver the mortgage loans as agreed, the participating financial institution is charged a fee to compensate us for the nonperformance.
(3)
These represent derivatives positions with counterparties for which we are in a net liability position and for which we have delivered securities collateral to the counterparty in an amount equal to or less than the net derivative liability, or derivative positions with counterparties for which we are in a net asset position and for which the counterparty has delivered collateral to us in an amount that exceeds our net derivative asset.
Uncleared derivatives. The credit risk arising from unsecured credit exposure on derivatives is mitigated by the credit quality of the counterparties and by the early termination ratings triggers contained in all master derivatives agreements. We enter into new uncleared derivatives only with nonmember institutions that have long-term senior unsecured credit ratings that are at or above single-A (or its equivalent) by S&P and Moody's, although risk-reducing trades may be approved for counterparties whose ratings have fallen below these ratings. We actively monitor these exposures and the credit quality of our counterparties, using stress testing of counterparty exposures and assessments of each counterparty's financial performance, capital adequacy, sovereign support, and related market signals. We can reduce or suspend credit limits and/or seek to reduce existing exposures, as appropriate, as a result of these monitoring activities. We do not enter into interest-rate-exchange agreements with other FHLBanks. We use master-netting agreements to reduce our credit exposure from counterparty defaults. The master agreements contain bilateral-collateral-exchange provisions that may require credit exposures beyond a defined amount to be secured by U.S. federal government or GSE-issued securities or cash. Exposures are measured daily, and adjustments to collateral positions are made daily. The master agreements may provide for lower amounts of unsecured exposure to lower-rated counterparties. These agreements may require us to deliver additional collateral to certain of our counterparties if our credit rating is downgraded by an NRSRO, which could increase our exposure to loss in the event of a default by a counterparty to which we were the net creditor at the time of any such default, as further detailed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 11 - Derivatives and Hedging Activities.
The following counterparties accounted for more than 10 percent of the total notional amount of uncleared derivatives outstanding (dollars in thousands):
We may deposit funds with these counterparties and their affiliates for short-term money-market investments, including overnight federal funds, term federal funds, and interest-bearing certificates of deposit. We also engage in short-term secured reverse repurchase agreements with affiliates of these counterparties. All of these counterparties have affiliates that buy, sell, and distribute our COs.
Cleared derivatives. The credit risk from unsecured credit exposure on cleared swaps is principally mitigated by the DCO's structural default protections. Our internal policies require that the DCO must have a rating of at least single-A or the equivalent. We actively monitor these exposures and the credit quality of our DCO counterparties, using stress testing of DCO counterparties exposures and assessments of the DCO's structural risk protections. We can reduce existing exposures to a DCO by unwinding any trade, by entering into an offsetting trade, or by moving trades to another DCO.
LIQUIDITY AND CAPITAL RESOURCES
Our financial structure is designed to enable us to expand and contract our assets, liabilities, and capital in response to changes in membership composition and member credit needs. Our primary source of liquidity is our access to the capital markets through CO issuance, which is described in Item 1 - Business - Consolidated Obligations. Outstanding COs and the condition of the market for COs are discussed below under - Debt Financing - Consolidated Obligations. Our equity capital resources are governed by our capital plan, certain portions of which are described under - Capital below as well as by applicable legal and regulatory requirements.
Liquidity
We monitor our financial position in an effort to ensure that we have ready access to sufficient liquid funds to meet normal transaction requirements, take advantage of investment opportunities, fund our member credit needs, and cover unforeseen liquidity demands. We strive to maintain the liquidity necessary to meet member-credit demands, repay maturing COs, meet other obligations and commitments, and respond to changes in membership composition.
We are not able to predict future trends in member-credit needs since they are driven by complex interactions among a number of factors, including, but not limited to mortgage originations, other loan portfolio growth, deposit growth, and the attractiveness of the pricing and availability of advances versus other wholesale borrowing alternatives.
Our contingency liquidity plans are intended to ensure that we are able to meet our obligations and the liquidity needs of members in the event of operational disruptions at the Bank or the Office of Finance or short-term disruptions of the capital markets.
For information and discussion of our guarantees and other commitments we may have, see - Off-Balance-Sheet Arrangements and Aggregate Contractual Obligations below, and for further information and discussion of the joint and several liability for FHLBank COs, see - Debt Financing - Consolidated Obligations below.
Internal Liquidity Sources / Liquidity Management
Liquidity Reserves for Deposits. Applicable law requires us to hold a total amount of cash, obligations of the U.S., and advances with maturities of less than five years, in an amount not less than the amount of total member deposits with us. We have complied with this requirement during the year ended December 31, 2015. The following table provides our liquidity position with respect to this requirement.
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(1)
For purposes of the regulatory requirement, liquid assets include cash, obligations of the U.S., and advances with maturities of less than five years.
We have developed a methodology and policies by which we measure and manage the Bank’s short-term liquidity needs based on projected net cash flow and contingent obligations.
Projected Net Cash Flow. We define projected net cash flow as projected sources of funds less projected uses of funds based on contractual maturities or expected option exercise periods, and settlement of committed asset and liabilities, as applicable. For mortgage-related cash flows and callable debt, we incorporate projected prepayments and call exercise.
Structural Liquidity. We define structural liquidity as projected net cash flow (defined above) less assumed secondary uses of funds, for which we assume the following:
•
all maturing advances are renewed;
•
member overnight deposits are withdrawn at a rate of 50 percent per day;
•
outstanding standby letters of credit are drawn down at a rate of 50 percent spread equally over 86 days;
•
uncommitted lines of credit are drawn upon at a rate of 10 percent of the previous day's balance; and
•
MPF master commitments are funded at a rate of 10 percent of the previous days' total amount on the first day and at a rate of one percent on each day thereafter.
The above assumptions for secondary uses of funds are in excess of our ordinary experience, and therefore represent a more stressful scenario than we expect to experience. We review these assumptions periodically.
This methodology for measuring projected net cash flow and structural liquidity has been established by management to monitor our liquidity position on a daily basis, and to help ensure that we meet all of our obligations as they come due and to meet our members' potential demand for liquidity from us in all cases. We may adjust the amount of liquidity maintained as market conditions change from time to time using projected net cash flow and structural liquidity measurements.
Liquidity Management Action Triggers. We maintain two liquidity management action triggers:
•
if structural liquidity is less than negative $1.0 billion on or before the fifth business day following the measurement date; and
•
if projected net cash flow falls below zero on or before the 21st day following the measurement date.
We did not breach either of these thresholds at any time during the year ended December 31, 2015. Senior management is notified if either liquidity threshold is breached and is required to determine whether or not any corrective action is necessary as a result.
The following table presents our projected net cash flow and structural liquidity as of December 31, 2015.
Contingency Liquidity. FHFA regulations require that we hold contingency liquidity in an amount sufficient to enable us to cover our operational requirements for a minimum of five business days without access to the CO debt markets. The FHFA defines contingency liquidity as projected sources of funds less uses of funds, excluding reliance on access to the CO debt markets and including funding a portion of outstanding standby letters of credit. For this purpose, outstanding standby letters of credit are assumed to be drawn down at a rate of 50 percent spread equally over 86 days following the measurement date. As defined by FHFA regulations, additional contingent sources of liquidity include the following:
•
marketable securities with a maturity greater than one week and less than one year that can be sold;
•
self-liquidating assets with a maturity of seven days or less;
•
assets that are generally accepted as collateral in the repurchase agreement market, for which we include 50 percent of unencumbered marketable securities with a maturity greater than one year; and
•
irrevocable lines of credit from financial institutions rated not lower than the second highest rating category by an NRSRO.
We complied with this regulatory requirement at all times during the year ended December 31, 2015. As of December 31, 2015 and 2014, we held a surplus of $12.0 billion and $12.4 billion, respectively, of contingency liquidity for the following five business days, exclusive of access to the proceeds of CO debt issuance.
The following table presents our contingency liquidity as of December 31, 2015.
Additional Liquidity Requirements. In addition, certain FHFA guidance requires us to maintain sufficient liquidity through short-term investments in an amount at least equal to our anticipated cash outflows under two different scenarios. One scenario assumes that we cannot borrow funds from the capital markets for a period of 15 business days and that during that time we do not renew any maturing, prepaid, and put or called advances. The second scenario assumes that we cannot raise funds in the capital markets for five business days and that during that period we will renew maturing and called advances for all members except very large, highly rated members. We were in compliance with these liquidity requirements at all times during the year ended December 31, 2015.
Balance Sheet Funding Gap Policy. Further, we are sensitive to maintaining an appropriate funding balance between our assets and liabilities and maintain a policy that limits the potential gap between assets inclusive of projected prepayments, funded by liabilities, inclusive of projected calls, maturing in less than one year. The established policy limits this imbalance to a gap of 20 percent of total assets and sets a management action trigger at a gap of 10 percent of total assets. We maintained compliance with this limit and its management action trigger at all times during the year ended December 31, 2015. During the year ended December 31, 2015, this gap averaged 4.7 percent (the maximum level at any month-end during the year was 5.0 percent and the minimum level at any month-end during the year was 0.1 percent). As of December 31, 2015, this gap was 5.0 percent, compared with 0.4 percent at December 31, 2014.
External Sources of Liquidity
FHLBank P&I Funding Contingency Plan Agreement. We have a source of emergency external liquidity through the FHLBank P&I Funding Contingency Plan Agreement. Under the terms of that agreement, in the event we do not fund our principal and interest payments under a CO by deadlines established in the agreement, the other FHLBanks will be obligated to fund any shortfall to the extent that any of the other FHLBanks have a net positive settlement balance (that is, the amount by which end-
of-day proceeds received by such FHLBank from the sale of COs on that day exceeds payments by such FHLBank on COs on the same day) in its account with the Office of Finance on the day the shortfall occurs. We would then be required to repay the funding FHLBanks. We have never drawn funding under this agreement.
Debt Financing - Consolidated Obligations
Our primary source of liquidity is through CO issuances. At December 31, 2015, and December 31, 2014, outstanding COs, including both CO bonds and CO discount notes, totaled $53.9 billion and $50.8 billion, respectively. CO bonds are generally issued with either fixed-rate coupon-payment terms or variable-rate coupon-payment terms that use a variety of indices for interest-rate resets. Some of the fixed-rate bonds that we have issued are callable bonds that may be redeemed at par on one or more dates prior to their maturity date. In addition, to meet our needs and the needs of certain investors in COs, fixed- and variable-rate bonds may also contain certain provisions that may result in complex coupon-payment terms and call or amortization features. When such COs (structured bonds) are issued, we enter into interest-rate-exchange agreements containing offsetting features, which effectively change the characteristics of the bond to those of a simple variable-rate bond.
The Office of Finance has established a methodology for the allocation of the proceeds from the issuance of COs when COs cannot be issued in sufficient amounts to satisfy all FHLBank demand for funding during periods of financial distress and when its existing allocation processes are deemed insufficient. See Item 1 -Business - Consolidated Obligations for additional information on the methodology.
In general, this methodology provides that the proceeds in such circumstances will be allocated among the FHLBanks based on relative FHLBank total regulatory capital, with FHLBanks with greater total regulatory capital in absolute terms receiving greater allocations of issuance proceeds. The Office of Finance will use this method in such periods unless it determines that there is an overwhelming reason to adopt a different allocation method. As is the case during any instance of a disruption in our ability to access the capital markets, market conditions or this allocation could adversely impact our ability to finance our operations, which could adversely impact our financial condition and results of operations.
See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 13 - Consolidated Obligations for a summary of CO bonds by contractual maturity dates and call dates as of December 31, 2015, and December 31, 2014. CO bonds outstanding for which we are primarily liable at December 31, 2015, and December 31, 2014, include issued callable bonds totaling $3.6 billion and $4.5 billion, respectively.
CO discount notes are also a significant funding source for us. CO discount notes are short-term instruments with maturities ranging from overnight to one year. We use CO discount notes primarily to fund short-term advances and investments, and longer-term advances and investments with short repricing intervals. CO discount notes comprised 52.8 percent and 49.8 percent of the outstanding COs for which we are primarily liable at December 31, 2015, and December 31, 2014, respectively, but accounted for 92.3 percent and 91.4 percent of the proceeds from the issuance of such COs during the years ended December 31, 2015 and 2014, respectively.
The table below shows our short-term borrowings for the years ended December 31, 2015, 2014, and 2013 (dollars in thousands).
Although we are primarily liable for our portion of COs, that is, those issued on our behalf, we are also jointly and severally liable with the other FHLBanks for the payment of principal and interest on COs issued by all of the FHLBanks. The par amounts of the FHLBanks' outstanding COs were $905.2 billion and $847.2 billion at December 31, 2015 and 2014, respectively. COs are backed only by the combined financial resources of the FHLBanks. COs are not obligations of the U.S. government, and the U.S. government does not guarantee them. We have never paid any obligations on behalf of the other FHLBanks.
We have evaluated the financial condition of the other FHLBanks based on known regulatory actions, publicly available financial information, and individual long-term credit rating downgrades as of each period presented. Based on this evaluation, as of December 31, 2015, and through the filing of this report, we believe there is a remote likelihood that we will be required to repay the principal or interest on any CO on behalf of another FHLBank.
The FHLBank Act authorizes the Secretary of the U.S. Treasury, at his or her discretion, to purchase COs of the FHLBanks aggregating not more than $4.0 billion under certain conditions. The terms, conditions, and interest rates are determined by the Secretary of the U.S. Treasury. There were no such purchases by the U.S. Treasury during the year ended December 31, 2015.
For additional information on COs, including their issuance, see Item 1 - Business - Consolidated Obligations.
Financial Conditions for Consolidated Obligations
We continue to operate in a prolonged, historically low interest-rate environment as discussed under Economic Conditions - Interest-Rate Environment. Overall, we have experienced relatively low CO issuance costs during the period covered by this report, reflecting the low interest-rate environment together with continuing investor preferences for low-risk investments. We have experienced good market demand for all tenors of COs with the strongest demand for short-term COs, and have been able to issue debt in the amounts and structures required to meet our funding and risk-management needs. During the period covered by this report, we experienced some increase in relative CO issuance costs as compared to yields in U.S. dollar interest rate swaps, particularly during a period of global market turbulence. However, investor demand for COs during the period remained strong and stable impacted in part by growing institutional investor demand for COs. We note that capacity among our CO underwriters has been occasionally somewhat constrained as a result of the imposition of new capital requirements on underwriters. So far, this development has not impeded our ability to meet our funding needs.
Capital
Total capital at December 31, 2015, was $3.0 billion compared with $2.9 billion at year-end 2014.
Capital stock declined by $76.5 million due to the repurchase of $602.1 million of excess capital stock (of which $256.7 million was mandatorily redeemable capital stock) and the reclassification of capital stock to mandatorily redeemable capital stock amounting to $54,000. Offsetting these decreases was the issuance of $269.1 million of capital stock.
The FHLBank Act and FHFA regulations specify that each FHLBank is required to satisfy certain minimum regulatory capital requirements. We were in compliance with these requirements at December 31, 2015, as discussed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 15 - Capital.
Our membership includes commercial banks, thrifts, credit unions, insurance companies, and community development financial institutions with capital stock outstanding by member type shown in the table below (dollars in thousands).
Capital stock subject to a stock redemption period is reclassified to mandatorily redeemable capital stock in the liability section of the statement of condition. Mandatorily redeemable capital stock totaled $42.0 million and $298.6 million at December 31, 2015, and December 31, 2014, respectively. For additional information on the redemption of our capital stock, see Item 1 - Business - Capital Resources - Redemption of Excess Stock and Item 8 - Financial Statements and Supplementary Data -Notes to the Financial Statements - Note 1 - Summary of Significant Accounting Policies - Mandatorily Redeemable Capital Stock.
We have the authority, but are not obliged, to repurchase excess stock, as discussed under Item 1 - Business - Capital Resources - Repurchase of Excess Stock. At December 31, 2015, and December 31, 2014, excess capital stock totaled $158.9 million and $633.0 million, respectively, as set forth in the following table (dollars in thousands):
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(1)
Total stock-investment requirement is rounded up to the nearest $100 on an individual member basis.
(2)
Class B capital stock outstanding includes mandatorily redeemable capital stock.
Capital Rule
The Capital Rule, among other things, establishes criteria for four capital classifications and corrective action requirements for FHLBanks that are classified in any classification other than adequately capitalized. An FHLBank is adequately capitalized if it has sufficient permanent and total capital to meet or exceed its risk-based and minimum capital requirements. FHLBanks that are adequately capitalized have no corrective action requirements. FHLBanks that are not adequately capitalized must submit capital restoration plans, are subject to corrective action requirements and are prohibited from paying dividends, redeeming or repurchasing excess stock, and subject to certain asset growth restrictions. The FHFA may place critically undercapitalized FHLBanks into conservatorship or receivership.
The Director of the FHFA has discretion to add to or modify the corrective action requirements for each capital classification other than adequately capitalized if the Director of the FHFA determines that such action is necessary to ensure the safe and sound operation of the FHLBank and the FHLBank's compliance with its risk-based and minimum capital requirements.
If we became classified into a capital classification other than adequately capitalized, we could be adversely impacted by the corrective action requirements for that capital classification.
The Capital Rule requires the Director of the FHFA to determine on no less than a quarterly basis the capital classification of each FHLBank. By letter dated December 10, 2015, the Director of the FHFA notified us that, based on September 30, 2015 financial information, we met the definition of adequately capitalized under the Capital Rule. We have not yet received our capital classification based on our December 31, 2015, financial information.
Internal Capital Practices and Policies
We also take steps as we believe prudent beyond legal or regulatory requirements in an effort to protect our capital, reflected in our targeted capital ratio operating range, internal minimum capital requirement in excess of regulatory requirements, minimum retained earnings target, and limitations on dividends.
Targeted Capital Ratio Operating Range
We target an operating capital ratio range as required by FHFA regulations. Currently, this range is set at 4.0 percent to 7.5 percent. Our capital ratio was 6.0 percent at December 31, 2015.
Internal Minimum Capital Requirement in Excess of Regulatory Requirements
To provide further protection for our capital base, we maintain an internal minimum capital requirement whereby the amount of paid-in capital stock and retained earnings (together, our actual regulatory capital) must exceed four percent of our total assets plus an amount we measure as our risk exposure with 99 percent confidence using our economic capital model (together, our internal minimum capital requirement). As of December 31, 2015, this internal minimum capital requirement equaled $2.9 billion, which was satisfied by our actual regulatory capital of $3.5 billion.
Retained Earnings and the Minimum Retained Earnings Target
At December 31, 2015, we had total retained earnings of $1.1 billion compared with our minimum retained earnings target of $700.0 million. We generally view our minimum retained earnings target as a floor for retained earnings rather than as a retained earnings limit and expect to continue to grow our retained earnings even though we exceed the target.
Our methodology for determining retained earnings adequacy and selection of the minimum retained earnings target incorporates an assessment of the various risks that could adversely impact retained earnings if trigger stress-scenario conditions were to occur. Principal elements are market risk and credit risk. Market risk is represented through the Bank's established limit for Value at Risk (VaR) market-risk measurement, which estimates the 99th percentile worst case of potential changes in our market value of equity due to potential shifts in yield curves applicable to our assets, liabilities, and off-balance-sheet transactions. Credit risk is represented through incorporation of valuation deterioration due but not limited to actual and potential adverse ratings migrations for our assets and actual and potential defaults.
Our minimum retained earnings target could be superseded by FHFA mandates, either in the form of an order specific to us or by promulgation of new regulations requiring a level of retained earnings that is different from our current target. Moreover, we may, at any time, change our methodology or assumptions for modeling our minimum retained earnings target and will do so when prudential or other reasons warrant such a change. Either of these events could result in us increasing our minimum retained earnings target and, in turn, reducing or eliminating dividends, as necessary.
For information on limitations on dividends, including limitations when we are under our minimum retained earnings target, see Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Excess Stock Management Program
We used the Excess Stock Management program on October 1, 2015, to unilaterally repurchase $310.2 million of excess stock from shareholders on a pro rata basis and expect to continue to use the program in 2016 as necessary to keep the amount of excess stock between zero and $200 million.
Restricted Retained Earnings and the Joint Capital Agreement
At December 31, 2015, our total retained earnings included $194.6 million in restricted retained earnings. Our capital plan and the Joint Capital Agreement require us to allocate a certain percentage of quarterly net income to a restricted retained earnings account, which we refer to as restricted retained earnings, in accordance with the Joint Capital Agreement. The Joint Capital Agreement is a voluntary capital initiative among the FHLBanks intended to build greater safety and soundness in the FHLBank System. Generally, the agreement requires each FHLBank to allocate an amount at least equal to 20 percent of its quarterly net income (net of that FHLBank's obligation to its Affordable Housing Program) to a restricted retained earnings account until the total amount in that account is equal to 1 percent of the daily average carrying value of that FHLBank's outstanding total COs (excluding fair-value adjustments) for the calendar quarter (total required contribution). The FHLBanks
commenced this obligation with their results at September 30, 2011. The percentage of the required allocation is subject to adjustment when an FHLBank has had an adjustment to a prior calendar quarter's net income. At December 31, 2015, our total required contribution to the restricted retained earnings account was $530.1 million compared with our total contribution on that date of $194.6 million. The agreement refers to the period of required contributions to the restricted retained earnings account as the “dividend restriction period.” Additionally, the agreement provides:
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that amounts held in an FHLBank's unrestricted retained earnings account may not be transferred into the restricted retained earnings account;
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during the dividend restriction period, an FHLBank shall redeem or repurchase capital stock only at par value, and shall only conduct such redemption or repurchase if it would not result in the FHLBank's total regulatory capital falling below its aggregate paid in amount of capital stock;
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that any quarterly net losses will be netted against the FHLBank's other quarters' net income during the same calendar year so that the minimum required annual allocation into the FHLBank's restricted retained earnings account is satisfied;
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if the FHLBank sustains a net loss for a calendar year, the net loss will be applied to reduce the FHLBank's retained earnings that are not in the FHLBank's restricted retained earnings account to zero prior to application of such net loss to reduce any balance in the FHLBank's restricted retained earnings account;
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if the FHLBank incurs net losses for a cumulative year-to-date period resulting in a decline to the balance of its restricted retained earnings account, the FHLBank's required allocation percentage will increase from 20 percent to 50 percent of quarterly net income until its restricted retained earnings account balance is restored to an amount equal to the regular required allocation (net of the amount of the decline);
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if the balance in the FHLBank's restricted retained earnings account exceeds 150 percent of its total required contribution to the account, the FHLBank may release such excess from the account;
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in the event of the liquidation of the FHLBank, or the taking of the FHLBank's retained earnings by future federal action, such event will not affect the rights of the FHLBank's Class B stockholders under the FHLBank Act in the FHLBank's retained earnings, including those held in the restricted retained earnings account;
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for the restriction on the payment of dividends from amounts in the restricted retained earnings account for at least one year following the termination of the Joint Capital Agreement; and
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for certain procedural mechanisms for determining when an automatic termination event has occurred.
The agreement will terminate upon an affirmative vote of two-thirds of the boards of directors of the then existing FHLBanks, or automatically if a change in the FHLBank Act, FHFA regulations, or other applicable law has the effect of:
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creating any new or higher assessment or taxation on the net income or capital of any FHLBank;
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requiring the FHLBanks to retain a higher level of restricted retained earnings than what is required under the agreement; or
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establishing general restrictions on dividend payments requiring a new or higher mandatory allocation of an FHLBank's net income to any retained earnings account than the amount specified in the agreement, or prohibiting dividend payments from any portion of an FHLBank's retained earnings not held in the restricted retained earnings account.
Off-Balance-Sheet Arrangements and Aggregate Contractual Obligations
Our significant off-balance-sheet arrangements consist of the following:
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commitments that obligate us for additional advances;
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standby letters of credit;
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commitments for unused lines-of-credit advances; and
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unsettled COs.
Off-balance-sheet arrangements are more fully discussed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 19 - Commitments and Contingencies.
Contractual Obligations. The following table presents our contractual obligations as of December 31, 2015.
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(1)
Includes CO bonds outstanding at December 31, 2015, at par value, based on the contractual maturity date of the CO bonds. No effect for call dates on callable CO bonds has been considered in determining these amounts.
(2)
Includes estimated interest payments for CO bonds. For floating-rate CO bonds, the forward interest-rate curve of the underlying index as of December 31, 2015, has been used to estimate future interest payments. No effect for call dates on callable CO bonds has been considered in determining these amounts.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates, and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities (if applicable), and the reported amounts of income and expenses during the reported periods. Although management believes these judgments, estimates, and assumptions to be reasonably accurate, actual results may differ.
We have identified five accounting estimates that we believe are critical because they require us to make subjective or complex judgments about matters that are inherently uncertain, and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These estimates include accounting for derivatives, the use of fair-value estimates, accounting for deferred premiums and discounts on prepayable assets, the allowance for loan losses, and other-than-temporary-impairment of investment securities. The Audit Committee of our board of directors has reviewed these estimates.
Accounting for Derivatives
Derivatives are required to be carried at fair value on the statement of condition. Any change in the fair value of a derivative is required to be recorded each period in current period earnings or other comprehensive income, depending on the type of hedge transaction. All of our derivatives are either 1) inherent to another activity, such as forward commitments to purchase mortgage loans under the MPF program, 2) embedded in a host financial instrument, such as an advance or an investment security, or 3) derivative contracts structured to offset some or all of the risk exposure inherent in our member-lending, investment, and funding activities. We are required to recognize unrealized losses or gains on derivative positions, regardless of whether offsetting gains or losses on the associated assets or liabilities being hedged are permitted to be recognized in a symmetrical manner. Therefore, the accounting framework imposed can introduce the potential for considerable income variability. Specifically, a mismatch can exist between the timing of income and expense recognition from assets or liabilities and the income effects of derivatives positioned to mitigate market-risk and cash-flow variability. Therefore, during periods of significant changes in interest rates and other market factors, our reported earnings may exhibit considerable variability. We generally employ hedging techniques that are effective under the hedge-accounting requirements. However, not all of our hedging relationships meet the hedge-accounting requirements. In some cases, we have elected to retain or enter into derivatives that are economically effective at reducing risk but do not meet the hedge-accounting requirements, either because the cost of the hedge was economically superior to nonderivative hedging alternatives or because no nonderivative hedging alternative was available, and available derivatives did not meet hedge accounting requirements. As required by FHFA regulation and our policy, derivatives that do not qualify as hedging instruments pursuant to GAAP may be used only if we document a nonspeculative purpose.
A hedging relationship is created from the designation of a derivative financial instrument as either hedging our exposure to changes in the fair value of a recognized asset, liability, or unrecognized firm commitment, or changes in future variable cash flows attributable to a recognized asset or liability or forecasted transaction. Fair-value hedge accounting allows for the offsetting changes in the fair value of the hedged risk in the hedged item to also be recorded in current period earnings.
The short-cut method can be used when the assumption can be made that the change in fair value of a hedged item, due to changes in the benchmark rate, exactly offsets the change in fair value of the related derivative. In many hedging relationships that use the short-cut method, we may designate the hedging relationship upon our commitment to disburse an advance or trade a CO provided that the period of time between the trade date and the settlement date of the hedged item is within established market-settlement conventions for the advances and CO markets. We define these market-settlement conventions to be five business days or less for advances and 30 calendar days or less, using a next business day convention, for COs. In such circumstances, although the advance or CO will not be recognized in the financial statements until settlement date, the hedge relationship qualifies for applying the short-cut method. We then record changes in the fair value of the derivative and hedged item beginning on the trade date.
Beginning in November 2014, to streamline certain operational processes, we voluntarily discontinued the use of short-cut hedge accounting for new hedge relationships entered into after that date. Short-cut hedge relationships entered into prior to that date will continue as short-cut hedge relationships until they mature or are terminated.
Hedge relationships not treated as short-cut accounting are treated as a long-haul fair-value hedge, where the change in the value of the hedged item attributable to changes in the benchmark interest rate must be measured separately from the derivative and effectiveness testing must be performed with results falling within established tolerances. If the hedge fails its effectiveness test, the hedge no longer qualifies for hedge accounting and the derivative is marked through current-period earnings without any offset related to the hedged item.
For derivative transactions that potentially qualify for long-haul fair-value hedge-accounting treatment, management must assess how effective the derivatives have been, and are expected to be, in hedging changes in the estimated fair values of the hedged items attributable to the risks being hedged. Hedge-effectiveness testing is performed at the inception of the hedging relationship and on an ongoing basis. We perform testing at hedge inception based on regression analysis of the hypothetical performance of the hedge relationship using historical market data. We then perform regression testing on an ongoing basis using accumulated actual values in conjunction with hypothetical values. Specifically, each month we use a consistently applied statistical methodology that uses a sample of at least 31 historical interest-rate environments and includes an R-square test, a slope test, and an F-statistic test. These tests measure the degree of correlation of movements in estimated fair values between the derivative and the related hedged item. For the hedging relationship to be considered effective, the R-square must be greater than 0.8, the slope must be between -0.8 and -1.25, and the computed F-statistic test significance must be less than 0.05.
We use the overnight-index swap curve for valuation of our interest-rate derivatives in which the recipient of collateral maintains the right to rehypothecate pledged collateral, while LIBOR is used as the discount rate for interest-rate derivatives in which the recipient of collateral has no right to rehypothecate pledged collateral. Additionally, we use the overnight-index swap curve as the discount rate for derivatives cleared through a DCO.
We use the LIBOR swap curve to discount cash flows on all associated hedged assets or liabilities in fair-value hedging relationships where the hedged risk is changes in fair value attributable to changes in the designated benchmark interest rate, LIBOR. For any such hedging relationship where the valuation of the derivative transaction is based on the overnight-index swap curve, there could be an increase in hedge ineffectiveness that in turn could result in the loss of hedge accounting for certain hedge relationships. Loss of hedge accounting for those hedge relationships would lead to increased net income volatility, which could be material. However, through December 31, 2015, no hedge relationships failed our hedge effectiveness criteria as a result of using the overnight-index swap curve as the discount rate for the derivative and the LIBOR swap curve as the discount rate for the hedged item.
The fair values of the derivatives and hedged items do not have any cumulative economic effect if the derivative and the hedged item are held to maturity, or mutual optional termination at par. Since these fair values fluctuate throughout the hedge period and eventually return to par value on the maturity date, the effect of fair values is normally only a timing issue.
For derivatives and hedged items that meet the requirements described above, we do not anticipate any significant impact on our financial condition or operating performance. For derivatives where no identified hedged item qualifies for hedge accounting, changes in the market value of the derivative are reflected in earnings. As of December 31, 2015, we held derivatives that are marked to market with no offsetting qualifying hedged item including $300.0 million notional of interest-rate caps, $562.5 million notional of interest-rate swaps, and $24.7 million notional of mortgage-delivery commitments. The
total fair value of these positions as of December 31, 2015, was an unrealized loss of $15.7 million. The following table shows the estimated changes in the fair value of these derivatives under alternative parallel interest-rate shifts:
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(1)
Given the low interest-rate environment experienced at the end of 2015, we do not believe that technical valuations generated through a down 100 basis point and a down 50 basis point rate shock are representative of potential shifts in the instruments' values.
These derivatives economically hedge certain advances, investment securities, and CO bonds. Although these economic hedges do not qualify or were not designated for hedge accounting, they are an acceptable hedging strategy under our risk-management program. Our projections of changes in value of the derivatives have been consistent with actual experience.
Fair-Value Estimates
Overview. We measure certain assets and liabilities, including investment securities classified as available-for-sale and trading, as well as all derivatives and mandatorily redeemable capital stock at fair value on a recurring basis. Additionally, certain held-to-maturity securities are measured at fair value on a nonrecurring basis due to the recognition of other-than-temporary impairment. Management also estimates the fair value of some of the collateral that borrowers pledge against advance borrowings to confirm that collateral is sufficient to meet regulatory requirements and to protect against losses. Accounting guidance defines fair value, establishes a framework for measuring fair value, establishes a fair-value hierarchy based on the inputs used to measure fair value, and requires certain disclosures for fair-value measurements. The book values and fair values of our financial assets and liabilities, along with a description of the valuation techniques used to determine the fair values of these financial instruments, is disclosed in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 18 - Fair Values.
We generally consider a market to be inactive if the following conditions exist: (1) there are few transactions for the financial instruments; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly either over time or among independent pricing services or dealers; and (4) there is a limited availability of public market information.
Fair value is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between willing market participants at the measurement date, or an exit price. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability. To determine the fair value or the exit price, entities must determine the unit of account, principal market, market participants, and for non-financial instruments the highest and best use. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy.
Fair values are based on quoted market prices or market-based prices, if such prices are available. If quoted market prices or market-based prices are not available, fair values are determined based on valuation models that use either:
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discounted cash flows, using market estimates of interest rates and volatility; or
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dealer prices and prices of similar instruments.
Pricing models and their underlying assumptions are based on management's best estimate with respect to:
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discount rates;
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prepayments;
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market volatility; and
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other factors.
These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the income and expense related thereto. The use of different assumptions, as well as changes in market conditions, could result in materially different net income and retained earnings.
Accounting guidance establishes a three-level fair-value hierarchy for classifying financial instruments that is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. The three levels of the fair-value hierarchy are:
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Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities.
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Level 2 - Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities.
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Level 3 - Unobservable inputs.
Each asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair-value measurement. The majority of our financial instruments carried at fair value fall within the Level 2 category and is valued primarily using inputs and assumptions that are observable in the market, can be derived from observable market data, or can be corroborated by recent trading activity of similar instruments with similar characteristics.
The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that are actively traded and have quoted market prices or parameters readily available, there is little to no subjectivity in determining fair value.
Valuation of Derivatives and Hedged Items. For purposes of estimating the fair value of derivatives and items for which we are hedging the changes in fair value attributable to changes in the designated benchmark interest rate, we employ a valuation model that uses market data from the Eurodollar futures, cash LIBOR, U.S. Treasury obligations, and the U.S. dollar interest-rate-swap markets to construct discount and forward-yield curves using standard financial market techniques.
As discussed under - Accounting for Derivatives, OIS is used as the discount rate for valuation of our uncleared derivatives in which the recipient of collateral maintains the right to rehypothecate pledged collateral and for all derivatives cleared through a DCO, while LIBOR continues to be the appropriate discount rate for uncleared derivatives in which the recipient of collateral has no right to rehypothecate pledged collateral.
The valuation adjustments for our hedged items in which the designated hedged risk is the risk of changes in fair value attributable to changes in the benchmark interest rate (LIBOR-based) are calculated using the same model that calculates the fair values of the associated hedging derivatives.
Valuation of Investment Securities. To ensure consistency in determining investment securities values, including the other-than-temporary impairment for private-label residential MBS and certain home equity loan investments (including home equity ABS) among the FHLBanks, the FHLBanks formed a pricing committee (the Pricing Committee) and established a formal process for key other-than-temporary impairment modeling assumptions used for cash-flow analyses for the majority of these securities. As a voting member, we provide input into the procedures considered by the Pricing Committee in determining fair values, and vote to adopt amendments to the procedures from time to time. We participate in the Pricing Committee as an important part of our continuing efforts to refine the valuation procedures for our investment securities and to enhance consistency among the FHLBanks on certain investment securities' valuation determinations.
For the period ended December 31, 2015, we employed the procedures to value our MBS that have been established by the Pricing Committee and also applied those procedures to value our non-MBS investments with the exception of floating-rate HFA securities. We have reviewed the Pricing Committee's procedures and determined that they are reasonably designed to determine that the estimated prices were exit prices. Accordingly, the following descriptions of our procedures for the period ended December 31, 2015, are the same as those established by the Pricing Committee. These processes are described in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 18 - Fair Values - Investment Securities.
The four designated and market-recognized pricing vendors from whom we collected prices used various proprietary models. The inputs to those models were derived from various sources including, but not limited to, benchmark yields, reported trades, dealer indications, issuer spreads, benchmark securities, bids, offers, and other market-related data. Since many private-label MBS (and to a lesser extent other investment securities) do not trade on a daily basis, the pricing vendors used available information such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing to determine the
prices for individual securities. Each pricing vendor has an established challenge process in place for all securities valuations, which facilitates resolution of potentially erroneous prices as identified by our methodology.
For the period ended December 31, 2015, we conducted reviews of the four pricing vendors to confirm and further augment our understanding of the vendors' pricing processes, methodologies, and control procedures. To the extent available, we also reviewed the vendors' independent auditors' reports regarding the internal controls over their valuation processes.
Our valuation technique first requires the establishment of a “median price” for each security using a formula that is based upon the number of vendor prices received:
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If four prices are received, the middle two prices are averaged to establish a median price;
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if three prices are received, the middle price is the median price;
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if two prices are received, the prices are averaged to establish a median price; and
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if one price is received, it is the median price (and also the final price), subject to further validation, consistent with the evaluation of “outliers” as discussed below.
In the cases where two or more vendor prices are obtained, each vendor price is compared to the median price defined above. Differences between all vendor prices received and the median price are then compared to the security's applicable tolerance parameters. All vendor prices that are within the security's tolerance parameters are averaged to arrive at the security's default price. In cases where one or more vendor prices have differences greater than the applicable tolerance parameter, these out-of-tolerance prices (the outliers) are subject to further analysis. Further analysis to exclude a vendor price or to determine if an outlier is a better estimate of fair value includes, but is not limited to, comparison to i) prices provided by a fifth, third-party recognized valuation service, ii) observed market prices for similar securities, iii) nonbinding dealer estimates, or iv) use of internal model prices, which we believe generally reflect the relevant facts and circumstances that a market participant would consider. Additionally, we ordinarily challenge a pricing vendor when a price falls outside of the tolerance parameters and/or if we determine that a price should be excluded as a result of our further analysis. When a pricing vendor agrees that its price is incorrect, we exclude that price from our determination of that security's final price. When a pricing vendor disagrees that its price is incorrect, our internal subject matter experts determine whether or not to consider that price in the determination of that security's final price in the valuation process based on all information available to the subject matter experts. In the case where management determines an outlier price is more representative of the security's price, then the outlier price will be used as the final price rather than the default price. If, on the other hand, management determines that an outlier (or outliers) is (are) in fact not representative of fair value, then the outlier(s) will be excluded from the default price calculation, and the default price is then used as the final price. In all cases, the final price is used to determine the fair value of the security.
As of December 31, 2015, four vendor prices were received for 96.1 percent of our investment securities and the final prices for substantially all of those securities were computed by averaging the four prices. Based on our review of the pricing methods and controls employed by the third-party pricing vendors and the relative lack of dispersion among the vendor prices (or, in those instances in which there were outliers or significant yield variances, our additional analyses), we believe the final prices used are reasonably likely to be exit prices and further that the fair-value measurements are classified appropriately in the fair-value hierarchy.
Deferred Premium/Discount Associated with Prepayable Mortgage-Backed Securities
When we purchase MBS, we often pay an amount that is different than the unpaid principal balance. The difference between the purchase price and the contractual note amount is a premium if the purchase price is higher, and a discount if the purchase price is lower. Accounting guidance permits us to amortize (or accrete) these premiums (or discounts) in a manner such that the yield recognized on the underlying asset is constant over the asset's estimated life.
We typically pay more than the unpaid principal balances when the interest rates on the purchased mortgages are greater than prevailing market rates for similar mortgages on the transaction date. The net purchase premiums paid are then amortized using the constant-effective-yield method over the expected lives of the mortgages as a reduction in their book yields (that is, interest income). Similarly, if we pay less than the unpaid principal balances due to interest rates on the purchased mortgages being lower than prevailing market rates on similar mortgages on the transaction date, the net discount is accreted in the same manner as the premiums, resulting in an increase in the mortgages' book yields. The constant-effective-yield amortization method is applied using expected cash flows that incorporate prepayment projections that are based on mathematical models that describe the likely rate of consumer refinancing activity in response to incentives created (or removed) by changes in interest rates. While changes in interest rates have the greatest effect on the extent to which mortgages may prepay, in general prepayment behavior can also be affected by factors not contingent on interest rates. Generally, however, when interest rates decline,
prepayment speeds are likely to increase, which accelerates the amortization of premiums and the accretion of discounts. The opposite occurs when interest rates rise.
We estimate prepayment speeds on each individual security using the most recent three months of historical constant prepayment rates, as available, or may subscribe to third-party data services that provide estimates of cash flows, from which we determine expected asset lives. The constant-effective-yield method uses actual historical prepayments received and projected future prepayment speeds, as well as scheduled principal payments, to determine the amount of premium/discount that should be recognized so that the book yield of each MBS is constant for each month until maturity.
In general, lower interest rates are expected to result in the acceleration of premium and discount amortization and accretion, compared with the effect of higher interest rates that would tend to decelerate the amortization and accretion of premiums and discounts. Exact trends will depend on the relationship between market interest rates and coupon rates on outstanding mortgage assets, the historical evolution of mortgage interest rates, the age of the mortgage loans, demographic and population trends, and other market factors. Changes in amortization will also depend on the accuracy of prepayment projections compared with actual experience. Prepayment projections are inherently subject to uncertainty because it is difficult to accurately predict future market conditions and the response of borrowing consumers in terms of refinancing activity to future market conditions even if the market conditions were known. However, actual prepayment speeds observed in these rate environments can be influenced by factors such as home price trends and lender credit underwriting standards. For example, in the recent very-low interest-rate environment, borrower refinancing activity has generally been lower than models would have predicted based on experience prior to the housing recession that commenced in 2008.
If we determine that an other-than-temporary impairment exists, we account for the investment security as if it had been purchased on the measurement date of the other-than-temporary impairment at an amortized cost basis equal to the previous amortized cost basis reduced by the other-than-temporary impairment recognized in income. The difference between the new amortized cost basis and the cash flows expected to be collected is amortized or accreted into interest income prospectively over the remaining life of the investment security based on the amount and timing of future estimated cash flows.
Upon subsequent evaluation of a debt security where there is no additional other-than-temporary impairment, we adjust the accretable yield on a prospective basis if there is a significant increase in the security's expected cash flows. The new accretable yield is used to calculate the amount to be recognized into income over the remaining life of the security so as to match the amount and timing of future cash flows expected to be collected. The estimated cash flows and accretable yield are re-evaluated on a quarterly basis.
The effect on interest income from the amortization and accretion of premiums and discounts on MBS, including MBS in both the held-to-maturity and available-for-sale portfolios and including accretion associated with a significant increase in a security's expected cash flows, for the years ended December 31, 2015, 2014, and 2013, was a net increase to income of $19.5 million, $16.7 million, and $10.4 million, respectively.
Allowance for Loan Losses
Advances. We have experienced no credit losses on advances and currently do not anticipate any credit losses on advances for the reasons discussed under - Financial Condition - Advances Credit Risk. Accordingly, we make no allowance for losses on advances.
At December 31, 2015, and December 31, 2014, we had rights to collateral, either loans or securities, on a member-by-member basis, with an estimated fair value in excess of outstanding advances. We believe that policies and procedures are in place to appropriately manage the credit risk associated with advances.
Mortgage Loans. We invest in both conventional mortgage loans and government mortgage loans under the MPF program. We have determined that no allowance for losses is necessary for government mortgage loans, as discussed under Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 10 - Allowance for Credit Losses. Conventional loans, in addition to having the related real estate as collateral, are credit enhanced either by qualified collateral pledged by the member, or by supplemental mortgage insurance purchased by the member. The credit enhancement is the participating financial institution's potential loss in the second-loss position after the first loss account is exhausted. We incur all losses in excess of the credit enhancement.
As of December 31, 2015, and December 31, 2014, the allowance for loan losses on the conventional mortgage loan portfolio was $1.0 million and $2.0 million, respectively. The allowance reflects our estimate of probable incurred losses inherent in the MPF portfolio as of December 31, 2015 and 2014.
Our allowance for loan-losses methodology estimates the amount of probable incurred losses that are inherent in the portfolio, but have not yet been realized. We then apply the risk-mitigating features of the MPF program to the estimated loss, which can include primary mortgage insurance, supplemental mortgage insurance, member-provided credit enhancements (described below), and any other credit enhancement. The credit enhancement represents the participating financial institution's continuing obligation to absorb a portion of the credit losses arising from the participating financial institution's master commitment(s). Additionally, certain credit-enhancement fees can be withheld from the participating financial institution to mitigate losses from our investments in MPF loans and therefore we consider our expectations by each master commitment for such withheld fees in determining the allowance for loan losses. More specifically the amount of credit-enhancement fees available to mitigate losses is calculated by adding accrued credit-enhancement fees to be paid to participating financial institutions and projected credit-enhancement fees to be paid to the participating financial institutions over the remaining estimated life of the master commitment and then subtracting any losses incurred or expected to be incurred.
For additional information on the allowance for loan losses, see Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 10 - Allowance for Credit Losses.
Other-Than-Temporary Impairment of Investment Securities
We evaluate held-to-maturity and available-for-sale investment securities in an unrealized loss position as of the end of each quarter for other-than-temporary impairment. For debt securities in an unrealized loss position, we assess whether (a) we have the intent to sell the debt security, or (b) it is more likely than not that we will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, an other-than-temporary impairment on the security must be recognized. Further, if the present value of cash flows expected to be collected (discounted at the security's effective yield) is less than the amortized cost basis of the security, an other-than-temporary impairment is considered to have occurred because the entire amortized cost basis of the security will not be recovered.
These evaluations are inherently subjective and consider a number of qualitative factors. In addition to monitoring the credit ratings of these securities for downgrades, as well as placement on negative outlook or credit watch, we evaluate other factors that may be indicative of other-than-temporary impairment. Depending on the type of security, these include, but are not limited to, an evaluation of the type of security, the length of time and extent to which the fair value of a security has been less than its cost, any credit enhancement or insurance, and certain other collateral-related characteristics such as FICO credit scores, loan-to-value ratios, delinquency and foreclosure rates, geographic concentrations, and the security's performance. If either our initial analysis identifies securities at risk of other-than-temporary impairment or the security is a private-label MBS, we perform additional testing of these investments.
At-risk securities and all private-label residential MBS are evaluated by estimating projected cash flows using models that incorporate projections and assumptions that are typically based on the structure of the security, existing credit enhancement, and certain economic assumptions, such as geographic housing prices, projected delinquency and default rates, expected loss severity on the collateral supporting our security, underlying loan-level borrower and loan characteristics, and prepayment speeds. The projected cash flows and losses are allocated to various security classes, including the security classes that we own, based on the cash flow and loss allocation rules of the individual security.
We perform our other-than-temporary impairment analysis for our private-label residential MBS using key modeling assumptions, inputs, and methodologies provided by the OTTI Governance Committee for our cash-flow projections used in analyzing credit losses and determining other-than-temporary impairment for private-label MBS. We participate in the OTTI Governance Committee, a committee that was formed by the FHLBanks to ensure consistency among the FHLBanks in their analyses of other-than-temporary impairment of private-label MBS in accordance with certain related guidance provided by the FHFA. The FHFA provides certain guidelines to the FHLBanks for determining other-than-temporary impairment with the objective of promoting consistency in the determination of other-than-temporary impairment for private-label MBS among the FHLBanks. In general terms, these guidelines provide that each FHLBank:
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will identify the private-label MBS in its portfolio that should be subject to a cash-flow analysis consistent with GAAP and other applicable regulatory guidance;
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will use the same key modeling assumptions, inputs, and methodologies as the other FHLBanks for generating the cash-flow projections used in analyzing credit losses and determining other-than-temporary impairment for private-label MBS;
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will consult with any other FHLBank that holds any common private-label MBS with it to ensure consistent results regarding the recognition of other-than-temporary impairment, including the determination of fair value and the credit-loss component, for each such security;
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is responsible for making its own determination of impairment and the reasonableness of assumptions, inputs, and methodologies used and performing the required present value calculations using appropriate historical cost bases and yields; and
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may engage another FHLBank to perform the cash-flow projections underlying its other-than-temporary impairment determination.
The modeling assumptions, inputs, and methodologies for the other-than-temporary impairment analyses of our private-label residential MBS are material to the determination of other-than-temporary impairment. Accordingly, management has reviewed the assumptions approved by the OTTI Governance Committee and determined that they are reasonable. We base this view on our review of the methodology used to derive and/or formulate these assumptions by monitoring trends in the behavior of the underlying collateral and by comparison to "most likely" projections reported by various market observers and participants. However, any changes to the assumptions, inputs, or methodologies for the other-than-temporary impairment analyses as described in this section could result in materially different outcomes to this analysis including the realization of additional other-than-temporary impairment charges, which may be substantial.
In accordance with related FHFA guidance, we have contracted with the FHLBanks of San Francisco and Chicago to perform cash-flow analyses for certain of our residential private-label MBS, as described in Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 7 - Other-Than-Temporary Impairment. We have tested the results of the FHLBank of San Francisco and the FHLBank of Chicago cash-flow modeling based on our internal modeling and determined that these results are reasonable. For each of these analyses, third-party models are employed to project expected losses associated with the underlying loan collateral and to model the resultant lifetime cash flows as to how they would pass through the deal structures underlying our MBS investments. These models use expected borrower default rates, projected loss severities, and forecasted voluntary prepayment speeds, all tailored to individual security product type. These analyses are based on the expected behavior of the underlying loans, whereby these loan-performance scenarios are applied against each security's credit-support structure to monitor credit-enhancement sufficiency to protect our investment. Model output includes projected cash flows, including any shortfalls in the capacity of the underlying collateral in conjunction with credit enhancements to fully return all contractual cash flows.
We own certain private-label MBS that are insured by third-party bond insurers (referred to as monoline insurers). The bond insurance on these investments guarantees the timely payments of principal and interest if these payments cannot be satisfied from the cash flows of the underlying mortgage pool. The cash-flow analysis of the MBS protected by such third-party insurance looks first to the performance of the underlying security, considering its embedded credit enhancement(s), which may be in the form of excess spread, overcollateralization, and/or credit subordination to determine the collectability of all amounts due. If these protections are deemed insufficient to make timely payment of all amounts due, then we consider the capacity of the third-party bond insurer to cover any shortfalls. Certain monoline insurers have been subject to adverse ratings, rating downgrades, and weakening financial performance measures. Accordingly, we have performed analyses to assess the financial strength of these monoline insurers to establish an expected case regarding the time horizon of the bond insurers' ability to fulfill their financial obligations and provide credit support. The projected time horizon of credit protection provided by an insurer is a function of claim-paying resources and anticipated claims in the future. If less than full insurance coverage is expected, the projection is referred to as the burn-out period and is expressed in months. The burn-out period for those monoline insurers is incorporated in the third-party cash-flow model as a key input. Any cash-flow shortfalls that occurred beyond the end of the burn-out period were considered not recoverable and the insured security was then deemed to be credit-impaired.
In instances in which a determination is made that a credit loss exists (defined as the difference between the present value of the cash flows expected to be collected, discounted at the security's effective yield, and the amortized cost basis, but limited to the difference between amortized cost and fair value of the security), but we do not intend to sell the debt security and it is not likely that we will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis, the impairment is separated into (a) the amount of the total impairment related to the credit loss and (b) the amount of the total impairment related to all other factors. If our cash-flow analysis results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, a credit loss exists), an other-than-temporary impairment is considered to have occurred. If we determine that an other-than-temporary impairment exists, we account for the investment security as if it had been purchased on the measurement date of the other-than-temporary impairment at an amortized cost basis equal to the previous amortized cost basis reduced by the other-than-temporary impairment recognized in income. The difference between the new amortized cost basis and the cash flows expected to be collected is amortized or accreted into interest income prospectively over the remaining life of the investment security based on the amount and timing of future estimated cash flows.
See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 7 - Other-Than-Temporary Impairment for additional information related to management's other-than-temporary impairment analysis for the current period.
RECENT ACCOUNTING DEVELOPMENTS
See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 2 - Recently Issued and Adopted Accounting Guidance for a discussion of recent accounting developments impacting or that could impact us.
LEGISLATIVE AND REGULATORY DEVELOPMENTS
FHFA Final Rule on FHLBank Membership
On January 20, 2016, the FHFA issued a rule effective on February 19, 2016, that, among other things:
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defines the “principal place of business” of an institution eligible for FHLBank membership to be the state in which it maintains its "home office" (as established under the laws under which the institution is organized), but only if the institution conducts business operations from its home office; and
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makes captive insurance companies ineligible for FHLBank membership
The rule defines a captive insurance company as a company that is authorized under state law to conduct an insurance business but whose primary business is not the underwriting of insurance for non-affiliated persons or entities.
Captive insurance company members that were admitted as FHLBank members prior to September 12, 2014 (the date the FHFA proposed this rule), will have their memberships terminated by February 18, 2021. Captive insurance company members that were admitted as FHLBank members after September 12, 2014, will have their memberships terminated by February 18, 2017. There are restrictions on the level and maturity of advances that FHLBanks can make to these members during the sunset periods.
We do not expect the rule to have a material impact on our financial condition or results of operations.
FHFA Final Rule on Responsibilities of Boards of Directors, Corporate Practices and Corporate Governance Matters
On November 19, 2015, the FHFA issued a rule effective on December 21, 2015, that, among other things, require each FHLBank to:
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operate an enterprise-wide risk-management program and assign its chief risk officer certain enumerated responsibilities;
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maintain a compliance program headed by a compliance officer who reports directly to the chief executive officer and must regularly report to the board of directors (or a board committee);
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maintain board committees specifically responsible for risk management; audit; compensation; and corporate governance; and
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designate in its bylaws a body of law to follow for its corporate governance and indemnification practices and procedures, choosing from the law of the jurisdiction in which the FHLBank maintains its principal office, the Delaware General Corporation Law; or the Revised Model Business Corporation Act. On March 18, 2016, we adopted revised bylaws which selected Massachusetts law for this purpose.
Additionally, the rule provides that the FHFA has the authority to review a regulated entity’s indemnification policies, procedures, and practices to ensure that they are conducted in a safe and sound manner.
We do not expect this rule to materially impact our financial condition or results of operation.
Joint Final Rule on Margin and Capital Requirements for Covered Swap Entities
In October 2015, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the FHFA (each an Agency and, collectively, the Agencies) jointly adopted final rules to establish minimum margin and capital requirements for registered swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants (Swap Entities) that are subject to
the jurisdiction of one of the Agencies (such entities, Covered Swap Entities, and the joint final rules, the Final Margin Rules). On January 6, 2016, the Commodity Futures Trading Commission (the CFTC) published its own version of the Final Margin Rules that generally mirrors the Final Margin Rules. The CFTC’s rules apply only to a limited number of registered swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants that are not subject to the jurisdiction of one of the Agencies.
When they take effect, the Final Margin Rules will subject non-cleared swaps and non-cleared security-based swaps between Covered Swap Entities and Swap Entities and between Covered Swap Entities and financial end users that have material swaps exposure (i.e., an average daily aggregate notional of $8 billion or more in non-cleared swaps), to a mandatory two-way initial margin requirement. The amount of the initial margin required to be posted or collected would be either the amount calculated by the Covered Swap Entity using a standardized schedule set forth as an appendix to the Final Margin Rules, which provides the gross initial margin (as a percentage of total notional exposure) for certain asset classes, or an internal margin model of the Covered Swap Entity conforming to the requirements of the Final Margin Rules that are approved by the Agency having jurisdiction over the particular Covered Swap Entity. The Final Margin Rules specify the types of collateral that may be posted or collected as initial margin (generally, cash, certain government securities, certain liquid debt, certain equity securities, certain eligible publicly traded debt, and gold); and set forth haircuts for certain collateral asset classes. Initial margin must be segregated with an independent, third-party custodian and, generally, may not be rehypothecated, except that cash funds may be placed with a custodian bank in return for a general deposit obligation under certain specified circumstances.
The Final Margin Rules will require variation margin to be exchanged daily for non-cleared swaps and non-cleared security-based swaps between Covered Swap Entities and Swap Entities and between Covered Swap Entities and all financial end-users (without regard to the swaps exposure of the particular financial end-user). The variation margin amount is the daily mark-to-market change in the value of the swap to the Covered Swap Entity, taking into account variation margin previously paid or collected. For non-cleared swaps and security-based swaps between Covered Swap Entities and financial end-users, variation margin may be paid or collected in cash or non-cash collateral that is considered eligible for initial margin purposes. Variation margin is not subject to segregation with an independent, third-party custodian, and may, if permitted by contract, be rehypothecated.
The variation margin requirement under the Final Margin Rules will become effective for the Bank on March 1, 2017, and the initial margin requirements under the Final Margin Rules are expected to become effective for the Bank on September 1, 2020.
We are not a Covered Swap Entity under the Final Margin Rules. Rather, we are a financial end-user under the Final Margin Rules, and would likely have material swaps exposure when the initial margin requirements under the Final Margin Rules become effective.
Since we are currently posting and collecting variation margin on non-cleared swaps, it is not anticipated that the variation margin requirement under the Final Margin Rules will have a material impact on our costs. However, when the initial margin requirements under the Final Margin Rules become effective, we anticipate that our cost of engaging in non-cleared swaps may increase.
FHFA Core Mission Achievement Advisory Bulletin 2015-05
On July 14, 2015, the FHFA issued an advisory bulletin that provides guidance establishing a ratio by which the FHFA will assess each FHLBank’s core mission achievement. Core mission achievement is determined using a ratio of primary mission assets, which includes advances and acquired member assets (mortgage loans acquired from members), to consolidated obligations. The core mission asset ratio will be calculated annually at year-end, using annual average par values.
The advisory bulletin provides the FHFA’s expectations about the content of each FHLBank’s strategic plan based on its ratio, as follows:
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when the ratio is at least 70 percent, the strategic plan should include an assessment of the FHLBank’s prospects for maintaining this level;
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when the ratio is at least 55 percent but less than 70 percent, the strategic plan should explain the FHLBank’s plan to increase the ratio; and
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when the ratio is below 55 percent, the strategic plan should include an explanation of the circumstances that caused the ratio to be at that level and detailed plans to increase the ratio. The advisory bulletin provides that if an FHLBank maintains a ratio below 55 percent over the course of several consecutive reviews, the FHLBank’s board of directors should consider possible strategic alternatives.
Our primary core mission achievement ratio for the year ended December 31, 2015, was 69.7 percent. We do not expect that complying with the advisory bulletin will materially impact our financial condition or results of operations.
Finance Agency Proposed Rule on Acquired Member Assets
On December 17, 2015, the Finance Agency published a proposed rule that would amend the current Acquired Member Assets rule, which governs an FHLBank’s ability to purchase and hold certain types of mortgage loans from its members. The proposed rule would allow an FHLBank to utilize its own model in lieu of a NRSRO ratings model to determine the credit rating for Acquired Member Assets loan assets and loan pools. The proposed rule would also eliminate the use of pool level insurance, such as supplemental mortgage insurance, as part of the required credit risk-sharing structure for Acquired Member Assets products; however, the FHLBanks are not currently acquiring Acquired Member Assets loans using this structure.
It is not possible to predict whether the proposed rule (if adopted) would have a negative impact on the volume of AMA loan assets or on our costs of operation.
Comments on the proposed rule are due on April 15, 2016.
Amendment of FHLBank Act to Make Privately-Insured Credit Unions Eligible for FHLBank Membership
On December 4, 2015, President Obama signed a bill known as the Fixing America’s Surface Transportation Act (“FAST Act”), which includes a provision that amends the FHLBank Act to allow privately insured credit unions to be eligible for FHLBank membership. The FAST Act requires privately insured credit unions to satisfy certain initial and ongoing eligibility and reporting requirements. The FHFA has indicated that it is reviewing the relevant portions of the FAST Act and that the FHLBanks should consult with the FHFA before acting on the membership application of any privately insured credit union.
CREDIT RATING AGENCY DEVELOPMENTS
As of February 29, 2016, Moody’s long-and short-term credit ratings for us and the 10 other FHLBanks are AAA and P-1, with a stable outlook.
As of February 29, 2016, S&P’s long- and short-term credit ratings for us and the 10 other FHLBanks are AA+ and A-1+, with a stable outlook.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Sources and Types of Market and Interest-Rate Risk
Market risk is the risk to earnings or shareholder value due to adverse movements in interest rates, market prices, or interest-rate spreads. Market risk arises in the normal course of business from our investment in mortgage assets, where risk cannot be eliminated; from the fact that assets and liabilities are priced in different markets; and from tactical decisions to, from time to time, assume some risk to generate income.
Our balance sheet is comprised of different portfolios that require different types of market- and interest-rate-risk management strategies. The majority of our balance sheet is comprised of assets that can be funded individually or collectively without imposing significant residual interest-rate risk on ourselves.
However, those assets with embedded options, particularly our mortgage-related assets, including the portfolio of whole loans acquired through the MPF program, our portfolio of MBS and ABS, and our portfolio of bonds issued by HFAs, represent more complex cash-flow structures and contain more risk of prepayment and/or call options.
Further, unequal moves in the various different yield curves associated with our assets and liabilities create risks that changes in individual portfolio or instrument valuations, or changes in projected income, will not be equally offset by changes in valuations or projected income associated with individual portfolios or instruments on the opposite side of the balance sheet, even if the financial terms of the opposing financial portfolios or instruments are closely matched.
These risks cannot always be profitably managed with a strategy in which each asset is offset by a liability with a substantially identical cash-flow structure. Therefore, we generally view each portfolio as a whole and allocate funding and hedging to these portfolios based on an evaluation of the collective market and interest-rate risks posed by these portfolios. We measure the
estimated impact to fair value of these portfolios as well as the potential for income to decline due to movements in interest rates, and make adjustments to the funding and hedge instruments assigned as necessary to keep the portfolios within established risk limits.
We also incur interest-rate risk in the investment of our capital and retained earnings in interest-earning assets. Traditionally we have sought to match our capital against liquid short-term money-market assets to maintain liquidity and to provide our members with a money-market-based return on capital that is responsive to changes in prevailing interest rates over time. While this capital investment strategy is comparatively risk-neutral in terms of our market risk, it exposes our interest income to the level and volatility of interest rates in the markets. As the FOMC sought to stimulate the U.S. economy during and after the prolonged economic recession through a low-rate accommodative policy, the net interest income realized on our investments has been lower than could have been realized on alternative longer-term investments.
Types of Market and Interest-Rate Risk
Interest-rate and market risk can be divided into several categories, including repricing risk, yield-curve risk, basis risk, and options risk. Repricing risk refers to differences in the average sensitivities of asset and liability yields attributable to differences in the average timing of maturities and/or coupon rate resets between assets and liabilities. Differences in the timing of repricing of assets and liabilities can cause spreads between assets and liabilities to either increase or decline.
Yield-curve risk reflects the sensitivity of net income to changes in the shape or slope of the yield curve that could impact the performance of assets and liabilities differently, even though average sensitivities are the same.
When assets and liabilities are affected by yield changes in different markets, basis risk can result. For example, if we invest in LIBOR-based floating-rate assets and fund those assets with short-term discount notes, potential compression in the spread between LIBOR and discount-note rates could adversely impact our net income.
We also face options risk, particularly in our portfolio of advances, mortgage loans, MBS, and HFA securities. When a borrower prepays an advance, we could suffer lower future income if the principal portion of the prepaid advance is reinvested in lower-yielding assets that continue to be funded by higher-cost debt. For this reason, we are required by regulation to assess a prepayment fee that makes us financially indifferent to the prepayment, or in the case of callable advances, to charge an interest rate that is reflective of the value of the member's option to prepay the advance without a fee. However, in the mortgage loan, MBS, and HFA-bond portfolios, borrowers or issuers often have the right to repay their obligations prior to maturity without penalty, potentially requiring us to reinvest the returned principal at lower yields. If interest rates decline, borrowers may be able to refinance existing mortgage loans at lower interest rates, resulting in the prepayment of these existing mortgages and forcing us to reinvest the proceeds in lower-yielding assets. If interest rates rise, borrowers may avoid refinancing mortgage loans for periods longer than the average term of liabilities funding the mortgage loans, causing us to have to refinance the assets at higher cost. This right of redemption is effectively a call option that we have written to the obligor. Another less prominent form of options risk includes coupon-cap risk, which may be embedded into certain floating-rate MBS and limit the amount by which asset coupon rates may increase.
Strategies to Manage Market and Interest-Rate Risk
General
We use various strategies and techniques in an effort to manage our market and interest-rate risk. Principal among our tools for interest-rate-risk management is the issuance of debt that can be used to match interest-rate-risk exposures of our assets. For example, we can issue a CO with a maturity of five years to fund an investment with a five year maturity. The debt may be noncallable until maturity or callable on and/or after a certain date.
COs may be issued to fund specific assets or to manage the overall exposure of a portfolio or the balance sheet. At December 31, 2015, fixed-rate noncallable debt, not hedged by interest-rate swaps, amounted to $14.3 billion, compared with $14.6 billion at December 31, 2014, and fixed-rate callable debt not hedged by interest-rate swaps amounted to $1.4 billion and $1.6 billion at December 31, 2015, and December 31, 2014, respectively.
To achieve certain risk-management objectives, we also use interest-rate derivatives that alter the effective maturities, repricing frequencies, or option-related characteristics of financial instruments. These may include swaps, swaptions, caps, collars, and floors; futures and forward contracts; and exchange-traded options. For example, as an alternative to issuing a fixed-rate bond to fund a fixed-rate advance, we might enter into an interest-rate swap that receives a floating-rate coupon and pays a fixed-rate coupon, thereby effectively converting the fixed-rate advance to a floating-rate advance.
Because the interest-rate swaps and hedged assets and liabilities trade in different markets, they are subject to basis risk that is reflected in our VaR calculations and fair-value disclosures, but that is not reflected in hedge ineffectiveness, because these interest-rate swaps are designed to only hedge changes in fair values of the hedged items that are attributable to changes in the benchmark LIBOR interest rate.
Advances
In addition to the general strategies described above, we use contractual provisions that require borrowers to pay us prepayment fees, which make us financially indifferent if the borrower prepays such advances prior to maturity. These provisions protect against a loss of income under certain interest-rate environments.
Prepayment-fee income can be used to offset the cost of purchasing and retiring high-cost debt to maintain our asset-liability sensitivity profile. In cases where derivatives are used to hedge prepaid advances, prepayment-fee income can be used to offset the cost of terminating the associated hedge.
Investments
We hold certain long-term bonds issued by U.S. federal agencies, U.S. federal government corporations and instrumentalities, and supranational institutions as available-for-sale. To hedge the market and interest-rate risk associated with these assets, we may enter into interest-rate swaps with matching terms to those of the bonds to create synthetic floating-rate assets. At December 31, 2015, and December 31, 2014, this portfolio of hedged investments had an amortized cost of $924.4 million and $928.6 million, respectively.
We also manage the market and interest-rate risk in our MBS portfolio. For MBS classified as held-to-maturity, we use debt that matches the characteristics of the portfolio assets. For example, for floating-rate ABS, we use debt that reprices on a short-term basis, such as CO discount notes or CO bonds that are swapped to a LIBOR-based floating-rate. For commercial MBS that are nonprepayable or prepayable for a fee for an initial period, we may use fixed-rate debt.
We also use interest-rate swaps to manage the fair-value sensitivity of the portion of our MBS portfolio that is classified as trading securities. These interest-rate-exchange agreements provide an economic offset to the duration and convexity risks arising from these assets.
Mortgage Loans
We manage the interest-rate and prepayment risk associated with mortgage loans through the issuance of both callable and noncallable debt to achieve cash-flow patterns and liability durations similar to those expected on the mortgage loans.
We mitigate our exposure to changes in interest rates by funding a portion of our mortgage portfolio with callable debt. When interest rates change, our option to redeem this debt offsets a large portion of the fair-value change driven by the mortgage-prepayment option. These bonds are effective in managing prepayment risk by allowing us to respond in kind to prepayment activity. Conversely, if interest rates increase, we may allow the debt to remain outstanding until maturity. We use various cash instruments including shorter-term debt, callable, and noncallable long-term debt to reprice debt when mortgages prepay faster or slower than expected. Our debt-repricing capacity depends on market demand for callable and noncallable debt, which fluctuates from time to time. Additionally, because the mortgage-prepayment option is not fully hedged by callable debt, the combined market value of our mortgage assets and debt will be affected by changes in interest rates.
Swapped Consolidated Obligation Debt
We may also issue bonds together with interest-rate swaps that receive a coupon rate that offsets the bond coupon rate and any optionality embedded in the bond, thereby effectively creating a floating-rate liability. We may employ this strategy to secure long-term debt that meets funding needs versus relying on short-term CO discount notes. Total CO bond debt used in conjunction with interest-rate-exchange agreements was $6.4 billion, or 25.2 percent of our total outstanding CO bonds at December 31, 2015, compared with $7.2 billion, or 28.4 percent of total outstanding CO bonds, at December 31, 2014.
Measurement of Market and Interest-Rate Risk and Related Policy Constraints
We measure our exposure to market and interest-rate risk using several techniques applied to the balance sheet and to certain portfolios within the balance sheet. Principal among these measurements as applied to the balance sheet is the potential future
change in market value of equity (MVE) and interest income due to potential changes in interest rates, interest-rate volatility, spreads, and market prices. We also measure VaR, duration of equity, convexity, and the other metrics discussed below.
We use certain quantitative systems to evaluate our risk position. These systems are capable of employing various interest-rate term-structure models and valuation techniques to determine the values and sensitivities of complex or option-embedded instruments such as mortgage loans; MBS; callable bonds and swaps; and adjustable-rate instruments with embedded caps and floors, among others. These models require the following:
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specification of the contractual and behavioral features of each instrument;
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determination and specification of appropriate market data, such as yield curves and implied volatilities;
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utilization of appropriate term-structure and prepayment models to reasonably describe the potential evolution of interest rates over time and the expected behavior of financial instruments in response;
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for option-free instruments, the expected cash flows are specified in accordance with the term structure of interest rates and discounted using spot rates derived from the same term structure; and
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for option-embedded instruments, the models use standardized option pricing methodology to determine the likelihood of embedded options being exercised or not.
We use various measures of market and interest-rate risk, as set forth below in this section. Some measures have associated, prescriptive management action triggers or limits under our policies, as described below, but others do not.
Market Value of Equity Estimation and Market Risk Limit. MVE is the net economic value of total assets and liabilities, including any off-balance-sheet items. In contrast to the GAAP-based shareholder's equity account, MVE represents the shareholder's equity account in present-value terms. Specifically, MVE equals the difference between the estimated market value of our assets and the estimated market value of our liabilities, net of the estimated market value of all derivatives.
Market Value of Equity/Book Value of Equity Ratio. MVE, and in particular, the ratio of MVE to the book value of equity (BVE), is a measure of the current value of shareholder investment based on market rates, spreads, prices, and volatility at the reporting date. However, we caution that care must be taken to properly interpret the results of the MVE analysis as the basis for these valuations may not be fully representative of future realized prices. Further, valuations are based on market curves and prices respective of individual assets, liabilities, and derivatives, and therefore are not representative of future net income to be earned by us through the spread between asset market curves and the market curves for funding costs. MVE should not be considered indicative of our market value as a going concern because it does not consider future new business activities, risk-management strategies, or the net profitability of assets after funding costs are subtracted.
For purposes of measuring this ratio, the BVE is equal to our permanent capital, which consists of the par value of capital stock including mandatorily redeemable capital stock, plus retained earnings. At December 31, 2015, our MVE was $3.4 billion and our BVE was $3.5 billion. At December 31, 2014, both our MVE and BVE was $3.6 billion. Our ratio of MVE to BVE was 97 percent at December 31, 2015, compared with 98 percent at December 31, 2014.
Market Value of Equity/Par Stock Ratio. We also measure the ratio of our MVE to the par value of our Class B Stock, which we refer to as our MVE to par stock ratio. We have established an MVE to par stock ratio floor of 100 percent with an associated management action trigger of 102 percent, reflecting our intent to preserve the value of our members' capital investment. As of December 31, 2015, and December 31, 2014, that ratio was 143 percent and 131 percent, respectively.
Value at Risk. VaR measures the change in our MVE to a 99th percent confidence interval, based on a set of stress scenarios (VaR stress scenarios) using historical interest-rate and volatility movements that have been observed over six-month intervals starting at the most recent month-end and going back monthly to 1992.
The table below presents the historical simulation VaR estimate as of December 31, 2015, and December 31, 2014, and represents the estimates of potential reduction to our MVE from potential future changes in interest rates and other market factors. Estimated potential market value loss exposures are expressed as a percentage of the current MVE and are based on the historical relative behavior of interest rates and other market factors over a 120-business-day time horizon.
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(1)
To be consistent with FHFA guidance, we have excluded VaR stress scenarios prior to 1992 because market-risk stress conditions are effectively captured in those scenarios beginning in 1992 and therefore properly present our current VaR exposure.
(2)
Loss exposure is expressed as a percentage of base MVE.
(3)
The MVE results for December 31, 2014, have been revised from last year's annual report on Form 10-K to conform to the current period methodology, which takes into account the value of cash pledged as collateral for derivative transactions.
The following table outlines our VaR exposure to the 99th percentile, consistent with FHFA regulations, over 2015 and 2014.
Our risk-management policy requires that VaR not exceed $275.0 million and an associated management action trigger of $225.0 million. Should the limit be exceeded, the policy requires management to notify the board of directors' Risk Committee of such breach. We complied with our VaR limit at all times during the year ended December 31, 2015.
Duration of Equity. Another measure of risk that we use is duration of equity. Duration of equity measures the percentage change to shareholder value due to movements in interest rates. A positive duration of equity generally indicates an appreciation in shareholder value in times of falling rates and a depreciation in shareholder value for increasing rate environments. We have established a limit of +/- 4.0 years for duration of equity with an associated management action trigger of +/- 3.5 years based on a balanced consideration of market-value sensitivity and net interest-income sensitivity. Our policies require us to notify our board of directors' Risk Committee of such breach. We did not breach this limit in 2015.
As of December 31, 2015, our duration of equity was +0.07 years, compared with +0.01 years at December 31, 2014.
Convexity Management Action Trigger and Limit. We measure the convexity of our MVE and have established a management action trigger at a decline of 10 percent and a limit at a decline of 15 percent in an up or down 200 basis point parallel rate shock scenario. Our policies require management to notify the board of director’s Risk Committee if the limit is breached. As per the percent change in MVE lines in the above tables, we satisfied the limit at each of December 31, 2015, and December 31, 2014.
MPF Portfolio Management Action Trigger of 25 Percent of Our VaR Limit. We have established a management action trigger for VaR exposure from our investments in mortgage loans through the MPF program such that the VaR from these investments shall not exceed 25 percent of our overall VaR limit. While we seek to limit interest-rate risk through matching asset maturity and optionality with its corresponding funding, mortgage loans cannot be perfectly match funded due to factors including, but not limited to, borrower prepayment behavior and basis risk between the swap and our funding curves. This management action
trigger was $68.8 million at December 31, 2015, based on our overall VaR limit of $275.0 million. Our actual MPF portfolio VaR exposure at December 31, 2015, was $66.6 million, compared with $49.6 million as of December 31, 2014.
Duration Gap. We measure the duration gap of our assets and liabilities, including all related hedging transactions. Duration gap is the difference between the estimated durations (percentage change in market value for a 100 basis point shift in interest rates) of assets and liabilities (including the effect of related hedges) and reflects the extent to which estimated sensitivities to market changes, including, but not limited to, maturity and repricing cash flows for assets and liabilities, are matched. Higher numbers, whether positive or negative, indicate greater sensitivity in the MVE in response to changing interest rates. A positive duration gap means that our total assets have an aggregate duration, or sensitivity to interest-rate changes, greater than our liabilities, and a negative duration gap means that our total assets have an aggregate duration shorter than our liabilities. Our duration gap was +0.05 months at December 31, 2015, compared with +0.01 months at December 31, 2014.
Income Simulation and Repricing Gaps. To provide an additional perspective on market and interest-rate risks, we have an income-simulation model that projects adjusted net income over the ensuing 12-month period using a range of potential interest-rate scenarios, including parallel interest-rate shocks, nonparallel interest-rate shocks, and nonlinear changes to our funding curve and LIBOR. The income simulation metric is based on projections of adjusted net income divided by regulatory capital. Regulatory capital is capital stock (including mandatorily redeemable capital stock) plus total retained earnings, and projections of adjusted net income exclude a) interest expense on mandatorily redeemable capital stock; b) projected prepayment penalties; c) loss on early extinguishment of debt; or d) changes in fair values from trading securities and hedging activities. The simulations are solely based on simulated movements in the swap and the CO curve and do not reflect potential impacts of credit events, including, but not limited to, potential, additional other-than-temporary impairment charges. Management has put in place escalation-action triggers whereby senior management is explicitly informed of instances where our projected return on regulatory capital would fall below three-month LIBOR over the following 12-month horizon in any of the assumed interest-rate scenarios. The results of this analysis for December 31, 2015, and December 31, 2014, showed that in the worst-case scenario, our return on regulatory capital falls to 135 basis points and 184 basis points, respectively, above the average yield on three-month LIBOR under a yield curve scenario wherein interest rates instantaneously rise by 300 basis points in a parallel fashion across all yield curves.
Economic Capital Ratio Limit. We have established a limit of 4.0 percent for the ratio of the MVE to the market value of assets, referred to as the economic capital ratio. FHFA regulations require us to maintain a regulatory capital ratio of book value of regulatory capital to book value of total assets of no less than 4.0 percent, as discussed in Item 8
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to financial statements and supplementary data:
Management's Report on Internal Control over Financial Reporting
The management of the Federal Home Loan Bank of Boston is responsible for establishing and maintaining adequate internal control over financial reporting.
Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of internal control over financial reporting as of December 31, 2015, based on the framework established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that assessment, management concluded that, as of December 31, 2015, internal control over financial reporting is effective based on the criteria established in Internal Control - Integrated Framework (2013).
Additionally, our internal control over financial reporting as of December 31, 2015, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of the Federal Home Loan Bank of Boston:
In our opinion, the accompanying statements of condition and the related statements of operations, comprehensive income, capital, and cash flows, present fairly, in all material respects, the financial position of the Federal Home Loan Bank of Boston (the Bank) at December 31, 2015, and 2014, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Bank maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Bank's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Bank's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Boston, Massachusetts
March 18, 2016
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(a) Fair values of held-to-maturity securities were $2,923,124 and $3,710,815 at December 31, 2015 and 2014, respectively.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF BOSTON
NOTES TO FINANCIAL STATEMENTS
Background Information
We are a federally chartered corporation and one of 11 district Federal Home Loan Banks (the FHLBanks or the FHLBank System). The FHLBanks are government-sponsored enterprises (GSEs) that serve the public by enhancing the availability of credit for residential mortgages and targeted community development. Each FHLBank operates in a specifically defined geographic territory, or district. We provide a readily available, competitively priced source of funds to our members and certain nonmember institutions located within the six New England states, which are Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont. Certain regulated financial institutions, including community development financial institutions (CDFIs) and insurance companies with their principal places of business in New England and engaged in residential housing finance, may apply for membership. Additionally, certain nonmember institutions (referred to as housing associates) that meet applicable legal criteria may also borrow from us. While eligible to borrow, housing associates are not our members and, therefore, are not allowed to hold capital stock. As a cooperative, current and former members own all of our outstanding capital stock and may receive dividends on their investment. We do not have any wholly or partially owned subsidiaries, and we do not have an equity position in any partnerships, corporations, or off-balance-sheet special-purpose entities.
All members must purchase our stock as a condition of membership, as well as a condition of engaging in certain business activities with us.
The FHFA, our primary regulator, is the independent federal regulator of the FHLBanks, Federal Home Loan Mortgage Corporation (Freddie Mac), and Federal National Mortgage Association (Fannie Mae). A purpose of the FHFA is to ensure that the FHLBanks operate in a safe and sound manner, including maintenance of adequate capital and internal controls. In addition, the FHFA is responsible for ensuring that 1) the operations and activities of each FHLBank foster liquid, efficient, competitive, and resilient national housing finance markets, 2) each FHLBank complies with the title and the rules, regulations, guidelines, and orders issued under the Housing and Economic Recovery Act (HERA) and the authorizing statutes, 3) each FHLBank carries out its statutory mission only through activities that are authorized under and consistent with HERA and the authorizing statutes, and 4) the activities of each FHLBank and the manner in which such FHLBank is operated is consistent with the public interest. Each FHLBank is a separate legal entity with its own management, employees, and board of directors.
The Office of Finance is the FHLBanks' fiscal agent and is a joint office of the FHLBanks established to facilitate the issuance and servicing of the FHLBanks' COs and to prepare the combined quarterly and annual financial reports of all the FHLBanks. As provided by the Federal Home Loan Bank Act of 1932, as amended (the FHLBank Act), and applicable regulations, COs are backed only by the financial resources of all the FHLBanks and are our primary source of funds. Deposits, other borrowings, and the issuance of capital stock, which is principally held by our current and former members, provide other funds. We primarily use these funds to provide loans, called advances, to invest in single-family mortgage loans under the Mortgage Partnership Finance® (MPF®) program, and also to fund other investments. In addition, we offer correspondent services, such as wire-transfer, investment-securities-safekeeping, and settlement services.
"Mortgage Partnership Finance", "MPF" and MPF Xtra are registered trademarks of the FHLBank of Chicago.
Note 1 - Summary of Significant Accounting Policies
Use of Estimates
These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of financial statements in accordance with GAAP requires management to make subjective assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. The most significant of these estimates include but are not limited to, fair-value estimates, other-than-temporary impairment analysis, the allowance for loan losses, and deferred premium/discounts associated with prepayable assets. Actual results could differ from these estimates.
Fair Value
We determine the fair-value amounts recorded on the statement of condition and in the note disclosures for the periods presented by using available market and other pertinent information, and reflect our best judgment of appropriate valuation methods. Although we use our best judgment in estimating the fair value of these financial instruments, there are inherent
limitations in any valuation technique. Therefore, these fair values may not be indicative of the amounts that would have been realized in market transactions at the reporting dates. See Note 18 - Fair Values for more information.
Financial Instruments Meeting Netting Requirements
We present certain financial instruments on a net basis when they have a legal right of offset and all other requirements for netting are met (collectively referred to as the netting requirements). For these financial instruments, we have elected to offset our asset and liability positions, as well as cash collateral received or pledged, when we have met the netting requirements.
The net exposure for these financial instruments can change on a daily basis; therefore, there may be a delay between the time this exposure change is identified and additional collateral is requested, and the time when this collateral is received or pledged. Likewise, there may be a delay for excess collateral to be returned. For derivative instruments that meet the requirements for netting, any excess cash collateral received or pledged is recognized as a derivative liability or derivative asset. See Note 11 - Derivatives and Hedging Activities for additional information regarding these agreements.
Based on the fair value of the related collateral held, the securities purchased under agreements to resell were fully collateralized for the periods presented. At December 31, 2015, we had $6.7 billion in securities purchased under agreements to resell. There were no offsetting amounts related to these securities at December 31, 2015.
Interest-Bearing Deposits, Securities Purchased Under Agreements to Resell, and Federal Funds Sold
These investments provide short-term liquidity and are carried at cost. Federal funds sold consist of short-term, unsecured loans transacted with counterparties that we consider to be of investment quality. Securities purchased under agreements to resell are treated as short-term collateralized loans that are classified as assets in the statement of condition. These securities purchased under agreements to resell are held in safekeeping in our name by third-party custodians, which we have approved. If the fair value of the underlying securities decreases below the fair value required as collateral, the counterparty has the option to provide additional securities in safekeeping in our name in an amount equal to the decrease or remit cash in such amount. If the counterparty defaults on this obligation, we will decrease the dollar value of the resale agreement accordingly. We have not sold or repledged the collateral received on securities purchased under agreements to resell. Securities purchased under agreements to resell averaged $4.8 billion during 2015 and $5.0 billion during 2014, and the maximum amount outstanding at any month-end during 2015 and 2014 was $8.1 billion and $7.8 billion, respectively.
Investment Securities
We classify investments as trading, available-for-sale, or held-to-maturity at the date of acquisition. Purchases and sales of securities are recorded on a trade date basis.
Trading. Securities classified as trading are held for liquidity purposes and carried at fair value. We record changes in the fair value of these investments through other income as net unrealized (losses) gains on trading securities. FHFA regulations prohibit trading in or the speculative use of these instruments and limit the credit risks we have from these instruments.
Available-for-sale. We classify certain investments that are not classified as held-to-maturity or trading as available-for-sale and carry them at fair value. Changes in fair value of available-for-sale securities not being hedged by derivatives, or in an economic hedging relationship, are recorded in other comprehensive income (loss) as net unrealized (losses) gains on available-for-sale securities. For available-for-sale securities that have been hedged under fair-value hedge designations, we record the portion of the change in fair value related to the risk being hedged in other income as net (losses) gains on derivatives and hedging activities together with the related change in the fair value of the derivative. The remainder of the change in the fair value of the investment is recorded in other comprehensive income (loss) as net unrealized (losses) gains on available-for-sale securities.
Held-to-Maturity. Certain investments for which we have both the ability and intent to hold to maturity are classified as held-to-maturity and are carried at cost, adjusted for periodic principal repayments, amortization of premiums and accretion of discounts using the level-yield method, previous other-than-temporary impairment, and accretion of the noncredit portion of other-than-temporary impairment recognized in other comprehensive income (loss).
Changes in circumstances may cause us to change our intent to hold certain securities to maturity without calling into question our intent to hold other debt securities to maturity in the future. Thus, the sale or transfer of a held-to-maturity security due to certain changes in circumstances, such as evidence of significant deterioration in the issuer's creditworthiness or changes in regulatory requirements, is not considered to be inconsistent with its original classification. Other events that are isolated,
nonrecurring, and unusual for us that could not have been reasonably anticipated may cause us to sell or transfer a held-to-maturity security without necessarily calling into question our intent to hold other debt securities to maturity. In addition, sale of a debt security that meets either of the following two conditions would not be considered inconsistent with the original classification of that security:
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the sale occurs near enough to its maturity date (or call date if exercise of the call is probable) that interest-rate risk is substantially eliminated as a pricing factor and the changes in market interest rates would not have a significant effect on the security's fair value; or
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the sale of a security occurs after we have already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term.
Premiums and Discounts. We amortize premiums and accrete discounts on mortgage-backed securities (MBS) using the level-yield method over the estimated lives of the securities. This method requires a retrospective adjustment of the effective yield each time we change the estimated life, based on actual prepayments received and changes in expected prepayments, as if the new estimate had been known since the original acquisition date of the securities. We estimate prepayment speeds on each individual security using the most recent three months of historical constant prepayment rates, as available, or may subscribe to third-party data services that provide estimates of future cash flows, from which we determine expected asset lives. We amortize premiums and accrete discounts on other investments using the level-yield method to the contractual maturity of the securities.
Gains and Losses on Sales. We compute gains and losses on sales of investment securities using the specific identification method and include these gains and losses in other income (loss).
Investment Securities - Other-than-Temporary Impairment
We evaluate our individual available-for-sale and held-to-maturity securities in an unrealized loss position for other-than-temporary impairment each quarter. An investment is considered impaired when its fair value is less than its amortized cost. We consider other-than-temporary impairment to have occurred if we:
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have an intent to sell the investment;
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believe it is more likely than not that we will be required to sell the investment before the recovery of its amortized cost based on available evidence; or
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do not expect to recover the entire amortized cost of the debt security.
Recognition of Other-than-Temporary Impairment. If either of the first two conditions above is met, we recognize an other-than-temporary impairment charge in earnings equal to the entire difference between the security's amortized cost and its fair value as of the statement of condition date.
For securities in an unrealized loss position that meet neither of the first two conditions (excluding agency MBS) and for each of our private-label MBS, we perform an analysis to determine if we will recover the entire amortized cost of each of these securities. The present value of the cash flows expected to be collected is compared with the amortized cost of the debt security to determine whether a credit loss exists. If the present value of the cash flows expected to be collected is less than the amortized cost of the debt security, the security is deemed to be other-than-temporarily impaired and the carrying value of the debt security is adjusted to its fair value. However, rather than recognizing the entire difference between the amortized cost and fair value in earnings, only the amount of the impairment representing the credit loss (that is, the credit component) is recognized in earnings, while the amount related to all other factors (that is, the noncredit component) is recognized in other comprehensive income (loss). For a security that is determined to be other-than-temporarily impaired, in the event that the present value of the cash flows expected to be collected is less than the fair value of the security, the credit loss on the security is limited to the amount of that security's unrealized losses.
In performing a detailed cash-flow analysis, we identify the best estimate of the cash flows expected to be collected. If this estimate results in a present value of expected cash flows (discounted at the security's effective yield) that is less than the amortized cost basis of a security (that is, a credit loss exists), other-than-temporary impairment is considered to have occurred. For determining the present value of variable-rate and hybrid private-label residential MBS, we use the effective interest rate derived from a variable-rate index, such as one-month LIBOR, plus the contractual spread, plus or minus a fixed-spread adjustment when there is an existing discount or premium on the security. Because the implied forward yield curve of a
selected variable-rate index changes over time, the effective interest rates derived from that index will also change over time and would therefore impact the present value of the subject security.
The total other-than-temporary impairment is presented in the statement of operations with an offset for the amount of the noncredit portion of other-than-temporary impairment that is recognized in other comprehensive income (loss). The remaining amount in the statement of operations represents the credit loss for the period.
Accounting for Other-than-Temporary Impairment Recognized in Other Comprehensive Income. For subsequent accounting of other-than-temporarily impaired securities, we record an additional other-than-temporary impairment if the present value of cash flows expected to be collected is less than the amortized cost of the security. The total amount of this additional other-than-temporary impairment (both credit and non-credit, if any) is determined as the difference between the security's amortized cost less the amount of other-than-temporary impairment recognized in other comprehensive income (loss) prior to the determination of this additional other-than-temporary impairment and its fair value. Any additional credit loss is limited to that security's unrealized losses, or the difference between the security's amortized cost and its fair value as of the statement of condition date. This additional credit loss, up to the amount in other comprehensive income (loss) related to the security, is reclassified out of other comprehensive income (loss) and recognized in earnings. Any credit loss in excess of the amount reclassified out of other comprehensive income (loss) is also recognized in earnings.
Interest Income Recognition. Upon subsequent evaluation of a debt security when there is no additional other-than-temporary impairment, we adjust the accretable yield on a prospective basis if there is a significant increase in the security's expected future cash flows. This adjusted yield is used to calculate the amount to be recognized into income over the remaining life of the security so as to match the amount and timing of future cash flows expected to be collected. Subsequent changes in estimated cash flows that are deemed significant will change the accretable yield on a prospective basis. For debt securities classified as held-to-maturity, the other-than-temporary impairment recognized in other comprehensive income (loss) is accreted to the carrying value of each security on a prospective basis, based on the amount and timing of future estimated cash flows (with no effect on earnings unless the security is subsequently sold or there are additional decreases in cash flows expected to be collected). The estimated cash flows and accretable yield are re-evaluated each quarter.
Advances
We report advances at amortized cost. Advances carried at amortized cost are reported net of premiums/discounts and any hedging adjustments, as discussed in Note 8 - Advances. We generally record our advances at par. However, we may record premiums or discounts on advances in the following cases:
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Advances may be acquired from another FHLBank when one of our members acquires a member of another FHLBank. In these cases, we may purchase the advances from the other FHLBank at a price that results in a fair market yield for the acquired advance.
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In the event that a hedge of an advance is discontinued, the cumulative hedging adjustment is recorded as a premium or discount and amortized over the remaining life of the advance.
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When the prepayment of an advance is followed by disbursement of a new advance and the transactions effectively represent a modification of the previous advance the prepayment fee received is deferred, recorded as a discount to the modified advance, and accreted over the life of the new advance.
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When an advance is modified under our advance restructuring program and our analysis of the restructuring concludes that the transaction is an extinguishment of the prior loan rather than a modification, the deferred prepayment fee is recognized into income immediately, recorded as premium on the new advance, and amortized over the life of the new advance.
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When we make an AHP advance, the present value of the variation in the cash flow caused by the difference in the interest rate between the AHP advance rate and our related cost of funds for comparable maturity funding is charged against the AHP liability and recorded as a discount on the AHP advance.
We amortize the premiums and accrete the discounts on advances to interest income using the level-yield method. We record interest on advances to interest income as earned.
Prepayment Fees. We charge borrowers a prepayment fee when they prepay certain advances before the original maturity. We record prepayment fees net of hedging fair-value adjustments included in the carrying value of the advance as prepayment fees on advances, net in the interest income section of the statement of operations.
Advance Modifications. In cases in which we fund a new advance concurrently with or within a short period of time of the prepayment of an existing advance by the same member, we evaluate whether the new advance meets the accounting criteria to
qualify as a modification of the existing advance or whether it constitutes a new advance. We compare the present value of cash flows on the new advance with the present value of cash flows remaining on the existing advance. If there is at least a 10 percent difference in the present value of cash flows or if we conclude the difference between the advances is more than minor based on a qualitative assessment of the modifications made to the advance's original contractual terms, the advance is accounted for as a new advance. In all other instances, the new advance is accounted for as a modification.
If a new advance qualifies as a modification of the existing advance, the net prepayment fee on the prepaid advance is deferred, recorded in the basis of the modified advance, and amortized to interest income over the life of the modified advance using the level-yield method. This amortization is recorded in advance-interest income. If the modified advance is hedged, changes in fair value are recorded after the amortization of the basis adjustment. This amortization results in offsetting amounts being recorded in net interest income and net (losses) gains on derivatives and hedging activities in other income.
For prepaid advances that were hedged and met the hedge-accounting requirements, we terminate the hedging relationship upon prepayment and record the prepayment fee net of the hedging fair-value adjustment in the basis of the advance as prepayment fees on advances, net in interest income. If we fund a new advance to a member concurrent with or within a short period of time after the prepayment of a previous advance to that member, we evaluate whether the new advance qualifies as a modification of the original hedged advance. If the new advance qualifies as a modification of the original hedged advance, the hedging fair-value adjustment and the prepayment fee are included in the carrying amount of the modified advance and are amortized in interest income over the life of the modified advance using the level-yield method. If the modified advance is also hedged and the hedge meets the hedging criteria, the modified advance is marked to fair value after the modification, and subsequent fair-value changes are recorded in other income as net (losses) gains on derivatives and hedging activities.
If a new advance does not qualify as a modification of an existing advance, prepayment of the existing advance is treated as an advance termination and any prepayment fee, net of hedging adjustments, is recorded to prepayment fees on advances, net in the interest income section of the statement of operations.
Commitment Fees
We record commitment fees for standby letters of credit to members as deferred fee income when received, and amortize these fees on a straight-line basis to service-fees income in other income over the term of the standby letter of credit. Based upon past experience, we believe the likelihood of standby letters of credit being drawn upon is remote.
Mortgage Loans Held for Portfolio
We participate in the MPF program through which we invest in conventional, residential, fixed-rate mortgage loans (conventional mortgage loans) and government-insured or -guaranteed residential fixed-rate mortgage loans (government mortgage loans) that are purchased from participating financial institutions (see Note 9 - Mortgage Loans Held for Portfolio). We classify our investments in mortgage loans for which we have the intent and ability to hold for the foreseeable future or until maturity or payoff as held for portfolio. As of December 31, 2015, all our investments in mortgage loans are held for portfolio. Accordingly, these investments are reported at their principal amount outstanding net of unamortized premiums, discounts, unrealized gains and losses from investments initially classified as mortgage loan commitments, direct write-downs, and the allowance for credit losses on mortgage loans.
Premiums and Discounts. We compute the amortization of mortgage-loan-origination fees (premiums and discounts) as interest income using the level-yield method over the contractual term to maturity of each individual loan, which results in income recognition in a manner that is effectively proportionate to the actual repayment behavior of the underlying assets and reflects the contractual terms of the assets without regard to changes in estimated prepayments based on assumptions about future borrower behavior.
Credit-Enhancement Fees. For conventional mortgage loans, participating financial institutions retain a portion of the credit risk on the loans in which we invest by providing credit-enhancement protection either through a direct liability to pay credit losses up to a specified amount or through a contractual obligation to provide supplemental mortgage insurance. Participating financial institutions are paid a credit-enhancement fee for assuming credit risk and in some instances all or a portion of the credit-enhancement fee may be performance-based. Credit-enhancement fees are paid monthly and are determined based on the remaining unpaid principal balance of the pertinent MPF loans. The required credit-enhancement amount varies depending on the MPF product. Credit-enhancement fees are recorded as an offset to mortgage-loan-interest income. To the extent that losses in the current month exceed performance-based credit-enhancement fees accrued, the remaining losses may be recovered from future performance-based credit-enhancement fees payable to the participating financial institution.
Other Fees. We record other nonorigination fees in connection with our MPF program activities in other income. Such fees include delivery-commitment-extension fees, pair-off fees, price-adjustment fees, and counterparty fees in connection with MPF products under which we facilitate third party investment in loans (non-investment MPF products) such as with
the MPF Xtra® product. Delivery-commitment-extension fees are charged when a participating financial institution requests to extend the period of the delivery commitment beyond the original stated expiration. Pair-off fees represent a make-whole provision; they are received when the amount funded under a delivery commitment is less than a certain threshold (under-delivery) of the delivery-commitment amount. Price-adjustment fees are received when the amount funded is greater than a certain threshold (over-delivery) of the delivery-commitment amount. To the extent that pair-off fees relate to under-deliveries of loans, they are recorded in service fee income. Fees related to over-deliveries represent purchase-price adjustments to the related loans acquired and are recorded as part of the carrying value of the loan. The FHLBank of Chicago pays us a counterparty fee for the costs and expenses of marketing activities for loans originated for sale under non-investment MPF products.
Mortgage-Loan Participations. We may purchase and sell participations in MPF loans from other FHLBanks from time to time. References to our investments in mortgage loans throughout this report include any participation interests we own.
Allowance for Credit Losses
An allowance for credit losses is a valuation allowance separately established for each identified portfolio segment, if necessary, to provide for probable losses inherent in our portfolio as of the statement of condition date. To the extent necessary, an allowance for credit losses for off-balance-sheet credit exposure is recorded as a liability.
Portfolio Segments. A portfolio segment is defined as the level at which an entity develops and documents a systematic methodology for determining its allowance for credit losses. We have established an allowance methodology for each of our portfolio segments. See Note 10 - Allowance for Credit Losses for additional information.
Nonaccrual Loans. We place conventional mortgage loans on nonaccrual status when the collection of the contractual principal or interest is 90 days or more past due. When a conventional mortgage loan is placed on nonaccrual status, accrued but uncollected interest is reversed against interest income in the current period. We generally record cash payments received on nonaccrual loans first as interest income and then as a reduction of principal as specified in the contractual agreement, unless we consider the collection of the remaining principal amount due to be doubtful. If we consider the collection of the remaining principal amount to be doubtful, cash payments received are applied first solely to principal until the remaining principal amount due is expected to be collected and then as a recovery of any charge-off, if applicable, followed by recording interest income. A loan on nonaccrual status may be restored to accrual status when the collection of the contractual principal and interest is less than 90 days past due. We do not place government mortgage loans on nonaccrual status when the collection of the contractual principal or interest is 90 days or more past due because of the U.S. government guarantee of the loan and the contractual obligations of each related servicer, as more fully discussed in Note 10 - Allowance for Credit Losses.
Impairment Methodology. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.
Loans that are on nonaccrual status and that are considered collateral-dependent are measured for impairment based on the fair value of the underlying property less estimated selling costs. Loans are considered collateral-dependent if repayment is expected to be provided solely by the sale of the underlying property, that is, there is no other available and reliable source of repayment. Collateral-dependent loans are impaired if the fair value of the underlying collateral less estimated selling costs is insufficient to recover the unpaid principal balance on the loan. Interest income on impaired loans is recognized in the same manner as nonaccrual loans as discussed above.
Charge-Off Policy. A charge-off is recorded if it is estimated that the recorded investment in a loan will not be recovered. We evaluate whether to record a charge-off on a conventional mortgage loan upon the occurrence of a confirming event. Confirming events include, but are not limited to, the occurrence of foreclosure or notification of a claim against any of the credit enhancements. We charge off the portion of outstanding conventional mortgage loan balances in excess of fair value of the underlying property, less cost to sell and adjusted for any available credit enhancements for loans that are 180 or more days past due, when the borrower has filed for bankruptcy protection and the loan is at least 30 days past due, or when there is evidence of fraud.
Troubled Debt Restructurings
We consider a troubled debt restructuring of a financing receivable to have occurred when we grant a concession to a borrower that we would not otherwise consider for economic or legal reasons related to the borrower's financial difficulties. We place conventional mortgage loans that are deemed to be troubled debt restructurings as a result of our modification program on nonaccrual when payments are 60 days or more past due.
Real Estate Owned
REO includes assets that have been received in satisfaction of debt or as a result of actual foreclosures. REO is recorded as other assets in the statement of condition and is carried at the lower of cost or fair value less estimated selling costs. Fair value is derived from third-party valuations of the property. If the fair value of the REO less estimated selling costs is less than the recorded investment in the MPF loan at the date of transfer, we recognize a charge-off to the allowance for credit losses. Subsequent realized gains and realized or unrealized losses are included in other income (loss) in the statement of operations.
Derivatives
All derivatives are recognized on the statement of condition at fair value and are reported as either derivative assets or derivative liabilities, net of cash collateral, including initial and variation margin, and accrued interest received from or pledged to clearing members and/or counterparties. We offset fair-value amounts recognized for derivatives and fair-value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from derivatives recognized at fair value executed with the same clearing member and/or counterparty when the netting requirements have been met. If these netted amounts are positive, they are classified as an asset and, if negative, they are classified as a liability. Derivative assets and derivative liabilities reported on the statement of condition also include net accrued interest. Cash flows associated with derivatives are reflected as cash flows from operating activities in the statement of cash flows unless the derivative meets the criteria to be a financing derivative.
Each derivative is designated as one of the following:
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a qualifying hedge of the change in fair value of a recognized asset or liability or an unrecognized firm commitment (a fair value hedge);
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a qualifying hedge of a forecasted transaction or the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a cash-flow hedge); or
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a nonqualifying hedge of an asset or liability (an economic hedge) for asset-liability-management purposes.
Accounting for Fair-Value and Cash-Flow Hedges. If hedging relationships meet certain criteria, including, but not limited to, formal documentation of the hedging relationship and an expectation to be highly effective, they qualify for fair-value or cash-flow hedge accounting and the offsetting changes in fair value of the hedged items attributable to the hedged risk are recorded either in earnings in the case of fair-value hedges or other comprehensive income (loss) in the case of cash-flow hedges. Our approaches to hedge accounting are:
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long-haul hedge accounting, which generally requires us to formally assess (both at the hedge's inception and at least quarterly) whether the derivatives that are used in hedging transactions have been effective in offsetting changes in the fair value or cash flows of hedged items attributable to the hedged risk or forecasted transactions and whether those derivatives may be expected to remain effective in future periods; and
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short-cut hedge accounting, which can be used for transactions for which the assumption can be made that the change in fair value of a hedged item, due to changes in the benchmark rate, exactly offsets the change in fair value of the related derivative. Under the short-cut method, the entire change in fair value of the interest-rate swap is considered to be effective at achieving offsetting changes in fair values or cash flows of the hedged asset or liability. Beginning in November 2014, to streamline certain operational processes, we voluntarily discontinued the use of short-cut hedge accounting for new hedge relationships entered into after that date; short-cut hedge relationships entered into prior to that date will continue as short-cut hedge relationships until they mature or are terminated.
Derivatives that are used in fair-value hedges are typically executed at the same time as the hedged items, and we designate the hedged item in a qualifying hedge relationship as of the trade date. In many hedging relationships that use the short-cut method, we may designate the hedging relationship upon our commitment to disburse an advance or trade a CO that settles within the shortest period of time possible for the type of instrument based on market-settlement conventions. In such circumstances, although the advance or CO will not be recognized in the financial statements until settlement date, the hedge meets the criteria for applying the short-cut method, provided all other short-cut criteria are also met. We then record the changes in fair value of the derivative and the hedged item beginning on the trade date.
Changes in the fair value of a derivative that is designated and qualifies as a fair-value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk (including changes that reflect losses or gains on firm commitments), are recorded in other income (loss) as net (losses) gains on derivatives and hedging activities.
Changes in the fair value of a derivative that is designated and qualifies as a cash-flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income (loss), a component of capital, until earnings are affected by the variability of the cash flows of the hedged transaction.
For both fair-value and cash-flow hedges, any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative differ from the change in the fair value of the hedged item attributable to the hedged risk or the variability in the cash flows of the forecasted transaction) is recorded in other income (loss) as net (losses) gains on derivatives and hedging activities.
Accounting for Economic Hedges. An economic hedge is defined as a derivative hedging specific or nonspecific assets, liabilities, or firm commitments that does not qualify or was not designated for fair-value or cash-flow hedge accounting, but is an acceptable hedging strategy under our risk-management policy. These economic hedging strategies also comply with FHFA regulatory requirements prohibiting speculative derivative transactions. An economic hedge by definition introduces the potential for earnings variability caused by the changes in fair value of the derivatives that are recorded in income but not offset by corresponding changes in the fair value of the economically hedged assets, liabilities, or firm commitments. As a result, we recognize only the net interest and the change in fair value of these derivatives in other income (loss) as net (losses) gains on derivatives and hedging activities with no offsetting fair-value adjustments for the economically hedged assets, liabilities, or firm commitments.
Accrued Interest Receivable and Payable. The differential between accrual of interest receivable and payable on derivatives designated as a fair-value hedge or as a cash-flow hedge is recognized through adjustments to the interest income or interest expense of the designated hedged investment securities, advances, COs, deposits, or other financial instruments. The differential between accrual of interest receivable and payable on economic hedges is recognized in other income (loss), along with changes in fair value of these derivatives, as net (losses) gains on derivatives and hedging activities.
Discontinuance of Hedge Accounting. We may discontinue hedge accounting prospectively when:
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we determine that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item attributable to the hedged risk (including hedged items such as firm commitments or forecasted transactions);
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the derivative and/or the hedged item expires or is sold, terminated, or exercised;
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it is no longer probable that the forecasted transaction will occur in the originally expected period;
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a hedged firm commitment no longer meets the definition of a firm commitment; or
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we determine that designating the derivative as a hedging instrument is no longer appropriate.
When hedge accounting is discontinued because we determine that the derivative no longer qualifies as an effective fair-value hedge of an existing hedged item, we either terminate the derivative or continue to carry the derivative on the statement of condition at its fair value and cease to adjust the hedged asset or liability for changes in fair value, and begin to amortize the cumulative basis adjustment on the hedged item into earnings over the remaining life of the hedged item using the level-yield method.
When hedge accounting is discontinued because we determine that the derivative no longer qualifies as an effective cash-flow hedge of an existing hedged item, we continue to carry the derivative on the statement of condition at its fair value and amortize the cumulative other comprehensive loss adjustment to earnings when earnings are affected by the existing hedged item.
If it is no longer probable that a forecasted transaction will occur by the end of the originally expected period or within two months thereafter, we immediately recognize the gain or loss that was in accumulated other comprehensive loss in earnings.
When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, we continue to carry the derivative on the statement of condition at its fair value, removing from the statement of condition any asset or liability that was recorded to recognize the firm commitment and recording it as a gain or loss in current period earnings.
Embedded Derivatives. We may issue debt, make advances, or purchase financial instruments in which a derivative is embedded. Upon execution of these transactions, we assess whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the advance, debt, deposit, or other financial instrument (the host contract) and whether a separate, nonembedded instrument with the same terms as the embedded instrument would meet the definition of a derivative. When we determine that (1) the embedded derivative has economic characteristics that are not clearly and closely related to the economic characteristics of the host contract and (2) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as a stand-alone derivative instrument. If the entire contract (the host contract and the embedded derivative) is to be measured at fair value, with changes in fair value reported in current earnings (for example, an investment security classified as trading, as well as hybrid financial instruments) or if we cannot reliably identify and measure the embedded derivative for purposes of separating that derivative from its host contract, the entire contract is carried on the statement of condition at fair value and no portion of the contract is designated as a hedging instrument. At December 31, 2015, and 2014, we had certain advances with embedded features that met the requirement to be separated from the host contract and designated the embedded features as stand-alone derivatives. The value of the embedded derivatives is included in total advances on the statement of condition. See Note 8 - Advances for the fair value of these embedded derivatives.
Premises, Software, and Equipment
We record premises, software, and equipment at cost less accumulated depreciation and amortization and compute depreciation on a straight-line basis over estimated useful lives ranging from three to 10 years. We amortize leasehold improvements on a straight-line basis over the shorter of the estimated useful life of the improvement or the remaining term of the lease. We capitalize improvements and major renewals but expense ordinary maintenance and repairs when incurred. We include gains and losses on disposal of premises, software, and equipment in other income (loss) on the statement of operations. The cost of purchased software and certain costs incurred in developing computer software for internal use are capitalized and amortized over future periods. At December 31, 2015, and 2014, we had $1.3 million and $1.2 million, respectively, in unamortized computer software costs.
Accumulated Depreciation and Amortization. Our accumulated depreciation and amortization related to premises, software, and equipment was $14.5 million and $14.9 million at December 31, 2015, and 2014, respectively.
Depreciation and Amortization Expense. Depreciation and amortization expense for premises, software, and equipment was $1.7 million, $1.9 million, and $1.9 million for the years ended December 31, 2015, 2014, and 2013, respectively. These amounts include $820,000, $857,000, and $714,000 of amortization of computer software costs for the years ended December 31, 2015, 2014, and 2013, respectively.
Disposal of Premises, Software, and Equipment. Net realized losses on disposal of premises, software, and equipment was $65,000 for the year ended December 31, 2015. There were no realized gains or losses on disposal of premises, software, and equipment in 2014 and 2013.
Consolidated Obligations
We record COs at amortized cost.
Discounts and Premiums. We accrete discounts and amortize premiums on COs to interest expense using the level-yield method over the contractual term to maturity of the CO.
Concessions on COs. We pay concessions to dealers in connection with the issuance of certain COs. The Office of Finance prorates the amounts paid to dealers based upon the percentage of debt issued that we assumed. We defer and amortize these dealer concessions using the level-yield method over the contractual term to maturity of the COs. Unamortized concessions are included in other assets on the statement of condition and the amortization of those concessions is included in CO interest expense on the statement of operations.
Mandatorily Redeemable Capital Stock
We reclassify stock subject to redemption from equity to a liability after a member exercises a written redemption request, gives notice of intent to withdraw from membership, or attains nonmember status by merger or acquisition, charter termination, or other involuntary termination from membership, since the shares meet the definition of a mandatorily redeemable financial instrument upon such instances. Member shares meeting this definition are reclassified to a liability at fair value. Dividends
declared on mandatorily redeemable capital stock are accrued at the expected dividend rate and reflected as interest expense on the statement of operations. The repayment of these mandatorily redeemable financial instruments is reflected as cash outflows in the financing activities section of the statement of cash flows once settled.
We do not take into consideration our members' right to cancel a redemption request in determining when shares of capital stock should be classified as a liability because such cancellation would be subject to a cancellation fee equal to two percent of the par amount of the shares of Class B stock that is the subject of the redemption notice. If a member cancels its written notice of redemption or notice of withdrawal, we will reclassify mandatorily redeemable capital stock from a liability to equity. After the reclassification, dividends on the capital stock will no longer be classified as interest expense.
Restricted Retained Earnings
The joint capital enhancement agreement, as amended (the Joint Capital Agreement) requires each FHLBank to contribute 20 percent of its quarterly net income to a separate restricted retained earnings account at that FHLBank until that account balance equals at least one percent of that FHLBank's average balance of outstanding COs for the previous quarter. Restricted retained earnings are not available to pay dividends, and we present them separate from other retained earnings on the statement of condition.
Litigation Settlements
Litigation settlement gains, net of related legal expenses, are recorded in other income (loss). A litigation settlement gain is considered realized and recorded when we receive cash or assets that are readily convertible to known amounts of cash or claims to cash. In addition, a litigation settlement gain is considered realizable and recorded when we enter into a signed agreement that is not subject to appeal, where the counterparty has the ability to pay, and the amount to be received can be reasonably estimated. Prior to being realized or realizable, we consider potential litigation settlement gains to be gain contingencies, and therefore they are not recorded in the statement of operations. The related legal expenses are contingent-based fees and are only incurred and recorded upon a litigation settlement gain.
FHFA Expenses
We fund a portion of the costs of operating the FHFA. The portion of the FHFA's expenses and working capital fund paid by the FHLBanks is allocated among the FHLBanks based on the pro rata share of the annual assessments based on the ratio of each FHLBank's minimum required regulatory capital to the aggregate minimum required regulatory capital of every FHLBank. We must pay an amount equal to one-half of our annual assessment twice each year.
Office of Finance Expenses
Each FHLBank's proportionate share of Office of Finance operating and capital expenditures has been calculated using a formula based upon the following components: (1) two-thirds based upon each FHLBank's share of total COs outstanding and (2) one-third divided equally among the FHLBanks.
Assessments
Affordable Housing Program. The FHLBank Act requires us to establish and fund an AHP based on positive annual net earnings, providing grants to members to assist in the purchase, construction, or rehabilitation of housing for very low- to moderate-income households. We charge the required funding for the AHP to earnings and establish a liability, except when annual net earnings are zero or negative, in which case there is no requirement to fund an AHP. We also issue AHP advances at interest rates below the customary interest rate for nonsubsidized advances. A discount on the AHP advance and charge against the AHP liability is recorded for the present value of the variation in the cash flow caused by the difference in the interest rate between the AHP advance rate and our related cost of funds for comparable maturity funding. The discount on AHP advances is accreted to interest income on advances using the level-yield method over the life of the advance. See Note 14 - Affordable Housing Program for additional information.
Cash Flows
In the statement of cash flows, we consider noninterest bearing cash and due from banks as cash and cash equivalents. Federal funds sold and interest-bearing deposits are not treated as cash equivalents for purposes of the statement of cash flows, but are instead treated as short-term investments and are reflected in the investing activities section of the statement of cash flows.
Related-Party Activities
We define related parties as members with 10 percent or more of the voting interests of our outstanding capital stock. See Note 20 - Transactions with Shareholders for additional information.
Segment Reporting
We report on an enterprise-wide basis. The enterprise-wide method of evaluating our financial information reflects the manner in which the chief operating decision-maker manages the business.
Reclassification
Certain amounts in the 2014 and 2013 financial statements have been reclassified to conform to the financial statement presentation for the year ended December 31, 2015.
Subsequent Events
Subsequent events have been evaluated through the date of filing this financial report with the Securities and Exchange Commission. See Note 22 - Subsequent Events for more information.
Note 2 - Recently Issued and Adopted Accounting Guidance
Contingent Put and Call Options in Debt Instruments (a consensus of the Emerging Issues Task Force). On March 14, 2016, the Financial Accounting Standards Board (FASB) issued updated guidance to clarify the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. Specifically, the updated guidance clarifies what steps are required when assessing whether the economic characteristics and risks of call (put) options are clearly and closely related to the economic characteristics and risks of their debt hosts, which is one of the criteria for bifurcating an embedded derivative. Consequently, when a call (put) option is contingently exercisable, an entity does not have to assess whether the event that triggers the ability to exercise a call (put) option is related to interest rates or credit risks. The guidance becomes effective for us for the interim and annual periods beginning on January 1, 2017, and early adoption is permitted. We are in the process of evaluating this guidance and its effect on our financial condition, results of operations, and cash flows.
Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships (a consensus of the Emerging Issues Task Force). On March 10, 2016, the FASB issued final guidance clarifying that the novation of a derivative contract (that is, a change in the counterparty) in a hedge accounting relationship does not, in and of itself, require dedesignation of that hedge accounting relationship. Hedge accounting relationships could continue as long as all of the other hedge accounting criteria are met, including the expectation that the hedge will be highly effective when the creditworthiness of the new counterparty to the derivative contract is considered. The guidance becomes effective for us for the interim and annual periods beginning on January 1, 2017, and early adoption is permitted. We are in the process of evaluating this guidance and its effect on our financial condition, results of operations, and cash flows.
Leases. On February 25, 2016, the FASB issued guidance which requires recognition of lease assets and lease liabilities on the statement of condition and disclosure of key information about leasing arrangements. In particular, this guidance requires a lessee, of operating or finance leases, to recognize on the statement of condition a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. However, for leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease assets and lease liabilities. Under previous GAAP, a lessee was not required to recognize lease assets and lease liabilities arising from operating leases on the statement of condition. The guidance becomes effective for us for the interim and annual periods beginning on January 1, 2019, and early application is permitted. We are in the process of evaluating this guidance and its effect on our financial condition, results of operations, and cash flows.
Recognition and Measurement of Financial Assets and Financial Liabilities. On January 5, 2016, the FASB issued amended guidance addressing certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This guidance, among other things:
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requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments;
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requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and
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eliminates the requirement for public entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.
This guidance becomes effective for us for the interim and annual periods beginning on January 1, 2018. Early adoption is only permitted for the classification of instrument-specific credit risk provision of the standard. We are in the process of evaluating this guidance and its effect on our financial condition, results of operations, and cash flows.
Accounting for Cloud Computing Arrangements. On April 15, 2015, the FASB issued amendments to clarify a customer's accounting for fees paid in a cloud computing arrangement. The amendments provide guidance to customers on determining whether a cloud computing arrangement includes a software license that should be accounted for as internal-use software. If the arrangement does not contain a software license, it would be accounted for as a service contract. We will adopt this new guidance on January 1, 2016, using the prospective approach, for all arrangements entered into or materially modified after the effective date. The adoption of this new guidance will not have a material impact on our financial condition, results of operations, and cash flows.
Simplifying the Presentation of Debt Issuance Costs. On April 7, 2015, the FASB issued guidance intended to simplify the presentation of debt issuance costs. This guidance requires a reclassification on the statement of condition of debt issuance costs related to a recognized debt liability from other assets to a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. Upon adoption of this guidance on January 1, 2016, we will reclassify debt issuance costs from other assets to COs on our statement of condition. The period-specific effects as a result of applying this guidance are required to be adjusted retrospectively to each individual period presented on the statement of condition. This guidance will not have a material impact on our financial condition, results of operations, and cash flows.
Revenue from Contracts with Customers. On May 28, 2014, the FASB issued its guidance on revenue from contracts with customers. This guidance outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance. In addition, this guidance amends the existing requirements for the recognition of a gain or loss on the transfer of non-financial assets that are not in a contract with a customer. This guidance applies to all contracts with customers except those that are within the scope of certain other standards, such as financial instruments, certain guarantees, insurance contracts, or lease contracts. The guidance provides the entities with the option of using the following two methods upon adoption: a full retrospective method, retrospectively to each prior reporting period presented; or a transition method, retrospectively with the cumulative effect of initially applying this guidance recognized at the date of initial application. We are in the process of evaluating this guidance and its effect on our financial condition, results of operations, and cash flows.
On August 12, 2015, the FASB issued an amendment to defer the effective date of the guidance issued in May 2014 by one year. The guidance is effective for us for interim and annual periods beginning on January 1, 2018. Early application is permitted only as of the interim and annual reporting periods beginning after December 15, 2016.
Note 3 - Cash and Due from Banks
Compensating Balances. We maintain collected cash balances with a commercial bank in return for certain services. The related agreement contains no legal restrictions on the withdrawal of funds. The average collected cash balance was $192.2 million and $189.9 million for the years ended December 31, 2015 and 2014, respectively.
Note 4 - Trading Securities
Major Security Types. Our trading securities as of December 31, 2015 and 2014, were (dollars in thousands):
Net unrealized (losses) gains on trading securities were as follows:
We do not participate in speculative trading practices and typically hold these investments over a longer time horizon.
Note 5 - Available-for-Sale Securities
Major Security Types. Our available-for-sale securities as of December 31, 2015, were (dollars in thousands):
_______________________
(1)
Amortized cost of available-for-sale securities includes adjustments made to the cost basis of an investment for accretion, amortization, collection of cash, and fair-value hedge accounting adjustments.
Our available-for-sale securities as of December 31, 2014, were (dollars in thousands):
_______________________
(1)
Amortized cost of available-for-sale securities includes adjustments made to the cost basis of an investment for accretion, amortization, collection of cash, and fair-value hedge accounting adjustments.
The following table summarizes our available-for-sale securities with unrealized losses as of December 31, 2015, which are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands):
The following table summarizes our available-for-sale securities with unrealized losses as of December 31, 2014, which are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands):
Redemption Terms. The amortized cost and fair value of our available-for-sale securities by contractual maturity at December 31, 2015 and 2014, were (dollars in thousands):
_______________________
(1)
MBS are not presented by contractual maturity because their expected maturities will likely differ from contractual maturities because borrowers of the underlying loans may have the right to call or prepay obligations with or without call or prepayment fees.
Interest-Rate-Payment Terms. The following table details additional interest-rate-payment terms for our available-for-sale securities (dollars in thousands):
Note 6 - Held-to-Maturity Securities
Major Security Types. Our held-to-maturity securities as of December 31, 2015, were (dollars in thousands):
Our held-to-maturity securities as of December 31, 2014, were (dollars in thousands):
The following table summarizes our held-to-maturity securities with unrealized losses as of December 31, 2015, which are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands).
The following table summarizes our held-to-maturity securities with unrealized losses as of December 31, 2014, which are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands).
Redemption Terms. The amortized cost, carrying value, and fair value of our held-to-maturity securities by contractual maturity at December 31, 2015 and 2014, are shown below (dollars in thousands). Expected maturities of some securities and MBS may differ from contractual maturities because borrowers of the underlying loans may have the right to call or prepay their obligations with or without call or prepayment fees.
_______________________
(1)
Carrying value of held-to-maturity securities represents the sum of amortized cost and the amount of noncredit-related other-than-temporary impairment recognized in accumulated other comprehensive loss.
(2)
MBS are not presented by contractual maturity because their expected maturities will likely differ from contractual maturities because borrowers of the underlying loans may have the right to call or prepay their obligations with or without call or prepayment fees.
Interest-Rate-Payment Terms. The following table details additional interest-rate-payment terms for investment securities classified as held-to-maturity (dollars in thousands):
Note 7 - Other-Than-Temporary Impairment
We evaluate our individual available-for-sale and held-to-maturity securities for other-than-temporary impairment each quarter.
Available-for-Sale Securities
We determined that none of our available-for-sale securities were other-than-temporarily impaired at December 31, 2015. At December 31, 2015, we held certain available-for-sale securities in an unrealized loss position. These unrealized losses reflect the impact of normal yield and spread fluctuations attendant with security markets. We consider these unrealized losses temporary because we expect to recover the entire amortized cost basis on these available-for-sale securities in an unrealized loss position and neither intend to sell these securities nor is it more likely than not that we will be required to sell these securities before the anticipated recovery of each security's remaining amortized cost basis. Additionally, there have been no shortfalls of principal or interest on any available-for-sale security. Regarding available-for-sale securities that were in an unrealized loss position as of December 31, 2015:
•
We expect debentures issued by a supranational institution that were in an unrealized loss position as of December 31, 2015, are expected to return contractual principal and interest based on our review and analysis of independent third-party credit reports on the supranational institution, and the supranational institution's triple-A (or equivalent) rating by each of the nationally recognized statistical rating organizations (NRSROs) that rates it.
•
Debentures issued by U.S. government-owned corporations are not obligations of the U.S. government and not guaranteed by the U.S. government. However, these securities are rated at the same level as the U.S. government by the NRSROs. These ratings reflect the U.S. government's implicit support of the government-owned corporation as well as the entity's underlying business and financial risk.
•
The probability of default on debt issued by Fannie Mae and Freddie Mac is remote given their status as GSEs and their support from the U.S. government.
•
The U.S. government-guaranteed securities that we hold are MBS issued by the Government National Mortgage Association (Ginnie Mae). The strength of Ginnie Mae's guarantees as a direct obligation from the U.S. government is sufficient to protect us from losses based on current expectations.
•
For MBS issued by Fannie Mae and Freddie Mac, which we sometimes refer to as agency MBS in this report, the strength of the issuers' guarantees through direct obligation or support from the U.S. government is sufficient to protect us from losses based on current expectations.
Held-to-Maturity Securities
HFA Securities. We have reviewed our investments in HFA securities and have determined that unrealized losses reflect the impact of normal market yield and spread fluctuations and illiquidity in the credit markets. We have determined that all unrealized losses are temporary given the creditworthiness of the issuers and the underlying collateral, including an assessment of past payment history (no shortfalls of principal or interest), property vacancy rates, debt service ratios, over-collateralization and other credit enhancement, and third-party bond insurance as applicable. As of December 31, 2015, none of our held-to-maturity investments in HFA securities that are in an unrealized loss position were rated below investment grade by an NRSRO. Because the decline in market value is attributable to changes in interest rates, credit spreads, and illiquidity in this market and not to a significant deterioration in the fundamental credit quality of these obligations, and because we do not intend to sell the investments nor is it more likely than not that we will be required to sell the investments before recovery of the amortized cost basis, we do not consider these investments to be other-than-temporarily impaired at December 31, 2015.
Agency MBS. For agency MBS, we determined that the strength of the issuers' guarantees through direct obligation or support from the U.S. government is sufficient to protect us from losses based on current expectations. Additionally, there have been no shortfalls of principal or interest on any such security. As a result, we have determined that, as of December 31, 2015, all of the gross unrealized losses on such MBS are temporary. We do not believe that the declines in market value of these securities are attributable to credit quality, and because we do not intend to sell the investments, nor is it more likely than not that we will be required to sell the investments before recovery of the amortized cost basis, we do not consider any of these investments to be other-than-temporarily impaired at December 31, 2015.
Private-Label Residential MBS and ABS Backed by Home Equity Loans. To ensure consistency in determination of the other-than-temporary impairment for private-label residential MBS and certain home equity loan investments (including home equity ABS) among all FHLBanks, the FHLBanks use an FHLBank System governance committee (the OTTI Governance Committee) and a formal process to ensure consistency in key other-than-temporary impairment modeling assumptions used for purposes of their cash-flow analyses for the majority of these securities. We use the FHLBanks' uniform framework and approved assumptions for purposes of our other-than-temporary impairment cash-flow analyses of our private-label residential MBS and certain home equity loan investments. For certain private-label residential MBS and home equity loan investments where underlying collateral data is not available, we have used alternative procedures to assess these securities for other-than-temporary impairment. We are responsible for making our own determination of impairment and the reasonableness of assumptions, inputs, and methodologies used and for performing the required present value calculations using appropriate historical cost bases and yields.
Our evaluation includes estimating the projected cash flows that we are likely to collect based on an assessment of available information, including the structure of the applicable security and certain assumptions to determine whether we will recover the entire amortized cost basis of the security, such as:
•
the remaining payment terms for the security;
•
prepayment speeds;
•
default rates;
•
loss severity on the collateral supporting each security based on underlying loan-level borrower and loan characteristics;
•
expected housing price changes; and
•
interest-rate assumptions.
In accordance with related guidance from the FHFA, we have contracted with the FHLBanks of San Francisco and Chicago to perform the cash-flow analysis underlying our other-than-temporary impairment decisions in certain instances. Specifically, we have contracted with the FHLBank of San Francisco to perform cash-flow analyses for our residential private-label MBS excluding our subprime private-label MBS, and with the FHLBank of Chicago to perform cash-flow analyses for our subprime private-label MBS. In the event that neither the FHLBank of San Francisco nor the FHLBank of Chicago has the ability to model a particular MBS that we own, we project the expected cash flows for that security based on our expectations as to how the underlying collateral and impact on deal structure resultant from collateral cash flows are forecasted to occur over time. These assumptions are based on factors including, but not limited to, loan-level data for each security and modeling variable expectations for securities similar in nature to securities modeled by either the FHLBank of San Francisco or the FHLBank of Chicago. We form our expectations for those securities by reviewing, when available, loan-level data for each security, and, when such loan-level data is not available for a security, by reviewing loan-level data for similar loan pools as a proxy for such data.
To assess whether the entire amortized cost basis of private-label residential MBS will be recovered, cash-flow analyses for each of our private-label residential MBS were performed. These analyses use two third-party models.
The first third-party model considers borrower characteristics and the particular attributes of the loans underlying our securities, in conjunction with assumptions about current home prices and future changes in home prices and interest rates, producing monthly projections of prepayments, defaults, loan modifications, and loss severities. A significant input to the first model is the forecast of future housing-price changes, based on an assessment of individual housing markets for the relevant states and core-based statistical areas (CBSA), as defined by the United States Office of Management and Budget. The OTTI Governance Committee developed a short-term housing price forecast, with projected changes ranging from a decrease of 3.0 percent to an increase of 8.0 percent over the 12- month period beginning October 1, 2015. For the vast majority of markets, the projected short-term housing price changes range from a increase of 2.0 percent to an increase of 5.0 percent. Thereafter, we have projected a unique recovery path for each relevant geographic area based on an internally developed framework derived from historical data.
The month-by-month projections of future loan level performance are derived from the first model to determine projected prepayments, defaults, loan modifications, and loss severities. These projections are then input into a second model that allocates the cash flows and losses among the various classes in the securitization structure in accordance with the cash-flow and loss-allocation rules prescribed by the securitization structure. In a securitization in which the credit enhancement for the senior securities is derived from the presence of subordinate securities, losses are generally allocated first to the subordinate securities until their principal balance is reduced to zero. The projected cash flows are based on a number of assumptions and expectations and the results of these models can vary significantly with changes in assumptions and expectations. The scenario of cash flows determined based on the model approach described above reflects a best estimate scenario and includes a base case current-to-trough housing price forecast and a base case housing price recovery path described in the prior paragraph.
For those securities for which an other-than-temporary impairment was determined to have occurred during the year ended December 31, 2015, the following table presents a summary of the average projected values over the remaining lives of the securities for the significant inputs used to measure the amount of the credit loss recognized in earnings, as well as related current credit enhancement. Credit enhancement is defined as the percentage of subordinated tranches, over-collateralization, and other credit enhancement, if any, in a security structure that will generally absorb losses before we will experience a credit loss on the security. The calculated averages represent the dollar-weighted average of Alt-A other-than-temporarily impaired private-label residential MBS (dollars in thousands).
_______________________
(1)
Securities are classified based upon the current performance characteristics of the underlying loan pool and therefore the manner in which the loan pool backing the security has been modeled (as prime, Alt-A, or subprime), rather than their classification of the security at the time of issuance.
The following table sets forth our securities for which other-than-temporary impairment credit losses were recognized during the life of the security through December 31, 2015 (dollars in thousands). Securities are classified in the table below based on their classifications at the time of issuance.
_______________________
(1)
We have instituted litigation in relation to certain of the private-label MBS in which we invested. Our complaint asserts, among others, claims for untrue or misleading statements in the sale of securities. It is possible that classifications of private-label MBS as provided herein when based on classification at the time of issuance as disclosed by those securities' issuance documents, as well as other statements about the securities, are inaccurate.
The following table presents a roll-forward of the amounts related to credit losses recognized in earnings. The roll-forward is the amount of credit losses on investment securities for which we recognized a portion of other-than-temporary impairment charges into accumulated other comprehensive loss (dollars in thousands).
_______________________
(1)
For the years ended December 31, 2015, 2014, and 2013, additional credit losses for which an other-than-temporary impairment charge was previously recognized relate to securities that were also previously impaired prior to January 1, 2015, 2014, and 2013.
(2)
Represents reductions related to securities having reached final maturity during the period and, therefore, are no longer held by us at the end of the period.
(3)
Represents amounts accreted as interest income during the current period.
Note 8 - Advances
General Terms. We offer a wide range of fixed- and variable-rate advance products with different maturities, interest rates, payment characteristics, and optionality. Advances have maturities ranging from one day to 30 years or even longer with the approval of our credit committee. At December 31, 2015 and 2014, we had advances outstanding with interest rates ranging from zero percent to 7.72 percent and (0.22) percent to 8.37 percent, respectively, as summarized below (dollars in thousands). Advances with negative interest rates contain embedded interest-rate features that have met the requirements to be separated from the host contract and are recorded as stand-alone derivatives, and which we economically hedge with derivatives containing offsetting interest-rate features.
_________________________
(1)
At December 31, 2015 and 2014, we had certain advances with embedded features that met the requirements to be separated from the host contract and designated as stand-alone derivatives.
We offer advances to members and eligible non-members that provide the right, based upon predetermined option exercise dates, to call the advance prior to maturity without incurring prepayment or termination fees (callable advances). We also offer certain floating-rate advances that may be contractually prepaid by the borrower on a floating-rate reset date without incurring prepayment or termination fees. If such advances are prepaid, replacement funding may be available. At December 31, 2015 and 2014, we had callable advances and floating-rate advances that may be prepaid on a floating-rate reset date without prepayment or termination fees outstanding totaling $6.5 billion and $5.9 billion, respectively. Other advances may only be prepaid by paying a fee (prepayment fee) that makes us financially indifferent to the prepayment of the advance.
_______________________
(1)
Also includes certain floating-rate advances that may be contractually prepaid by the borrower on a floating-rate reset date without incurring prepayment or termination fees.
We offer putable advances that provide us with the right to put the fixed-rate advance to the borrower (and thereby extinguish the advance) on predetermined exercise dates (put dates), and offer, subject to certain conditions, replacement funding at then-current advances rates. Generally, we would exercise the put options when interest rates increase. At December 31, 2015 and 2014, we had putable advances outstanding totaling $2.2 billion and $2.3 billion, respectively.
The following table sets forth our advances outstanding by the year of contractual maturity or next put date for putable advances (dollars in thousands):
Interest-Rate-Payment Terms. The following table details interest-rate-payment types for our outstanding advances (dollars in thousands):
Credit-Risk Exposure and Security Terms. Our potential credit risk from advances is principally concentrated in commercial banks, insurance companies, savings institutions, and credit unions. At December 31, 2015 and 2014, we had $14.2 billion and $10.7 billion, respectively, of advances issued to members with at least $1.0 billion of advances outstanding. These advances were made to five borrowers and three borrowers, respectively, at December 31, 2015 and 2014, representing 39.4 percent and 32.0 percent, respectively, of total par value of outstanding advances. For information related to our credit risk on advances and allowance for credit losses, see Note 10 - Allowance for Credit Losses.
Prepayment Fees. We record prepayment fees received from borrowers on certain prepaid advances net of any associated basis adjustments related to hedging activities on those advances and net of deferred prepayment fees on advance prepayments considered to be loan modifications. Additionally, for certain advances products, the prepayment-fee provisions of the advance agreement could result in either a payment from the borrower or to the borrower when such an advance is prepaid, based upon market conditions at the time of prepayment (referred to as a symmetrical prepayment fee). Advances with a symmetrical prepayment fee provision are hedged with derivatives containing offsetting terms, so that we are financially indifferent to the borrower's decision to prepay such advances. The net amount of prepayment fees is reflected as interest income in the statement of operations.
We also offer an advance restructuring program under which the prepayment fee on prepaid advances may be satisfied by the borrower's agreement to pay an interest rate on a new advance sufficient to amortize the prepayment fee by the maturity date of the new advance, rather than paying the fee in immediately available funds to us. If we conclude an advance restructuring is an extinguishment of the prior loan rather than a modification, the deferred prepayment fee is recognized into income immediately.
For the years ended December 31, 2015, 2014, and 2013, net advance prepayment fees recognized in income are reflected in the following table (dollars in thousands):
Note 9 - Mortgage Loans Held for Portfolio
We invest in mortgage loans through the MPF program. These investments (MPF loans) are either guaranteed or insured by federal agencies, as is the case with government mortgage loans, or are credit-enhanced by the related entity that sold the loan (a participating financial institution), as is the case with conventional mortgage loans. All such investments are held for portfolio. The mortgage loans are typically originated and credit-enhanced by the related participating financial institution. The majority of these loans are serviced by the originating institution or an affiliate thereof. However, a portion of these loans are sold servicing-released by the participating financial institution and serviced by a third-party servicer.
The following table presents certain characteristics of these investments (dollars in thousands):
The following table details the par value of mortgage loans held for portfolio (dollars in thousands):
See Note 10 - Allowance for Credit Losses for information related to our credit risk from our investments in mortgage loans and allowance for credit losses based on these investments.
Note 10 - Allowance for Credit Losses
An allowance for credit losses is a valuation allowance separately established for each identified portfolio segment, if necessary, to provide for probable losses inherent in our portfolio as of the statement of condition date. To the extent necessary, an allowance for credit losses for off-balance-sheet credit exposure is recorded as a liability.
Portfolio Segments. We have established an allowance methodology for each of our portfolio segments. A portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. We have developed and documented a systematic methodology for determining an allowance for credit losses for our:
•
credit products, such as our advances and letters of credit;
•
investments in government mortgage loans held for portfolio;
•
investments in conventional mortgage loans held for portfolio;
•
investments via term securities purchased under agreements to resell; and
•
investments via term federal funds sold.
Classes of Financing Receivables. Classes of financing receivables generally are a disaggregation of a portfolio segment to the extent that is needed to understand the exposure to credit risk arising from these financing receivables. We determined that no further disaggregation of portfolio segments identified above is needed as we assessed and measured the credit risk arising from these financing receivables at the portfolio segment level.
Secured Member Credit Products
We manage our credit exposure to secured member credit products through an integrated approach that generally includes establishing a credit limit for each borrower, an ongoing review of each borrower's financial condition, and collateral and lending policies that are intended to limit risk of loss while balancing borrowers' needs for a reliable source of funding. In addition, we lend to eligible borrowers in accordance with the FHLBank Act, FHFA regulations, and other applicable laws. The FHLBank Act requires us to obtain sufficient collateral to secure our credit products. The estimated value of the collateral pledged to secure each borrower's credit products is calculated by applying collateral discounts, or haircuts, to the market value or unpaid principal balance of the collateral, as applicable. We accept certain investment securities, residential mortgage loans, deposits, and other assets as collateral. We require all borrowers that pledge securities collateral to place physical possession of
such securities collateral with our safekeeping agent, the borrower's approved designated agent, or the borrower's securities corporation, subject to a control agreement giving us appropriate control over such collateral. In addition, community financial institutions are eligible to use expanded statutory collateral provisions for small-business and agriculture loans. Members also pledge their Bank capital stock as collateral. Collateral arrangements may vary depending upon borrower credit quality, financial condition, performance, borrowing capacity, and our overall credit exposure to the borrower. We can call for additional or substitute collateral to further safeguard our security interest. We believe our policies appropriately manage our credit risks arising from our credit products.
Depending on the financial condition of the borrower, we may allow the borrower to retain possession of loan collateral pledged to us while agreeing to hold such collateral for our benefit or require the borrower to specifically assign or place physical possession of such loan collateral with us or a third-party custodian that we approve.
We are provided an additional safeguard for our security interests by Section 10(e) of the FHLBank Act, which generally affords any security interest granted by a borrower to the Bank priority over the claims and rights of any other party. The exceptions to this prioritization are limited to claims that would be entitled to priority under otherwise applicable law and are held by bona fide purchasers for value or by secured parties with higher priority perfected security interests. However, the priority granted to our security interests under Section 10(e) of the FHLBank Act may not apply when lending to insurance company members. This is due to the anti-preemption provision contained in the McCarran-Ferguson Act, which provides that federal law does not preempt state insurance law unless the federal law expressly regulates the business of insurance. Thus, if state law conflicts with Section 10(e) of the FHLBank Act, the protection afforded by this provision may not be available to us. However, we perfect our security interests in the collateral pledged by our members, including insurance company members, by filing UCC-1 financing statements, taking possession or control of such collateral, or taking other appropriate steps.
Using a risk-based approach and taking into consideration each borrower's financial strength, we consider the types and level of collateral to be the primary indicator of credit quality on our credit products. At December 31, 2015, and 2014, we had rights to collateral, on a borrower-by-borrower basis, with an estimated value in excess of our outstanding extensions of credit.
We continue to evaluate and make changes to our collateral guidelines based on market conditions. At December 31, 2015, and 2014, none of our secured member credit products outstanding were past due, on nonaccrual status, or considered impaired. In addition, there were no troubled debt restructurings related to credit products during the years ended December 31, 2015, and 2014.
Based upon the collateral held as security, our credit extension and collateral policies, management's credit analysis, and the repayment history on secured member credit products, we have not recorded any allowance for credit losses on our secured member credit products at December 31, 2015 and 2014. At December 31, 2015 and 2014, no liability to reflect an allowance for credit losses for off-balance-sheet credit exposures was recorded. See Note 19 - Commitments and Contingencies for additional information on our off-balance-sheet credit exposure.
Government Mortgage Loans Held for Portfolio
We invest in government mortgage loans secured by one- to four-family residential properties. Government mortgage loans are mortgage loans insured or guaranteed by the Federal Housing Administration, the U.S. Department of Veterans Affairs, the Rural Housing Service of the U.S. Department of Agriculture, or by the U.S. Department of Housing and Urban Development.
The servicer provides and maintains insurance or a guarantee from the applicable government agency. The servicer is responsible for compliance with all government agency requirements and for obtaining the benefit of the applicable insurance or guaranty with respect to defaulted government-guaranteed mortgage loans. Any losses incurred on these loans that are not recovered from the insurer or guarantor are absorbed by the related servicer. Therefore, we only have credit risk for these loans if the servicer fails to pay for losses not covered by insurance or guarantees. Based on our assessment of our servicers for our government loans, there is no allowance for credit losses for the government mortgage loan portfolio as of December 31, 2015 and 2014. In addition, these mortgage loans are not placed on nonaccrual status due to the government guarantee or insurance on these loans and the contractual obligation of the loan servicers to repurchase their related loans when certain criteria are met.
Conventional Mortgage Loans Held for Portfolio
Our methodology for determining our loan loss reserve consists of estimating loan loss severity using a third-party model incorporating delinquency to default transition performance of the loans, relevant market conditions affecting the performance of the loans, and portfolio level credit protection, particularly credit enhancements, as discussed below under - Credit Enhancements. Our inputs to the third-party model consist of loan-related characteristics, such as credit scores, occupancy
statuses, loan-to-value ratios, property types, and locations. We update our view of the loan transition performance and market conditions quarterly and periodically adjust our methodology to reflect the changes in the loans’ performances and the market.
Individually Evaluated Mortgage Loans. Certain conventional mortgage loans, primarily impaired mortgage loans that are considered collateral-dependent, may be specifically identified for purposes of calculating the allowance for credit losses. A mortgage loan is considered collateral-dependent if repayment is only expected to be provided by the sale of the underlying property, that is, if it is considered likely that the borrower will default and there is no credit enhancement from a participating financial institution to offset losses under the master commitment. The estimated credit losses on impaired collateral-dependent loans may be separately determined because sufficient information exists to make a reasonable estimate of the inherent loss on these loans on an individual loan basis. Loans that are considered collateral-dependent are measured for impairment based on the fair value of the underlying property less estimated selling costs. The resulting incurred loss is equal to the difference between the carrying value of the loan and the estimated fair value of the collateral less estimated selling costs. Additionally, for our investments in loans modified under our temporary loan modification plan, on the effective date of a loan modification we measure the present value of expected future cash flows discounted at the loan's effective interest rate and reduce the carrying value of the loan accordingly.
Collectively Evaluated Mortgage Loans. We evaluate the credit risk of our investments in conventional mortgage loans for impairment on a collective basis that considers loan-pool-specific attribute data, at the master commitment pool level, including historical delinquency migration, applies estimated loss severities, and incorporates available credit enhancements to establish our best estimate of probable incurred losses at the reporting date. Migration analysis is a methodology for estimating the rate of default experienced on pools of similar loans based on our historical experience. We apply migration analysis to conventional loans that are currently not past due, loans that are 30 to 59 days past due, 60 to 89 days past due, and 90 to 179 days past due. We then estimate the dollar amount of loans in these categories that we believe are likely to migrate to a realized loss position and apply a loss severity factor to estimate losses that would be incurred at the statement of condition date. The losses are then reduced by the probable cash flows resulting from available credit enhancement. Credit enhancement cash flows that are projected and assessed as not probable of receipt are not considered in reducing estimated losses.
Estimating a Margin of Imprecision. We also assess a factor for the margin of imprecision to the estimation of credit losses for the homogeneous population. The margin of imprecision is a factor in the allowance for credit losses that recognizes the imprecise nature of the measurement process and is included as part of the mortgage loan allowance for credit loss. This amount represents a subjective management judgment based on facts and circumstances that exist as of the reporting date that is unallocated to any specific measurable economic or credit event and is intended to cover other inherent losses that may not be captured in our methodology. The actual loss that may occur on homogeneous populations of mortgage loans may differ from the estimated loss.
Credit Quality Indicators. Key credit quality indicators for mortgage loans include the migration of past due loans, nonaccrual loans, loans in process of foreclosure, and impaired loans. The tables below set forth certain key credit quality indicators for our investments in mortgage loans at December 31, 2015 and 2014 (dollars in thousands):
_______________________
(1)
Includes loans where the decision of foreclosure or similar alternative such as pursuit of deed-in-lieu of foreclosure has been reported.
(2)
Loans that are 90 days or more past due or in the process of foreclosure expressed as a percentage of the recorded investment in the total loan portfolio class.
(3)
Includes conventional mortgage loans with contractual principal or interest payments 90 days or more past due and not accruing interest.
_______________________
(1)
Includes loans where the decision of foreclosure or similar alternative such as pursuit of deed-in-lieu of foreclosure has been reported.
(2)
Loans that are 90 days or more past due or in the process of foreclosure expressed as a percentage of the recorded investment in the total loan portfolio class.
(3)
Includes conventional mortgage loans with contractual principal or interest payments 90 days or more past due and not accruing interest as well as loans modified within the previous six months under our temporary loan modification plan.
Individually Evaluated Impaired Loans. The following tables present the recorded investment, par value and any related allowance for impaired loans individually assessed for impairment at December 31, 2015 and 2014, and the average recorded investment and interest income recognized on these loans during the years ended December 31, 2015 and 2014 (dollars in thousands).
Credit Enhancements. Our allowance for credit losses factors in the credit enhancements associated with conventional mortgage loans under the MPF program. These credit enhancements apply after the homeowner's equity is exhausted and can include primary and/or supplemental mortgage insurance or other kinds of credit enhancement. The credit-enhancement amounts estimated to protect us against credit losses are determined through the use of a model. Any incurred losses that would be recovered from the credit enhancements are not reserved as part of our allowance for loan losses. In such cases, a receivable is generally established to reflect the expected recovery from credit-enhancement arrangements.
Conventional mortgage loans are required to be credit enhanced so that the risk of loss is limited to the losses equivalent to an investor in a double-A rated MBS at the time of purchase. We share the risk of credit losses on our investments in mortgage loans with the related participating financial institution by structuring potential losses on these investments into layers with respect to each master commitment. We analyze the risk characteristics of our mortgage loans using a third-party model to determine the credit enhancement amount at the time of purchase. This credit-enhancement amount is broken into a first-loss account and a credit-enhancement obligation of each participating financial institution, which is calculated based on the risk analysis to equal the difference between the amounts needed for the master commitment to have a rating equivalent to a double-A rated MBS and our initial first-loss account exposure.
The first-loss account represents the first layer or portion of credit losses that we absorb with respect to our investments in mortgage loans after considering the borrower's equity and primary mortgage insurance. The participating financial institution is required to cover the next layer of losses up to an agreed-upon credit-enhancement obligation amount, which may consist of a direct liability of the participating financial institution to pay credit losses up to a specified amount, a contractual obligation of a participating financial institution to provide supplemental mortgage insurance, or a combination of both. We absorb any remaining unallocated losses.
The aggregate amount of the first-loss account is documented and tracked but is neither recorded nor reported as an allowance for loan losses in our financial statements. As credit and special hazard losses are realized that are not covered by the liquidation value of the real property or primary mortgage insurance, they are first charged to us, with a corresponding reduction of the first-loss account for that master commitment up to the amount in the first-loss account at that time. Over time, the first-loss account may cover the expected credit losses on a master commitment, although losses that are greater than expected or that occur early in the life of a master commitment could exceed the amount in the first-loss account. In that case, the excess losses would be charged to the participating financial institution's credit-enhancement amount, then to us after the participating financial institution's credit-enhancement amount has been exhausted.
For loans in which we buy or sell participations from or to other FHLBanks that participate in the MPF program (MPF Banks), the amount of the first-loss account remaining to absorb losses for loans that we own is partly dependent on the percentage of our participation in such loans. Assuming losses occur on a proportional basis between loans that we own and loans owned by other MPF Banks, at December 31, 2015 and 2014, the amount of first-loss account remaining for losses allocable to us was $17.5 million and $17.1 million, respectively.
Participating financial institutions are paid a credit-enhancement fee for assuming credit risk and in some instances all or a portion of the credit-enhancement fee may be performance-based. For certain MPF products, our losses incurred under the first-loss account can be mitigated by withholding future performance-based credit-enhancement fees that would otherwise be payable to the participating financial institutions. We record credit-enhancement fees paid to participating financial institutions as a reduction to mortgage-loan-interest income. We incurred credit-enhancement fees of $3.1 million, $3.0 million, and $3.0 million during the years ended December 31, 2015, 2014, and 2013, respectively.
Withheld performance-based credit-enhancement fees can mitigate losses from our investments in mortgage loans and therefore we consider our expectations for each master commitment for such withheld fees in determining the allowance for loan losses. More specifically, we determine the amount of credit-enhancement fees available to mitigate losses as follows: accrued credit-enhancement fees to be paid to participating financial institutions; plus projected credit-enhancement fees to be paid to the participating financial institutions using the weighted average life of the loans within each relevant master commitment; minus any losses incurred or expected to be incurred.
The following table demonstrates the impact on our estimate of the allowance for credit losses resulting from the loss-mitigating features of conventional mortgage loans (dollars in thousands).
Roll-Forward of Allowance for Credit Losses on Mortgage Loans. The following table presents a roll-forward of the allowance for credit losses on conventional mortgage loans for the years ended December 31, 2015, 2014, and 2013, as well as the recorded investment in mortgage loans by impairment methodology at December 31, 2015, 2014, and 2013 (dollars in thousands). The recorded investment in a loan is the par amount of the loan, adjusted for accrued interest, unamortized premiums or discounts, deferred derivative gains and losses, and direct write-downs. The recorded investment is net of any valuation allowance.
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(1)
These amounts exclude government mortgage loans because we make no allowance for credit losses based on our investments in government mortgage loans, as discussed above under - Government Mortgage Loans Held for Portfolio.
Troubled Debt Restructurings. We consider a troubled debt restructuring of a financing receivable to have occurred when we grant a concession to a borrower that we would not otherwise consider for economic or legal reasons related to the borrower's financial difficulties. We have granted a concession when we do not expect to collect all amounts due to us under the original contract as a result of the restructuring.
Our program for mortgage loan troubled debt restructurings primarily involves modifying the borrower's monthly payment for a period of up to 36 months to achieve a housing expense ratio of no more than 31 percent of their qualifying monthly income. The principal amortization schedule for the outstanding principal balance is first recalculated to reflect a new principal and interest payment for a term not to exceed 40 years. This would result in a balloon payment at the original maturity date of the loan as the maturity date and number of remaining monthly payments are not adjusted. If the 31 percent housing expense ratio is not achieved through reamortization, the interest rate is reduced for the temporary modification period of up to 36 months in 0.125 percent increments below the original note rate, to a floor rate of 3.00 percent, resulting in reduced principal and interest payments, until the desired 31 percent housing expense ratio is met. A loan is considered a troubled debt restructuring after the borrower has successfully completed a three month trial-period following the monthly payment modification.
A mortgage loan considered to be a troubled debt restructuring is individually evaluated for impairment when determining its related allowance for credit losses. When a loan first becomes a troubled debt restructuring, we compare the carrying value of the loan at the time of modification with the present value of the revised cash flows discounted at the original effective yield on the loan. Credit loss is measured by factoring the loss severity rate incurred as of the reporting date as well as the economic loss attributable to delaying the original contractual principal and interest due dates, if applicable.
As of December 31, 2015, we had mortgage loans with a recorded investment of $7.7 million that we considered troubled debt restructurings, of which $7.2 million were performing and $479,000 were nonperforming. As of December 31, 2014, we had mortgage loans with a recorded investment of $6.7 million that we considered troubled debt restructurings, of which $3.1 million were performing and $3.6 million were nonperforming.
REO. At December 31, 2015 and 2014, we had $3.6 million and $4.3 million, respectively, in assets classified as REO. During the years ended December 31, 2015, 2014, and 2013, we sold REO assets with a recorded carrying value of $6.3 million, $8.3 million, and $12.1 million, respectively. Upon the sale of these REO properties, and inclusive of any proceeds received from primary mortgage-insurance coverage, we recognized net gains totaling $868,000 and net losses totaling $377,000 and $3.0 million during the years ended December 31, 2015, 2014, and 2013, respectively. Gains and losses on the sale of REO assets are recorded in other income.
Federal Funds Sold and Securities Purchased Under Agreements to Resell.
These investments are all short term (less than three months), and they are generally transacted with counterparties that we consider to be of investment quality. We invest in federal funds sold and we evaluate these investments for purposes of an allowance for credit losses only if the investment is not paid when due. All investments in federal funds sold as of December 31, 2015 and 2014, were repaid according to their contractual terms. Securities purchased under agreements to resell are considered collateralized financing arrangements and effectively represent short-term loans. The terms of these loans are structured such that if the market value of the underlying securities decreases below the market value required as collateral, the counterparty must provide additional securities as collateral in an amount equal to the decrease or remit cash in such amount. If we determine that an agreement to resell is impaired, the difference between the fair value of the collateral and the amortized cost of the agreement is charged to earnings. Based upon the collateral held as security, we determined that no allowance for credit losses was needed for the securities purchased under agreements to resell at December 31, 2015 and 2014.
Note 11 - Derivatives and Hedging Activities
Nature of Business Activity
We are exposed to interest-rate risk primarily from the effects of interest-rate changes on interest-earning assets and interest-bearing liabilities that finance these assets. The goal of our interest-rate risk-management strategy is to manage interest-rate risk within appropriate limits. As part of our effort to mitigate the risk of loss, we have established policies and procedures, which include guidelines on the amount of exposure to interest-rate changes we will accept. In addition, we monitor the risk to our interest income, net interest margin, and average maturity of interest-earning assets and interest-bearing liabilities.
Consistent with FHFA regulations, we enter into derivatives to manage the interest-rate-risk exposures inherent in otherwise unhedged assets and liabilities and achieve our risk-management objectives. FHFA regulation prohibits us from trading in or the speculative use of these derivative instruments. The use of derivatives is an integral part of our financial management strategy. We may enter into derivatives that do not necessarily qualify for hedge accounting.
The most common ways in which we use derivatives are to:
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change the repricing frequency of assets and liabilities from fixed to floating or floating to fixed, considering interest-rate-risk management and funding needs;
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hedge the cash flows of assets and liabilities that have embedded options, considering interest-rate-risk management and funding needs; and
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hedge the mark-to-market sensitivity of existing assets or liabilities or of anticipated transactions.
Application of Derivatives
We may use derivatives to adjust the effective maturity, repricing frequency, or option characteristics of our financial instruments, including our advances products, investments, and COs to achieve risk-management objectives. We use derivatives as:
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a fair-value hedge of a non-derivative financial instrument or a cash-flow hedge of a forecasted transaction; and
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an economic hedge in general asset-liability management where derivatives serve a documented risk-mitigation purpose but do not qualify for hedge accounting. These hedges are primarily used to manage certain mismatches between the coupon features of our assets and liabilities. For example, we use derivatives in our overall interest-rate-risk management to manage the interest-rate sensitivity of COs to approximate more closely the interest-rate sensitivity of assets (both advances and investments), and/or to manage the interest-rate sensitivity of advances, investments, or mortgage loans to approximate more closely the interest-rate sensitivity of liabilities.
We transact most of our derivatives with large banks and major broker-dealers. Some of these banks and broker-dealers or their affiliates buy, sell, and distribute COs. Derivative transactions may be either over-the-counter with a counterparty (uncleared derivatives) or cleared through a futures commission merchant (clearing member) with a derivatives clearing organization (DCO) as the counterparty (cleared derivatives).
Once a derivative transaction has been accepted for clearing by a DCO, the derivative transaction is novated and the executing counterparty is replaced with the DCO. We are not a derivatives dealer and do not trade derivatives for short-term profit.
Types of Derivatives
We may use the following derivatives to reduce funding costs and/or to manage our interest-rate risks.
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Interest-Rate Swaps. An interest-rate swap is an agreement between two entities to exchange cash flows in the future. The agreement sets the dates on which the cash flows will be paid and the manner in which the cash flows will be calculated. One of the simplest forms of an interest-rate swap involves the promise by one party to pay cash flows equivalent to the interest on a notional amount at a predetermined fixed rate for a given period of time. In return for this promise, this party receives cash flows equivalent to the interest on the same notional amount at a variable-rate index for the same period of time. The variable-rate index we utilize in most of our derivative transactions is LIBOR.
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Optional Termination Interest-Rate Swaps. In an optional termination interest-rate swap, one counterparty has the right, but not the obligation, to terminate the interest-rate swap prior to its stated maturity date. We use optional termination interest-rate swaps to hedge callable CO bonds and putable advances. In each case, we own an option to terminate the hedged item, that is, redeem a callable bond or demand repayment of a putable advance on specified dates, and the counterparty to the optional termination interest-rate swap owns the option to terminate the interest-rate swap on those same dates.
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Forward-Start Interest-Rate Swaps. A forward-start interest-rate swap is an interest-rate swap (as described above) with a deferred effective date. We designate forward-start interest-rate swaps as cash-flow hedges of expected debt issuances.
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Swaptions. A swaption is an option on an interest-rate swap that gives the buyer the right to enter into a specified interest-rate swap at a certain time in the future. When used as a hedge, a swaption can protect us if we are planning to lend or borrow funds in the future against future interest-rate changes. We may enter into both payer swaptions and receiver swaptions. A payer swaption is the option to make fixed interest payments at a later date and a receiver swaption is the option to receive fixed interest payments at a later date.
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Interest-Rate Cap and Floor Agreements. In an interest-rate cap agreement, a cash flow is generated if the price or rate of an underlying variable rises above a certain threshold or cap price. In an interest-rate floor agreement, a cash flow is generated if the price or rate of an underlying variable falls below a certain threshold or floor price. These agreements are intended to serve as protection against the interest rate on a variable-rate asset or liability falling below or rising above a certain level.
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Futures/Forwards Contracts. We may use futures and forward contracts to hedge interest-rate risk. For example, certain mortgage purchase commitments that we enter into are considered derivatives. We may hedge these commitments by selling MBS to-be-announced (TBA) for forward settlement. A TBA represents a forward contract for the sale of MBS at a future agreed-upon date for an established price.
Types of Assets and Liabilities Hedged
We formally document at inception all relationships between derivatives designated as hedging instruments and hedged items, as well as our risk-management objectives and strategies for undertaking various hedge transactions and our method of assessing hedge effectiveness. This process includes linking all derivatives that are designated as fair-value or cash-flow hedges
to specific assets or liabilities on the statement of condition; firm commitments; or forecasted transactions. We also formally assess (both at the hedge's inception and monthly on an ongoing basis) whether the derivatives that are used in hedging transactions have been effective in offsetting changes in the fair value or cash flows of the hedged items attributable to the hedged risk and whether those derivatives may be expected to remain effective in future periods. We typically use regression analyses or other statistical or scenario-based analyses to assess the effectiveness of our hedges. We apply hedge accounting to hedges that we deem highly effective and that otherwise meet the hedge-accounting requirements. When we determine that a derivative has not been or is not expected to be effective as a hedge, we discontinue hedge accounting prospectively, as discussed below.
Investments. We primarily invest in U.S. agency obligations, MBS, ABS, and the taxable portion of HFA securities, which may be classified as held-to-maturity, available-for-sale, or trading securities. The interest-rate and prepayment risk associated with these investment securities is managed through a combination of debt issuance and derivatives. FHFA guidance and our policies limit this source of interest-rate risk by restricting the types of mortgage investments we may own to those with limited average life changes under certain interest-rate-shock scenarios and establishing limitations on duration of equity and changes to market value of equity. We may manage our prepayment and duration risk by funding investment securities with COs that have call features or by hedging the prepayment risk with caps or floors, optional termination interest rate swaps, or swaptions.
For available-for-sale securities to which a qualifying fair-value hedge relationship has been designated, we record the portion of the change in fair value related to the risk being hedged in other income as net (losses) gains on derivatives and hedging activities together with the related change in fair value of the derivative, and the remainder of the change in fair value is recorded in other comprehensive loss as net unrealized loss on available-for-sale securities.
We may also manage the risk arising from changing market prices or cash flows of investment securities classified as trading by entering into economic hedges that offset the changes in fair value or cash flows of the securities. These economic hedges are not specifically designated as hedges of individual assets, but rather are collectively managed to provide an offset to the changes in the fair values of the assets. The market-value changes of trading securities are included in net unrealized (losses) gains on trading securities in the statement of operations, while the changes in fair value of the associated derivatives are included in other income as net (losses) gains on derivatives and hedging activities.
Advances. We offer an array of advance structures intended to meet our members' funding needs. These advances may have maturities up to 30 years with variable or fixed rates and may include early termination features or options. The repricing characteristics and optionality embedded in certain advances may create interest-rate risk. We may use interest-rate swaps to manage the repricing and/or options characteristics of advances to more closely match the characteristics of our funding liabilities. Typically, we hedge fixed-rate advances with interest-rate swaps where we pay a fixed-rate coupon and receive a variable-rate coupon, effectively converting the advance to a floating-rate advance. This type of hedge is treated as a fair-value hedge. Additionally, certain floating-rate advances that contain either an interest-rate cap or floor, or both a cap and a floor, may be hedged with a derivative containing an offsetting cap and/or floor, where the hedge relationship is treated as a fair-value hedge.
With each issuance of a putable advance, we effectively purchase from the related borrower an embedded put option that enables us to terminate a fixed-rate advance on predetermined put dates, and offer, subject to certain conditions, replacement funding at then-current advances rates. We may hedge a putable advance by entering into a derivative that is cancelable by the derivative counterparty, where we pay a fixed-rate coupon and receive a variable-rate coupon. This type of hedge is treated as a fair-value hedge. The swap counterparty would normally exercise its option to cancel the derivative at par on any defined exercise date if interest rates had risen, and at that time, we could, at our option, require immediate repayment of the advance.
Additionally, the borrower's ability to prepay an advance can create interest-rate risk. When a borrower prepays an advance, we could suffer lower future income if the principal portion of the prepaid advance were invested in lower-yielding assets that continue to be funded by higher-cost debt. To protect against this risk, we generally charge a prepayment fee that makes us financially indifferent to a borrower's decision to prepay an advance. If the advance is hedged with a derivative instrument, the prepayment fee will generally offset the cost of terminating the designated hedge. When we offer advances (other than short-term advances) that a borrower may prepay without a prepayment fee, we usually finance such advances with callable debt or otherwise hedge this option.
COs. We may enter into derivatives to hedge (or partially hedge, depending on the risk strategy) the interest-rate risk associated with our specific debt issuances, including using derivatives to change the effective interest-rate sensitivity of debt to better match the characteristics of funded assets. We endeavor to manage the risk arising from changing market prices and volatility of a CO by matching the cash inflow on the derivative with the cash outflow on the CO.
As an example of such a hedging strategy, when fixed-rate COs are issued, we simultaneously enter into a matching derivative in which the counterparty pays us fixed-interest cash flows designed to mirror in timing and amount the interest cash outflows we pay on the CO. At the same time, we may pay a variable cash flow that closely matches the interest payments we receive on short-term or variable-rate assets. In some cases, the hedged CO may have a nonstatic coupon that is subject to fair-value risk and that is matched by the receivable coupon on the hedging interest-rate swap. These transactions are treated as fair-value hedges.
In a typical cash-flow hedge of anticipated CO issuance, we may enter into interest-rate swaps for the anticipated issuance of fixed-rate CO bonds to lock in a spread between an earning asset and the cost of funding. The interest-rate swap is terminated upon issuance of the fixed-rate CO bond. Changes in fair value of the hedging derivative, to the extent that the hedge is effective, will be recorded in accumulated other comprehensive loss and reclassified into earnings in the period or periods during which the cash flows of the fixed-rate CO bond affects earnings (beginning upon issuance and continuing over the life of the CO bond).
Firm Commitments. Mortgage-purchase commitments are considered derivatives. We may hedge these commitments by selling MBS TBA or other derivatives for forward settlement. These hedges do not qualify for hedge accounting treatment. The mortgage purchase commitment and the TBA used in the economic hedging strategy are recorded on the statement of condition at fair value, with changes in fair value recognized in current period earnings. When the mortgage purchase commitment derivative settles, the current market value of the commitment is included with the basis of the mortgage loan. The basis adjustments on the resulting performing loans are then amortized into net interest income over the life of the loans.
We may also hedge a firm commitment for a forward-starting advance through the use of an interest-rate swap. In this case, the swap functions as the hedging instrument for both the firm commitment and the subsequent advance. The fair-value change associated with the firm commitment is recorded as a basis adjustment of the advance at the time the commitment is terminated and the advance is issued. The basis adjustment is then amortized into interest income over the life of the advance.
Financial Statement Impact and Additional Financial Information. The notional amount of derivatives is a factor in determining periodic interest payments or cash flows received and paid. However, the notional amount of derivatives reflects our involvement in the various classes of financial instruments and represents neither the actual amounts exchanged nor our overall exposure to credit and market risk; the overall risk is much smaller. The risks of derivatives can be measured meaningfully on a portfolio basis that takes into account the counterparties, the types of derivatives, the items being hedged, and any offsets between the derivatives and the items being hedged.
The following table presents the fair value of derivatives, including the effect of netting adjustments and cash collateral as of December 31, 2015 and 2014 (dollars in thousands):
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(1)
Mortgage-delivery commitments are classified as derivatives with changes in fair value recorded in other income.
(2)
Amounts represent the effect of master-netting agreements intended to allow us to settle positive and negative positions with the same counterparty. Cash collateral and related accrued interest posted was $92.9 million and $45.5 million at December 31, 2015, and 2014, respectively. The change in cash collateral posted is included in the net change in interest-bearing deposits in the statement of cash flows. Cash collateral and related accrued interest received was $750,000 and $290,000 at December 31, 2015 and 2014.
Net (losses) gains on derivatives and hedging activities recorded in Other Income (Loss) for the years ended December 31, 2015, 2014, and 2013 were as follows (dollars in thousands):
The following tables present, by type of hedged item, the gains (losses) on derivatives and the related hedged items in fair-value hedge relationships and the impact of those derivatives on our net interest income for the years ended December 31, 2015, 2014, and 2013 (dollars in thousands):
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(1)
The net interest on derivatives in fair-value hedge relationships is presented in the statement of operations as interest income or interest expense of the respective hedged item.
The following table presents the gains (losses) recognized in accumulated other comprehensive loss, the gains (losses) reclassified from accumulated other comprehensive loss into income, and the effect of our hedging activities on our net (losses) gains on derivatives and hedging activities in the statement of income for our forward-start interest-rate swaps associated with hedged CO bonds in cash-flow hedge relationships (dollars in thousands).
For the years ended December 31, 2015, 2014, and 2013, there were no reclassifications from accumulated other comprehensive loss into earnings as a result of the discontinuance of cash-flow hedges because the original forecasted transactions were not expected to occur by the end of the originally specified time period or within a two-month period thereafter. As of December 31, 2015, the maximum length of time over which we are hedging our exposure to the variability in future cash flows for forecasted transactions is eight years.
As of December 31, 2015, the amount of deferred net losses on derivatives accumulated in other comprehensive loss related to cash flow hedges expected to be reclassified to earnings during the next 12 months is $23.8 million.
Managing Credit Risk on Derivatives. We are subject to credit risk on our hedging activities due to the risk of nonperformance by nonmember counterparties (including DCOs and their clearing members acting as agent to the DCOs as well as uncleared counterparties) to the derivative agreements. We manage credit risk through credit analysis, collateral requirements and adherence to the requirements set forth in our policies, U.S. Commodity Futures Trading Commission (the CFTC) regulations, and FHFA regulations. All counterparties must execute master-netting agreements prior to entering into any uncleared derivative with us.
Our master-netting agreements for uncleared derivatives contain bilateral-collateral exchange agreements that require that credit exposure beyond a defined threshold amount (which may be zero) be secured by readily marketable, U.S. Treasury or GSE securities, or cash. The level of these collateral threshold amounts (when applicable) varies according to the counterparty's Standard & Poor's Rating Service (S&P) or Moody's Investors Services (Moody's) long-term credit ratings. Credit exposures are then measured daily and adjustments to collateral positions are made in accordance with the terms of the master-netting agreements. These master-netting agreements also contain bilateral ratings-tied termination events permitting us to terminate all outstanding derivatives transactions with a counterparty in the event of a specified rating downgrade by Moody's or S&P. Based on credit analyses and collateral requirements, we do not anticipate any credit losses on our derivative agreements.
We execute uncleared derivatives with nonmember counterparties with long-term ratings of single-A (or equivalent) or better by the major NRSROs at the time of the transaction, although risk-reducing trades (trades that reduce our net credit exposure or
exposure sensitivity to the counterparty) are permitted for counterparties whose ratings have fallen below these ratings. Some of these counterparties or their affiliates buy, sell, and distribute COs. See Note 13 - Consolidated Obligations for additional information.
For cleared derivatives, the DCO is our counterparty. The DCO notifies the clearing member of the required initial and variation margin and our agent (clearing member) in turn notifies us. We post initial margin and exchange variation margin through a clearing member who acts as our agent to the DCO and who guarantees our performance to the DCO, subject to the terms of relevant agreements. These arrangements expose us to institutional credit risk in the event that one of our clearing members or one of the DCOs fails to meet its obligations. The use of cleared derivatives is intended to mitigate credit risk exposure because the DCO, which is fully secured at all times through margin maintained with its clearing members, is substituted for the credit risk exposure of individual counterparties in uncleared derivatives and collateral is posted at least once daily for changes in the fair value of cleared derivatives through a clearing member.
We have analyzed the rights, rules, and regulations governing our cleared derivatives and determined that those rights, rules, and regulations should result in a net claim through each of our clearing members with the related DCO upon an event of default including a bankruptcy, insolvency or similar proceeding involving the DCO or one of our clearing members, or both. For this purpose, net claim generally means a single net amount reflecting the aggregation of all amounts indirectly owed by us to the relevant DCO and indirectly payable to us from the relevant DCO. Based on this analysis, we are presenting a net derivative receivable or payable for all of our transactions through a particular clearing member with a particular DCO.
Certain of our uncleared derivatives master-netting agreements contain provisions that require us to post additional collateral with our uncleared derivatives counterparties if our credit ratings are lowered. Under the terms that govern such agreements, if our credit rating is lowered by Moody's or S&P to a certain level, we are required to deliver additional collateral on uncleared derivatives in a net liability position. In the event of a split between such credit ratings, the lower rating governs. The aggregate fair value of all uncleared derivatives with these provisions that were in a net-liability position (before cash collateral and related accrued interest) at December 31, 2015, was $456.0 million for which we had delivered collateral with a post-haircut value of $393.6 million in accordance with the terms of the master-netting agreements. The following table sets forth the post-haircut value of incremental collateral that certain uncleared derivatives counterparties could have required us to deliver based on incremental credit rating downgrades at December 31, 2015 (dollars in thousands).
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(1)
Ratings are expressed in this table according to S&P's conventions but include the equivalent of such rating by Moody's. If there is a split rating, the lower rating is used.
For cleared derivatives, the DCO determines initial margin requirements. We note that we clear our trades via clearing members of the DCOs. These clearing members who act as our agent to the DCOs are CFTC- registered futures commission merchants. Our clearing members may require us to post margin in excess of DCO requirements based on our credit or other considerations, including but not limited to, credit rating downgrades. We were not required to post any such excess margin by our clearing members based on credit considerations at December 31, 2015.
Offsetting of Certain Derivatives. We present derivatives, related cash collateral, including initial and variation margin, received or pledged, and associated accrued interest, on a net basis by clearing members and/or by counterparty.
The following table presents separately the fair value of derivatives meeting or not meeting netting requirements, with and without the legal right of offset, including the related collateral received from or pledged to counterparties, based on the terms of our master netting arrangements or similar agreements as of December 31, 2015 and 2014 (dollars in thousands).
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(1)
Includes non-cash collateral at fair value. Any overcollateralization with a counterparty is not included in the determination of the net amount. At December 31, 2015 and 2014, we had additional net credit exposure of $3.1 million and $4.0 million, respectively, due to instances where our collateral pledged to a counterparty exceeded our net derivative liability position.
Note 12 - Deposits
We offer demand and overnight deposits for members and qualifying nonmembers. In addition, we offer short-term interest-bearing deposit programs to members. Members that service mortgage loans may deposit funds collected in connection with mortgage loans pending disbursement of such funds to the owners of the mortgage loans. We classify these items as "other" in the following table.
Deposits classified as demand, overnight, and other pay interest based on a daily interest rate. Term deposits pay interest based on a fixed rate determined at the issuance of the deposit. The average interest rates paid on average deposits during 2015 and 2014 was 0.018 percent and 0.014 percent, respectively.
The following table details interest- and noninterest-bearing deposits (dollars in thousands):
Note 13 - Consolidated Obligations
COs consist of CO bonds and CO discount notes. CO bonds are issued primarily to raise intermediate- and long-term funds and are not subject to any statutory or regulatory limits on maturity. CO discount notes are issued to raise short-term funds and have original maturities of up to one year. These notes sell at less than their face amount and are redeemed at par value when they mature.
Although we are primarily liable for our portion of COs (that is, those issued from which we received issuance proceeds), we are also jointly and severally liable with the other FHLBanks for the payment of principal and interest on all COs. The FHFA, at its discretion, may require any FHLBank to make principal or interest payments due on any CO whether or not the CO represents a primary liability of such FHLBank. Although an FHLBank has never paid the principal or interest payments due on a CO on behalf of another FHLBank, if that event should occur, FHFA regulations provide that the paying FHLBank is entitled to reimbursement from the noncomplying FHLBank for any payments made on its behalf and other associated costs, including interest to be determined by the FHFA. If, however, the FHFA determines that the noncomplying FHLBank is unable to satisfy its repayment obligations, the FHFA may allocate the outstanding liabilities of the noncomplying FHLBank among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank's participation in all COs outstanding. The FHFA reserves the right to allocate the outstanding liabilities for the COs among the FHLBanks in any other manner it may determine to ensure that the FHLBanks operate in a safe and sound manner. See Note 19 - Commitments and Contingencies for additional information regarding the FHLBanks' joint and several liability.
The par values of the FHLBanks' outstanding COs, including COs held by other FHLBanks, were approximately $905.2 billion and $847.2 billion at December 31, 2015 and 2014, respectively. Regulations require each FHLBank to maintain unpledged qualifying assets equal to outstanding COs for which it is primarily liable. Such qualifying assets include cash; secured advances; obligations of or fully guaranteed by the U.S.; obligations, participations, or other instruments of or issued by Fannie Mae or Ginnie Mae; mortgages, obligations, or other securities which are or ever have been sold by Freddie Mac under the FHLBank Act; and such securities as fiduciary and trust funds may invest in under the laws of the state in which the FHLBank is located. Any assets subject to a lien or pledge for the benefit of holders of any issues of COs are treated as if they were free from lien or pledge for purposes of compliance with these regulations.
COs - Bonds. The following table sets forth the outstanding CO bonds for which we were primarily liable at December 31, 2015 and 2014, by year of contractual maturity (dollars in thousands):
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(1)
The CO bonds' weighted-average rate excludes concession fees.
COs outstanding were issued with either fixed-rate coupon-payment terms or variable-rate coupon-payment terms that may use a variety of indices for interest-rate resets, including the federal funds effective rate, LIBOR, and others. To meet the expected specific needs of certain investors in COs, both fixed-rate CO bonds and variable-rate CO bonds may contain features, which may result in complex coupon-payment terms and call options. When these COs are issued, we may enter into derivatives containing features that offset the terms and embedded options, if any, of the CO bonds.
Our CO bonds outstanding at December 31, 2015 and 2014, included (dollars in thousands):
The following is a summary of the CO bonds for which we were primarily liable at December 31, 2015 and 2014, by year of contractual maturity or next call date for callable CO bonds (dollars in thousands):
CO bonds, beyond having fixed-rate or variable-rate interest-rate payment terms, may also have the following interest-rate payment terms:
Step-Up bonds pay interest at increasing fixed rates for specified intervals over the life of the CO bond and can be called at our option on the step-up dates.
The following table sets forth the CO bonds for which we were primarily liable by interest-rate-payment type at December 31, 2015 and 2014 (dollars in thousands):
COs - Discount Notes. Outstanding CO discount notes for which we were primarily liable, all of which are due within one year, were as follows (dollars in thousands):
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(1)
The CO discount notes' weighted-average rate represents a yield to maturity excluding concession fees.
Concessions on COs. Unamortized concessions on COs were $6.1 million and $6.4 million at December 31, 2015 and 2014, respectively, and are included in other assets on the statement of condition. The amortization of these concessions is included in CO interest expense and totaled $2.4 million, $2.1 million, and $2.9 million in 2015, 2014, and 2013, respectively.
Note 14 - Affordable Housing Program
The FHLBank Act requires each FHLBank to establish and maintain an AHP to provide subsidies in the form of direct grants and below-market interest-rate advances (AHP advances). These funds are intended to assist in the purchase, construction, or rehabilitation of housing for very low-, low-, and moderate-income households. Annually, the FHLBanks must set aside for the AHP the greater of $100 million or 10 percent of net income before interest expense associated with mandatorily redeemable capital stock and the assessment for AHP. We accrue this expense monthly based on our net earnings, and the accruals are accumulated into our AHP payable account. We reduce our AHP payable account as we disburse the funds either in the form of direct grants to member institutions or as a discount on below-market-rate AHP advances. We had outstanding principal in AHP advances of $100.7 million and $100.5 million at December 31, 2015 and 2014, respectively.
If we experience a net loss during a quarter, but still have net earnings for the year, our obligation to the AHP would be calculated based on our net earnings for that calendar year. In annual periods where our net earnings are zero or less, our AHP assessment is zero since our required annual contribution is limited to our annual net earnings. If the result of the aggregate 10 percent calculation described above were less than $100 million for all the FHLBanks, then each FHLBank would be required to contribute such prorated sums as may be required to assure that the aggregate contributions of the FHLBanks equals $100 million. The proration would be made on the basis of the income of the FHLBanks for the year, except that the required annual AHP contribution for an FHLBank cannot exceed its net earnings for the year pursuant to an FHFA regulation. Each FHLBank's required annual AHP contribution is limited to its annual net earnings. Our AHP expense for 2015, 2014, and 2013 was $32.3 million, $17.6 million, and $24.2 million, respectively.
There was no shortfall, as described above, in 2015, 2014, or 2013. If an FHLBank is experiencing financial instability and finds that its required AHP contributions are contributing to the financial instability, the FHLBank may apply to the FHFA for a temporary suspension of its contributions. We did not make such an application in 2015, 2014, or 2013.
The following table presents a roll-forward of the AHP liability for the years ended December 31, 2015 and 2014 (dollars in thousands):
Note 15 - Capital
We are subject to capital requirements under our capital plan, the FHLBank Act, and FHFA regulations:
1.
Risk-based capital. We are required to maintain at all times permanent capital, defined as Class B stock, including Class B stock classified as mandatorily redeemable capital stock, and retained earnings, in an amount at least equal to the sum of our credit-risk capital requirement, market-risk capital requirement, and operations-risk capital requirement, calculated in accordance with FHFA rules and regulations, referred to herein as the risk-based capital requirement. Only permanent capital satisfies the risk-based capital requirement.
2.
Total regulatory capital. We are required to maintain at all times a total capital-to-assets ratio of at least four percent. Total regulatory capital is the sum of permanent capital, the amount paid-in for Class A stock, the amount of any general loss allowance if consistent with GAAP and not established for specific assets, and other amounts from sources determined by the FHFA as available to absorb losses. We have never issued Class A stock.
3.
Leverage capital. We are required to maintain at all times a leverage capital-to-assets ratio of at least five percent. Leverage capital is defined as the sum of permanent capital weighted 1.5 times and all other capital without a weighting factor.
The FHFA may require us to maintain a greater amount of permanent capital than is required as defined by the risk-based capital requirements.
The following tables demonstrate our compliance with our regulatory capital requirements at December 31, 2015 and 2014 (dollars in thousands):
We are a cooperative whose members and former members own all of our capital stock. Shares of capital stock cannot be purchased or sold except between us and our members at $100 per share par value. We have only issued Class B stock and each member is required to purchase Class B stock equal to the sum of 0.35 percent of certain member assets eligible to secure advances under the FHLBank Act, 3.00 percent for overnight advances, 4.00 percent for advances with an original maturity greater than overnight and up to three months, and 4.50 percent for all other advances and other specified assets related to activity between us and the member.
The Gramm-Leach-Bliley Act of 1999, as amended, made FHLBank membership voluntary for all members. Members may redeem Class B stock after no sooner than five years' notice provided in accordance with our capital plan (the redemption-notice period). The effective date of termination of membership for any member that voluntarily withdraws from membership is the end of the redemption-notice period, at which time any stock that is held as a condition of membership shall be divested, subject to any other applicable restrictions at that time. At that time, any stock held pursuant to activity-based stock investment requirements shall remain outstanding until such requirements are eliminated by disposition of the related business activity. Any member that withdraws from membership may not be readmitted to membership in any FHLBank until five years from the divestiture date for all capital stock that is held as a condition of membership. This restriction does not apply if the member is transferring its membership from one FHLBank to another on an uninterrupted basis.
The redemption-notice period can also be triggered by the involuntary termination of membership of a member by our board of directors or by the FHFA, the merger or acquisition of a member into a nonmember institution, or the relocation of a member to a principal location outside our district. At the end of the redemption-notice period, if the former member's activity-based stock investment requirement is greater than zero, we may require the associated remaining obligations to us to be satisfied in full prior to allowing the member to redeem the remaining shares.
Because our Class B stock is subject to redemption in certain instances, we can experience a reduction in our capital, particularly due to membership terminations due to merger and acquisition activity. However, there are several mitigants to this risk, including, but not limited to, the following:
•
the activity-based portion of the stock-investment requirement allows us to retain stock beyond the redemption-notice period if the associated member-related activity is still outstanding, until the obligations are paid in full;
•
the redemption notice period allows for a significant period in which we can restructure our balance sheet to accommodate a reduction in capital;
•
our board of directors may modify the membership stock-investment requirement or the activity-based stock-investment requirement, or both, to address expected shortfalls in capitalization due to membership termination; and
•
our board of directors or the FHFA may suspend redemptions in the event that such redemptions would cause us not to meet our minimum regulatory capital requirements.
Our board of directors may declare and pay dividends in either cash or capital stock, subject to limitations in applicable law and our capital plan.
Restricted Retained Earnings. Pursuant to the Joint Capital Agreement, and our capital plan, we, together with the other FHLBanks, are required to contribute 20 percent of our quarterly net income to a restricted retained earnings account until the balance of that account equals at least one percent of the FHLBank's average balance of outstanding COs (excluding fair-value adjustments) for the calendar quarter. At December 31, 2015, our total contribution requirement totaled $530.1 million. As of
December 31, 2015 and 2014, restricted retained earnings totaled $194.6 million and $136.8 million, respectively. These restricted retained earnings are not available to pay dividends.
Mandatorily Redeemable Capital Stock. We will reclassify capital stock subject to redemption from equity to liability once a member exercises a written notice of redemption, gives notice of intent to withdraw from membership, or attains nonmember status by merger or acquisition, charter termination, or involuntary termination from membership. Dividends related to capital stock classified as a liability are accrued at the expected dividend rate and reported as interest expense in the statement of operations. If a member cancels its written notice of redemption or notice of withdrawal, we will reclassify mandatorily redeemable capital stock from a liability to equity. After the reclassification, dividends on the capital stock would no longer be classified as interest expense.
At December 31, 2015 and 2014, we had $42.0 million and $298.6 million, respectively, in capital stock subject to mandatory redemption. Redemption of capital stock is subject to the redemption-notice period and our satisfaction of applicable minimum capital requirements. For the years ended December 31, 2015, 2014, and 2013, dividends on mandatorily redeemable capital stock of $1.6 million, $8.8 million, and $5.8 million, respectively, were recorded as interest expense.
The following table is a roll-forward of our capital stock that is subject to mandatory redemption during the years ended December 31, 2015, 2014, and 2013 (dollars in thousands).
The number of stockholders holding mandatorily redeemable capital stock was five, seven, and six at each of December 31, 2015, 2014, and 2013, respectively.
Consistent with our capital plan, we are not required to redeem membership stock until the expiration of the redemption-notice period. Furthermore, we are not required to redeem activity-based stock until the later of the expiration of the redemption-notice period or the activity to which the capital stock relates no longer remains outstanding. If activity-based stock becomes excess stock as a result of an activity-based asset no longer outstanding, we may repurchase such shares, in our sole discretion, subject to the statutory and regulatory restrictions on excess capital-stock redemption discussed below. The year of redemption in the following table represents the end of the redemption-notice period. However, as discussed above, if activity to which the capital stock relates remains outstanding beyond the redemption-notice period, the activity-based stock associated with this activity will remain outstanding until the activity no longer remains outstanding. The following table sets forth the amount of mandatorily redeemable capital stock by year of expiry of the redemption-notice period at December 31, 2015 and 2014 (dollars in thousands).
_______________________
(1)
Amount represents mandatorily redeemable capital stock that has reached the end of the five-year redemption-notice period but the member-related activity remains outstanding. Accordingly, these shares of stock will not be redeemed until the activity is no longer outstanding.
A member may cancel or revoke its written notice of redemption or its notice of withdrawal from membership prior to the end of the redemption-notice period. Our capital plan provides that we will charge the member a cancellation fee in the amount of 2.0 percent of the par amount of the shares of Class B stock that is the subject of the redemption notice. We will assess a
redemption-cancellation fee unless the board of directors decides that it has a bona fide business purpose for waiving the imposition of the fee, and such a waiver is consistent with the FHLBank Act.
Excess Capital Stock. Our capital plan provides us with the discretion to repurchase capital stock from a member at par value if that stock is not required by the member to meet its total stock investment requirement (excess capital stock) subject to all applicable limitations. In conducting any repurchases, we repurchase any shares that are the subject of an outstanding redemption notice from the member from whom we are repurchasing prior to repurchasing any other shares that are in excess of the member's total stock-investment requirement. We may also allow the member to sell the excess capital stock at par value to another one of our members.
Beginning on December 8, 2008, we instituted a moratorium on all excess capital stock repurchases to help preserve our capital in the light of the challenges that arose at that time, principally due to our investments in private-label MBS. Effective January 1, 2015, we rescinded the moratorium on excess capital stock repurchases. At December 31, 2015 and 2014, members and nonmembers with capital stock outstanding held excess capital stock totaling $158.9 million and $633.0 million, respectively, representing approximately 6.7 percent and 23.3 percent, respectively, of total capital stock outstanding. FHFA rules limit our ability to create member excess capital stock under certain circumstances. We may not pay dividends in the form of capital stock or issue new excess capital stock to members if our excess capital stock exceeds one percent of our total assets or if the issuance of excess capital stock would cause our excess capital stock to exceed one percent of our total assets. At December 31, 2015, we had excess capital stock outstanding totaling 0.3 percent of our total assets. For the year ended December 31, 2015, we complied with the FHFA's excess capital stock rule.
Capital Classification Determination. We are subject to the FHFA's regulation on FHLBank capital classification and critical capital levels (the Capital Rule). The Capital Rule, among other things, defines criteria for four capital classifications and corrective action requirements for FHLBanks that are classified in any classification other than adequately capitalized. An adequately capitalized FHLBank is one that has sufficient permanent and total capital to satisfy its risk-based and minimum capital requirements. We satisfied these requirements at December 31, 2015. However, pursuant to the Capital Rule, the FHFA has discretion to reclassify an FHLBank and modify or add to corrective action requirements for a particular capital classification. If we become classified into a capital classification other than adequately capitalized, we will be subject to the corrective action requirements for that capital classification in addition to being subject to prohibitions on declaring dividends and redeeming or repurchasing capital stock. By letter dated December 10, 2015, the Director of the FHFA notified us that, based on September 30, 2015, financial information, we met the definition of adequately capitalized under the Capital Rule.
Note 16 - Accumulated Other Comprehensive Loss
The following table presents a summary of changes in accumulated other comprehensive loss for the years ended December 31, 2015, 2014, and 2013 (dollars in thousands):
_______________________
(1)
Recorded in net amount of impairment losses reclassified to (from) accumulated other comprehensive loss in the statement of operations.
(2)
Recorded in net (losses) gains on derivatives and hedging activities in the statement of operations.
(3)
Recorded in other operating expenses in the statement of operations.
(4)
Amortization of hedging activities includes $8.7 million recorded in CO bond interest expense and $16,000 recorded in net (losses) gains on derivatives and hedging activities in the statement of operations.
(5)
Amortization of hedging activities includes $23.8 million recorded in CO bond interest expense and $14,000 recorded in net (losses) gains on derivatives and hedging activities in the statement of operations.
Note 17 - Employee Retirement Plans
Qualified Defined Benefit Multiemployer Plan. We participate in the Pentegra Defined Benefit Plan for Financial Institutions (the Pentegra Defined Benefit Plan), a funded, tax-qualified, noncontributory defined-benefit pension plan. The Pentegra Defined Benefit Plan is treated as a multiemployer plan for accounting purposes, but operates as a multiple-employer plan under the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code. Accordingly, certain multiemployer plan disclosures are not applicable to the Pentegra Defined Benefit Plan. Under the Pentegra Defined Benefit Plan, contributions made by a participating employer may be used to provide benefits to employees of other participating employers since assets contributed by an employer are not segregated in a separate account or restricted to provide benefits only to employees of that employer. Also, in the event a participating employer is unable to meet its contribution requirements, the required contributions for the other participating employers could increase proportionately. The plan covers substantially all of our employees. For the year ended December 31, 2015, in addition to our required contribution, we made voluntary contributions of $7.0 million to the Pentegra Defined Benefit Plan. We were not required nor did we pay a funding improvement surcharge to the plan for the years ended December 31, 2015, 2014, and 2013.
The Pentegra Defined Benefit Plan operates on a fiscal year from July 1 through June 30. The Pentegra Defined Benefit Plan files one Form 5500 on behalf of all employers who participate in the plan. The Employer Identification Number is 13-5645888 and the three-digit plan number is 333. We do not have any collective bargaining agreements in place.
The Pentegra Defined Benefit Plan's annual valuation process includes calculating the plan's funded status and separately calculating the funded status of each participating employer. The funded status is defined as the market value of assets divided by the funding target (100 percent of the present value of all benefit liabilities accrued at that date). As permitted by ERISA, the Pentegra Defined Benefit Plan accepts contributions for the prior plan year up to eight and a half months after the asset valuation date. Accordingly, the market value of assets at the valuation date (July 1) will increase by any subsequent contributions designated for the immediately preceding plan year ended June 30.
The most recent Form 5500 available for the Pentegra Defined Benefit Plan is for the plan year ended June 30, 2014. For the Pentegra Defined Benefit Plan plan years ended June 30, 2014 and 2013, our contributions did not represent more than five percent of the total contributions to the Pentegra Defined Benefit Plan.
The following table sets forth our net pension costs and funded status under the Pentegra Defined Benefit Plan (dollars in thousands):
______________________
(1)
The increase in the funded status from July 1, 2013 to July 1, 2014, of both the Pentegra Defined Benefit Plan as a whole and our funded status, reflects a provision contained in the Highway and Transportation Funding Act of 2014 (HATFA), which was signed into law by President Obama on August 8, 2014, and which modifies the interest rates that had been set by the Moving Ahead for Progress in the 21st Century Act (MAP-21). MAP-21, signed into law by President Obama in 2012, changed the calculation of the discount rate used in measuring the pension plan liability. MAP-21 allows plan sponsors to measure the pension plan liability using a 25-year average of interest rates plus or minus a corridor. Prior to MAP-21, the discount rate used in measuring the pension plan liability was based on the 24-month average of interest rates. HATFA amended MAP-21 by extending the time period and reducing the rate at which the 25-year corridors widen.
Over time, the pension funding stabilization effect of MAP-21 will decline because the 24-month smoothed segment rates and the amended 25-year corridors are likely to converge.
(2)
The funded status as of July 1, 2015, is preliminary and may increase because the plan's participants were permitted to make contributions for the plan year ended June 30, 2015, through March 15, 2016. Contributions made on or before March 15, 2016, and designated for the plan year ended June 30, 2015, will be included in the final valuation as of July 1, 2015. The final funded status as of July 1, 2015, will not be available until the Form 5500 for the plan year July 1, 2015, through June 30, 2016 is filed. This Form 5500 is due to be filed no later than April 2017.
(3)
The funded status as of July 1, 2014, is preliminary and may increase because the plan's participants were permitted to make contributions for the plan year ended June 30, 2014, through March 15, 2015. Contributions made on or before March 15, 2015, and designated for the plan year ended June 30, 2014, will be included in the final valuation as of July 1, 2014. The final funded status as of July 1, 2014, will not be available until the Form 5500 for the plan year July 1, 2014, through June 30, 2015 is filed. This Form 5500 is due to be filed no later than April 2016.
Qualified Defined Contribution Plan. We also participate in the Pentegra Defined Contribution Plan for Financial Institutions, a tax-qualified defined contribution plan. The plan covers substantially all of our employees. We contribute a percentage of the participants' compensation by making a matching contribution equal to a percentage of voluntary employee contributions, subject to certain limitations. Our matching contributions are charged to compensation and benefits expense.
Nonqualified Defined Contribution Plan. We also maintain the Thrift Benefit Equalization Plan, a nonqualified, unfunded deferred compensation plan covering certain of our senior officers and directors. The plan's liability consists of the accumulated compensation deferrals and the accumulated earnings on these deferrals. Our obligation from this plan was $6.3 million and $5.6 million at December 31, 2015 and 2014, respectively, which is recorded in other liabilities on the statement of condition. We maintain a rabbi trust intended to satisfy future benefit obligations which is recorded in other assets on the statement of condition.
The following table sets forth expenses relating to our defined contribution plans (dollars in thousands):
Nonqualified Supplemental Defined Benefit Retirement Plan. We also maintain a nonqualified, single-employer unfunded defined-benefit plan covering certain senior officers, for which our obligation is detailed below. We maintain a rabbi trust intended to meet future benefit obligations.
Postretirement Benefits. We sponsor a fully insured postretirement benefit program that includes life insurance benefits for eligible retirees. We provide life insurance to all employees who retire on or after age 55 after completing six years of service. No contributions are required from the retirees. There are no funded plan assets that have been designated to provide postretirement benefits.
In connection with the nonqualified supplemental defined benefit retirement plan and postretirement benefits, we recorded the following amounts as of December 31, 2015 and 2014 (dollars in thousands):
______________________
(1)
Represents the projected benefit obligation for the nonqualified supplemental defined benefit retirement plan and the accumulated postretirement benefit obligation for postretirement benefits.
Amounts recognized in other liabilities on the statement of condition for our nonqualified supplemental defined benefit retirement plan and postretirement benefits at December 31, 2015 and 2014, were $13.1 million and $13.3 million, respectively.
Amounts recognized in other comprehensive income for our nonqualified supplemental defined benefit retirement plan and postretirement benefits as of December 31, 2015 and 2014, were (dollars in thousands):
The accumulated benefit obligation for the nonqualified supplemental defined benefit retirement plan was $10.0 million and $8.9 million at December 31, 2015 and 2014, respectively.
The following table presents the components of net periodic benefit cost and other amounts recognized in accumulated other comprehensive loss for our nonqualified supplemental defined benefit retirement plan and postretirement benefits for the years ended December 31, 2015, 2014, and 2013 (dollars in thousands):
The estimated net actuarial loss that will be amortized from accumulated other comprehensive loss into net periodic benefit cost during 2016 is $473,000 for our nonqualified supplemental defined benefit retirement plan and $4,000 for our postretirement benefits.
Key assumptions used for the actuarial calculations to determine benefit obligations and net periodic benefit cost for our nonqualified supplemental defined benefit retirement plan and postretirement benefits at December 31, 2015 and 2014, were:
The discount rate for the nonqualified supplemental defined benefit retirement plan as of December 31, 2015, was determined by using a discounted cash-flow approach, which incorporates the timing of each expected future benefit payment. The estimate of the future benefit payments is based on the plan's census data, benefit formula and provisions, and valuation assumptions reflecting the probability of decrement and survival. The present value of the future benefit payments is then determined by using duration-based interest-rate yields from the Citigroup Pension Discount Curve as of December 31, 2015, and solving for the single discount rate that produces the same present value.
Our nonqualified supplemental defined benefit retirement plan and postretirement benefits are not funded; therefore, no contributions will be made in 2016 other than the payment of benefits.
Estimated future benefit payments for our nonqualified supplemental defined benefit retirement plan and postretirement benefits, reflecting expected future services, for the years ending December 31 are (dollars in thousands):
Note 18 - Fair Values
The carrying values, fair values, and fair-value hierarchy of our financial instruments at December 31, 2015 and 2014, were as follows (dollars in thousands). These fair values do not represent an estimate of our overall market value as a going concern, which would take into account, among other things, our future business opportunities and the net profitability of our assets and liabilities.
_______________________
(1)
Carried at fair value on a recurring basis.
_______________________
(1)
Carried at fair value on a recurring basis.
Fair-Value Methodologies and Techniques
We have determined the fair-value amounts above using available market and other pertinent information and our best judgment of appropriate valuation methods. Although we use our best judgment in estimating the fair value of these financial instruments, there are inherent limitations in any estimation technique or valuation methodology. For example, because an active secondary market does not exist for a portion of our financial instruments, in certain cases, fair values are not subject to precise quantification or verification and may change as economic and market factors and evaluation of those factors change. Therefore, these fair values are not necessarily indicative of the amounts that would be realized in current market transactions, although they do reflect our judgment of how a market participant would estimate the fair values.
Fair-Value Hierarchy. Fair value is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal (or advantageous) market for the asset or liability at the measurement date (an exit price).
We record trading securities, available-for-sale securities, derivative assets, derivative liabilities, and certain other assets at fair value on a recurring basis, and on occasion certain private-label MBS, certain mortgage loans, and certain other assets on a non-recurring basis. U.S. GAAP establishes a fair-value hierarchy and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The inputs are evaluated and an overall level for the fair-value measurement is determined. This overall level is an indication of market observability of the fair-value measurement for the asset or liability. An entity must disclose the level within the fair value hierarchy in which the measurements are classified.
The fair-value hierarchy prioritizes the inputs used to measure fair value into three broad levels:
Level 1
Quoted prices (unadjusted) for identical assets or liabilities in an active market that the reporting entity can access on the measurement date.
Level 2
Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified or contractual term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following: (1) quoted prices for similar assets or liabilities in active markets; (2) quoted prices for identical or similar assets or liabilities in markets that are not active; (3) inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates and yield curves that are observable at commonly quoted intervals, volatilities, and prepayment speeds); and (4) inputs that are derived principally from or corroborated by observable market data (e.g., implied spreads).
Level 3
Unobservable inputs for the asset or liability.
We review the fair-value hierarchy classifications on a quarterly basis. Changes in the observability of the valuation inputs may result in a reclassification of certain assets or liabilities. These reclassifications are reported as transfers in/out as of the beginning of the quarter in which the changes occur. There were no such transfers during the years ended December 31, 2015 and 2014.
Summary of Valuation Methodologies and Primary Inputs
Cash and Due from Banks. The fair value approximates the recorded carrying value.
Interest-Bearing Deposits. The fair value approximates the recorded carrying value.
Securities Purchased under Agreements to Resell. The fair value is determined by calculating the present value of expected future cash flows. The discount rates used in these calculations are the rates for securities with similar terms.
Federal Funds Sold. The fair value is determined by calculating the present value of the expected future cash flows. The discount rates used in these calculations are the rates for federal funds with similar terms.
Investment Securities. We determine the fair values of our investment securities, other than HFA floating-rate securities, based on prices obtained for each of these securities that we request from four designated third-party pricing vendors. The fair value of each such security is the average of such vendor prices that are within a cluster pricing tolerance range. A cluster is defined as a group of available vendor prices for a given security that is within a defined price tolerance range of the median vendor price depending on the security type. An outlier is any vendor price that is outside of the defined cluster and is evaluated for reasonableness. The use of the average of available vendor prices within a cluster and the evaluation of reasonableness of outlier prices does not discard available information. In addition, the fair values produced by this method are reviewed for reasonableness.
We request prices on each of our securities subject to this fair-value method from four third-party vendors, when available. These pricing vendors use methods that generally employ, but are not limited to, benchmark yields, recent trades, dealer estimates, valuation models, benchmarking of like securities, sector groupings, and/or matrix pricing. We establish a median price for each security using a formula that is based on the number of prices received:
•
if four prices are received, the average of the two middle prices is used;
•
if three prices are received, the middle price is used;
•
if two prices are received, the average of the two prices is used; and
•
if one price is received, it is used subject to validation of outliers as described below.
Vendor prices that are outside of a defined cluster are identified as outliers and are subject to additional review including, but not limited to, comparison to prices provided by an additional third-party valuation vendor, prices for similar securities, and/or nonbinding dealer estimates, or the use of internal model prices, which we believe reflect the facts and circumstances that a market participant would consider. We also perform this analysis in those limited instances where no third-party vendor price or only one third-party vendor price is available to determine fair value. If the analysis indicates that an outlier (or outliers) is (are)
not representative of fair value and that the average of the vendor prices within the tolerance threshold of the median price is the best estimate, then we use the average of the vendor prices within the tolerance threshold of the median price as the final price. If, on the other hand, we determine that an outlier (or some other price identified in the analysis) is a better estimate of fair value, then the outlier (or the other price as appropriate) is used as the final price. In all cases, the final price is used to determine the fair value of the security.
As of December 31, 2015, four vendor prices were received for 96.1 percent of our investment securities and the final prices for substantially all of those securities were computed by averaging the four prices. The relative proximity of the prices received supports our conclusion that the final computed prices are reasonable estimates of fair value. Based on the current low level of market activity for private-label residential MBS, the nonrecurring fair-value measurements for such securities as of December 31, 2015 and 2014, fell within Level 3 of the fair-value hierarchy. Our fixed-rate HFA securities fall within Level 3 of the fair-value hierarchy due to the current lack of market activities for these bonds.
Investment Securities - HFA Floating Rate Securities. The fair value is determined by calculating the present value of the expected future cash flows. The discount rates used in these calculations are the rates for securities with similar terms. Our floating rate HFA securities also fall within Level 3 of the fair-value hierarchy due to the current lack of market activity for these bonds.
Advances. We determine the fair value of advances by calculating the present value of expected future cash flows from the advances and excluding the amount of accrued interest receivable. The discount rates used in these calculations are the current replacement rates for advances with similar terms. We calculate our replacement advance rates at a spread to our cost of funds. Our cost of funds approximates the CO curve. See - COs within this note for a discussion of the CO curve. We use market-based expectations of future interest-rate volatility implied from current market prices for similar options to estimate the fair values of advances with optionality. In accordance with the FHFA's advances regulations, advances with a maturity or repricing period greater than six months require a prepayment fee sufficient to make us financially indifferent to the borrower's decision to prepay the advances. Therefore, we do not assume prepayment risk when we determine the fair value of advances. Additionally, we do not account for credit risk in determining the fair value of our advances due to the strong credit protections that mitigate the credit risk associated with advances. Collateral requirements for advances provide surety for the repayment such that the probability of credit losses on advances is very low. We have the ability to establish a blanket lien on all financial assets of most members, and in the case of federally insured depository institutions, our lien has a statutory priority over all other creditors with respect to collateral that has not been perfected by other parties. All of these factors serve to mitigate credit risk on advances.
Mortgage Loans. The fair values for mortgage loans are determined based on quoted market prices of similar mortgage loans adjusted for credit and liquidity risk.
The fair value of impaired conventional mortgage loans is based on the lower of the carrying value of the loans or fair value of the collateral less estimated costs to sell. The fair value of impaired government mortgage loans is equal to the unpaid principal balance.
REO. Fair value is derived from third-party valuations of the property, which fall within Level 3 of the fair-value hierarchy.
Accrued Interest Receivable and Payable. The fair value approximates the recorded carrying value.
Derivative Assets/Liabilities - Interest-Rate-Exchange Agreements. We base the fair values of interest-rate-exchange agreements on available market prices of derivatives having similar terms, including accrued interest receivable and payable. The fair-value methodology uses standard valuation techniques for derivatives such as discounted cash-flow analysis and comparisons with similar instruments.
The fair values of all interest-rate-exchange agreements are netted by clearing member and/or by counterparty, including cash collateral received from or delivered to the counterparty. If these netted amounts are positive, they are classified as an asset, and if negative, they are classified as a liability. We generally use a midmarket pricing convention based on the bid-ask spread as a practical expedient for fair-value measurements. Because these estimates are made at a specific point in time, they are susceptible to material near-term changes. We have evaluated the potential for the fair value of the instruments to be affected by counterparty risk and our own credit risk and have determined that no adjustments were significant to the overall fair-value measurements.
The discounted cash-flow model uses market-observable inputs (inputs that are actively quoted and can be validated to external sources), including the following:
•
Discount rate assumption. At December 31, 2015 and 2014, we used either the overnight-index swap (OIS) curve or the LIBOR swap curve depending on the terms of the ISDA agreement we have with each derivative counterparty.
•
Forward interest-rate assumption. LIBOR swap curve.
•
Volatility assumption. Market-based expectations of future interest-rate volatility implied from current market prices for similar options.
Derivative Assets/Liabilities - Commitments to Invest in Mortgage Loans. Commitments to invest in mortgage loans are recorded as derivatives in the statement of condition. The fair values of such commitments are based on the end-of-day delivery commitment prices provided by the FHLBank of Chicago and a spread, derived from MBS TBA delivery commitment prices with adjustment for the contractual features of the MPF program, such as servicing and credit-enhancement features.
Deposits. We determine the fair values of term deposits by calculating the present value of expected future cash flows from the deposits and reducing this amount by any accrued interest payable. The discount rates used in these calculations are the rates of currently issued deposits with similar terms.
COs. We estimate fair values based on the cost of issuing comparable term debt, excluding non-interest selling costs. Fair values of COs without embedded options are determined based on internal valuation models that use market-based yield curve inputs obtained from the Office of Finance. Fair values of COs with embedded options are determined by internal valuation models with market-based inputs obtained from the Office of Finance and derivative dealers.
The inputs used to determine the fair values of COs are as follows:
•
CO Curve. The Office of Finance constructs an internal yield curve, referred to as the CO curve, using the U.S. Treasury curve as a base yield curve that is then adjusted by adding indicative spreads obtained from market observable sources. These market indications are generally derived from pricing indications from dealers, historical pricing relationships, recent GSE debt trades, and secondary market activity.
•
Volatility Assumption. To estimate the fair values of COs with optionality, we use market-based expectations of future interest-rate volatility implied from current market prices for similar options.
Mandatorily Redeemable Capital Stock. The fair value of capital stock subject to mandatory redemption is generally equal to its par as indicated by contemporaneous member purchases and sales at par value. Capital stock can only be acquired by our members at par value and redeemed at par value. Our capital stock is not traded and no market mechanism exists for the exchange of capital stock outside of our cooperative structure.
Commitments. For fixed-rate advance commitments, fair value considers the difference between current levels of interest rates and the committed rates.
Subjectivity of Estimates. Estimates of the fair value of financial assets and liabilities using the methodologies described above are highly subjective and require judgments regarding significant matters such as the amount and timing of future cash flows, prepayment speed assumptions, expected interest-rate volatility, possible distributions of future interest rates used to value options, and the selection of discount rates that appropriately reflect market and credit risks. The use of different assumptions could have a material effect on the fair-value estimates. Since these estimates are made as of a specific point in time, they are susceptible to material near-term changes.
Fair Value Measured on a Recurring Basis.
The following tables present our assets and liabilities that are measured at fair value on the statement of condition, which are recorded on a recurring basis at December 31, 2015 and 2014, by fair-value hierarchy level (dollars in thousands):
_______________________
(1)
These amounts represent the application of the netting requirements which allow us to settle positive and negative positions and also cash collateral and related accrued interest held or placed with the same clearing member and/or counterparty.
_______________________
(1)
These amounts represent the application of the netting requirements which allow us to settle positive and negative positions and also cash collateral and related accrued interest held or placed with the same clearing member and/or counterparty.
Fair Value on a Nonrecurring Basis
We measure certain held-to-maturity investment securities, mortgage loans held for portfolio, and REO at fair value on a nonrecurring basis, that is, they are not measured at fair value on an ongoing basis but are subject to fair-value adjustments only in certain circumstances (for example, upon recognizing an other-than-temporary impairment on a held-to-maturity security).
The following tables present financial assets by level within the fair-value hierarchy which were recorded at fair value on a nonrecurring basis. During the year ended December 31, 2015, the fair values presented are as of the date the fair value adjustment was recorded. The fair values presented at December 31, 2014, are as of period-end.
Note 19 - Commitments and Contingencies
Joint and Several Liability. COs are backed by the financial resources of the FHLBanks. The FHFA has authority to require any FHLBank to repay all or a portion of the principal and interest on COs for which another FHLBank is the primary obligor. No FHLBank has ever been asked or required to repay the principal or interest on any CO on behalf of another FHLBank. We evaluate the financial condition of the other FHLBanks primarily based on known regulatory actions, publicly available financial information, and individual long-term credit-rating action as of each period-end presented. Based on this evaluation, as of December 31, 2015, and through the filing of this report, we believe there is a remote likelihood that we will be required to repay the principal or interest on any CO on behalf of another FHLBank.
We have considered applicable FASB guidance and determined it is not necessary to recognize a liability for the fair value of our joint and several liability for all of the COs. The joint and several obligation is mandated by FHFA regulations and is not the result of an arms-length transaction among the FHLBanks. The FHLBanks have no control over the amount of the guaranty or the determination of how each FHLBank would perform under the joint and several obligation. Because the FHLBanks are subject to the authority of the FHFA as it relates to decisions involving the allocation of the joint and several liability for the FHLBanks' COs, the FHLBanks' joint and several obligation is excluded from the initial recognition and measurement provisions. Accordingly, we have not recognized a liability for our joint and several obligation related to other FHLBanks' COs at December 31, 2015 and 2014. The par amounts of other FHLBanks' outstanding COs for which we are jointly and severally liable totaled $851.4 billion and $796.4 billion at December 31, 2015 and 2014, respectively. See Note 13 - Consolidated Obligations for additional information.
Off-Balance-Sheet Commitments
The following table sets forth our off-balance-sheet commitments as of December 31, 2015 and 2014 (dollars in thousands):
__________________________
(1)
The amount of standby letters of credit outstanding excludes commitments to issue standby letters of credit that expire within one year. At December 31, 2015 and 2014, these amounts totaled $27.3 million and $26.2 million, respectively. Also excluded are commitments to issue standby letters of credit that expire after one year totaling $4.0 million at December 31, 2015.
(2)
Commitments for unused line-of-credit advances are generally for periods of up to 12 months. Since many of these commitments are not expected to be drawn upon, the total commitment amount does not necessarily indicate future liquidity requirements.
(3)
We had $25.0 million and $15.0 million, in unsettled CO bonds that were hedged with associated interest-rate swaps at December 31, 2015 and 2014, respectively.
Standby Letters of Credit. A standby letter of credit is a financing arrangement pursuant to which we agree for a fee to fund the associated obligation to a third-party beneficiary should the primary obligor fail to fund such obligation. If we are required to make payment for a beneficiary's draw, the payment amount is converted into a collateralized advance to the primary obligor. The original terms of these standby letters of credit have original expiration periods of up to 20 years, currently expiring no later than 2024. Our unearned fees for the value of the guarantees related to standby letters of credit are recorded in other liabilities and totaled $831,000 and $745,000 at December 31, 2015 and 2014, respectively.
We monitor the creditworthiness of our members and housing associates that have standby letter of credit agreements outstanding based on our evaluations of the financial condition of the member or housing associate. We review available financial data, which can include regulatory call reports filed by depository institution members, regulatory financial statements filed with the appropriate state insurance department by insurance company members, audited financial statements of housing associates, SEC filings, and rating-agency reports to ensure that potentially troubled members are identified as soon as possible. In addition, we have access to most members' regulatory examination reports. We analyze this information on a regular basis.
Standby letters of credit are fully collateralized at the time of issuance. Based on our credit analyses and collateral requirements, we have not deemed it necessary to record any additional liability on these commitments.
Commitments to Invest in Mortgage Loans. Commitments to invest in mortgage loans are generally for periods not to exceed 45 business days. Such commitments are recorded as derivatives at their fair values on the statement of condition.
Pledged Collateral. We have pledged securities, as collateral, related to derivatives. See Note 11 - Derivatives and Hedging Activities for additional information about our pledged collateral and other credit-risk-related contingent features.
Lease Commitments. We charged to operating expense net rental costs of approximately $2.9 million, $2.8 million, and $2.7 million for the years ended December 31, 2015, 2014, and 2013, respectively. Future minimum rentals at December 31, 2015, were as follows (dollars in thousands):
Lease agreements for our premises generally provide for increases in the basic rentals resulting from increases in property taxes and maintenance expenses. We do not expect any such increases to have a material effect on us.
Legal Proceedings. We are subject to various legal proceedings arising in the normal course of business from time to time. We would record an accrual for a loss contingency when it is probable that a loss has been incurred and the amount can be reasonably estimated. Management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material effect on our financial condition, results of operations, or cash flows.
Other commitments and contingencies are discussed in Note 8 - Advances, Note 11 - Derivatives and Hedging Activities, Note 13 - Consolidated Obligations, Note 14 - Affordable Housing Program, Note 15 - Capital, and Note 17 - Employee Retirement Plans.
Note 20 - Transactions with Shareholders
We are a cooperative whose members own our capital stock and may receive dividends on their investment in our capital stock. In addition, certain former members and nonmembers that still have outstanding transactions with us are also required to maintain their investment in our capital stock until the transactions mature or are paid off. All advances are issued to members or housing associates, and mortgage loans held for portfolio are generally acquired from our members or housing associates. We also maintain demand-deposit accounts for members and housing associates primarily to facilitate settlement activities that are directly related to advances, mortgage-loan purchases, and other transactions between us and the member or housing associate. In instances where the member has an officer who serves as a director of the Bank, those transactions are subject to the same eligibility and credit criteria, as well as the same terms and conditions, as transactions with all other members.
Related Parties. We define related parties as members with 10 percent or more of the voting interests of our capital stock outstanding. Under the FHLBank Act and FHFA regulations, each member directorship is designated to one of the six states in our district. Each member eligible to vote is entitled to cast by ballot one vote for each share of stock that it was required to hold as of the record date, which is December 31, of the year prior to each election, subject to the limitation that no member may cast more votes than the average number of shares of our stock that is required to be held by all members located in such member's state. Eligible members are permitted to vote all their eligible shares for one candidate for each open member directorship in the state in which the member is located and for each open independent directorship. A nonmember stockholder is not entitled to cast votes for the election of directors unless it was a member as of the record date. At December 31, 2015 and 2014, no shareholder owned more than 10 percent of the total voting interests due to statutory limits on members' voting rights, therefore, we did not have any related parties.
Shareholder Concentrations. We consider shareholder concentrations as members or nonmembers whose capital stock holdings (including mandatorily redeemable capital stock) are in excess of 10 percent of total capital stock outstanding. The following tables present transactions with shareholders whose holdings of capital stock exceed 10 percent or more of total capital stock outstanding at December 31, 2015 and 2014 (dollars in thousands):
We held sufficient collateral to support the advances to the above institution such that we do not expect to incur any credit losses on these advances.
We recognized interest income on outstanding advances and fees on letters of credit from Citizens Bank, N.A. during the years ended December 31, 2015, 2014, and 2013 as follows (dollars in thousands):
We did not receive any prepayment fees from Citizens Bank, N.A. during 2015, 2014 and 2013.
Transactions with Directors' Institutions. We provide, in the ordinary course of business, products and services to members whose officers or directors serve on our board of directors. In accordance with FHFA regulations, transactions with directors' institutions are conducted on the same terms as those with any other member.
The following table presents the outstanding balances of capital stock, advances, and accrued interest receivable with members whose officers or directors serve on our board of directors, and those balances as a percentage of our total balance as reported on our statement of condition (dollars in thousands):
Note 21 - Transactions with Other FHLBanks
We may occasionally enter into transactions with other FHLBanks. These transactions are summarized below.
Overnight Funds. We may borrow or lend unsecured overnight funds from or to other FHLBanks. All such transactions are at current market rates. Interest income and interest expense related to these transactions with other FHLBanks are included within other interest income and interest expense from other borrowings in the statement of operations.
MPF Mortgage Loans. We pay a transaction-services fee to the FHLBank of Chicago for our participation in the MPF program. This fee is assessed monthly, and is based upon the amount of mortgage loans which we invested in after January 1, 2004, and which remain outstanding on our statement of condition. For the years ended December 31, 2015, 2014 and 2013, we recorded $1.8 million, $1.6 million, and $1.5 million, respectively in MPF transaction-services fee expense to the FHLBank of Chicago which has been recorded in the statement of operations as other expense.
COs. From time to time, one FHLBank may transfer to another FHLBank the COs for which the transferring FHLBank was originally the primary obligor but upon transfer the assuming FHLBank becomes the primary obligor. During the years ended December 31, 2015 and 2013, we assumed debt obligations with a par amount of $80.0 million and $70.0 million, respectively, and a fair value of approximately $87.8 million and $80.1 million, respectively, on the day they were assumed, which had been the obligations of another FHLBank. During the year ended December 31, 2014, there were no transfers of COs between us and other FHLBanks.
Note 22 - Subsequent Events
On February 18, 2016, the board of directors declared a cash dividend at an annualized rate of 3.42 percent based on capital stock balances outstanding during the fourth quarter of 2015. The dividend, including dividends on mandatorily redeemable capital stock, amounted to $19.9 million and was paid on March 2, 2016.
On March 3, 2016, we conducted a partial repurchase of excess capital stock under the Excess Stock Management Program in the amount of $105.3 million. Of this amount, $36,000 was repurchased from mandatorily redeemable capital stock.
Supplementary Financial Data
Supplementary financial data for the years ended December 31, 2015 and 2014, are included in the following tables. The following unaudited results of operations include, in the opinion of management, all adjustments necessary for a fair statement of the results of operations for each quarterly period presented below.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Our senior management is responsible for establishing and maintaining a system of disclosure controls and procedures designed to ensure that information required to be disclosed by us in the reports filed or submitted under the Securities
Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. Our disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of controls and procedures.
We have evaluated the effectiveness of the design and operation of our disclosure controls and procedures, with the participation of the president and chief executive officer and chief financial officer, as of the end of the period covered by this report. Based on that evaluation, our president and chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of the end of the fiscal year covered by this report.
Management's Report on Internal Control over Financial Reporting
Management's report on internal control over financial reporting as of December 31, 2015, is included in Item 8 - Financial Statements and Supplementary Data - Management's Report on Internal Control over Financial Reporting.
The Bank's independent registered public accounting firm, PricewaterhouseCoopers LLP, has also issued a report regarding the effectiveness of the Bank's internal control over financial reporting as of December 31, 2015, which is included in Item 8 - Financial Statements and Supplementary Data - Report of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP.
Changes in Internal Control over Financial Reporting
During the quarter ended December 31, 2015, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our board of directors is constituted of a combination of industry directors nominated and elected by our members on a state-by-state basis (member directors) and independent directors nominated by our board and elected by a plurality of all our members (independent directors). Our board of directors is currently constituted of nine member directors and seven independent directors. Two of the independent directors are designated as public interest directors.
An FHFA regulation (the Election Regulation) regarding FHLBank board of director elections and director eligibility gives the Director of the FHFA the annual responsibility to determine the size of each FHLBank's board of directors. Further, for each FHLBank, the Election Regulation requires the Director of the FHFA to allocate:
•
the directorships between member directorships and independent directorships, subject to the requirement that a majority, but no more than 60 percent, of the directorships be member directorships; and
•
the member directorships among the states in each FHLBank's district based on the number of shares of FHLBank stock required to be held by members in each state, subject to any state statutory minimum. For us, the only state statutory minimum is for Massachusetts, which is three member directorships.
If, during a director's term of office, the Director of the FHFA eliminates the directorship to which he or she has been elected or, for member directorships, redesignates such directorship to another state, the director's term will end as of December 31 of the year in which the Director of the FHFA takes such action.
Based on the requirements of the Election Regulation, the Director of the FHFA allocated our member directorships among the six New England states that comprise our district for each of 2015 and 2016 as follows:
Our annual election was completed in the fourth quarter of 2015 and involved elections for one Maine member directorship, one Massachusetts member directorship, and two independent directorships. See - Annual Director Elections below for additional information on the election.
Director Requirements
Board of director elections are conducted in accordance with applicable law, including the Election Regulation, and our governance documents. Accordingly:
•
each director is required to be a U.S. citizen;
•
no director may be a member of our management;
•
each director is elected for a four-year term (unless the Director of the FHFA designates a shorter term for staggering purposes); and
•
no director can be elected to more than three consecutive full terms.
Additional requirements are applicable to member directors, independent directors, and nominees for each as set forth in the following two sections. Apart from such additional requirements, however, FHLBanks are not permitted to establish additional eligibility criteria for directorships.
The Election Regulation provides for members to elect directors by ballot, rather than by voting at a meeting. As a result, we do not solicit proxies, and members are not permitted to solicit or use proxies to cast their votes in the election. A member may not split its votes among multiple nominees for a single directorship. There are no family relationships between any current director (or any of the nominees from the most recent election), any executive officer, and any proposed executive officer. No director or executive officer has an involvement in any legal proceeding required to be disclosed pursuant to Item 401(f) of Regulation S-K.
Member Director and Member Director Nominee Requirements and Nominations
Candidates for member directorships in a particular state are nominated by members in that state. Each member that is required to hold stock as of the record date, which is December 31 of the year prior to each election (the record date), may nominate and vote for representatives from members in its respective state for open member directorships. FHLBank boards of directors are not permitted to nominate or elect member directors, although they may elect a director to fill a vacant member directorship. Further, the Election Regulation provides that no director, officer, employee, attorney, or agent, other than in a personal capacity, may support the nomination or election of a particular individual for a member directorship. In addition to the requirements applicable to all directors, each member director and each nominee for member directorships must be an officer or director of a member that is in compliance with the minimum capital requirements established by its regulator.
Because of the foregoing requirements for member director nominations and elections, we do not know what factors our members considered in nominating candidates for member directorships or in voting to elect our member directors. However, when our board of directors has a vacancy in a member directorship, FHFA regulations require the remaining directors to elect a director to fill the vacancy and, in those instances, we can know what was considered in electing such directors. In 2014, the board elected a candidate, Director Michael R. Tuttle, to fill the Vermont member directorship, because our nomination process in Vermont did not result in a candidate to stand for election by the members. The board elected Director Tuttle following a robust process of inviting all Vermont members to put forward a candidate, conducting telephonic interviews with six interested officers of Vermont members, and conducting in-person interviews with three. The board selected Director Tuttle due to his industry knowledge and broad experience with a complex financial institution, including business management, finance and accounting, strategic planning, and credit and risk management.
Independent Director and Independent Director Nominee Requirements and Nominations
Candidates for independent directorships are nominated by our board of directors. In addition to the requirements applicable to all directors, each independent director is required to be a bona fide resident of our district, and no independent director may serve as an officer, employee, or director of any of our members or other recipient of advances from us and may not be an officer of any FHLBank. At least two of the independent directors must be public interest directors. Public interest directors, as defined by FHFA regulations, are independent directors who have at least four years of experience representing consumer or community interests in banking services, credit needs, housing, or consumer financial protection. Pursuant to FHFA regulations, each independent director must either satisfy the requirements to be a public interest director or have knowledge or experience in one or more of the following areas: auditing and accounting, derivatives, financial management, organizational management, project development, risk-management practices, and the law.
Our members are permitted to (and we ask them to) identify candidates to be considered for inclusion on the nominee slate for independent directorship, but to be considered for nomination, an individual must submit an application to us. We are required to submit information about nominees for independent directorships to the FHFA for review prior to announcing such nominations. In addition, our board of directors is required by FHFA regulations to consult with the Advisory Council (a council that reviews and advises on our AHP program) in establishing the independent director nominee slate. Before nominating any individual for an independent directorship, other than for a public interest directorship, our board of directors must determine that the nominee's knowledge or experience is commensurate with that needed to oversee a financial institution with a size and complexity that is comparable to ours. The Election Regulation permits our directors, officers, attorneys, employees, agents, and Advisory Council to support the candidacy of the board of director nominees for independent directorships.
In determining whom to nominate for independent directorships, the board of directors selected:
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Eric Chatman in 2015, based on his affordable housing experience, particularly through his role as president and executive officer of the Connecticut Housing Finance Authority; his prior FHLBank experience as treasurer of the FHLBank of Des Moines; his private banking experience; and his significant capital markets experience;
•
Emil J. Ragones in 2015, based on his experience as a former partner at Ernst & Young specializing in information technology audit and controls and related experience in implementing business strategies for financial systems, incorporating or improving information technology and financial controls, addressing regulatory examination findings surrounding information technology and financial controls, and reviewing governance matters applicable to information technology;
•
Joan Carty in 2014, to serve as a public interest director, based on her experience serving as president and chief executive officer of Housing Development Fund, a Stamford, Connecticut-based CDFI that finances multifamily housing, lends directly to low- and moderate-income households for first-time purchases, and provides homeownership counseling, homebuyer education, and foreclosure-intervention counseling;
•
Patrick E. Clancy in 2014, to serve as a public interest director, based on his experience as a developer of affordable housing, particularly through his role as president and chief executive officer of The Community Builders, a Boston, Massachusetts-based nonprofit corporation that has developed more than 25,000 affordable housing units over the past 40 years;
•
Cornelius K. Hurley in 2013, based on his legal and banking experience, having served as general counsel of a large regional bank, and as director of the Center for Finance, Law and Policy at Boston University School of Law, in Boston, Massachusetts;
•
Andrew J. Calamare in 2012, based on his significant experience in business; organizational management; legal, bank regulatory, and insurance company matters; as well as multiple boards of directors that represent consumer or community interests; and
•
Jay F. Malcynsky in 2012, based on his significant experience in law, government-relations and political consulting as well as his involvement in multiple boards of directors of charitable organizations.
Further, all of the independent directors have been independent directors of the Bank prior to their most recent nominations, and our board of directors considered their experience gained from serving on our board in selecting them for their most recent nominations.
Additional information on the backgrounds of our directors, including these independent directors, is available under - Information Regarding Current Directors.
Annual Director Elections
For the election of both member and independent directors, each member eligible to vote is entitled to cast by ballot one vote for each share of stock that it was required to hold as of the record date, subject to the limitation that no member may cast more votes than the average number of shares of our stock that are required to be held by all members located in such member's state. Eligible members are permitted to vote all their eligible shares for one candidate for each open member directorship in the state in which the member is located and for each open independent directorship. For independent directors, unless the board of directors nominates more persons than there are independent directorships to be filled in an election, the candidates must receive at least 20 percent of the number of votes eligible to be cast in the election to be elected. If no nominee receives at least 20 percent of the eligible votes, the Election Regulation requires us to identify additional nominees and conduct additional elections until the directorship is filled.
As contemplated by the Election Regulation, no in-person meeting of the members was held in connection with the election. Information about the results of the election was reported to the members via email and on a current report on Form 8-K filed with the SEC on October 23, 2015, as supplemented by two Form 8-K/As filed with the SEC on October 28, 2015, and January 14, 2016.
Information Regarding Current Directors
The term for each director position is four years unless a shorter term is assigned to a director position by the FHFA to implement staggering of the expiration dates of the terms. None of our directors serve as an executive officer of the Bank.
Member Directors
The member directors currently serving on the board of directors provided the information set forth below regarding their principal occupation, business experience, and other matters.
Donna L. Boulanger, age 62, has served as president, chief executive officer and trustee of North Brookfield Savings Bank, located in North Brookfield, Massachusetts, since February 2008. Ms. Boulanger also currently serves on the boards of directors of the Massachusetts Bankers Association and the Depositors Insurance Fund, which is also a Bank member. Ms. Boulanger began serving as a director of the Bank on January 1, 2014, and her current term will conclude on December 31, 2017.
Stephen G. Crowe (vice chair), age 65, serves as a director of MountainOne Bank and a trustee of MountainOne Financial, its holding company. Mr. Crowe is a Massachusetts certified public accountant. From 2002 to 2012, Mr. Crowe served as president and chief executive officer of MountainOne Bank. Mr. Crowe served as president and chief executive officer of Williamstown Savings Bank from 1994 to 2009 and Hoosac Bank from 2002 to 2009. Mr. Crowe is also a former director of The Savings Bank Life Insurance Company of Massachusetts, which is also a Bank member. Mr. Crowe served as a treasurer of the American Bankers Association in 2011 and 2012, and served on the board of trustees for the Massachusetts College of Liberal Arts from 2004 to 2014. Mr. Crowe's service as a director of the Bank began on January 1, 2012, and his current term will conclude on December 31, 2019.
Martin J. Geitz, age 59, has served as president and chief executive officer of The Simsbury Bank & Trust Company, located in Simsbury, Connecticut, since October 2004, and its holding company, SBT Bancorp, Inc., since its formation in 2005. Mr. Geitz is also a member of the board of directors of The Simsbury Bank & Trust Company and SBT Bancorp, Inc. Mr. Geitz began serving as a director of the Bank on January 1, 2014, and his current term will conclude on December 31, 2017.
John W. McGeorge, age 71, has served as chairman of the board of Needham Bank, of Needham, Massachusetts, since April 2006. Mr. McGeorge also served as chief executive officer of Needham Bank from April 2006 until May 2015, and as president of Needham Bank from April 2006 through April 2012. Mr. McGeorge began serving as a director of the Bank on January 1, 2014, and his current term will conclude on December 31, 2017.
Gregory R. Shook, age 65, has served as president, chief executive officer and a director of Essex Savings Bank, Essex Connecticut, since July 22, 1999. Mr. Shook also serves on the board of directors of Essex Financial Services, Inc. a subsidiary of Essex Savings Bank. Additionally, Mr. Shook served from 2011 to 2013 on the initial Federal Reserve Bank of Boston, First District, Community Depository Institutions Advisory Council. Mr. Shook began serving as a director of the Bank on January 1, 2015, and his current term will conclude on December 31, 2016.
Stephen R. Theroux, age 66, has served as president, since 2007, and chief executive officer, since 2012, of Lake Sunapee Bank, FSB, located in Newport, New Hampshire, and its holding company, New Hampshire Thrift Bancshares, Inc. Mr. Theroux also serves as a director and vice-chair of both companies. Mr. Theroux joined Lake Sunapee Bank, FSB, in 1987 and has served as its chief financial officer, chief operating officer, and corporate secretary at various times throughout his career. Mr. Theroux also serves as a director of Lake Sunapee Bank Group. In addition, Mr. Theroux has served as chairman of the Board of Charter Trust Company, located in Concord, New Hampshire, since 2014. Mr. Theroux is also a past chairman of the board of Proctor Academy, located in Andover, New Hampshire, and currently serves as a trustee. Mr. Theroux began serving as a director of the Bank on January 1, 2015, and his current term will conclude on December 31, 2018.
John F. Treanor, age 68, has served as a director of The Washington Trust Company, located in Westerly, Rhode Island, since 2001. Mr. Treanor also served as president and chief operating officer at The Washington Trust Company for 10 years prior to his retirement in October 2009. Prior positions included executive vice president, chief financial officer, and chief operating officer of Springfield Institution for Savings in Springfield, Massachusetts (1994 to 1999); executive vice president, treasurer, and chief financial officer of Sterling Bancshares Corporation in Waltham, Massachusetts (1991 to 1994); and various senior management positions at Shawmut National Corporation in Boston, Massachusetts and Hartford, Connecticut (1969-1991). Mr. Treanor also serves on the board of directors of Thielsch Engineering Company. Mr. Treanor has served as a director of the Bank since January 1, 2011, and his current term will conclude on December 31, 2016.
Michael R. Tuttle, age 61, has served as a director of Merchants Bank since 2006 and as a director of Merchants Bancshares, Inc., located in South Burlington, Vermont, since 2007. He is also the former president and chief executive officer of each of Merchants Bancshares Inc. (from 2007 through 2015) and Merchants Bank (from 2006 through 2014). Mr. Tuttle is also a former director of Fairpoint Communication, Inc. Mr. Tuttle began serving as a director of the Bank on January 1, 2015, and his current term will conclude on December 31, 2018.
John Witherspoon, age 59, has served as president and chief executive officer of Skowhegan Savings Bank in Skowhegan, Maine, since November 2007. Mr. Witherspoon began serving as a director of the Bank on January 1, 2016, and his current term will conclude on December 31, 2019.
Independent Directors
The independent directors currently serving on the board provided the following information about their principal occupation, business experience, and other matters.
Andrew J. Calamare (chair), age 60, has served as president and chief executive officer of The Co-operative Central Bank, located in Boston, Massachusetts, since March 2015, and served as executive vice president of The Co-operative Central Bank between January 2011 and March 2015. Prior to that position, Mr. Calamare served as president and chief executive officer of the Life Insurance Association of Massachusetts since 2000. Previously, Mr. Calamare served as of counsel with the law firm Quinn and Morris, as special counsel to the Rhode Island General Assembly, and as Commissioner of Banks for the Commonwealth of Massachusetts. Mr. Calamare has served as a director of the Bank since March 30, 2007, and his current term will conclude on December 31, 2016.
Joan Carty, age 64, has served as president and chief executive officer of Housing Development Fund in Stamford, Connecticut, since 1994. She has also served as executive director of Bridgeport Neighborhood Fund, of Bridgeport, Connecticut; Neighborhood Preservation Program, of Stamford, Connecticut; and Neighborhood Housing Services, of Brooklyn, New York. Ms. Carty has served as a director of the Bank since January 1, 2008, and her current term will conclude on December 31, 2018.
Eric Chatman, age 55, served as president and executive director of the Connecticut Housing Finance Authority from April 2012 until March 2015 and, in that capacity, was responsible for the policy development, strategic planning and execution of the Connecticut Housing Finance Authority affordable housing finance mission. Prior to serving in that role, Mr. Chatman served as deputy director and chief financial officer of the Iowa Finance Authority from 2008 to 2012. Mr. Chatman has also held various corporate finance, treasury, and capital markets roles, both domestic and international, including treasurer of the Federal Home Loan Bank of Des Moines. Mr. Chatman has served as a director of the Bank since June 16, 2014, and his current term will conclude on December 31, 2019.
Patrick E. Clancy, age 69, served from 1977 through 2011 as president and chief executive officer of The Community Builders, a Boston-based nonprofit corporation that has developed or redeveloped approximately 25,000 units of affordable and mixed-income housing. He continues to engage in the field as an independent consultant and developer. Mr. Clancy has served as director of the Bank since March 30, 2007, and his current term will conclude on December 31, 2018.
Cornelius K. Hurley, age 70, has served as director of the Boston University Center for Finance, Law & Policy, the successor to the Morin Center for Banking and Financial Law at Boston University School of Law, since 2005. Prof. Hurley also serves as a director of Computershare Trust Company, N.A., located in Canton, Massachusetts, a wholly owned subsidiary of Computershare, Ltd. Prior to serving as director of the Center for Finance, Law & Policy, Prof. Hurley served as managing director of The Secura Group from 1990 to 1997, and as general counsel and director of human resources of Shawmut National Corporation and its predecessor companies from 1981 to 1990. He also previously served as assistant general counsel to the Board of Governors of the Federal Reserve System. Prof. Hurley was appointed as a director of the Bank on March 30, 2007, for a term that expired on December 31, 2008. Prof. Hurley was reappointed as a director of the Bank on April 16, 2009, to fill an open vacancy on the board, and has served on the board of directors continuously since that date. His current term will conclude on December 31, 2017.
Jay F. Malcynsky, age 62, has served as president and managing partner of Gaffney, Bennett and Associates, Inc., a Connecticut-based corporation specializing in government relations and political consulting, since 1984. Mr. Malcynsky is also a practicing lawyer in Connecticut and Washington, D.C., specializing in administrative law and regulatory compliance. Mr. Malcynsky previously served as a director of the Bank from 2002 to 2004. Mr. Malcynsky was reappointed as a director on March 30, 2007, and his current term will conclude on December 31, 2016.
Emil J. Ragones, age 69, is an adjunct professor at the Boston College Carroll School of Management in the Masters of Science in Accounting Program, a position he has held since January 2013. He served as executive in residence at Accounting Management Solutions, Inc., located in Boston, Massachusetts, from 2008 through April 2015, providing accounting and financial management services. Mr. Ragones previously worked at Ernst & Young for 39 years, including 24 years of service as an audit partner. In addition to performing financial statement audits, Mr. Ragones specialized in providing information technology auditing, as well as advisory and consulting services to clients in a variety of industries, including financial services. Prior to his retirement from Ernst & Young in 2007, Mr. Ragones spent seven years in the firm's National Professional Practice office for assurance and advisory business services. Mr. Ragones has served as a director of the Bank since September 24, 2010, and his current term will conclude on December 31, 2019.
Audit Committee Financial Expert
Our board of directors has a standing Audit Committee that satisfies the "Audit Committee" definition under Section 3(a)(58)(A) of the Securities Exchange Act of 1934. Our board of directors' Audit Committee Charter is available in full on our website at the following location: http://www.fhlbboston.com/downloads/aboutus/Audit_Committee_Charter.pdf.
The members of the Audit Committee are Directors Ragones (chair), Crowe (vice chair), Chatman, Malcynsky, Treanor, and Calamare (ex officio). The board has determined that Director Crowe is the "audit committee financial expert" within the meaning of the SEC rules. Mr. Crowe is not an auditor or accountant for us, does not perform fieldwork, and is not a Bank employee. In accordance with the SEC's safe harbor relating to Audit Committee financial experts, a person designated or identified as an Audit Committee financial expert will not be deemed an "expert" for purposes of federal securities laws. In addition, such a designation or identification does not impose on any such person any duties, obligations, or liabilities that are greater than those imposed on such persons as a member of the Audit Committee and board of directors in the absence of such designation or identification and does not affect the duties, obligations, or liabilities of any other member of the Audit Committee or board of directors. See Item 13 - Certain Relationships and Related Transactions, and Director Independence for additional information regarding Mr. Crowe’s independence.
Report of the Audit Committee
The Audit Committee assists the board in fulfilling its oversight responsibilities for (1) the integrity of our financial reporting, (2) the establishment of an adequate administrative, operating, and internal accounting control system, (3) our compliance with legal and regulatory requirements, (4) the independent registered public accounting firm's independence, qualifications, and performance, (5) the independence and performance of our internal audit function, and (6) our compliance with internal policies and procedures. The Audit Committee has adopted, and annually reviews, a charter outlining the practices it follows.
Management is responsible for the Bank's internal controls and the financial reporting process. PricewaterhouseCoopers LLP (PwC), our independent registered public accounting firm, is responsible for performing an independent audit of the financial statements and the effectiveness of internal control over financial reporting in accordance with auditing standards promulgated by the Public Company Accounting Oversight Board (PCAOB). Our internal auditors are responsible for preparing an annual audit plan and conducting internal audits under the direction of the Director of Internal Audit, who is accountable to the Audit Committee. The Audit Committee acts in an oversight role with the responsibility to monitor and oversee these processes.
The Audit Committee discussed with our internal auditors and PwC the overall scope and plans for their respective audits. The Audit Committee meets with the internal auditors and PwC, with and without management present, to discuss the results of their examinations, their evaluations of the Bank's internal controls, and the overall quality of the Bank's financial reporting.
The Audit Committee has reviewed and discussed the audited financial statements with management, including a discussion of the quality, not just the acceptability, of the accounting principles used, the reasonableness of significant accounting judgments and estimates, and the clarity of disclosures in the financial statements. In addressing the quality of management's accounting judgments, members of the Audit Committee asked for representations and reviewed certifications prepared by the chief executive officer and chief financial officer that the audited financial statements present, in all material respects, the financial condition and results of operations, and have expressed to both management and PwC their general preference for conservative policies when a range of accounting options is available. In meeting with PwC, the Audit Committee asked them to address and discuss their responses to several questions that the Audit Committee believes are particularly relevant to its oversight. These questions include:
•
Are there significant judgments or estimates made by management in preparing the financial statements that would have been made differently had PwC themselves prepared and been responsible for the financial statements?
•
Based on PwC's experience, and their knowledge of the Bank, do the financial statements present fairly, with clarity and completeness, the Bank's financial position and performance for the reporting period in accordance with GAAP and SEC disclosure requirements?
•
Based on PwC's experience, and their knowledge of the Bank, has the Bank implemented internal controls and internal audit procedures that are appropriate for the Bank?
The Audit Committee believes that by focusing its discussions with PwC, it promotes a meaningful discussion that provides a basis for its oversight judgments.
The Audit Committee has discussed with PwC the matters required to be discussed by PCAOB Auditing Standard No. 16, Communications with Audit Committees, PwC has provided to the Audit Committee the written disclosures and the letter required by PCAOB Rule 3526, Communication with Audit Committees Concerning Independence, and the Audit Committee has discussed with PwC their independence.
In reliance on these reviews and discussions, and the report of the independent registered public accounting firm, the Audit Committee has recommended to the board of directors, and the board of directors has approved, that the audited financial statements be included in the Bank's annual report on Form 10-K for the year ended December 31, 2015, for filing with the SEC.
Executive Officers
The following table sets forth the names, titles, and ages of our executive officers:
_________________________
(1)
Each of the executive officers listed serves on our Management Committee, with the exception of Mr. Donahue.
Edward A. Hjerpe III has served as president and chief executive officer since July 2009. Mr. Hjerpe joined us from Strata Bank and Service Bancorp, Inc., where he was interim chief executive officer from September 2008 until joining us. Mr. Hjerpe was a financial, strategy, and management consultant from August 2007 to September 2008. He was both president and chief operating officer of the New England Region of Webster Bank and senior vice president of Webster Financial Corporation from May 2004 to June 2007. Prior to those roles, Mr. Hjerpe served as executive vice president, chief operating officer, and chief financial officer at FIRSTFED AMERICA BANCORP, Inc. from July 1997 to May 2004. Mr. Hjerpe also worked with us from 1988 to 1997, first as vice president and director of financial analysis and economic research, and ultimately as executive vice president and chief financial officer. Mr. Hjerpe has been involved in numerous community, civic, industry, and nonprofit organizations over the course of his career. He currently serves as a member of the board of directors of the Office of Finance and as a member of the FHLBank Presidents Conference. He is also a former member and past chair of the board of Dental Services of Massachusetts, a current member and past chair of the board of trustees of St. Anselm College in Manchester, New Hampshire, and a current member of the board of directors of the Pentegra Defined Benefit Plan for Financial Institutions. Mr. Hjerpe earned a B.A. in business and economics from St. Anselm College, and an M.A. and Ph.D. in economics from the University of Notre Dame.
George H. Collins has served as executive vice president and chief risk officer since January 2015 and is also our chief compliance officer. Mr. Collins previously served as senior vice president and chief risk officer, a position he held since November 2006. Prior to assuming that position, Mr. Collins served as first vice president, director of market risk management from 2005 to 2006. Mr. Collins joined us in July 2000 as vice president and assistant treasurer. He holds a B.S. in applied mathematics and economics from the State University of New York at Stony Brook.
M. Susan Elliott has served as executive vice president and chief business officer since October 2009. Prior to assuming that position, Ms. Elliott served as executive vice president of member services since January 1994. She previously served as senior vice president and director of marketing from August 1992 to January 1994. Ms. Elliott joined us in 1981. Ms. Elliott holds a B.S. from the University of New Hampshire and an M.B.A. from Babson College.
Frank Nitkiewicz has served as executive vice president and chief financial officer since January 2006. Prior to assuming that position, Mr. Nitkiewicz served as senior vice president, chief financial officer, and treasurer from August 1999 until December 31, 2005, and senior vice president and treasurer from October 1997 to August 1999. Mr. Nitkiewicz joined us in
1991. He holds a B.S. and a B.A. from the University of Maryland and an M.B.A. from the Kellogg Graduate School of Management at Northwestern University.
Timothy J. Barrett has served as senior vice president and treasurer since November 2010. Prior to employment with us, Mr. Barrett served as assistant treasurer at FMR LLC, the parent company of Fidelity Investments from September 2008 to October 2010; as treasurer and chief investment officer at Fidelity Personal Bank & Trust from August 2007 to September 2008; as managing director, global treasury at Investors Bank & Trust from September 2004 to July 2007; in various senior roles in treasury at FleetBoston Financial (including merged entities) from 1985 to 2004; and as an investment manager for Citibank, NA from 1981 to 1985. Mr. Barrett received his B.A. from St. Anselm College and his M.B.A. from Rensselaer Polytechnic Institute.
Brian G. Donahue has served as senior vice president, controller, and chief accounting officer since January 2013, and previously as first vice president, controller and chief accounting officer since February 2010. Prior to assuming that position, Mr. Donahue served as first vice president and controller since 2007, vice president and controller from 2004 to 2007, assistant vice president and assistant controller from 2001 to 2004, and in progressively responsible positions from 1992 to 1999, when he served as assistant controller. Mr. Donahue worked for two years as assistant vice president and division controller for State Street Bank and Trust Company, from 1999 to 2001. Prior to joining us in 1992, Mr. Donahue was an associate with Price Waterhouse. Mr. Donahue earned his B.B.A. from James Madison University and his M.B.A. from Boston University, and is a certified public accountant.
Barry F. Gale has served as senior vice president and executive director of human resources since April 2013. Prior to employment with us, Mr. Gale served as senior director of human resources at Thomson Reuters, where he spent 18 years in progressively senior roles. Prior to that position, Mr. Gale served in human resources roles at Citizens Financial Group and The Colonial Group. Mr. Gale holds a B.S. in business management from The University of Massachusetts, Boston.
Sean R. McRae has served as senior vice president and chief information officer since April 2014. Prior to employment with us, Mr. McRae worked for Thomson Reuters for 19 years in a variety of technology leadership roles, the most recent of which was serving as chief technology officer of their global emerging markets business. Prior to Thomson Reuters, Mr. McRae served as software engineer, application architect, network engineer, business analyst, and project manager at John Hancock in Boston. Mr. McRae holds a B.S. in Computer Science from Bridgewater State College.
Carol Hempfling Pratt has served as senior vice president and general counsel since June 2010. Prior to employment with us, Ms. Pratt spent her entire legal career specializing in corporate and banking law at the Boston law firm of Foley Hoag LLP, where she began as an associate in 1984 and was promoted to partner in 1992. Ms. Pratt holds a B.A. from Northwestern University and a J.D. from Northwestern University School of Law.
Code of Ethics and Business Conduct
We have adopted a Code of Ethics and Business Conduct that sets forth the guiding principles and rules of behavior by which we operate and conduct our daily business with our customers, vendors, shareholders, and with our employees. The Code of Ethics and Business Conduct applies to all directors and employees, including the chief executive officer, chief financial officer, and chief accounting officer, and all other professionals serving in a finance, accounting, treasury, or investor-relations role. The purpose of the Code of Ethics and Business Conduct is to avoid conflicts of interest and to promote honest and ethical conduct and compliance with the law, particularly as related to the maintenance of our financial books and records and the preparation of our financial statements. The Code of Ethics and Business Conduct can be found on our website (http://www.fhlbboston.com/downloads/aboutus/code_of_ethics.pdf). All future amendments to, or waivers from, the Code of Ethics and Business Conduct will be posted on our website. The information contained within or connected to our website is not incorporated by reference into this annual report on Form 10-K and should not be considered part of this or any report filed with the SEC.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Compensation Discussion and Analysis
Executive Summary
We attract, reward, and retain senior managers, including our president, chief financial officer, and other most highly compensated executive officers (the named executive officers) by offering a total rewards package that includes base salary, cash incentive opportunities, qualified and nonqualified retirement plans, and certain perquisites.
For the year ended December 31, 2015, the named executive officers were:
Edward A. Hjerpe III
President and Chief Executive Officer;
Frank Nitkiewicz
Executive Vice President and Chief Financial Officer;
M. Susan Elliott
Executive Vice President and Chief Business Officer;
George H. Collins
Executive Vice President and Chief Risk Officer;
Carol Hempfling Pratt
Senior Vice President and General Counsel; and
Timothy J. Barrett
Senior Vice President and Treasurer.
Compensation program objectives are set forth in our Total Rewards Philosophy, which was used in determining the total rewards packages for the named executive officers for 2015. Total rewards packages, including base salary, cash incentive opportunities, and retirement plans, were set based on each named executive officer's performance, tenure, experience, and complexity of position and to be competitive in the labor market for senior managers in which we compete. Overall, the named executive officers were awarded increases in base salary based on our Total Rewards Philosophy (defined below) reflecting performance and market conditions, effective January 1, 2016. Additionally, we adopted an executive incentive plan (an EIP) in 2015 (the 2015 EIP). Cash incentives awarded under EIPs in 2015 were generally determined based on the criteria set forth in the 2015 EIP and the 2013 EIP. Finally, all Bank employees, including the named executive officers, were awarded a special cash bonus equal to 4 percent of base salary as of December 1, 2015, in recognition of our success for the year ended December 31, 2015, reflected in our record net income for the year as well as a number of measures that are indicators of our success against meaningful criteria for the past several years.
Compensation Committee
Pursuant to a charter approved by the board of directors, the Human Resources and Compensation Committee (the Compensation Committee) assists the board of directors in developing and maintaining human resources and compensation policies that support our business objectives. The Compensation Committee develops and recommends the compensation philosophy for the board of directors' review and approval. The Compensation Committee reviews and recommends to the board of directors, for its approval, human resources policies and plans applicable to the compensation philosophy, such as compensation, benefits, and incentive plans in which the named executive officers may participate.
The members of the Compensation Committee are:
John W. McGeorge, Chair
Jay F. Malcynsky, Vice Chair
Joan Carty
Martin J. Geitz
Michael R. Tuttle; and
Andrew J. Calamare (ex officio).
Compensation Committee Interlocks and Insider Participation
No member of the Compensation Committee has at any time been an officer or employee with us. None of our executive officers has served or is serving on our board of directors or the compensation committee of any entity whose executive officers served on the Compensation Committee or our board of directors.
Compensation Committee Report
The Compensation Committee has reviewed and discussed with management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K. Based on our review and discussion, we recommended to the board of directors that the Compensation Discussion and Analysis be included in the annual report on the Form 10-K for the year ending December 31, 2015.
Shareholder Advisory Vote on Executive Compensation
We are governed and directors are elected as described under Item 10 - Directors, Executive Officers and Corporate Governance. As such, we do not engage in a proxy process and have not otherwise engaged in any activity that would require a consent solicitation of our members. Accordingly, there is no shareholder advisory vote on executive compensation in determining our compensation policies and decisions.
Objectives of our Compensation Program and What it is Designed to Reward
We are committed to providing a compensation package that enables us to attract, retain, motivate, and reward highly skilled executive officers, including the named executive officers, who contribute significantly to the achievement of our mission, goals, and objectives. The FHFA reviews FHLBank compensation of the named executive officers, as described under - FHFA Oversight of Executive Compensation.
In 2014, the Compensation Committee retained McLagan Partners (McLagan), a compensation consulting firm specializing in the financial services industry, to assist with a comprehensive total rewards study. A major outcome of the study was the adoption of an updated "Total Rewards Philosophy," the principles of which have been the basis for determining total compensation for the named executive officers since that time.
The Total Rewards Philosophy defines compensation goals, competitive market and peer groups, components and comparability of the total rewards package, performance evaluation and compensation, and responsibility for administration and oversight of compensation and benefits programs. The Compensation Committee and board of directors are responsible for periodically reviewing the Total Rewards Philosophy to ensure consistency with our overall business objectives, the competitive market, and our financial condition.
The Total Rewards Philosophy provides for a total compensation and benefits package for employees, including the named executive officers, that:
•
is tailored to our unique cooperative structure;
•
is reasonable, comparable, and competitive in the marketplace in which we compete and therefore enables us to attract, retain, motivate, and reward talent;
•
is aligned with prudent risk-management practices;
•
directly links individual total rewards opportunities to our mission and annual and long-term business and financial strategies while also considering business unit/team, and individual performance; and
•
capitalizes on the perceived value of compensation and benefits to employees while optimizing the efficiency of employee-related expenses.
Risk and Bank Compensation Practices and Policies
Our chief risk officer reviews the design of our compensation plans and policies, including the 2015 EIP, to ensure these plans do not promote or reward imprudent risk taking. Additionally, the 2015 EIP includes long-term incentive opportunities based on the average core return on capital stock over the three-year period starting January 1, 2015, and ending December 31, 2017, and targeted regulatory results at December 31, 2017, with associated deferred payouts of 50 percent of the 2015 EIP's awards, which are intended to align management's interests with risk-management objectives.
Further, as described under - Executive Incentive Plan - Additional Conditions on Long-Term Awards, the long-term incentive opportunities are subject to reduction or elimination in certain cases including in the case of certain material revisions to our financial results or to data used to determine the 2015 short-term awards, which are intended to further reduce the risk of imprudent risk-taking.
Further, our chief risk officer and our head of human resources jointly engage in periodic reviews of our compensation practices and policies in an effort to ensure that such practices or policies do not result in risks that are reasonably likely to have a material adverse effect. They report on the results of these reviews to the Compensation Committee at least annually. In
developing that report, compensation policies and practices are reviewed first on a stand-alone basis, then in combination with enterprise-wide risk-management controls that constrain risk-taking, and finally in conjunction with procedural risk controls at the business department level that are intended to further mitigate risk-taking activities. In January 2016, the Compensation Committee concluded that none of the compensation policies or plans in effect are reasonably likely to have a material adverse effect on the Bank based on the report and related discussions.
Compensation plans and policies for staff engaged in risk-management and compliance functions are designed to manage any conflict of interests and promote independence in risk management in a manner independent of the financial performance of the business areas these personnel monitor. For example, as discussed under - Executive Incentive Plan - Incentive Goals, Mr. Collins' goals, as chief risk officer, differ somewhat and have different weightings under the 2015 EIP than the other named executive officers. These differences are intended to align his incentives with appropriately managing our risk profile. Likewise, all participants in the 2015 EIP working in our enterprise risk-management (ERM) department have somewhat different goals and weightings than their peers in other departments. Additionally, the review of the chief risk officer includes input by the board of directors’ Risk Committee.
In addition to our internal processes, the FHFA has oversight authority over our executive compensation. In the exercise of this authority, the FHFA has issued certain compensation principles, one of which is that executive compensation should be consistent with sound risk management and preservation of the par value of FHLBank stock. Also, the FHFA reviews all executive compensation, including the 2015 EIP, relative to these principles and such other factors as the FHFA determines to be appropriate, prior to their effectiveness. For additional information on this oversight, see - FHFA Oversight of Executive Compensation.
Overview of the Labor Market for Senior Managers
The labor market in which we compete for senior managers, including the named executive officers, is across a broad group of organizations representing different industries. In particular, we experience a greater frequency of competition for talent with financial services firms, including commercial banks, other FHLBanks, other GSEs, such as Fannie Mae and Freddie Mac, and other financial institutions, including those in the private sector. We also recognize that a “one-size-fits-all” approach to compensation may need to be adjusted at times to attract employees that may have critical skills (e.g., technology staff) to attract and retain the most qualified and highly sought-after staff. The local financial services labor market is dominated by asset-management firms that may be labor market competitors even though they are not business competitors. As a result, we may, at times, have to expand recruiting efforts to a regional or national basis to recruit named executive officers and other senior executives with the specialized skills needed to manage the complex risks of a wholesale lending and mortgage loan investment operation. For these reasons, we must be positioned to offer comparable compensation packages to attract, retain, motivate, and reward top talent. When setting compensation levels, we also consider the cost of living in the Boston area.
Our competitive peer groups for our named executive officers include:
•
The other FHLBanks, particularly for determining mix of pay within the total rewards package due to the FHLBank System’s unique cooperative structure. We consider, in particular, those FHLBanks in major metropolitan areas that share a similar cost of living as the Boston area.
•
The commercial/regional banks, GSEs and diversified financial firm peers as the primary peer group for competitive positioning for total rewards for all levels of our positions that require financial services experience. For executive officers, we may consider peers that are smaller in assets or adjust the level of a matched position versus larger asset peers to establish reasonable market benchmarks.
Both peer groups are considered in setting the total rewards package. However, no specific target among the peer groups is selected for named executive officer compensation. Rather, the data is used as a general matter to ensure the total rewards packages remain competitive as determined by the Compensation Committee relative to those peer groups.
The first competitive peer group consists of the other FHLBanks that serve as the primary peer group for determining the proportionate mix of pay and benefits. While all of the FHLBanks share the same mission, they may differ in their relative mix of products and services and location among urban and smaller-city locations, both of which impact labor-market competition and compensation by individual FHLBank. However, due to the FHLBank System's unique cooperative structure, all FHLBanks generally must rely on a similarly structured total rewards package for the named executive officers, including base salary, cash incentives, and benefits, since none can offer equity-based compensation opportunities such as those offered at their non-FHLBank competitors. In 2015, we participated in, and used the results of, the annual McLagan FHLBank System
survey of key positions to determine whether the total rewards packages for the named executive officers, as well as the proportionate mix of pay and benefits, are competitive for each matched position as discussed below in more detail.
The second primary peer group, commercial/regional banks, serves as a relevant comparator group for competitive positioning of the total rewards package for those positions requiring financial services experience, including the named executive officers. The commercial/regional bank peer group focuses on large and mid-sized commercial/regional banks and financial services firms but excludes large global investment banks. Both the Bank and commercial banks engage in wholesale lending and share similarities in several functional areas, particularly middle-office and support areas. The commercial bank peer group consists mostly of banks with multiple product lines/offerings and significant assets. The most significant difference between us and the commercial/regional bank peer group is that we are focused on wholesale banking activities while the peer group generally engages in both wholesale and retail activities. The market analysis focuses on the wholesale activities and excludes retail-focused positions.
We worked with McLagan to match several of the positions held by the named executive officers to comparable positions in the commercial/regional banks peer group of McLagan's proprietary 2015 FHLB Custom Survey. Named executive officer positions were matched to those survey positions that represented realistic job opportunities based on scope, similarity of positions, experience, complexity, and responsibilities. Realistic job opportunities included positions for which the named executive officers would be qualified at the external firms as well as positions at the firm that we would consider when recruiting for experienced executives.
The following is a list of survey participants that were included by McLagan in the commercial/regional banks peer group in the 2015 FHLB Custom Survey as well as proxy data from smaller public peers with assets between $5 and $20 billion. Not all participants reported positions that matched the data set for the named executive officers.
ABN AMRO
Espirito Santo Investment
Park National Corp.
AIB Capital Markets
EverBank
People's United Bank
Ally Financial Inc.
F.N.B. Corp.
Pinnacle Financial Partners
Ameriprise Financial, Inc.
Fannie Mae
PNC Bank
Associated Banc-Corp
FCB Financial Holdings Inc.
PrivateBancorp Inc.
Astoria Financial Corp.
Fidelity Investments
Provident Financial Services
Australia & New Zealand Banking Group
Fifth Third Bank
Prudential Financial
Banc of California Inc.
First Citizens Bank
Putnam Investments
BancFirst Corp.
First Commonwealth Financial
Rabobank
Banco Bilbao Vizcaya Argentaria
First Financial Bancorp.
Rabobank Nederland
Banco Santander
First Financial Bankshares
RBS / Citizens Bank
BancorpSouth Inc.
First Interstate BancSystem
Regions Financial Corporation
Bank Hapoalim
First Merchants Corp.
Renasant Corp.
Bank of America
First Merit Bank
Royal Bank of Canada
Bank of Hawaii Corp.
First Midwest Bancorp Inc.
Sallie Mae
Bank of Ireland Corporate Banking
First Niagara
Santander Bank, NA
Bank of the Ozarks Inc.
Flushing Financial Corp.
Societe Generale
Bank of the West
Freddie Mac
South State Corporation
BankUnited Inc.
Fulton Financial Corp.
Standard Chartered Bank
Bayerische Landesbank
GE Capital
State Street Bank & Trust Company
BBCN Bancorp Inc.
Glacier Bancorp Inc.
Sterling Bancorp
BBVA Compass
Great Western Bancorp
Sumitomo Mitsui Banking Corporation
Berkshire Hills Bancorp Inc.
Hancock Bank
Sumitomo Mitsui Trust Bank
BlackRock, Inc.
Heartland Financial USA Inc.
SunTrust Banks
BMO Capital Markets
Hilltop Holdings Inc.
Susquehanna Bancshares Inc.
BNP Paribas
Home BancShares Inc.
SVB Financial Group
BOK Financial Corporation
HSBC
Synovus
Boston Private Financial
Huntington Bancshares, Inc.
Talmer Bancorp Inc.
Branch Banking & Trust Co.
IBERIABANK Corp.
TCF Financial Corp
Brookline Bancorp Inc.
Independent Bank Corp.
TCF Financial Corp.
Brown Brothers Harriman & Co. Capital Group
ING
TD Securities
Capital Bank Finl Corp
International Bancshares Corp.
Texas Capital Bancshares Inc.
Capital One
Investors Bancorp Inc
The Bank Of New York Mellon
Cathay General Bancorp
JPMorgan
The Bank of Nova Scotia
Chemical Financial Corp.
KBC Bank
The CIT Group
China Merchants Bank
KeyCorp
The Norinchukin Bank, New York Branch
CIBC World Markets
Landesbank Baden-Wuerttemberg
The Northern Trust Corporation
Citigroup
Lloyds Banking Group
The Vanguard Group, Inc.
Citizens Financial Group
M&T Bank Corporation
Tompkins Financial Corporation
City National Bank
Macquarie Bank
Trustmark Corp.
CLSA
MB Financial Inc.
U.S. Bancorp
Columbia Banking System Inc.
Mitsubishi Securities
UMB Financial Corp.
Comerica
Mitsubishi UFJ Trust & Banking Corporation
Umpqua Holding Corporation
Commerzbank
Mizuho Bank
UniCredit
Commonwealth Bank of Australia
Mizuho Capital Markets
Union Bkshs Corp
Community Bank System Inc.
MUFG Union Bank
United Bankshares Inc.
Crédit Agricole CIB
National Australia Bank
United Community Banks Inc.
Credit Industriel et Commercial
National Penn Bancshares Inc.
United Financial Bancorp
Cullen Frost Bankers, Inc.
Natixis
United Overseas Bank Group
Customers Bancorp Inc
NBT Bancorp Inc.
Valley National Bancorp
CVB Financial Corp.
New York Community Bank
Washington Federal Inc.
DBS Bank
Nomura Securities
Webster Bank
Dexia
Nord/LB
Wells Fargo Bank
DnB Bank
Northwest Bancshares, Inc.
WesBanco Inc.
DVB Bank
OCBC Bank
Westamerica Bancorp.
DZ Bank
Old National Bancorp
Western Alliance Bancorp
Eagle Bancorp Inc
Opus Bank
Westpac Banking Corporation
Erste Group Bank AG
PacWest Bancorp
Zions Bancorporation
Data from international banks only contained results from their U.S. operations.
Elements of our Compensation Plan and Why Each Element is Selected
We compensate the named executive officers principally based on their performance, skills, experience, the criticality of the role, and tenure through a package that consists of a mix of base salary, annual and deferred cash-incentive opportunities, qualified and nonqualified retirement plans, and various other health and welfare benefits, that is, total rewards. From time to time, we will also award special cash bonuses outside of an EIP to compensate a named executive officer based on unusual or exemplary circumstances. Each compensation element is discussed in greater detail below. Due to our cooperative structure, we cannot offer equity-based compensation programs, so we offer higher base salaries, cash-incentive opportunities, and certain retirement benefits to keep our compensation packages competitive relative to the market and to replace some of the value of compensation that competitors might offer through equity-based compensation programs. The named executive officers may also be provided with certain additional perquisites. Although we do not engage in benchmarking, the Total Rewards Philosophy provides that our total rewards package, including that for named executive officers, should be comparable with the total rewards package for matched positions in the two primary peer groups, as discussed under - Overview of the Labor Market for Senior Managers above. Historically, the Compensation Committee has set total rewards packages for each of the named executive officers so that their total rewards package of base salary, cash incentives, and retirement plans would be
comparable with the total rewards packages at the commercial/regional bank peer group, including base salary and short- and long-term incentives, and so that their total cash compensation, that is, base salary plus cash incentives, would be competitive with total cash compensation of the named executive officer's peers at other FHLBanks. The Compensation Committee has also considered total cash compensation at the other FHLBanks as the comparator since it includes base salaries and cash incentives, but does not consider the value of retirement plans since they are generally of similar value across the FHLBank System. The Compensation Committee has been informed by the same data in setting current total rewards packages.
How we Determine the Amount for Each Element of our Compensation Plan
The board of directors sets annual goals and objectives for the chief executive officer. In 2015, these goals and objectives were developed to align with our strategic business plan. At the end of the year, the chief executive officer provides the Compensation Committee with a self-assessment of his corporate and individual achievements. Based on the Compensation Committee's evaluation of his performance and review of competitive market data for the defined peer groups, the Compensation Committee determines and recommends an appropriate total compensation and benefits package to the board of directors for approval. In the case of other named executive officers, the chief executive officer reviews individual performance and submits market data and recommendations to the Compensation Committee regarding appropriate compensation, although the board of director’s Risk Committee provides input on the evaluation of the chief risk officer. The Compensation Committee reviews these recommendations and submits its recommendations to the full board of directors. The board of directors reviews the recommendations and approves the compensation it considers appropriate giving consideration to the Total Rewards Philosophy.
The Compensation Committee does not set specific, predetermined targets for the allocation of total rewards between base salary, cash incentives, and benefits, including retirement and other health and welfare plans and perquisites. Rather, the Compensation Committee considers the value and mix of the total rewards package offered to each named executive officer compared with the total rewards package for positions of comparable scope, responsibility, and complexity of position at the two defined peer groups, the incumbent's performance, experience and tenure, and internal equity.
Base Salary
Base salary adjustments for all named executive officers are considered at least annually as part of the year-end annual performance review process and more often if considered necessary by the Compensation Committee during the year, such as in recognition of a promotion or to ensure internal equity.
After review and nonobjection by the FHFA, the board of directors awarded the named executive officers an increase in base salary on February 5, 2016, with retroactive application to January 1, 2016. In determining the amount of the increases, the Compensation Committee considered market data from the McLagan 2015 FHLB Custom Survey, discussed under - Overview of the Labor Market for Senior Managers above. Additionally, the Compensation Committee considered the recommendations of Mr. Hjerpe for the other named executive officers based on individual performance, tenure, experience, and complexity of the named executive officer's position and internal equity. Mr. Hjerpe recommended, and the board of directors awarded at the recommendation of the Compensation Committee, increases in base salary for each of the named executive officers. The percentage increases in base salary were generally consistent with merit and adjustment increases granted to staff.
The following table sets forth the base salary increases:
Executive Incentive Plan
General Overview of EIPs
EIPs are cash incentive plans which are reviewed by the Compensation Committee and may be adopted by the board of directors on an annual basis. EIPs are not necessarily adopted every year. For example, no EIP was adopted in 2009 based on our annual net loss in 2008 and expectations of additional losses in 2009. Generally, EIPs are used to promote achievement of strategic objectives by aligning cash incentive opportunities for corporate officers, including the named executive officers, with our short- and long-term financial performance and strategic direction. These incentive opportunities are also designed to facilitate retention and commitment of key officers. EIPs generally include specific goals, such as goals based on profitability, business growth, regulatory examination results and remediation, and operational goals for each of the corporate officers, including the named executive officers.
The Compensation Committee reviews each component of the EIP's plan design including, eligible participants, goals, goal weighting, achievement levels, and payout opportunities. The Compensation Committee administers the EIP and has full power and binding authority to construe, interpret, and administer and adjust the EIP during or at the end of the plan year for extraordinary circumstances. Extraordinary circumstances may include changes in, among other things, business strategy, termination or commencement of business lines, significant growth or consolidation of the membership base, impact of severe economic fluctuations, or significant regulatory or other changes impacting us or the FHLBank System. The Committee may not make adjustments for extraordinary circumstances that include changes to goals, weights, or levels of achievement without resubmission to the FHFA.
Purpose of the 2015 EIP
The 2015 EIP is intended to:
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reflect a reasonable assessment of our financial situation and prospects while rewarding achievement of our financial plan and strategic objectives in our strategic business plan;
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reinforce and reward our commitment to conservative, prudent, sound risk-management practices and preservation of the par value of our capital stock;
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tie a significant percentage of incentive awards to our long-term financial condition and performance; and
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recognize the importance of individual performance through metrics linked to our strategic goals and/or objectives of the participant’s principal functions and independent of the areas that they monitor.
2015 EIP Plan Design
The design of the 2015 EIP was guided by principles intended to:
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promote achievement of our financial plan and strategic objectives in our strategic business plan;
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provide a total rewards package that is competitive with other financial institutions in the labor markets in which we compete; and
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facilitate the retention and commitment of our corporate officers.
Incentive Goals
The 2015 EIP's short-term financial and nonfinancial goals were derived from, or are consistent with, our strategic business plan and objectives and were generally weighted based on desired business outcomes. Where possible, the goal achievement levels have generally been set so that the target achievement level is consistent with projections in our strategic business plan. For certain nonfinancial EIP goals for which there is no direct reference in the strategic business plan, the goals and goal achievement levels are established consistent with our strategic objectives and the impact of achievement of the objectives. To mitigate unnecessary or excessive risk-taking, the 2015 EIP contains measures for overall performance that are achieved through Bankwide collaboration of activity but cannot be individually attained or altered by participants in the 2015 EIP. Additionally, the 2015 EIP includes long-term incentive opportunities based on the average core return on capital stock over the three-year period starting January 1, 2015, and ending December 31, 2017, and targeted regulatory results at December 31, 2017, which are intended to align management's interests with our long-term financial performance and condition. Further, Mr. Collins' goals, as chief risk officer, differ somewhat and have different weightings than the other named executive officers, which are intended to align his incentives with appropriately managing our risk profile and are intended to be independent of the financial performance of the individual business areas that ERM monitors. Further, as described in greater detail under - Determination of Awards under the 2015 EIP, the Compensation Committee and the board of directors maintained authority over all awards under the 2015 EIP, however, the 2015 EIP prohibits award payouts to participants that do not receive a performance rating of “consistently meets expectations” or better.
Short-Term Incentive Goals and Actual Achievement
The 2015 EIP includes the following short-term incentive goals for the named executive officers:
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Pre-assessment, pre-other-than-temporary-impairment core return on capital stock (the core return goal): Pre-assessment, pre-other-than-temporary-impairment core return on capital stock (as such term is defined in the 2015 EIP and referred to in this report as core return on capital stock) is a measure of return on capital stock that excludes or adjusts the timing of recognition of the impact of AHP expenses, gains (losses) on debt retirement, net prepayment fees, net unrealized gains (or losses) attributable to hedges, other-than-temporary-impairment credit losses on private-label MBS, gains from the accretion of prior other-than-temporary-impairment credit losses due to improvements in projected private-label MBS performance, and private-label MBS litigation settlement income. The difference between GAAP return on capital stock and this measure of return on capital stock is that GAAP return on capital stock does not provide for the exclusions described in the immediately prior sentence, and core return on capital stock includes shares classified as mandatorily redeemable capital stock. Achievement of this goal was subject to compliance with our VaR and duration of equity limits for at least 10 of the 12 months of the year. We complied with these limits for 12 months. These limits are described under Item 7A - Quantitative and Qualitative Disclosures about Market Risk - Measurement of Market and Interest-Rate Risk and Related Policy Constraints.
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Housing Finance Agency (the HFA goal): This goal is measured by the promotion our products and services to HFAs and their use of our products and services.
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Economic and community development initiative (the ECDI goal): This goal is measured by our outreach to understand economic development needs in New England and potential strategies to address them.
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Individual, Bankwide, or department-specific initiatives goal (the individual goal): Unlike the other short-term goals, this goal is measured according to each individual EIP participant's successful contributions toward the achievement of Bankwide strategic goals or completion of department-specific initiatives. Individual goals for all plan participants are established at the beginning of the plan year but can be modified throughout the year on a case-by-case basis with the written approval of the chief executive officer, except for the named executive officers. Revisions to individual goals for the named executive officers must be recommended by the chief executive officer and approved by the Compensation Committee. Each EIP participant, including the named executive officers, establishes an individual goal comprised of two
to four initiatives that are evaluated by that participant's manager, except in the case of Mr. Hjerpe who, in his role as president and chief executive officer, establishes his goal and initiatives in concert with the Compensation Committee. Achievement of Mr. Hjerpe's individual goal is evaluated by the Compensation Committee at the end of the year and the Compensation Committee, in turn, makes a recommendation to the board of directors. Initiatives within each participant's individual goal may be weighted equally or may have different weights based on the criticality of the initiative and the participant's ability to influence the outcome.
The 2015 EIP includes the following short-term incentive goals for the named executive officers, except for Mr. Collins:
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New business and mission goal (the new business goal): This goal is measured by the total amount of advances originated during 2015 to depository institution members with maturities of greater than or equal to one year in term (and not pre-payable without fee), including advances restructurings that result in extension of the advance in maturity of one year or longer, but excluding certain AHP-related advances and advances to insurance company members.
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Insurance advances disbursements (the insurance advances goal): This goal is measured by the amount of new advances originated in 2015 (any type and maturity of advance) to insurance company members.
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Insurance membership (the insurance membership goal): This goal is measured by the number of insurance companies approved for membership by the president and chief executive officer in 2015.
Mr. Collins' short-term incentive goals, as chief risk officer, differ somewhat and have different weightings from the other named executive officers. These differences are intended to align his incentives with appropriately managing our risk profile and are intended to be independent of the financial performance of the individual business areas that ERM monitors. Under the 2015 EIP, Mr. Collins' short-term incentive goals include the core return goal and individual goal but exclude the new business goal, insurance advances goal, and insurance membership goal. Mr. Collins' short-term goals also include:
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Bankwide ERM initiatives (the ERM goals): These goals are described and measured as set forth in Table 11.2. Mr. Collins' achievement of these goals was evaluated by Mr. Hjerpe in his capacity as Mr. Collins' manager.
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Remediation of 2014 Report of Examination Findings (the remediation goal): This goal is measured by the clearance rate of 2014 FHFA examination findings that identified our weaknesses, excluding a finding on our asset classification report.
The following Table 11.1 sets forth the named executive officers' short-term goals and the related weight for all goals and the levels of achievement, and the actual achievement for each of those goals, other than ERM and individual goals which are set forth in Tables 11.2 and 11.3, respectively, for the year ended December 31, 2015.
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(1)
These performance levels were adjusted from the amounts originally established in the 2015 EIP. The 2015 EIP provides that the originally established performance levels were to be adjusted up or down by 1.25 basis points for every basis point by which the average daily federal funds rate deviated from the 0.25 percent assumed in our strategic business plan. In 2015, the average daily federal funds rate deviation was 11.45 basis points, resulting in a 14.31 basis point downward adjustment for each of the performance levels. In addition, the 2015 EIP provides that each of the originally established performance levels were to be adjusted up or down by one basis point for every $7.5 million by which the quantity of our average stock outstanding minus the average aggregate stock investment requirement for all shareholders (average excess stock) is greater or less than the $361.5 million assumed in our strategic business plan. In 2015, average excess stock was $424.6 million, resulting in a 8.41 basis point decrease for each of the performance levels. Taken together, these adjustments amounted to a 22.72 basis point decrease for each of the performance levels.
The following table 11.2 sets forth the ERM Goals and the actual achievement for the year ended December 31, 2015.
The following Table 11.3 sets forth the named executive officers' individual, Bankwide or department specific goals, levels of achievement, and actual results. Each component of each named executive officer’s individual, Bankwide or department specific goals was weighted equally.
Long-Term Incentive Goals
In addition, the 2015 EIP includes two long-term incentive goals. The first, weighted at 67 percent of the total long-term opportunity, is based on our average core return on capital stock over the three-year period starting January 1, 2015, and ending December 31, 2017. The 2015 EIP provides that the performance levels for this goal will be adjusted up or down by 1.45 basis points for every basis point by which the average daily federal funds rate deviates from the 1.06 percent that we have forecast. In addition, the 2015 EIP provides that each of the performance levels will be adjusted up or down by one basis point for every $7.5 million by which the quantity of our average stock outstanding minus the average aggregate stock investment requirement for all shareholders is greater or less than the average excess stock that we have forecast for the period.
For information on how core return on capital stock is determined, see - Short-Term Incentive Goals and Actual Achievement.
The second long-term incentive goal will be measured by the achievement of certain targeted regulatory goals by December 31, 2017. This goal is weighted at 33 percent of the total long-term opportunity.
Incentive Opportunities under the 2015 EIP
Incentive opportunities under the 2015 EIP are based on each named executive officer's base salary at December 31, 2015 (referred to as 2015 incentive salaries).
The following Table 11.4 sets forth the combined short and long-term incentive opportunities under the 2015 EIP, in each case expressed as percentages of the named executive officers' 2015 incentive salaries:
At the conclusion of 2015, individual awards were calculated based on actual goal achievement as of December 31, 2015. Participants were eligible to receive 50 percent of such award in a cash payment in March 2016, following non-objection by the FHFA and approval of the board of directors. Table 11.5 below sets forth the incentive opportunities for the short-term incentive opportunity that were payable in March 2016, in each case expressed as percentages of the named executive officers' 2015 incentive salaries:
The remaining 50 percent of the combined award, calculated at the end of 2015, then becomes the target long-term incentive opportunity, with threshold and excess incentive opportunities tied to threshold and excess levels of achievement of the long-term goal, as set forth in Table 11.6 below.
Determination of Awards under the 2015 EIP
Awards for the short-term goals, other than the ERM and individual goals under the 2015 EIP, were based on actual goal achievement determined objectively at the conclusion of the year. Results for each goal were measured and the award for each goal was then calculated independently based on the following formula:
If the result for the goal were less than the threshold level of achievement (Table 11.1), the award for that goal would have been zero absent an act of discretion. For goals achieved above the excess level of achievement (Table 11.1), there were no incremental payouts for achievements above excess per plan design. The remaining annual goals were achieved at a level between the threshold and excess levels of achievement. In administering the EIP, as with prior EIPs, the Compensation Committee determined that participants would receive an interpolated award for having exceeded threshold. In such instance, the award for each goal would be calculated according to the following formula:
Our staff calculated the named executive officers' awards under the 2015 EIP's short-term goals, in accordance with actual year-end results and the foregoing formulas. Mr. Hjerpe reviewed the results of each of the other named executive officer's level of achievement under that named executive officer's individual goal, and for Mr. Collins, also the ERM goals, and made award recommendations to the Compensation Committee for the Compensation Committee's consideration. Mr. Hjerpe recommended that Mr. Collins be awarded a payout of threshold for his individual goals because his actual achievement was very close to achieving the threshold criteria and the results of the 2015 FHFA regulatory examination were positive. The Compensation Committee discussed and adopted those recommendations. The Compensation Committee determined Mr. Hjerpe's incentive award for his individual goal following the Compensation Committee's review of the level of achievement for this goal as provided by Mr. Hjerpe and the Compensation Committee's assessment of Mr. Hjerpe's achievement of this goal. The Compensation Committee and board of directors determined that Mr. Hjerpe achieved all three of his goals at excess, as set forth in Table 11.3.
Based on those calculations and determinations, the combined incentive awards were calculated, by goal, as follows:
The named executive officers were eligible to receive 50 percent of the combined award illustrated above in a cash payment in March 2016, following approval of the board of directors. The below table's column “short-term award” sets forth the short-term incentive award paid to the named executive officers in March 2016 and the remaining 50 percent which then becomes the target level of achievement for the long-term incentive opportunity.
Final awards under the 2015 EIP's long-term incentive opportunities cannot be determined until after December 31, 2017, since they are based on average core return on capital stock over the three-year period starting January 1, 2015, and ending December 31, 2017, and targeted regulatory results as of December 31, 2017. Based on the Bank's and individual levels of achievement as of December 31, 2015, the named executive officers are eligible for long-term incentive opportunities, payable in March 2018, as follows:
Additional Conditions on Long-Term Awards
Long-term awards are subject to the following additional conditions:
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Participants must be employed by us on the payment date in March 2018 to receive the long-term award, although participants that terminate employment by reason of death or disability or who are eligible to retire prior to that date may receive payment of the award in certain instances, as detailed in the 2015 EIP.
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Subject to the discretion of the board of directors, the calculated long-term award may be reduced or eliminated (but not to a number that is less than zero) for some or all participants, as applicable, if, during calendar years 2016 and/or 2017, any of the following occur such that if it had occurred prior to the year-end 2015 calculations, it would have negatively impacted the goal results and reduced the associated payout calculation:
◦
operational errors or omissions result in material revisions to our 2015 financial results, information submitted to the FHFA, or data used to determine the combined award at year-end 2015;
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significant information to the SEC, Office of Finance, and/or FHFA is submitted materially beyond any deadline or applicable grace period, other than late submissions that are caused by acts of God or other events beyond the reasonable control of the participants; or
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we fail to make sufficient progress, as determined by the FHFA, in the timely remediation of examination and other supervisory findings relevant to the goal results or payout calculation.
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The actual payment of the long-term award is subject to the final approval of the board of directors and review and non-objection by the FHFA (to the extent required by the FHFA).
Retirement and Deferred Compensation Plans
We offer participation in qualified and nonqualified retirement plans to the named executive officers as key elements of our total rewards package. The benefits received under these plans are intended to enhance the competitiveness of our total compensation and benefits relative to the market by complementing the named executive officers' base salary and cash incentive opportunities. We maintain four retirement plans in which the named executive officers participate, including:
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Pentegra Defined Benefit Plan for Financial Institutions (the Pentegra Defined Benefit Plan), a funded, tax-qualified, noncontributory plan that provides retirement benefits for all eligible employees;
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Pension Benefit Equalization Plan (the Pension BEP), a nonqualified, unfunded defined benefit plan covering certain senior officers, as defined in the plan, which includes the named executive officers and other personnel as determined by the board of directors;
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Pentegra Defined Contribution Plan for Financial Institutions (the Pentegra Defined Contribution Plan), a 401(k) thrift plan, under which we match employee contributions for all eligible employees; and
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Thrift Benefit Equalization Plan (the Thrift BEP), a nonqualified, unfunded defined contribution plan with a deferred compensation feature, which is available to the named executive officers, directors, and such other personnel as determined by the board of directors.
The Compensation Committee believes that the Thrift BEP, together with the Pension BEP, provide retirement benefits that are necessary for our total rewards package to remain competitive, particularly compared with labor market competitors that may offer equity-based compensation. Additional information regarding these plans can be found with the Pension Benefits and Nonqualified Deferred Compensation tables below.
All benefits payable under the Pension BEP and Thrift BEP are paid solely out of our general assets, or from assets set aside in rabbi trusts subject to the claims of our creditors in the event of our insolvency.
Perquisites
Perquisites for the named executive officers may include supplemental life insurance (Mr. Nitkiewicz and Ms. Elliott only), airline program memberships, spouse travel during business, child care when traveling on business, parking, or a 100 percent mass transportation subsidy. Mr. Hjerpe is also eligible for the personal use of an automobile. The Compensation Committee believes that the perquisites offered to the named executive officers are reasonable and necessary for the total compensation package to remain competitive in recruiting and retaining them.
Change-in-Control Agreement
We have a change-in-control agreement with Mr. Hjerpe. The board of directors had determined that having the change in control agreement in place would be an effective recruitment and retention tool since the events under which we provide payment to Mr. Hjerpe would provide a measure of protection to Mr. Hjerpe in the instance of our relocation in excess of 50 miles or his termination of employment or material diminution in duties or base compensation resulting from merger, consolidation, reorganization, sale of all or substantially all of our assets, or our liquidation or dissolution. Under the terms of the change of control agreement, in the event that either:
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Mr. Hjerpe terminates his employment with us for a Good Reason (as defined in the change in control agreement) that is not remedied within certain cure periods by us; or
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we (or our successor in the event of a reorganization) terminate Mr. Hjerpe's employment without Cause (as defined by the change in control agreement).
We have agreed to pay Mr. Hjerpe an amount equal to his annualized base salary at the time of such termination to be paid in equal installments over the following 12 months according to our regular payroll cycle during such period. Notwithstanding the foregoing, our obligation to pay Mr. Hjerpe such amount will be subject to Mr. Hjerpe's execution of our standard release of claims agreement and our compliance with applicable statutory and regulatory requirements at the time such payment would otherwise be made. Payments to Mr. Hjerpe under the change-in-control agreement are in lieu of any severance payments that would be otherwise payable to him.
Employment Status and Severance Benefits
Pursuant to the FHLBank Act, our employees, including the named executive officers as of December 31, 2015, are "at will" employees. Each may resign his or her employment at any time and we may terminate his or her employment at any time for any reason or no reason, with or without cause, and with or without notice. Under our severance policy, all regular full- and part-time employees who work at least 1,000 hours per year whose employment is terminated involuntarily for reasons other than "cause," (as determined by us at our sole discretion), are provided with severance packages reflecting their status in the organization and tenure. Severance packages for employees leaving by mutual agreement or terminated for cause is at our sole discretion, provided that such severance shall not exceed that paid to employees terminated involuntarily for reasons other than cause. The severance policy does not constitute a contractual relationship between the Bank and the named executive officers, and we reserve the right to modify, revoke, suspend, terminate, or change the severance policy at any time without notice.
To receive this severance benefit, individuals must agree to execute our standard release of claims agreement. In addition and at our sole discretion, we may provide outplacement and/or such other services as may assist in ensuring a smooth career transition.
As chief executive officer, Mr. Hjerpe is eligible for 12 months of base pay under the severance policy unless he has received payments under the change in control agreement in lieu of any severance payments that would otherwise be payable to him by us. Based on their statuses as executive officers, Mr. Nitkiewicz, Ms. Elliott, Mr. Collins, Ms. Pratt, and Mr. Barrett are eligible for a minimum of six months and a maximum of 12 months of base pay under the severance policy, depending on their tenure of employment. All severance packages for executive officers, including the named executive officers, must have the approval of the chief executive officer and the Compensation Committee prior to making any award under the severance policy.
FHFA Oversight of Executive Compensation
The FHFA provides certain oversight of FHLBank executive officer compensation. Section 1113 of HERA requires that the Director of the FHFA prohibit an FHLBank from paying compensation to its executive officers that is not reasonable and comparable to that paid for employment in similar businesses involving similar duties and responsibilities. In connection with
this responsibility, the FHFA has issued final rules on executive compensation and golden parachute payments, which provide for oversight of such compensation and payments. In addition to those rules, the FHFA has issued an advisory bulletin on principles for FHLBank executive compensation together with certain protocols for the review of proposed FHLBank compensation actions. We await express non-objection from the FHFA to any proposed award of compensation to our named executive officers prior to making any such award. The FHFA could issue additional rules, advisory bulletins, and/or review protocols that could further impact named executive officer compensation.
Compensation Tables
The following table sets forth all compensation received from the Bank for the years ended December 31, 2015, 2014, and 2013, by our named executive officers.
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(1)
Amounts shown are not reduced to reflect the named executive officers' elections, if any, to defer receipt of salary into the Pentegra Defined Contribution Plan or the Thrift BEP.
(2)
In 2015, all Bank employees, including the named executive officers, were awarded a special cash bonus equal to 4 percent of base salary as of December 1, 2015, in recognition of our success for the year ended December 31, 2015, reflected in our record net income for the year as well as a number of measures that are indicators of our success against meaningful criteria for the past several years. Ms. Pratt and Mr. Barrett received an additional bonus of $344 as a cash award for their five years of service. The amount of these awards is the same amount paid to any employee that completed five years of service in 2015.
(3)
Represents amounts paid under the 2015 EIP during 2016 in respect of service performed in 2015, under the 2014 EIP during 2015 in respect of service performed in 2014, and under the 2013 EIP during 2014 in respect of service performed in 2013.
(4)
Represents amounts paid under the 2013, 2012, and 2011 EIP for satisfying long-term goals based on our adjusted retained earnings at December 31, 2015, December 31, 2014, and December 31, 2013, respectively, which amounts were $883.3 million, $815.7 million, and $722.3 million, respectively. The amounts paid under the 2013 EIP also reflect a payout based on the results of that plan’s regulatory goal.
(5)
The amounts shown reflect the actuarial increase/decrease in the present value of the named executive officer's benefits under all pension plans established by us determined using interest-rate and mortality-rate assumptions consistent with those used in our financial statements. No amount of above market earnings on nonqualified deferred compensation is reported because above market rates are not possible under the Thrift BEP, the only such plan that we offer.
(6)
See the Other Compensation Table below for amounts, which include our match on employee contributions to the Thrift BEP and the Pentegra Defined Contribution Plan, insurance premiums paid by us with respect to supplemental life insurance, and perquisites.
(7)
The change in pension values under the Pentegra Defined Benefit Plan and Pension BEP for Mr. Nitkiewicz decreased by $76,000 during 2013. In accordance with SEC guidance, the amount reported in the table is $0.
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(1)
Amounts include our contributions to the Pentegra Defined Contribution Plan, as well as contributions to the Thrift BEP. Contributions to the Thrift BEP are also shown in the Nonqualified Deferred Compensation Table below.
The Pentegra Defined Contribution Plan, a 401(k) thrift plan, excludes hourly, flex staff, and short-term employees from participation, but continues to include all other employees. Employees may elect to defer one percent to 50 percent of their
plan salary, as defined in the plan document. We make contributions based on the amount the employee contributes, up to the first three percent of plan salary, multiplied by the following factors:
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100 percent during the second and third years of employment.
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150 percent during the fourth and fifth years of employment.
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200 percent following completion of five or more years of employment.
Participant deferrals are limited on an annual basis by Internal Revenue Code (IRC) rules. For 2015, the maximum elective deferral amount was $18,000 (or $24,000 per year for participants who attain age 50 in 2015), and the maximum matching contribution under the terms of the Pentegra Defined Contribution Plan was $15,900 (three percent multiplied by two multiplied by the $265,000 IRC compensation limit).
A description of the Thrift BEP follows the Nonqualified Deferred Compensation Table.
(2)
Amount for Mr. Hjerpe includes the following perquisites: personal use of a Bank-owned vehicle, parking, reimbursement for mass transportation, spousal travel expenses, and airline program memberships.
The following table shows the potential payouts for our non-equity incentive plan awards under the 2015 EIP, for our named executive officers:
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(1)
Amounts represent potential awards under the 2015 EIP; actual amounts awarded are reflected in the Summary Compensation Table above. See Executive Incentive Plans above for further discussion of performance goals and plan payouts.
Retirement Plan
The following table sets forth the pension benefits for the fiscal year ended December 31, 2015, for our named executive officers.
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(1)
Equals number of years of credited service as of December 31, 2015.
(2)
See Item 8 - Financial Statements and Supplementary Data - Notes to the Financial Statements - Note 17 - Employee Retirement Plans for a description of valuation methods and assumptions.
(3)
Number of years of credited service for the Pentegra Defined Benefit Plan includes 16.59 years of service at the Bank and 7.08 years of service at FIRSTFED AMERICA BANCORP, Inc., which entities are both participants in the Pentegra Defined Benefit Plan.
(4)
Number of years of credited service for the Pentegra Defined Benefit Plan includes 2.33 years of service at the FHLBank of Pittsburgh.
(5)
Number of years of credited service for the Pension BEP includes recognition of 2.83 years of service at the FHLBank of Pittsburgh.
We participate in the Pentegra Defined Benefit Plan to provide retirement benefits for eligible employees, including the named executive officers. Employees become eligible to participate in the Pentegra Defined Benefit Plan the first day of the month following satisfaction of our waiting period, which is one year of service with us. The Pentegra Defined Benefit Plan excludes hourly paid employees, flex staff, and short-term employees from participation. Participants are 20 percent vested in their retirement benefit after the completion of two years of employment and vest at an additional 20 percent per year thereafter until they are fully vested after the completion of six years of employment. Participants who have reached age 65 are automatically 100 percent vested, regardless of completed years of employment. All of the named executive officers are participants in the Pentegra Defined Benefit Plan and are 100 percent vested in their benefits pursuant to the plan's provisions except for Ms. Pratt and Mr. Barrett, who are 80 percent vested.
Benefits under the Pentegra Defined Benefit Plan are based on the participant's years of service and earnings, defined as base salary excluding the participant's voluntary contribution to the Thrift BEP, subject to the applicable IRC limits on annual earnings ($265,000 for 2015). In general, participants' benefits are calculated as 2.00 percent multiplied by the participant's years of benefit service multiplied by the high three-year average salary. Annual benefits provided under the plan are subject to IRC limits, which vary by age and benefit option selected. The regular form of benefit is a straight life annuity with a 12 times initial death benefit feature. Lump sum and other additional payout options are also available. Participants are eligible for a lump sum option beginning at age 45. Benefits are payable in the event of retirement, death, disability, or termination of employment if vested. Normal retirement is age 65, but a participant may elect early retirement as early as age 45. However, if a participant elects early retirement, the normal retirement benefit is reduced by an early retirement factor based on the participant's age when beginning early retirement. If the sum of the participant's age and vesting service at the time of termination of employment is at least 70, that is, the "Rule of 70," the benefit is reduced by an early retirement factor of one and a half percent per year for each year that payments commence before age 65. If age and vesting service do not equal at least 70, the benefit is reduced by an early retirement factor.
The amount of pension benefits payable from the Pension BEP to a named executive officer is the amount that would be payable to the executive under the Pentegra Defined Benefit Plan:
•
ignoring the limits on benefit levels imposed by the IRC (including the limit on annual compensation discussed above);
•
including in the definition of salary any amounts deferred by a participant under the Thrift BEP in the year deferred and any incentive compensation in the year paid;
•
recognizing the participant's full tenure with us or any other employer participating in the Pentegra Defined Benefit Plan from initial date of employment to the date of membership in the Pentegra Defined Benefit Plan, for each named executive officer who was a participant before January 1, 2009, and for all other participants, recognizing only the participant's years of service with us from initial date of employment with us, but disregarding prior service of participants who were re-employed by us and received a full distribution of the Pension BEP benefit at the time of termination;
•
applying an increased benefit accrual rate of 2.375 percent of the participant's highest three-year average salary, multiplied by the participant's total benefit service, for those whose most recent date of hire by the Bank is prior to January 9, 2006, and who have continuously been an “Executive Officer” (as such term is defined by the plan) since January 1, 2008, and, for all other participants, applying the same accrual rate and average salary as the participant is eligible to receive under the Pentegra Defined Benefit Plan; and
•
reduced by the participant's actual accrued benefit from the Pentegra Defined Benefit Plan.
Total benefits payable under both the Pentegra Defined Benefit Plan and the Pension BEP are subject to an overall maximum annual benefit amount not to exceed a specified percentage of high three-year or high five-year average salary as applicable as follows: Mr. Hjerpe, 80 percent as president; Mr. Nitkiewicz, Ms. Elliott, and Mr. Collins, 70 percent as executive vice presidents; and Ms. Pratt and Mr. Barrett 65 percent as senior vice presidents. Our only named executive officer that has reached the maximum annual benefit amount is Ms. Elliott. All benefits payable under the Pension BEP are paid solely from either our general assets or from assets held in a rabbi trust subject to the claims of our creditors in the event of the Bank's insolvency. In 2009, the Pension BEP was amended to require that we contribute at least annually to any rabbi trust so established an amount to fund participant benefits on a plan termination basis and anticipated administrative, trust and investment advisory expenses that may be paid by the trust over the next 12 months. Previously, no funding standard has been applied to the Pension BEP rabbi trust which was established in 2005. Retirement benefits from the Pentegra Defined Benefit Plan and the Pension BEP are not subject to any offset provision for Social Security benefits.
Nonqualified Deferred Compensation
The following table sets forth the nonqualified deferred compensation for the fiscal year ended December 31, 2015, for our named executive officers.
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(1)
Amounts are also reported as salary in the Summary Compensation Table above.
(2)
Amounts are also reported as contributions to defined contribution plans in the Other Compensation Table above.
Thrift BEP participants may elect to defer receipt of up to 100 percent of base salary and/or incentive compensation into the Thrift BEP. We match participant contributions based on the amount the employee contributes, typically, up to the first three percent of compensation beginning with the initial date of membership in the Thrift BEP, and then according to the same schedule as the Pentegra Defined Contribution Plan after the first year of service. However, in 2010 the board of directors adopted the Second Amendment to the Thrift BEP so that the Compensation Committee has the flexibility to modify our
matching contribution rate in an offer letter, employment agreement, or other writing approved by the Compensation Committee so long as our maximum matching contribution rate does not exceed the maximum matching contribution rate available to any participant under the Pentegra Defined Contribution Plan (the Contribution Limit). The Compensation Committee has granted such a modification to Ms. Pratt permitting her matching contribution rate to be at the Contribution Limit irrespective of her tenure at the Bank. Our matching contribution is immediately vested at 100 percent, as in the Pentegra Defined Contribution Plan. Participants may defer their contributions into one or more investment funds as elected by the participant. Participants may elect to receive distributions in a lump sum or in semi-annual installments over a period that does not exceed 11 years. Participants may withdraw contributions under the plan's hardship provisions and may also begin to receive distributions while still employed through scheduled distribution accounts.
The Thrift BEP provides participants an opportunity to defer taxation on income and to make-up for benefits that would have been provided under the Pentegra Defined Contribution Plan except for IRC limitations on annual contributions under 401(k) thrift plans. It also provides participants with an opportunity for incentive compensation to be deferred and matched. The Compensation Committee and board of directors approve participation in the Thrift BEP. All of the named executive officers are current participants. All benefits payable under the Thrift BEP are paid solely from our general assets or from assets held in a rabbi trust subject to the claims of our creditors in the event of our insolvency. In 2009, the Thrift BEP was amended to require us to contribute at least quarterly to any rabbi trust established for the Thrift BEP an amount to fund participant benefits on a plan termination basis. A rabbi trust was established for the Thrift BEP effective January 1, 2010.
Post-Termination Payment
The following table represents the amount that would be payable to the named executive officers as of December 31, 2015, had their employment been terminated involuntarily for reasons other than "cause" on that date. Under our severance policy (and for Mr. Hjerpe, under the change in control agreement) and based on status in the organization and tenure for Mr. Hjerpe, Mr. Nitkiewicz, Ms. Elliott and Mr. Collins, the amount is equal to 12 months' base salary and for Ms. Pratt and Mr. Barrett the amount is equal to six months' base salary, all based on annual salary in effect on December 31, 2015.
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(1)
Severance payments do not result in an acceleration of retirement or other benefit plans as described above.
(2)
Severance payments to Mr. Hjerpe may consist of either payments under our severance policy or under the change in control agreement but not both. Each, however, provides for 12 months of base salary.
Director Compensation
In 2015, we paid members of the board of directors fees for each board and committee meeting that they attend. FHFA regulations permit the payment of reasonable director compensation, and such compensation is subject to the FHFA's oversight. We are a cooperative and our capital stock may only be held by current and former members, so we do not provide compensation to our directors in the form of stock or stock options. The amounts paid to the members of the board of directors for attendance at board and committee meetings during the year ended December 31, 2015, along with the annual maximum compensation amounts are detailed in the following tables:
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(1)
In 2015, the Bank's maximum for spouse/guest travel expenses (perquisites) were $2,000 for the chair and vice chair of the board and $1,000 for all other board members. There was no maximum in 2014.
The aggregate amounts earned or paid to individual members of the board of directors for attendance at board and committee meetings during 2015 are detailed in the following table:
Directors may elect to defer the receipt of meeting fees pursuant to the Thrift BEP, although there is no Bank-matching contribution for such deferred fees. For additional information on the Thrift BEP, see - Retirement and Deferred Compensation Plans above. FHFA regulations permit the payment or reimbursement of reasonable expenses incurred by directors in performing their duties, and in accordance with those regulations, we have adopted a policy governing such payment and reimbursement of expenses. Such paid and reimbursed board of director expenses aggregated to $165,000 for the year ended December 31, 2015.
The 2016 Director Compensation Policy provides for fees paid for attendance at board and committee meetings and retainers paid in arrears at the end of each quarter. The policy provides for maximums on total director compensation and potential reduction based on attendance and performance.
Attendance Fees
The following table sets forth the attendance fees for 2016.
Quarterly Retainers
The following table sets forth the quarterly retainers for 2016.
Maximum Compensation
The following table sets forth maximum director compensation for 2016.
The Bank will also pay/reimburse directors for expenses related to the directors’ attendance at board meetings.
Reduction in Compensation Based on Attendance and Performance
The board may vote to reduce or eliminate a director’s final quarterly retainer payment if (i) the director has not attended at least 75 percent of all regular and special meetings of the Board and the committees on which the director served during the year, or (ii) the board determines the director has consistently demonstrated a lack of engagement and participation in meetings attended.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
We are a cooperative, our members or former members own all of our outstanding capital stock, and our directors are elected by and a majority are from our membership. Each member is eligible to vote for the open member directorships in the state in which its principal place of business is located and for each open independent directorship. See Item 10 - Directors, Executive Officers and Corporate Governance for additional information on the election of our directors. Membership is voluntary, and members must give notice of their intent to withdraw from membership. Members that withdraw from membership may not be readmitted to membership for five years.
We do not offer any compensation plan under which our equity securities are authorized for issuance. Members, former members, and successors to former members, including affiliated institutions under common control of a single holding company, holding five percent or more of our outstanding capital stock as of February 29, 2016, are noted in the following table.
Additionally, due to the fact that a majority of our board of directors is elected from our membership, these member directors serve as officers or directors of members that own our capital stock. The following table provides capital stock outstanding to members whose officers or directors were serving as our directors as of February 29, 2016:
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Transactions with Related Persons
We have a cooperative ownership structure. As such, capital stock ownership in the Bank is a prerequisite to transacting any member business with us. Our members and certain former members or their successors own all of our stock, the majority of our directors are elected by and from the membership, and we conduct our advances and mortgage loan business almost exclusively with members. Grants under the AHP and AHP advances are also made in partnership or in connection with our members. Therefore, in the normal course of business, we extend credit and offer services and AHP benefits to members whose officers and directors may serve as our directors, as well as to entities that hold five percent or more of our capital stock. It is our policy that extensions of credit, all other Bank products and services, and AHP benefits are offered on terms and conditions that are no more favorable to such members than the terms and conditions of comparable transactions with other members.
In addition, we may purchase short-term investments, federal funds, and MBS from, and enter into interest-rate-exchange agreements with, members or their affiliates whose officers or directors serve as directors of the Bank, as well as from members or their affiliates who hold five percent or more of our capital stock. All such purchase transactions are effected at the then-current market rate and all MBS are purchased through securities brokers or dealers, also at the then-current market rate.
For the year ended December 31, 2015, the review and approval of transactions with related persons was governed by our Conflict of Interest Policy for Bank Directors (the Conflict Policy), our Code of Ethics and Business Conduct (Code of Ethics) and our Related Persons Transaction Policy (the Related Persons Policy), each of which are in writing. Under the Conflict Policy, each director is required to disclose to the board of directors all actual or potential conflicts of interest, including any personal financial interest that he or she has, as well as such interests of any immediate family member or business associate of the director known to the director, in any matter to be considered by the board of directors or in which another person does, or proposes to do, business with the Bank. Following such disclosure, the board is empowered to determine whether an actual conflict exists. In the event the board determines the existence of a conflict with respect to any matter, the affected director is required to be recused from all further considerations relating to that matter. The Conflict Policy is administered by the Governance Committee of the board of directors.
The Code of Ethics requires that all directors and executive officers (as well as all other employees) avoid conflicts of interest, or the appearance of conflicts of interest. In particular, subject to limited exceptions for interests arising through ownership of mutual funds and certain financial interests acquired prior to employment by the Bank, no employee may have a financial interest in any of our members that is not transacted in the ordinary course of the member's business and, in the case of an extension of credit, involves more than the normal risk of repayment or of loss to the member. Employees are required to disclose annually all financial interests and financial relationships with members. These disclosures are reviewed by our ethics officer, who is principally responsible for enforcing the Code of Ethics on a day-to-day basis. The ethics officer is charged with attempting to resolve any apparent conflict involving an employee other than our president and chief executive officer and, if an apparent conflict has not been resolved within 60 days, to report it to our president and chief executive officer for resolution. The ethics officer is charged with reporting any apparent conflict involving a director or our president and chief executive officer to the Governance Committee of the board of directors for resolution. Our ethics officer is Carol Hempfling Pratt, senior vice president, general counsel and corporate secretary of the Bank.
The Related Persons Policy provides for the board of director’s Governance Committee’s review of certain transactions not in the ordinary course of our business that would be with related persons to determine whether such transactions would be in the best interests, or not be inconsistent with the best interests, of the Bank and our members.
Director Independence
General
The board of directors is required to evaluate and report on the independence of the directors of the Bank under two distinct director independence standards. First, FHFA regulations establish independence criteria for directors who serve as members of the board of directors' Audit Committee. Second, SEC rules require that our board of directors apply the independence criteria of a national securities exchange or automated quotation system in assessing the independence of our directors.
As of the date of this report, our board of directors is constituted of nine member directors and seven independent directors, as discussed in Item 10 - Directors, Executive Officers and Corporate Governance. None of our directors is an "inside" director. That is, none of our directors is a Bank employee or officer. Further, our directors are prohibited from personally owning stock or stock options in the Bank. Each of the member directors, however, is a senior officer, director, or trustee of an institution that is a member of the Bank that is encouraged to engage in transactions with us on a regular basis, and some of the independent directors also engage in transactions either directly or indirectly with us from time to time in the ordinary course of the Bank's business.
FHFA Regulations Regarding Independence
The FHFA regulations on director independence standards prohibit an individual from serving as a member of the board of directors' Audit Committee if he or she has one or more disqualifying relationships with us or our management that would interfere with the exercise of that individual's independent judgment. Disqualifying relationships considered by the board are: employment with the Bank at any time during the last five years; acceptance of compensation from us other than for service as a director; being a consultant, advisor, promoter, underwriter, or legal counsel for the Bank at any time within the last five years; and being an immediate family member of an individual who is or who has been within the past five years, a Bank executive officer. The board assesses the independence of each director who serves on the Audit Committee under the FHFA's regulations on these independence standards. As of March 18, 2016, all of our directors serving on the board of directors' Audit Committee were independent under these criteria.
SEC Rule Regarding Independence
SEC rules require our board of directors to adopt a standard of independence to evaluate its directors. Pursuant thereto, the board adopted the independence standards of the New York Stock Exchange (the NYSE) to determine which of its directors are independent, which members of its Audit Committee are not independent, and whether the board of directors' Audit Committee financial expert is independent.
After applying the NYSE independence standards, the board determined that, as of March 18, 2016, all of our independent (that is, nonmember) directors are independent, including Directors Calamare, Carty, Chatman, Clancy, Hurley, Malcynsky, and Ragones. Based upon the fact that each member director is a senior official of an institution that is a member of the Bank (and thus is an equity holder in the Bank), that each such institution routinely engages in transactions with us, and that such transactions occur frequently and are encouraged, the board of directors has determined that for the present time it would conclude that none of the member directors meets the independence criteria under the NYSE independence standards.
It is possible that under a strict reading of the NYSE objective criteria for independence (particularly the criterion regarding the amount of business conducted with us by the director's institution), a member director could meet the independence standard on a particular day. However, because the amount of business conducted by a member director's institution may change frequently, and because we generally desire to increase the amount of business we conduct with each member, the directors deemed it inappropriate to draw distinctions among the member directors based upon the amount of business conducted with us by any director's institution at a specific time.
The board of directors has a standing Audit Committee and a standing Compensation Committee. For the reasons noted above, the board of directors determined that none of the current member directors on these committees, including Directors Crowe, Geitz, McGeorge, Treanor, and Tuttle, are independent under the NYSE standards for these committees. The board determined that all of the independent directors on these committees, including Directors Calamare (ex-officio), Carty, Chatman, Malcynsky and Ragones, are independent under the NYSE independence standards for these committees. The board of directors also determined that Director Crowe is the "Audit Committee financial expert" within the meaning of the SEC rules, and further determined that as of March 18, 2016, is not independent under NYSE standards. As stated above, the board of directors determined that each director on the Audit Committee is independent under the FHFA's regulations applicable to the board of director's Audit Committee.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table sets forth the aggregate fees billed by PwC for professional services rendered in connection with the audit of our financial statements for 2015 and 2014, as well as the fees billed by PwC for audit-related and other services rendered by PwC to us during 2015 and 2014.
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(1)
Audit fees consist of fees incurred in connection with the audit of our financial statements, including audit of internal controls over financial reporting, review of quarterly or annual management's discussion and analysis, and review of financial information filed with the SEC.
(2)
Audit-related fees consist of fees related to accounting research and consultations, operations reviews of new products and supporting processes, and fees related to participation in and presentations at conferences.
(3)
All other fees consist of fees related to research regarding healthcare initiatives amongst the FHLBanks.
The Audit Committee selects our independent registered public accounting firm and preapproves all audit services to be provided by it to us. The Audit Committee also reviews and preapproves all audit-related and nonaudit-related services rendered by the independent registered public accounting firm in accordance with the Audit Committee's charter. In its review of these services and related fees and terms, the Audit Committee considers, among other things, the possible effect of the performance of such services on the independence of our independent registered public accounting firm.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
a) Financial Statements
Our financial statements are set forth under Item 8 - Financial Statements and Supplementary Data of this report on Form 10-K.
b) Financial Statement Schedule
None.
c) Exhibits
* Management contract or compensatory plan.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.