Item 1: Business
General
One of 11 FHLBanks, FHLBank Topeka is a federally chartered corporation organized on October 13, 1932 under the authority of the Federal Home Loan Bank Act of 1932, as amended (Bank Act). Our primary business is making collateralized loans and providing other banking services to member institutions (members) and certain qualifying non-members (housing associates). We are a cooperative owned by our members and are generally limited to providing products and services only to those members. Each FHLBank operates as a separate corporate entity with its own management, employees, and board of directors. We are exempt from federal, state, and local taxation, except for real property taxes. We do not have any wholly- or partially-owned subsidiaries and do not have an equity position in any partnerships, corporations, or off-balance sheet special purpose entities.
We are supervised and regulated by the Federal Housing Finance Agency (FHFA), an independent agency in the executive branch of the U.S. government. The FHFA’s mission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.
Any federally insured depository institution, insurance company, or community development financial institution (CDFI) certified by the CDFI fund, whose principal place of business is located in Colorado, Kansas, Nebraska, or Oklahoma is eligible to become one of our members. Except for community financial institutions (CFIs), applicants for membership must demonstrate they are engaged in residential housing finance or otherwise support our housing mission, and have a significant business presence in our district. CFIs are defined in the Housing and Economic Recovery Act of 2008 (Recovery Act) as those institutions that have, as of the date of the transaction at issue, less than a specified amount of average total assets over the three years preceding that date (subject to annual adjustment by the FHFA director based on the consumer price index). For 2017, this asset cap was $1.1 billion.
Our members are required to purchase and hold our capital stock as a condition of membership, and only members are permitted to purchase capital stock. All capital stock transactions are governed by our capital plan, which was developed under, is subject to, and operates within specific regulatory and statutory requirements.
Member institutions own nearly all of our outstanding capital stock and may receive dividends on that stock. Former members own capital stock as long as they have outstanding business transactions with us. A member must own an amount of capital stock in the FHLBank based on the member’s total assets, and each member may be required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank, including advances and Acquired Member Assets (AMA). As a result of these stock purchase requirements, we conduct business with related parties in the normal course of business. For disclosure purposes, we include in our definition of a related party any member institution (or successor) that is known to be the beneficial owner of more than five percent of any class of our voting stock and any person who is, or at any time since the beginning of our last fiscal year (January 1) was, one of our directors or executive officers, among others. Information on business activities with related parties is provided in Tables 86 and 87 under Item 12 - “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
Our business activities include providing collateralized loans, known as advances, to members and housing associates, and acquiring residential mortgage loans from members. By law, only certain general categories of collateral are eligible to secure FHLBank obligations. We also provide members and housing associates with letters of credit and certain correspondent services, such as safekeeping, wire transfers, and cash management.
FHFA regulations require that our strategic business plan describes how our business activities will achieve our mission, consistent with the FHFA’s core mission asset (CMA) guidance. Our strategic business plan includes a balance sheet management strategy consistent with this guidance, which includes emphasis on the issuance of advances and acquisition of member mortgage loans through the MPF Program. Our ratio of average advances and average mortgage loans to average consolidated obligations (CMA ratio) utilizing par balances as outlined in our strategic plan was 77 percent as of December 31, 2017. We generally intend to maintain the CMA ratio within the range of 70 to 80 percent, which exceeds the FHFA's recommended minimum ratio of 70 percent utilizing par balances. However, because this ratio is dependent on several variables, such as member demand for our advance and mortgage loan products, it is possible that we may be unable to maintain the ratio at this level indefinitely.
Our primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance. The Office of Finance is a joint office of the FHLBanks that facilitates the issuance and servicing of the consolidated obligations. The FHFA and the U.S. Secretary of the Treasury oversee the issuance of all FHLBank debt. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally viewed the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, the FHLBanks have historically had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings and the issuance of capital stock.
Standard & Poor’s (S&P) and Moody’s Investor Service (Moody’s) base their ratings of the FHLBanks and the debt issues of the FHLBank System in part on the FHLBanks’ relationship with the U.S. government. S&P currently rates the long-term credit ratings on the senior unsecured debt issues of the FHLBank System and all FHLBanks (including FHLBank Topeka) at AA+. S&P rates all FHLBanks and the FHLBank System’s short-term debt issues at A-1+. S&P’s rating outlook for the FHLBank System’s senior unsecured debt and all FHLBanks is stable. Moody’s has affirmed the long-term Aaa rating on the senior unsecured debt issues of the FHLBank System and the FHLBanks and a short-term issuer rating of P-1, with a rating outlook of stable for senior unsecured debt.
Business Segments
We do not currently manage or segregate our operations by business or geographical segment.
Advances
We make advances to members and housing associates based on the value of the security of their residential mortgages and other eligible collateral. A brief description of our standard advance product offerings is as follows:
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Line of credit advances are variable rate, non-amortizing, prepayable, revolving line products that provide an alternative to the purchase of Federal funds, brokered deposits or repurchase agreement borrowings;
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Short-term fixed rate advances are non-amortizing, non-prepayable loans with terms to maturity from 3 to 93 days;
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Regular fixed rate advances are non-amortizing loans, prepayable potentially with a fee, with terms to maturity from 94 days to 360 months;
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Symmetrical fixed rate advances are non-amortizing loans with terms to maturity from 94 days to 360 months, prepayable with a fee, but the borrower also has the contractual ability to realize a gain from the market movement of interest rates upon prepayment;
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Adjustable rate advances are non-amortizing loans with terms to maturity from 4 to 180 months, which are: (1) prepayable with a fee on interest rate reset dates, if the variable interest rate is tied to any one of a number of standard indices including the London Interbank Offered Rate (LIBOR), Treasury bills, Federal funds, or U.S. Prime; or (2) prepayable without a fee if the variable interest rate is tied to one of our short-term fixed rate advance products;
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Callable advances can have a fixed or variable rate of interest for the term of the advance and contain an option(s) that allows for the prepayment of the advance without a fee on specified dates, with terms to maturity of 12 to 360 months for fixed rate loans or terms to maturity of 4 to 180 months for variable rate loans;
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Amortizing advances are fixed rate loans with terms to maturity of 12 to 360 months, prepayable with a fee, that contain a set of predetermined principal payments to be made during the life of the advance;
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Convertible advances are non-amortizing, fixed rate loans with terms to maturity of 12 to 180 months that contain an option(s) that allows us to convert the fixed rate advance to a prepayable, adjustable rate advance that re-prices monthly based upon our one-month short-term, fixed rate advance product. Once we exercise our option to convert the advance, it can be prepaid without a fee on the initial conversion date or on any interest rate reset date thereafter;
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Forward settling advance commitments lock in the rate and term of future funding of regular and amortizing fixed rate advances up to 24 months in advance;
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Member option advances are fixed rate advances with terms from 12 to 360 months that provide the member with an option to prepay without a fee at specific intervals throughout the life of the advance and are issued at a discount to reflect the cost of that option;
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Structured advances are other advance types (e.g., regular fixed rate, callable, amortizing or adjustable rate) with terms from 12 to 180 months with an embedded interest rate cap, floor, or collar; and
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Standby credit facilities are variable rate, non-amortizing, prepayable, revolving standby credit lines that provide the ability to draw advances after normal cutoff times.
Customized advances may be created on request, including advances with embedded interest rate floors and caps. All embedded derivatives in customized advances are evaluated to determine whether they are clearly and closely related to the advances. See Notes 1 and 8 in the Notes to Financial Statements under Item 8 for information on accounting for embedded derivatives. The types of derivatives used to hedge risks embedded in our advance products are indicated in Tables 61 and 62 under Item 7A - “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk Management.”
We also offer a variety of specialized advance products to address housing and community development needs. The products include advances priced at our cost of funds plus reasonable administrative expenses. These advance products address needs for low-cost funding to create affordable rental and homeownership opportunities, and for commercial and economic development activities, including those that benefit low- and moderate-income neighborhoods. Refer to Item 1 - “Business - Other Mission-Related Activities” for more details.
In addition to members, we also make advances to housing associates. To qualify as a housing associate, the applicant must: (1) be approved under Title II of the National Housing Act of 1934; (2) be a chartered institution having succession; (3) be subject to the inspection and supervision of some governmental agency; (4) lend its own funds as its principal activity in the mortgage field; and (5) have a financial condition that demonstrates that advances may be safely made. Housing associates are not subject to certain provisions of the Bank Act that are applicable to members, such as the capital stock purchase requirements, but the same regulatory lending requirements generally apply to them as apply to members. Restrictive collateral provisions apply if the housing associate does not qualify as a state housing finance agency (HFA). We currently have three housing associates who are customers and all three are state HFAs.
At the time an advance is originated, we are required to obtain and then to maintain a security interest in sufficient collateral of the borrower, which is eligible in one or more of the following categories:
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Fully disbursed, whole first mortgages on 1-4 family residential property or securities representing a whole interest in such mortgages;
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Securities issued and guaranteed or insured by the U.S. government, U.S. government agencies and mortgage GSEs including, without limitation, MBS issued or guaranteed by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) or Government National Mortgage Association (Ginnie Mae);
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Cash or deposits in an FHLBank;
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Other acceptable real estate-related collateral, provided such collateral has a readily ascertainable market value and we can perfect a security interest in such property (e.g., privately issued collateralized mortgage obligations (CMOs), mortgages on multifamily residential real property, second mortgages on 1-4 family residential property, mortgages on commercial real estate); or
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In the case of any CFI, secured loans to small business, small farm and small agri-business or securities representing a whole interest in such secured loans.
As additional security for a member’s indebtedness, we have a statutory lien on that member’s FHLBank stock. Additional collateral may be required to secure a member’s or housing associate’s outstanding credit obligations at any time (whether or not such collateral would be eligible to originate an advance), at our discretion.
The Bank Act affords any security interest granted to us by any of our members, or any affiliate of any such member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. The only exceptions are claims and rights held by actual bona fide purchasers for value or by parties that are secured by actual perfected security interests, and provided that such claims and rights would otherwise be entitled to priority under applicable law. In addition, our claims are given certain preferences pursuant to the receivership provisions in the Federal Deposit Insurance Act. Most members provide us a blanket lien covering substantially all of the member’s assets and consent for us to file a financing statement evidencing the blanket lien. Based on the blanket lien, the financing statement and the statutory preferences, we normally do not take control of collateral, other than securities collateral, pledged by blanket lien borrowers. We take control of all securities collateral through delivery of the securities to us or to an approved third-party custodian. With respect to non-blanket lien borrowers (typically insurance companies, CDFIs, and housing associates), we take control of all collateral. If the financial condition of a blanket lien member warrants such action because of the deterioration of the member’s financial condition, regulatory concerns about the member or other factors, we will take control of sufficient collateral intended to fully collateralize the member’s indebtedness to us.
Table 11 under Item 7 - "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" presents the amount of total interest income contributed by our advance products. Tables 27 and 28 under Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition” present information on our five largest borrowers as of December 31, 2017 and 2016 and the accrued interest income associated with the five borrowers providing the highest amount of interest income for the years ended December 31, 2017 and 2016.
Mortgage Loans
We purchase various residential mortgage loan products from participating financial institutions (PFIs) under the MPF Program, a secondary mortgage market structure created and maintained by FHLBank of Chicago. Under the MPF Program, we invest in qualifying 5- to 30-year conventional conforming and government-guaranteed or -insured (by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service of the Department of Agriculture (RHS) and the Department of Housing and Urban Development (HUD)) fixed rate mortgage loans on 1-4 family residential properties. These portfolio mortgage products, along with residential loans sold under the MPF Xtra and MPF Government MBS products, where the PFI sells a loan under the MPF Program structure to Fannie Mae or FHLBank of Chicago, respectively, for securitization, collectively provide our members an opportunity to further their cooperative partnership with us.
The MPF Program helps fulfill our housing mission and provides an additional source of liquidity to FHLBank members that choose to sell mortgage loans into the secondary market rather than holding them in their own portfolios. MPF Program portfolio mortgage loans are considered AMAs, a core mission activity of the FHLBanks, as defined by FHFA regulations.
Allocation of Risk: The MPF Program is designed to allocate risks associated with residential mortgage loans between the PFIs and us. PFIs have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing PFIs to originate residential mortgage loans, whether through retail or wholesale operations, and to retain or sell servicing rights of residential mortgage loans, the MPF Program gives control of those functions that mostly impact credit quality to PFIs. We are responsible for managing the interest rate, prepayment and liquidity risks associated with holding residential mortgage loans in portfolio.
Under the FHFA’s AMA regulation, the PFI must “bear the economic consequences” of certain losses with respect to a master commitment based upon the MPF product and other criteria. To comply with these regulations, MPF purchases and fundings are structured so the credit risk associated with MPF loans is shared with PFIs (excluding the MPF Xtra and government-guaranteed loan products). In order to share the credit risk with our PFIs, we use a model licensed from a Nationally Recognized Statistical Rating Organization (NRSRO) to determine the amount of credit enhancement obligation (CE obligation), needed to achieve a credit equivalent rating that is permissible under the AMA regulation and consistent with our risk appetite. The master commitment defines the pool of MPF loans for which the CE obligation is determined so the risk associated with investing in such a pool of MPF loans is equivalent to investing in a BBB-rated asset (effective December 2016). For master commitments with loans funded prior to December 2016, the CE obligation makes the risk equivalent to an AA-rated asset, unless the PFI has requested a realignment of the CE obligation.
The CE obligation methodology described above is applied to MPF portfolio products involving conventional mortgage loans. Subsequent to any private mortgage insurance (PMI), we share in the credit risk of the loans with the PFI. We assume the first layer of loss coverage as defined by the First Loss Account (FLA). If losses beyond the FLA layer are incurred for a pool, the PFI assumes the loan losses up to the amount of the CE obligation, or supplemental mortgage insurance (SMI) policy purchased to replace a CE obligation or to reduce the amount of the CE obligation to some degree, as specified in a master commitment agreement for each pool of conventional mortgage loans purchased from the PFI. The CE obligation provided by the PFI ensures they retain a credit stake in the loans they sell and PFIs are compensated for managing this credit risk, either as a credit enhancement fee (CE fee) paid monthly or a one-time upfront fee paid at purchase. In some instances, depending on the MPF product type (see Table 1), all or a portion of the CE fee may be performance-based. Any losses in excess of our responsibility under the FLA and the member’s CE obligation or SMI policy for a pool of MPF loans are our responsibility. All loss allocations among us and our PFIs are based upon formulas specific to pools of loans covered by a specific MPF product and master commitment (see Table 2). PFIs’ CE obligations must be fully collateralized with assets considered eligible under our collateral policy. See Item 1 - “Business - Advances” for a discussion of eligible collateral.
There are three MPF portfolio products from which PFIs currently may choose (see Table 1). MPF Original, MPF 125, and MPF Government are closed loan products in which we purchase loans acquired or closed by the PFI. Under these MPF portfolio products, the PFI performs all traditional retail loan origination functions. As mentioned above, MPF Xtra essentially represents a loan sale from the PFI to an end buyer that is not FHLBank Topeka. The end buyer of the mortgages under the MPF Xtra product is Fannie Mae. MPF Government MBS is essentially a loan sale of government loans from the PFI to FHLBank of Chicago for securitization into Ginnie Mae MBS. We receive a counterparty fee from our PFIs for facilitating their participation in the MPF Xtra and MPF Government MBS products.
The MPF portfolio products involving conventional mortgage loans are termed credit-enhanced products, because we share in the credit risk of the loans (as described above) with the PFIs. The MPF Government, MPF Government MBS, and MPF Xtra products do not have a first loss and/or credit enhancement structure.
Table 11 under Item 7 - "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" presents the amount of total interest income contributed by our mortgage loan products. Table 29 under Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition” presents the outstanding balances of mortgage loans sold to us, net of participations, from our top five PFIs and the percentage of those loans to total mortgage loans outstanding.
PFI Eligibility: Members and housing associates may apply to become PFIs. We review the general eligibility of the member, its servicing qualifications, and its ability to supply documents, data, and reports required to be delivered by PFIs under the MPF Program. A Participating Financial Institution Agreement provides the terms and conditions for the sale or funding of MPF loans by PFIs, including required CE obligations, and establishes the terms and conditions for servicing MPF loans. All of the PFI’s CE obligations under this agreement are secured in the same manner as the other obligations of the PFI under its regular advances agreement with us. We have the right under the advances agreement to request additional collateral to secure the PFI’s MPF CE obligations and cover repurchase risk.
MPF Provider: FHLBank of Chicago serves as the MPF Provider for the MPF Program. It maintains the structure of MPF residential loan products and the eligibility rules for MPF loans, including MPF Xtra loans and MPF Government MBS loans, which primarily fall under the rules and guidelines provided by Fannie Mae and Ginnie Mae. In addition, the MPF Provider manages the pricing and delivery mechanism for MPF loans and the back-office processing of MPF loans in its role as master servicer and program custodian. 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. We utilize the capability under the individual FHLBank pricing option to change the pricing offered to our PFIs for all MPF products, but any pricing changes made affect all delivery commitment terms and loan note rates in the same amount for all PFIs.
The MPF Provider publishes and maintains documentation (referred to as Guides) that details the requirements PFIs must follow in originating, underwriting or selling and servicing MPF loans. As indicated, under the MPF Xtra and MPF Government MBS products, we are a conduit that PFIs use to sell loans to FHLBank of Chicago, which simultaneously sells the loans to Fannie Mae or pools the loans into Ginnie Mae MBS, respectively. The MPF Provider maintains the infrastructure through which we can fund or purchase MPF loans through our PFIs. In exchange for providing these services, we pay the MPF Provider a transaction services fee, which is based upon the unpaid principal balances (UPB) before any charge-offs of MPF loans funded since January 1, 2004. Beginning in 2016, we also pay the MPF Provider a fixed service cost on a quarterly basis.
MPF Servicing: PFIs selling residential mortgage loans under the MPF Program may either retain the servicing function or transfer it and the servicing rights to an approved PFI servicer. If a PFI chooses to retain the servicing function, it receives a servicing fee. PFIs may utilize approved subservicers to perform the servicing duties. If the PFI chooses to transfer servicing rights to an approved third-party provider, the servicing is transferred concurrently with the sale of the residential mortgage loan with the PFI receiving a servicing-released premium. The servicing fee is paid to the third-party servicer. All servicing-retained and servicing-released PFIs are subject to the rules and requirements set forth in the MPF Servicing Guide. Throughout the servicing process, the master servicer monitors PFI compliance with MPF Program requirements and makes periodic reports to the MPF Provider.
Mortgage Standards: The MPF Program has adopted ability-to-repay and safe harbor qualified mortgage requirements for all mortgages with loan application dates on or after January 10, 2014. PFIs are required to deliver residential mortgage loans that meet the eligibility requirements in the MPF Guides. The eligibility guidelines in the MPF Guides applicable to the conventional mortgage loans in our portfolio are broadly summarized as follows:
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Mortgage characteristics: MPF loans must be qualifying 5- to 30-year conforming conventional, fixed rate, fully amortizing mortgage loans, secured by first liens on owner-occupied 1- to 4-unit single-family residential properties and single-unit second homes.
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Loan-to-value (LTV) ratio and PMI: The maximum LTV for conventional MPF loans is 95 percent, though Affordable Housing Program (AHP) MPF mortgage loans may have LTVs up to 100 percent. Conventional MPF mortgage loans with LTVs greater than 80 percent are insured by PMI from a mortgage guaranty insurance company that has successfully passed an internal credit review and is approved under the MPF Program.
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Documentation and compliance: Mortgage documents and transactions are required to comply with all applicable laws. MPF mortgage loans are documented using standard Fannie Mae/Freddie Mac uniform instruments.
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Government loans: Government mortgage loans sold under the MPF Program have substantially the same parameters as conventional MPF mortgage loans except that their LTVs may not exceed the LTV limits set by the applicable government agency and they must meet all requirements to be insured or guaranteed by the applicable government agency.
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Ineligible mortgage loans: Loans not eligible for sale under the MPF Program include residential mortgage loans unable to be rated by S&P, loans not meeting eligibility requirements, loans classified as high cost, high rate, high risk, Home Ownership and Equity Protection Act loans or loans in similar categories defined under predatory or abusive lending laws, or subprime, non-traditional, or higher-priced mortgage loans.
Loss Calculations: Losses under the FLA for conventional mortgage loans are defined differently than losses for financial reporting purposes. The differences reside in the timing of the recognition of the loss and how the components of the loss are recognized. Under the FLA, a loss is the difference between the recorded loan value and the total proceeds received from the sale of a residential mortgage property after paying any associated expenses, not to exceed the amount of the FLA. The loss is recognized upon sale of the mortgaged property. For financial reporting purposes, when a mortgage loan is deemed a loss, the difference between the recorded loan value and the appraised value of the property securing the loan (fair market value) less the estimated costs to sell is recognized as a charge to the Allowance for Credit Losses on Mortgage Loans in the period the loss status is assigned to the loan. After foreclosure, any expenses associated with carrying the loan until sale are recognized as real estate owned (REO) expenses in the current period.
A majority of the states, and some municipalities, have enacted laws prohibiting mortgage loans considered predatory or abusive. Some of these laws impose liability for violations not only on the originator, but also upon purchasers and assignees of mortgage loans. We take measures that we consider reasonable and appropriate to reduce our exposure to potential liability under these laws and are not aware of any potential or pending claim, action, or proceeding asserting that we are liable under these laws. However, there can be no assurance that we will never have any liability under predatory or abusive lending laws.
Table 1 presents a comparison of the different characteristics for each of the MPF products either held on our balance sheet as of December 31, 2017 or currently offered as a loan sale from the PFI to FHLBank of Chicago:
Table 1
Future payouts of performance-based CE fees are reduced when losses are allocated to the FLA. The annual offset is limited to fees payable in a given year but could be reduced in subsequent years if losses exceed the annual CE fee. The overall reduction is limited to the FLA amount for the life of the pool of loans covered by a master commitment agreement.
The credit enhancement paid upfront when the mortgage loan is purchased is based upon the present value of the monthly CE fee payments, with consideration for expected prepayments.
The MPF 100 product is currently inactive due to regulatory requirements relating to loan originator compensation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
Due to higher costs associated with the acquisition of supplemental insurance policies, the MPF Plus product is currently not active.
Two government master commitments have been grandfathered and paid 2 bps per year. All other government master commitments are not paid a CE fee.
Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2017:
Table 2
Starts at zero and increases monthly over the life of the master commitment.
LLCE represents the sum of the loan level credit enhancement amounts of the loans sold into the pool of loans covered by the master commitment agreement.
The S&P Level’s Pool Size Factor (PSF) is applied at the MPF FHLBank level against the total of loans in portfolio.
SMI represents the coverage obtained from the supplemental mortgage insurer. The initial premium for the insurance is determined based on a sample $100 million loan pool. The final premium determination is made during the 13th month of the master commitment agreement, at which time any premium adjustment is determined based on actual characteristics of loans submitted. The SMI generally covers a portion of the PFI’s CE obligation, which typically ranges from 200 to 250 bps of the dollar amount of loans delivered into a mortgage pool, but the PFI may purchase an additional level of coverage to completely cover the PFI’s CE obligation. The CE fees paid to PFIs for this program are capped at a maximum of 14 bps, which is broken into two components, fixed and variable. The fixed portion of the CE fee is paid to the SMI insurer for the coverage discussed above and is a negotiated rate depending on the level of SMI coverage, ranging from 6 to 8 bps. The variable portion is paid to the PFI, and ranges from 6 to 8 bps, with payments commencing the 13th month following initial loan purchase under the master commitment agreement.
PCE represents the CE obligation that the PFI elects to retain rather than covering with SMI. Under this MPF product, the retained amount can range from 0 to 20 bps.
Investments
A portfolio of investments is maintained for liquidity and asset/liability management purposes. We maintain a portfolio of short-term investments in highly-rated institutions, including overnight Federal funds, term Federal funds, interest-bearing certificates of deposit and demand deposits, commercial paper, and securities purchased under agreements to resell (i.e., reverse repurchase agreements). A longer-term investment portfolio is also maintained, which includes securities issued or guaranteed by the U.S. government, U.S. government agencies and GSEs, as well as MBS that are issued by U.S. government agencies and housing GSEs (GSE securities are not explicitly guaranteed by the U.S. government) or privately issued MBS that carried the highest ratings from Moody’s, Fitch Ratings (Fitch) or S&P at the date of acquisition. We no longer purchase private-label MBS, although we continue to hold a small percentage of private-label MBS in our investment portfolio.
Under FHFA regulations, we are prohibited from investing in certain types of securities including:
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Instruments, such as common stock, that represent an ownership in an entity, other than stock in small business investment companies or certain investments targeted to low-income persons or communities;
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Instruments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks;
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Non-investment-grade debt instruments other than certain investments targeted to low-income persons or communities, and instruments that were downgraded after purchase;
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Whole mortgages or other whole loans other than: (1) those acquired under our MPF Program; (2) certain investments targeted to low-income persons or communities; (3) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from an NRSRO; (4) MBS or asset-backed securities (ABS) backed by manufactured housing loans or home equity loans; and (5) certain foreign housing loans authorized under Section 12(b) of the Bank Act;
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Non-U.S. dollar denominated securities;
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Interest-only or principal-only stripped MBS, CMOs, real estate mortgage investment conduits (REMICs) and eligible ABS;
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Residual-interest or interest-accrual classes of CMOs, REMICs and eligible ABS; and
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Fixed rate MBS, CMOs, REMICs and eligible ABS, or floating rate MBS, CMOs, REMICs and eligible ABS that on the trade date are at rates equal to their contractual cap or that have average lives which vary by more than six years under an assumed instantaneous interest rate change of 300 bps.
In addition to the above limitations on allowable types of MBS investments, the FHFA limits our purchase of MBS by requiring that the aggregate value of MBS owned not exceed 300 percent of our month-end total regulatory capital, as most recently reported to the FHFA, on the day we purchase the securities. Aggregate value is calculated with the total amortized cost of available-for-sale and held-to-maturity MBS and the total fair value of trading MBS. Further, quarterly increases in holdings of MBS are restricted to no more than 50 percent of regulatory capital as of the beginning of such quarter. We generally utilize our MBS authority to maintain a portfolio of MBS investments approximating 300 percent of our total regulatory capital. As of December 31, 2017, the amortized cost of our MBS/CMO portfolio represented 288 percent of our regulatory capital.
Debt Financing - Consolidated Obligations
Consolidated obligations, consisting of bonds and discount notes, are our primary liabilities and represent the principal source of funding for advances, traditional mortgage products, and investments. Consolidated obligations are the joint and several obligations of the FHLBanks, backed only by the financial resources of the FHLBanks. Consolidated obligations are not obligations of the U.S. government, and the U.S. government does not guarantee them; however, the capital markets have traditionally viewed the FHLBanks’ obligations as “Federal agency” debt. As such, the FHLBanks historically have had reasonably stable access to funding at relatively favorable spreads to U.S. Treasuries. Our ability to access the capital markets through the sale of consolidated obligations, across the maturity spectrum and through a variety of debt structures, assists us in managing our balance sheet effectively and efficiently. Moody’s currently rates the FHLBanks’ consolidated obligations Aaa/P-1, and S&P currently rates them AA+/A-1+. These ratings measure the likelihood of timely payment of principal and interest on consolidated obligations and also reflect the FHLBanks’ status as GSEs, which generally implies the expectation of a high degree of support by the U.S. government even though their obligations are not guaranteed by the U.S. government.
FHFA regulations govern the issuance of debt on behalf of the FHLBanks and related activities, and authorize the FHLBanks to issue consolidated obligations, through the Office of Finance as their agent, under the authority of Section 11(a) of the Bank Act. No FHLBank is permitted to issue individual debt under Section 11(a) without FHFA approval. We are primarily and directly liable for the portion of consolidated obligations issued on our behalf. In addition, we are jointly and severally liable with the other FHLBanks for the payment of principal and interest on the consolidated obligations of all FHLBanks under Section 11(a). The FHFA, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the FHFA determines that the non-complying FHLBank is unable to satisfy its obligations, then the FHFA may allocate the non-complying FHLBank’s outstanding consolidated obligation debt among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis the FHFA may determine. If the principal or interest on any consolidated obligation issued on behalf of a specific FHLBank is not paid in full when due, that FHLBank may not pay dividends to, or redeem or repurchase shares of stock from, any member of that specific FHLBank.
Table 3 presents the par value of our consolidated obligations and the combined consolidated obligations of all the FHLBanks as of December 31, 2017 and 2016 (in millions):
Table 3
FHFA regulations provide that we must maintain aggregate assets of the following types, free from any lien or pledge, in an amount at least equal to the amount of consolidated obligations 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 that have any guaranty, insurance or commitment from the U.S. government or any agency of the U.S. government; and
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Investments described in Section 16(a) of the Bank 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.
Table 4 illustrates our compliance with the FHFA’s regulations for maintaining aggregate assets at least equal to the amount of consolidated obligations outstanding as of December 31, 2017 and 2016 (dollar amounts in thousands):
Table 4
The Office of Finance has responsibility for facilitating and executing the issuance of the consolidated obligations on behalf of the FHLBanks. It also prepares the FHLBanks’ Combined Quarterly and Annual Financial Reports, services all outstanding debt, serves as a source of information for the FHLBanks on capital market developments and manages the FHLBanks’ relationship with the NRSROs with respect to ratings on consolidated obligations. In addition, the Office of Finance administers two tax-exempt government corporations, the Resolution Funding Corporation and the Financing Corporation, which were established as a result of the savings and loan crisis of the 1980s.
Consolidated Obligation Bonds: Consolidated obligation bonds are primarily used to satisfy our term funding needs. Typically, the maturities of these bonds range from less than one year to 30 years, but the maturities are not subject to any statutory or regulatory limit. Consolidated obligation bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members.
Consolidated obligation bonds generally are issued with either fixed or variable rate payment terms that use a variety of standardized indices for interest rate resets including, but not limited to, LIBOR, Constant Maturity Swap, U.S. Prime and Three-Month U.S. Treasury Bill Auction Yield. In addition, to meet the specific needs of certain investors in consolidated obligations, both fixed and variable rate bonds may also contain certain embedded features, which result in complex coupon payment terms and call features. Normally, when such a complex consolidated obligation bond is issued, we simultaneously enter into a derivative containing mirror or offsetting features to synthetically convert the terms of the complex bond to a simple variable rate callable bond tied to one of the standardized indices. We also simultaneously enter into derivatives containing offsetting features to synthetically convert the terms of some of our fixed rate callable and bullet bonds and floating rate bonds to a simple variable rate callable or bullet bond tied to one of the standardized indices.
Consolidated Obligation Discount Notes: The Office of Finance also sells consolidated obligation discount notes on behalf of the FHLBanks that generally are used to meet short-term funding needs. These securities have maturities up to one year and are offered daily through certain securities dealers in a discount note selling group. In addition to the daily offerings of discount notes, the FHLBanks auction discount notes with fixed maturity dates ranging from 4 to 26 weeks through competitive auctions held twice a week utilizing the discount note selling group. The amount of discount notes sold through the auctions varies based upon market conditions and/or on the funding needs of the FHLBanks. Discount notes are generally sold at a discount and mature at par.
Use of Derivatives
The FHLBank’s Risk Management Policy (RMP) establishes guidelines for our use of derivatives. Interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, futures, forward contracts, and other derivatives can be used as part of our interest rate risk management and funding strategies. This policy, along with FHFA regulations, prohibits trading in, or the speculative use of, derivatives and limits credit risk to counterparties that arises from derivatives. In general, we have the ability to use derivatives to reduce funding costs for consolidated obligations and to manage other risk elements such as interest rate risk, mortgage prepayment risk, unsecured credit risk, and foreign currency risk.
Generally, we use derivatives by designating them as either a fair value or cash flow hedge of an underlying financial instrument, firm commitment, or forecasted transaction and in asset/liability management (i.e., economic hedge). Economic hedges are defined as derivatives hedging specific or non-specific underlying assets, liabilities, or firm commitments that do not qualify for hedge accounting, but are acceptable hedging strategies under our RMP. For example, we use derivatives in our overall interest rate risk management to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of assets, including advances, investments and mortgage loans, and/or to adjust the interest rate sensitivity of advances, investments, and mortgage loans to approximate more closely the interest rate sensitivity of liabilities. We also use derivatives to manage embedded options in assets and liabilities, to hedge the market value of existing assets, liabilities, and anticipated transactions, to hedge the duration risk of prepayable instruments, to mitigate adverse impacts to earnings from the contraction or extension of certain assets (e.g., advances or mortgage assets) and liabilities, and to reduce funding costs as discussed below.
We often execute derivatives concurrently with the issuance of consolidated obligation bonds (collectively referred to as swapped consolidated obligation bond transactions) to reduce funding costs or to alter the characteristics of our liabilities to more closely match the characteristics of our assets. At times, we also execute derivatives concurrently with the issuance of consolidated obligation discount notes in order to create synthetic variable rate debt at a cost that is often lower than funding alternatives and comparable variable rate cash instruments issued directly by us. This strategy of issuing consolidated obligations while simultaneously entering into derivatives enables us to more effectively fund our variable rate and short-term fixed rate assets. It also allows us, in some instances, to offer a wider range of advances at more attractive prices than would otherwise be possible. Swapped consolidated obligation transactions depend on price relationships in both the FHLBank consolidated obligation market and the derivatives market, primarily the interest rate swap market. If conditions in these markets change, we may adjust the types or terms of the consolidated obligations issued and derivatives utilized to better match assets, meet customer needs, and/or improve our funding costs.
We frequently purchase interest rate caps with various terms and strike rates to manage embedded interest rate cap risk associated with our variable rate MBS and CMO portfolios. Although these derivatives are valid economic hedges against the prepayment and option risk of our portfolio of MBS and CMOs, they are not specifically linked to individual investment securities and therefore do not receive fair value or cash flow hedge accounting. The derivatives are marked to fair value through earnings. We may also use interest rate caps and floors, swaptions, and callable swaps to manage and hedge prepayment and option risk on MBS, CMOs and mortgage loans.
See Item 7A - “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk Management” for further information on derivatives.
Deposits
The Bank Act allows us to accept deposits from our members, housing associates, any institution for which we are providing correspondent services, other FHLBanks, and other government instrumentalities. We offer several types of deposit programs, including demand, overnight, and term deposits.
Liquidity Requirements: To support deposits, FHFA regulations require us to have at least an amount equal to current deposits received from our members invested in obligations of the U.S. government, deposits in eligible banks or trust companies, or advances with maturities not exceeding five years. In addition, we must meet the additional liquidity policies and guidelines outlined in our RMP. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Risk Management - Liquidity Risk Management” for further discussion of our liquidity requirements.
Capital, Capital Rules and Dividends
FHLBank Capital Adequacy and Form Rules: The Gramm-Leach-Bliley Act (GLB Act) allows us to have two classes of stock, and each class may have sub-classes. Class A Common Stock is conditionally redeemable on six months’ written notice from the member, and Class B Common Stock is conditionally redeemable on five years’ written notice from the member, subject in each case to certain conditions and limitations that may restrict our ability to effectuate such redemptions. Membership is voluntary. However, other than non-member housing associates (see Item 1 - “Business - Advances”), membership is required in order to utilize our credit and mortgage finance products. Members that withdraw may not reapply for membership for five years.
The GLB Act and the FHFA rules and regulations define total capital for regulatory capital adequacy purposes as the sum of an FHLBank’s permanent capital, plus the amounts paid in by its stockholders for Class A Common Stock; any general loss allowance, if consistent with U.S. generally accepted accounting principles (GAAP) and not established for specific assets; and other amounts from sources determined by the FHFA as available to absorb losses. The GLB Act and FHFA regulations define permanent capital for the FHLBanks as the amount paid in for Class B Common Stock plus the amount of an FHLBank’s retained earnings, as determined in accordance with GAAP.
Under the GLB Act and the FHFA rules and regulations, we are subject to risk-based capital rules. Only permanent capital can satisfy our risk-based capital requirement. In addition, the GLB Act specifies a five percent minimum leverage capital requirement based on total FHLBank capital, which includes a 1.5 weighting factor applicable to permanent capital, and a four percent minimum total capital requirement that does not include the 1.5 weighting factor applicable to permanent capital. We may not redeem or repurchase any of our capital stock without FHFA approval if the FHFA or our Board of Directors determines that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital, even if we are in compliance with our minimum regulatory capital requirements. Therefore, a member’s right to have its excess shares of capital stock redeemed is conditional on, among other factors, the FHLBank maintaining compliance with the three regulatory capital requirements: risk-based, leverage, and total capital.
Following are highlights from our capital plan:
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Two classes of authorized stock - Class A Common Stock and Class B Common Stock;
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Both classes have $100 par value per share and both are defined as common stock;
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Class A Common Stock is required for membership. The membership or asset-based stock requirement for each member is currently 0.1 percent of that member's total assets at the end of the prior calendar year, with a minimum requirement of 10 shares ($1,000) and a cap of 5,000 shares ($500,000);
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To the extent a member’s asset-based requirement in Class A Common Stock is insufficient to support its calculated activity-based requirement, Class B Common Stock must be purchased in order to support that member’s activities with us. The activity-based stock requirement is the sum of the stock requirements for each activity less the asset-based stock requirement in Class A Common Stock and is calculated whenever a member enters into a transaction, such as an advance (4.5 percent of outstanding advances (range = 4.0 to 6.0 percent));
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Excess stock is calculated daily. We may exchange excess Class B Common Stock for Class A Common Stock, but only if we continue to meet our regulatory capital requirements after the exchange;
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A member may hold excess Class A Common Stock or Class B Common Stock, subject to our right to repurchase excess stock or to exchange excess Class B Common Stock for Class A Common Stock, or may ask to redeem all or part of its excess Class A Common Stock or Class B Common Stock. A member may also ask to exchange all or part of its excess Class A Common Stock or Class B Common Stock for Class B Common Stock or Class A Common Stock, respectively, but all such exchanges are completed at our discretion;
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As a member increases its activities with us above the amount of activity supported by its asset-based requirement, excess Class A Common Stock is first exchanged for Class B Common Stock to meet the activity requirement prior to the purchase of additional Class B Common Stock;
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Under the plan, the Board of Directors establishes a dividend parity threshold that is a rate per annum expressed as a positive or negative spread relative to a published reference interest rate index (e.g., LIBOR, Federal funds, etc.) or an internally calculated reference interest rate based upon any of our assets or liabilities (e.g., average yield on advances, average cost of consolidated obligations, etc.);
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Class A Common Stock and Class B Common Stock share in dividends equally up to the dividend parity threshold, then the dividend rate for Class B Common Stock can exceed the rate for Class A Common Stock, but the Class A Common Stock dividend rate can never exceed the Class B Common Stock dividend rate;
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A member may submit a redemption request to us for any or all of its excess Class A Common Stock and/or Class B Common Stock;
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Within five business days of receipt of a redemption request for excess Class A Common Stock, we must notify the member if we decline to repurchase the excess Class A Common Stock, at which time the six-month waiting period will apply. Otherwise, we will repurchase any excess Class A Common Stock within five business days, though it is usually repurchased on the same date as the member’s redemption request;
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Within five business days of receipt of a redemption request for excess Class B Common Stock, we must notify the member if we decline to repurchase the excess Class B Common Stock, at which time the five-year waiting period will apply. Otherwise, we will repurchase any excess Class B Common Stock within five business days, though it is usually repurchased on the same date as the member’s redemption request;
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A member may cancel or revoke its written redemption request prior to the end of the redemption period (six months for Class A Common Stock and five years for Class B Common Stock) or its written notice of withdrawal from membership prior to the end of a six-month period starting on the date we received the member’s written notice of withdrawal from membership. Our capital plan provides that we will charge the member a cancellation fee in accordance with a schedule where the amount of the fee increases with the passage of time. There is no grace period after the submission of a redemption request during which the member may cancel its redemption request without being charged a cancellation fee; and
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Each required share of Class A Common Stock and Class B Common Stock is entitled to one vote subject to the statutorily imposed voting caps.
See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital” for additional information regarding capital.
Dividends: We may pay dividends from unrestricted retained earnings and current income. (For a discussion regarding restricted retained earnings, please see Joint Capital Enhancement Agreement under this Item 1.) Our Board of Directors may declare and pay dividends in either cash or capital stock. Under our capital plan, all dividends that are payable in capital stock must be paid in the form of Class B Common Stock, regardless of the class of stock upon which the dividend is being paid.
Consistent with FHFA guidance in Advisory Bulletin (AB) 2003-AB-08, Capital Management and Retained Earnings, we adopted guidelines to establish a minimum or threshold level for our retained earnings in light of alternative possible future financial and economic scenarios, which are currently included under our RMP. Our minimum (threshold) level of retained earnings is calculated quarterly and re-evaluated by the Board of Directors as part of each quarterly dividend declaration. The retained earnings threshold effective for the period presented ending March 31, 2017 and all subsequent periods includes detailed calculations of five components:
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Market risk, which is calculated using a Monte Carlo simulation where the 99 percent confidence level result over a 90-day simulation horizon will represent the minimum market risk exposure level;
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Credit risk, which requires that retained earnings be sufficient to credit-enhance all of our assets from their actual rating levels to the equivalent of triple-A ratings (where advances are considered to be triple-A rated);
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Pre-settlement risk, which is based upon the pre-settlement risk exposure associated with recently issued and unsettled debt issuance and is based on the current daily potential maximum price risk exposure, based on the 99th percentile of daily price risk calculated on the most recent 10 years of daily activity. For periods presented prior to March 31, 2017, pre-settlement risk was not a component of the retained earnings threshold;
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Operations risk, which is calculated using a combination of: (1) the Basel II standardized approach; and (2) our operational risk event loss history, taking into consideration operational loss events reported by the FHLBank System that could impact us in the future; and
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Net income volatility, which is calculated using: (1) the largest net loss on derivative hedging activities under 100-basis-point interest rate shock scenarios (maximum derivative hedging loss under up or down shocks); and (2) dividend payment risk, computed as four times the dollar amount of dividends paid on all stock (including mandatorily redeemable capital stock) for the most recently paid quarterly dividend.
The retained earnings threshold was considered by the Board of Directors when dividends were declared during the last two years, but the retained earnings threshold calculated in accordance with the RMP did not significantly affect the amount of dividends declared and paid. Tables 5 and 6 reflect the quarterly retained earnings threshold calculations utilized during 2017 and 2016 (in thousands), respectively, compared to the actual amount of retained earnings at the end of each quarter:
Table 5
Table 6
Under our retained earnings policy, any shortage of actual retained earnings with respect to the retained earnings threshold is to be met over a period generally not to exceed one year from the quarter-end calculation. The policy also provides that meeting the established retained earnings threshold has priority over the payment of dividends, but that the Board of Directors must balance dividends on capital stock against the period over which the retained earnings threshold is met. The retained earnings threshold level fluctuates from period to period because it is a function of the size and composition of our balance sheet and the risks contained therein at that point in time.
Joint Capital Enhancement Agreement (JCE Agreement) - We, along with the other FHLBanks, entered into a JCE Agreement intended to enhance the capital position of each FHLBank. More specifically, the intent of the JCE Agreement is to allocate a portion of each FHLBank’s earnings to a Separate Restricted Retained Earnings Account (RRE Account) at that FHLBank. Thus, in accordance with the JCE Agreement, each FHLBank allocates 20 percent of its net income to an RRE Account and will do so until the balance of the account equals at least one percent of that FHLBank’s average balance of outstanding consolidated obligations for the previous quarter.
Key provisions under the JCE Agreement are as follows:
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Under the JCE Agreement, each FHLBank will build its RRE Account to a minimum of one percent of its total outstanding consolidated obligations through the 20 percent allocation. For this purpose, total outstanding consolidated obligations is based on the most recent quarter's average carrying value of all consolidated obligations for which an FHLBank is the primary obligor, excluding hedging adjustments (Total Consolidated Obligations). Under the JCE Agreement, an FHLBank may make voluntary allocations above 20 percent of its net income and/or above the targeted balance of one percent of its Total Consolidated Obligations.
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The JCE Agreement provides that any quarterly net losses of an FHLBank may be netted against its net income, if any, for other quarters during the same calendar year to determine the minimum required year-to-date or annual allocation to its RRE Account. Any year-to-date or annual losses must first be allocated to the unrestricted retained earnings of an FHLBank until such retained earnings are reduced to a zero balance. Thereafter, any remaining losses may be applied to reduce the balance of an FHLBank’s RRE Account, but not below a zero balance. In the event an FHLBank incurs a net loss for a cumulative year-to-date or annual period that results in a decrease to the balance of its RRE Account below the balance of the RRE Account as of the beginning of that calendar year, such FHLBank’s quarterly allocation requirement will thereafter increase to 50 percent of quarterly net income until the cumulative difference between the allocations made at the 50 percent rate and the allocations that would have been made at the regular 20 percent rate is equal to the amount of the decrease to the balance of its RRE Account at the beginning of that calendar year.
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If the size of an FHLBank’s balance sheet would decrease and consequently, Total Consolidated Obligations would decline, the percent allocated could exceed the targeted one percent of Total Consolidated Obligations. The JCE Agreement provides that if an FHLBank's RRE Account exceeds 1.5 percent of its Total Consolidated Obligations, such FHLBank may transfer amounts from its RRE Account to the unrestricted retained earnings account, but only to the extent that the balance of its RRE Account remains at least equal to 1.5 percent of the FHLBank’s Total Consolidated Obligations immediately following such transfer. Finally, the JCE Agreement provides that during periods in which an FHLBank’s RRE Account is less than one percent of its Total Consolidated Obligations, such FHLBank may pay dividends only from unrestricted retained earnings or from the portion of quarterly net income not required to be allocated to its RRE Account.
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The JCE Agreement can be voluntarily terminated by an affirmative vote of two-thirds of the boards of directors of the FHLBanks, or automatically after the occurrence of a certain event after following certain proscribed procedures (Automatic Termination Event). An Automatic Termination Event means: (1) a change in the FHLBank Act, or another applicable statute, that will have the effect of creating a new, or higher, assessment or taxation on net income or capital of the FHLBanks; or (2) a change in the FHLBank Act, or another applicable statute, or relevant regulations that will result in a higher mandatory allocation of an FHLBank’s quarterly net income to any retained earnings account other than the annual amount, or total amount, specified in an FHLBank’s capital plan. An FHLBank’s obligation to make allocations to the RRE Account terminates after it has been determined that an Automatic Termination Event has occurred and one year thereafter the restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, are also terminated. Upon the voluntary termination of the JCE Agreement, an FHLBank’s obligation to make allocations to its RRE Account is terminated on the date written notice of termination is delivered to the FHFA, and restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, terminate one year thereafter.
Tax Status
We are exempt from all federal, state and local taxation except for real property taxes.
Assessments
We are subject to a regulatory AHP assessment based on a percentage of our earnings. The FHLBanks are required to set aside annually the greater of an aggregate of $100 million or 10 percent of their current year’s income before charges for AHP. In accordance with FHFA guidance for the calculation of AHP expense, interest expense on mandatorily redeemable capital stock is added back to income before charges for AHP.
Other Mission-Related Activities
In addition to supporting residential mortgage lending, one of our core missions is to support related housing and community development. We administer and fund a number of targeted programs specifically designed to fulfill that mission. These programs provide housing opportunities for thousands of very low-, low- and moderate-income households and strengthen communities primarily in Colorado, Kansas, Nebraska, and Oklahoma.
Affordable Housing Program: Amounts specified by the AHP requirements described in Item 1 - “Business - Assessments” are reserved for this program. AHP provides cash grants to members to finance the purchase, construction, or rehabilitation of very low-, low-, and moderate-income owner occupied or rental housing. In addition to the competitive AHP program funds, a customized homeownership set-aside program called the Homeownership Set-aside Program (HSP) is offered under the AHP. The HSP provides down payment, closing cost, and purchase-related repair assistance to first-time homebuyers in Colorado, Kansas, Nebraska, and Oklahoma.
Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 3.5 percent, 3.9 percent and 3.9 percent of total advances outstanding as of December 31, 2017, 2016, and 2015, respectively. Programs offered during 2017 under the CICA Program, which is not funded through the AHP, include:
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Community Housing Program (CHP) - CHP makes loans available to members for financing the construction, acquisition, rehabilitation, and refinancing of owner-occupied housing for households whose incomes do not exceed 115 percent of the area’s median income and rental housing occupied by or affordable for households whose incomes do not exceed 115 percent of the area’s median income. For rental projects, at least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. We provide advances for CHP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs; and
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Community Development Program (CDP) - CDP provides advances to members to finance CDP-qualified member financing including loans to small businesses, farms, agri-businesses, public or private utilities, schools, medical and health facilities, churches, day care centers, or for other community development purposes that meet one of the following criteria: (1) loans to firms that meet the Small Business Administration’s definition of a qualified small business concern; (2) financing for businesses or projects located in an urban neighborhood, census tract or other area with a median income at or below 100 percent of the area median; (3) financing for businesses, farms, ranches, agri-businesses, or projects located in a rural community, neighborhood, census tract, or unincorporated area with a median income at or below 115 percent of the area median; (4) firms or projects located in a Federal Empowerment Zone, Enterprise Community or Champion Community, Native American Area, Brownfield Area, Federally Declared Disaster Area, United States Department of Agriculture Drought Area, or Community Adjustment and Investment Program Area; (5) businesses in urban areas in which at least 51 percent of the employees of the business earn at or below 100 percent of the area median; or (6) businesses in rural areas in which at least 51 percent of the employees of the business earn at or below 115 percent of the area median. We provide advances for CDP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs.
Other Housing and Community Development Programs. We have established a voluntary program intended to promote homebuyer education in our district. The Rural First-time Homebuyer Education Program provides up to $75,000 annually to support rural homeownership education and counseling while actively encouraging participating organizations to seek supplemental funding from other sources. The goal of the program is to support rural education and counseling in all four states in the district, especially in those areas with HSP-participating members. This program is not funded through AHP funds.
Competition
Advances: Demand for advances is affected by, among other things, the cost of alternative sources of liquidity available to our members, including deposits from members’ customers and other sources of liquidity that are available to members. Members mostly access alternative funding other than advances through the brokered deposit market and through repurchase agreements with commercial customers. Large members may have broader access to funding through repurchase agreements with investment banks and commercial banks as well as access to the national and global credit markets. While the availability of alternative funding sources to members can influence member demand for advances, the cost of the alternative funding relative to advances is the primary consideration when accessing alternative funding. Other considerations include product availability through the FHLBank, the member’s creditworthiness, ease of execution, level of diversification, and availability of member collateral for other types of borrowings.
Mortgage Loans: We are subject to competition in purchasing conventional, conforming fixed rate residential mortgage loans and government-guaranteed residential mortgage loans. We face competition in customer service, the prices paid for these assets, and in ancillary services such as automated underwriting. The most direct competition for purchasing residential mortgage loans comes from the other housing GSEs, which also purchase conventional, conforming fixed rate mortgage loans, specifically Fannie Mae and Freddie Mac. To a lesser extent, we also compete with regional and national financial institutions that buy and/or invest in mortgage loans. Depending on market conditions, these investors may seek to hold, securitize, or sell conventional, conforming fixed rate mortgage loans. We continuously reassess our potential for success in attracting and retaining members for our mortgage loan products and services, just as we do with our advance products. We compete for the purchase of mortgage loans primarily on the basis of price, products, and services offered.
Debt Issuance: We compete with the U.S. government (including debt programs explicitly guaranteed by the U.S. government), U.S. government agencies, Fannie Mae, Freddie Mac, and other GSEs, as well as corporate, sovereign, and supranational entities for funds raised through the issuance of unsecured debt in the national and global capital markets. Collectively, Fannie Mae, Freddie Mac, and the FHLBanks are generally referred to as the housing GSEs, and the cost of the debt of each can be positively or negatively affected by political, financial, or other news that reflects upon any of the three housing GSEs. If the supply of competing debt products increases without a corresponding increase in demand, our debt costs may increase, or less debt may be issued. We compete for the issuance of debt primarily on the basis of rate, term, and structure of the debt, but also on the liquidity position and perceived risk of the issuer.
Derivatives: The sale of callable debt and the simultaneous execution of callable interest rate swaps with options that mirror the options in the debt have been an important source of competitive funding for us. As such, the depth of the markets for callable debt and mirror-image derivatives is an important determinant of our relative cost of funds. There is considerable competition among high-credit-quality issuers, especially among the three housing GSEs, for callable debt and for derivatives. There can be no assurance that the current breadth and depth of these markets will be sustained.
Regulatory Oversight, Audits and Examinations
General: We are supervised and regulated by the FHFA, which is an independent agency in the executive branch of the U.S. government. The FHFA is responsible for providing supervision, regulation and housing mission oversight of the FHLBanks to promote their safety and soundness so they serve as a reliable source of liquidity and funding for housing finance and community investment. The FHFA is headed by a Director appointed by the President of the United States for a five-year term, with the advice and consent of the Senate. The Federal Housing Finance Oversight Board advises the Director with respect to overall strategies and policies in carrying out the duties of the Director. The Federal Housing Finance Oversight Board is comprised of the Secretary of the Treasury, Secretary of HUD, Chair of the Securities and Exchange Commission (SEC), and the Director, who serves as the Chairperson of the Board. The FHFA is funded in part through assessments from the FHLBanks, with the remainder of its funding provided by Fannie Mae and Freddie Mac; no tax dollars or other appropriations support the operations of the FHFA or the FHLBanks. To assess our safety and soundness, the FHFA conducts annual, on-site examinations, as well as periodic on-site and off-site reviews. Additionally, we are required to submit monthly information on our financial condition and results of operations to the FHFA. This information is available to all FHLBanks.
Before a government corporation issues and offers obligations to the public, the Government Corporation Control Act provides that the Secretary of the Treasury shall prescribe the form, denomination, maturity, interest rate, and conditions of the obligations; the manner and time issued; and the selling price. The Bank Act also authorizes the Secretary of the Treasury, at his or her discretion, to purchase consolidated obligations up to an aggregate principal amount of $4 billion. No borrowings under this authority have been outstanding since 1977. The U.S. Treasury receives the FHFA’s annual report to Congress, monthly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks.
Audits and Examinations: We have an internal audit department and our Board of Directors has an audit committee. The Chief Audit Executive reports directly to the audit committee. In addition, an independent registered public accounting firm audits our annual financial statements and effectiveness of internal controls over financial reporting. The independent registered public accounting firm conducts these audits following standards of the Public Company Accounting Oversight Board (United States) and Government Auditing Standards issued by the Comptroller General of the United States. The FHLBanks, the FHFA, and Congress all receive the audit reports. We must submit annual management reports to Congress, the President of the United States, the Office of Management and Budget, and the Comptroller General. These reports include a statement of financial condition, a statement of operations, a statement of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent public accounting firm on the financial statements.
The Comptroller General has authority under the Bank Act to audit or examine the FHFA and the individual FHLBanks and to decide the extent to which they fairly and effectively fulfill the purposes of the Bank Act. Furthermore, the Government Corporation Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent registered public accounting firm. If the Comptroller General conducts such a review, then he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the applicable FHLBank. The Comptroller General may also conduct his or her own audit of any financial statements of any individual FHLBank.
Personnel
As of February 28, 2018, we had 233 employees. Our employees are not represented by a collective bargaining unit, and we have a good relationship with our employees.
Legislative and Regulatory Developments
FHFA Final Rule on Minority and Women Inclusion. On July 13, 2017, the FHFA issued a final rule, effective August 24, 2017, amending its Minority and Women Inclusion regulations to clarify the scope of the FHLBanks' obligation to promote diversity and ensure inclusion. The final rule updates the existing FHFA regulations aimed at promoting diversity and the inclusion and participation of minorities, women, and individuals with disabilities, and the businesses they own ("MWDOB") in all FHLBank business and activities, including management, employment, customer outreach and access, MWDOB participation in financial transactions with the FHLBanks, and contracting. The final rule encourages the FHLBanks to expand contracting opportunities for MWDOBs and minorities, women, and individuals with disabilities through subcontracting arrangements and to track the cumulative spend associated with such diverse subcontracting arrangements. In addition, the final rule requires each FHLBank to:
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Develop stand-alone, board-approved diversity and inclusion strategic plans or incorporate diversity and inclusion principles into its existing strategic planning processes and adopt strategies for promoting diversity and ensuring inclusion;
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Amend its policies on equal opportunity in employment by adding sexual orientation, gender identity, and status as a parent to the list of protected classifications;
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Establish a process to grant or deny requests for accommodations to employees and job applicants based on their religious beliefs or practices;
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Provide information in its annual reports to the FHFA about its efforts to advance diversity and inclusion through identifying and selecting MWDOB firms for participation in financial transactions with the FHLBank, identifying ways in which it may give consideration to MWDOB business with the FHLBank when reviewing and evaluating vendor contract proposals, and enhancing customer access by MWDOB businesses (including through the FHLBank's affordable housing and community investment programs;
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Report data regarding the number of diverse individuals currently in supervisory or managerial positions and its strategies for promoting the diversity of supervisors and managers;
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Classify and provide additional data in its annual reports about the number of, and amounts paid under, its MWDOB contracts, as well as demographic data regarding the categories of MWDOB entities to which it awards vendor contracts; and
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Provide data to the FHFA regarding the type of contracts it considers exempt from these diversity and inclusion requirements, as well as the criteria and rationale for establishing such exemptions and an analysis of any potential negative or adverse impact such exemptions might have on contracting opportunities for MWDOB businesses or diverse individuals.
We do not expect this final rule to materially affect our financial condition or results of operations, but we anticipate that it may result in increased costs and substantially increase the amount of data tracking, monitoring, and reporting that will be required of us.
FHFA Proposed Rule on Capital Requirements. On July 3, 2017, the FHFA published a proposed rule to adopt, with amendments, the Federal Housing Finance Board regulations pertaining to the capital requirements for the FHLBanks. The proposed rule would carry over most of the existing regulations without material change, but would substantively revise the credit risk component of the risk-based capital requirement, as well as the limitations on extensions of unsecured credit and derivative exposure. The main revisions would remove requirements that the FHLBanks calculate credit risk capital charges and unsecured credit limits based on ratings issued by an NRSRO, and instead require that the FHLBanks establish and use their own internal rating methodology. With respect to derivatives, the proposed rule would impose a new capital charge for cleared derivatives, which under the existing rule do not carry a capital charge, and would change the way that the capital charge and risk limits are calculated for uncleared derivatives, in both cases to align with the Dodd-Frank Act’s clearing mandate and derivatives reforms. The proposed rule also would revise the percentages used in the regulation’s tables to calculate credit risk capital charges for advances and for non-mortgage assets. The FHFA proposes to retain for now the percentages used in the tables to calculate capital charges for mortgage-related assets, and to address at a later date the methodology for residential mortgage assets. While a March 2009 regulatory directive pertaining to certain liquidity matters would remain in place, the FHFA also proposes to rescind certain minimum regulatory liquidity requirements and address these liquidity requirements in a new regulatory directive.
We submitted a joint comment letter with the other FHLBanks on August 31, 2017. We continue to evaluate the proposed rule but do not expect this rule, if adopted as proposed, to materially affect our financial condition or results of operations.
Information Security Management Advisory Bulletin. On September 28, 2017, the FHFA issued Advisory Bulletin 2017-02, which supersedes previous guidance on an FHLBank’s information security program. The advisory bulletin describes three main components of an information security program and reflects the expectation that each FHLBank will use a risk-based approach to implement its information security program. The advisory bulletin contains expectations related to: (1) governance, including guidance related to roles and responsibilities, risk assessments, industry standards, and cyber-insurance; (2) engineering and architecture, including guidance on network security, software security, and security of endpoints; and (3) operations, including guidance on continuous monitoring, vulnerability management, baseline configuration, asset life cycle, awareness and training, incident response and recovery, user access management, data classification and protection, oversight of third parties, and threat intelligence sharing.
We do not expect this advisory bulletin to materially affect our financial condition or results of operations, but we anticipate that it may result in increased costs relating to enhancements to our information security program.
Federal Reserve Board (FRB), Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) Final Rules on Mandatory Contractual Stay Requirements for Qualified Financial Contracts (QFCs). On September 12, 2017, the FRB published a final rule, effective November 13, 2017, requiring certain global systemically important banking institutions (GSIBs) regulated by the FRB to amend their covered QFCs to limit a counterparty’s immediate termination or exercise of default rights under the QFCs in the event of bankruptcy or receivership of the GSIB or an affiliate of the GSIB. Covered QFCs include derivatives, repurchase agreements and reverse repurchase agreements, and securities lending and borrowing agreements. On September 27, 2017, and on November 29, 2017, the FDIC and OCC respectively adopted final rules that are both substantively identical to the FRB rule, both effective January 1, 2018, with respect to QFCs entered into with certain FDIC- and OCC-supervised institutions.
Although we are not a covered entity under these rules, as a counterparty to covered entities under QFCs, we may be required to amend QFCs entered into with FRB-regulated GSIBs or applicable FDIC- and OCC-supervised institutions. These rules may impact our ability to terminate business relationships with covered entities and could adversely impact the amount we recover in the event of the bankruptcy or receivership of a covered entity. However, we do not expect these final rules, or the proposed amendments to the Swap Margin Rules, to materially affect our financial condition or results of operations. We do not expect this final rule to materially affect our financial condition or results of operations.
OCC, FRB, FDIC, Farm Credit Administration, and FHFA Proposed Rule on Margin and Capital Requirements for Covered Swap Entities. On February 21, 2018, OCC, FRB, FDIC, Farm Credit Administration, and FHFA published a joint proposed amendment to each agency’s final rule on Margin and Capital Requirements for Covered Swap Entities (“Swap Margin Rules”) to conform the definition of “eligible master netting agreement” in such rules to the FRB’s, OCC’s, and FDIC’s final QFC rules, and to clarify that a legacy swap will not be deemed to be a covered swap under the Swap Margin Rules if it is amended to conform to the QFC Rules.
Comments on the proposed rule are due by April 23, 2018. We continue to evaluate the proposed rule, but we do not expect this rule, if adopted substantially as proposed, to materially affect our financial condition or results of operations.
Where to Find Additional Information
We file our annual, quarterly, and current reports and related information with the SEC. You may read and copy such material at the public reference facilities maintained by the SEC at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-732-0330 for more information on the public reference room. You can also find our SEC filings at the SEC’s website at www.sec.gov. Additionally, on our website at www.fhlbtopeka.com, you can find a link to the SEC’s website which can be used to access our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Except for the documents specifically incorporated by reference into this Annual Report on Form 10-K, information contained on our website or that can be accessed through our website is not incorporated by reference into this Annual Report on Form 10-K. Reference to our website is made as an inactive textual reference.
Item 1A:
Item 1A: Risk Factors
Our business has been, and may continue to be, adversely impacted by legislation and other ongoing actions by the U. S. government in response to periodic disruptions in the financial markets. To the extent that any actions by the U.S. government in response to an economic downturn, recession, inflation or other macro-level events or conditions cause a significant decrease in the aggregate amount of advances or increase our operating costs, our financial condition and results of operations may be adversely affected. Our primary regulator, the FHFA, also continues to issue proposed and final regulatory and other requirements as a result of the Recovery Act, the Dodd-Frank Act and other mandates. We cannot predict the effect of any new regulations or other regulatory guidance on our operations. Changes in regulatory requirements could result in, among other things, an increase in our cost of funding or overall cost of doing business, or a decrease in the size, scope or nature of our membership base, or our lending, investment, or mortgage loan activity, which could negatively affect our financial condition and results of operations. See Item 1 - “Business - Legislative and Regulatory Developments” for more information on potential future legislation and other regulatory activity affecting us.
We are subject to a complex body of laws and regulatory and other requirements that could change in a manner detrimental to our operations. The FHLBanks are GSEs organized under the authority of the Bank Act, and, as such, are governed by federal laws, regulations and other guidance adopted and applied by the FHFA. In addition, Congress may amend the Bank Act or pass other legislation that significantly affects the rights, obligations, and permissible activities of the FHLBanks and the manner in which the FHLBanks carry out their housing-finance and liquidity missions and business operations. The U.S. Congress is considering broad legislation for reform of GSEs as a result of the disruptions in the financial and housing markets and the conservatorships of Fannie Mae and Freddie Mac. We do not know how, when, or to what extent GSE reform legislation will be adopted, and if adopted, how it would impact the business or operations of the FHLBank or the FHLBank System. We are, or may also become, subject to further regulations promulgated by the SEC, Commodity Futures Trading Commission (CFTC), Federal Reserve Board, Financial Crimes Enforcement Network, or other regulatory agencies.
We cannot predict whether new regulatory or other requirements will be promulgated by the FHFA or other regulatory agencies, or whether Congress will enact new legislation, and we cannot predict the effect of any new regulatory requirements or legislation on our operations. Changes in regulatory, statutory or other requirements could result in, among other things, an increase in our cost of funding and the cost of operating our business, a change in our permissible business activities, or a decrease in the size, scope or nature of our membership or our lending, investment or mortgage loan activities, which could negatively affect our financial condition and results of operations.
We share a regulator with Fannie Mae and Freddie Mac. The FHFA currently serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae, and Freddie Mac. Because the business models of Fannie Mae and Freddie Mac are significantly different from that of the FHLBanks, there is a risk that actions by the FHFA toward Fannie Mae and Freddie Mac may have an unfavorable impact on the FHLBanks’ operations and/or financial condition. In addition, there is a risk that our funding costs and access to funds could be adversely affected by changes in investors’ perception of the systemic risks associated with Fannie Mae and Freddie Mac.
Changes to our balance sheet management strategies could adversely impact our results of operations. In 2015, the FHFA issued an advisory bulletin establishing a CMA 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 the average par balances of advances and mortgage loans acquired from members, to the average par balance of consolidated obligations. Any adjustments to our balance sheet to meet and/or maintain CMA ratios may result in lower net income and, therefore, adversely impact our financial condition and results of operations as we continue to implement and maintain a core mission asset balance sheet.
An increase in required AHP contributions could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. The FHLBank Act requires each FHLBank to contribute to its AHP the greater of: (1) 10 percent of the FHLBank’s net earnings for the previous year; or (2) that FHLBank’s pro rata share of an aggregate of $100 million, the proration of which is based on the net earnings of the FHLBanks for the previous year. A failure of the FHLBanks to make the minimum $100 million annual AHP contribution in a given year could result in an increase in our required AHP contribution, which could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock.
We may not be able to pay dividends at rates consistent with past practices. Our Board of Directors may only declare dividends on our capital stock, payable to members, from our unrestricted retained earnings and current net income. Our ability to pay dividends also is subject to statutory and regulatory requirements, including meeting all regulatory capital requirements. The potential promulgation of regulations or other requirements by the FHFA that would require higher levels of required or restricted retained earnings could lead to higher levels of retained earnings, and thus, lower amounts of unrestricted retained earnings available to be paid out to our members as dividends. Failure to meet any of our regulatory capital requirements would prevent us from paying any dividend.
Events such as changes in our market risk profile, credit quality of assets held, and increased volatility of net income caused by the application of certain GAAP accounting guidance may affect the adequacy of our retained earnings and may require us to increase our threshold level of retained earnings and correspondingly reduce our dividends from historical payout ratios to achieve and maintain the threshold amounts of retained earnings under our RMP. Additionally, FHFA regulations on capital classifications could restrict our ability to pay dividends. Further, our ability to pay dividends at historical rates is impacted directly by our net income, so a decline in net income could result in a decline in dividend rates.
Changes in our credit ratings may adversely affect our business operations. As of March 13, 2018, we are rated Aaa with a stable outlook by Moody’s and AA+ with a stable outlook by S&P. Adverse revisions to or the withdrawal of our credit ratings could adversely affect us in a number of ways. It might influence counterparties to limit the types of transactions they would be willing to enter into with us or cause counterparties to cease doing business with us. We have issued letters of credit to support deposits of public unit funds with our members. In some circumstances, loss of or reduction in any of our current ratings could result in our letters of credit no longer being acceptable to collateralize public unit deposits or other transactions. We have also executed various standby bond purchase agreements (SBPA) in which we provide a liquidity facility for bonds issued by the HFAs by agreeing to purchase the bonds in the event they are tendered and cannot be remarketed in accordance with specified terms and conditions. If our current short-term ratings are reduced, suspended, or withdrawn, the issuers will have the right to terminate these SBPAs, resulting in the loss of future fees that would be payable to us under these agreements.
Changes in the credit standing of the U.S. Government or other FHLBanks, including the credit ratings assigned to the U.S. Government or those FHLBanks, could adversely affect us. Pursuant to criteria used by S&P and Moody’s, the FHLBank System’s debt is linked closely to the U.S. sovereign rating because of the FHLBanks’ status as GSEs and the public perception that the FHLBank System would be likely to receive U.S. government support in the event of a crisis. The U.S. government’s fiscal challenges could impact the credit standing or credit rating of the U.S. government, which could in turn result in a revision of the rating assigned to us or the consolidated obligations of the FHLBank System.
The FHLBanks issue consolidated obligations that are the joint and several liability of all FHLBanks. Significant developments affecting the credit standing of one or more of the other FHLBanks, including revisions in the credit ratings of one or more of the other FHLBanks, could adversely affect the cost of consolidated obligations. An increase in the cost of consolidated obligations would adversely affect our cost of funds and negatively affect our financial condition. As of March 13, 2018, the consolidated obligations of the FHLBanks are rated Aaa/P-1 by Moody’s and AA+/A-1+ by S&P. All of the FHLBanks are rated Aaa with a stable outlook by Moody’s and AA+ with a stable outlook by S&P. Changes in the credit standing or credit ratings of one or more of the other FHLBanks could result in a revision or withdrawal of the ratings of the consolidated obligations by the rating agencies at any time, which may negatively affect our cost of funds and our ability to issue consolidated obligations for our benefit.
We may become liable for all or a portion of the consolidated obligations of one or more of the other FHLBanks. We are jointly and severally liable with the other FHLBanks for all consolidated obligations issued on behalf of all FHLBanks through the Office of Finance. We cannot pay any dividends to members or redeem or repurchase any shares of our capital stock unless the principal and interest due on all our consolidated obligations have been paid in full. If another FHLBank were to default on its obligation to pay principal or interest on any consolidated obligation, the FHFA may allocate the outstanding liability among one or more of the remaining FHLBanks on a pro rata basis or on any other basis the FHFA may determine. As a result, our ability to pay dividends to our members or to redeem or repurchase shares of our capital stock could be affected not only by our own financial condition, but also by the financial condition of one or more of the other FHLBanks.
The yield on, or value of, our MBS investments may be adversely affected by increased delinquency rates and credit losses related to mortgage loans that back our MBS investments. Trends in unemployment, home price growth, and foreclosure inventory have generally been moving in a positive direction for the past several years, which has supported the underlying health of our MBS investments. However, if one or more of these macroeconomic variables deteriorates noticeably, delinquency and/or default rates on the underlying collateral supporting these investments will likely increase, and we could experience reduced yields or losses on our MBS investments. Any increase in delinquency rates and credit losses related to mortgage loans pooled into MBS/CMO and HFA securities, which are insured by one of the monoline mortgage insurance companies, could adversely affect the yield on or value of our MBS/CMO and HFA investments. The magnitude of potential losses in the home mortgage loan market could potentially overwhelm one or more of the monoline mortgage insurance companies resulting in such company’s failure to perform. If collateral losses exceed the coverage ability of the insurance company, the MBS/CMO or HFA bondholders could experience losses of principal. Furthermore, market illiquidity has, from time to time, increased the amount of management judgment required to value private-label MBS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS and other investment securities. If we decide to sell securities due to credit deterioration, the price we may ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than the fair value reflected in our financial statements.
Loan modification and liquidation programs could have an adverse impact on the value of our MBS investments. Efforts of mortgage servicers to modify delinquent loans in order to mitigate losses may include reductions in interest rates and/or principal on these loans. Losses from such loan modifications may be allocated to investors in MBS backed by these loans in the form of lower interest payments and/or reductions in future principal amounts received. In addition, efforts by the U.S. government to address delinquent mortgage loans could result in reductions in interest rates and/or principal and may also result in additional foreclosures that could result in an adverse impact on the value of our MBS investments.
Many servicers are contractually required to advance principal and interest payments on delinquent loans backing MBS investments, regardless of whether the servicer has received payment from the borrower, provided that the servicer believes it will be able to recoup the advanced funds from the underlying property securing the mortgage loan. Once the related property is liquidated, the servicer is entitled to reimbursement for these advances and other expenses incurred while the loan was delinquent. Such reimbursements may result in higher losses than we may have expected or experienced to date being allocated to our MBS investments backed by such loans, which may have an adverse impact on our results of operations and financial condition.
Defaults by one or more of our institutional counterparties on its obligations to us could adversely affect our results of operations or financial condition. We have a high concentration of credit risk exposure to financial institutions as counterparties, the majority of which are located within the United States, Canada, Australia, and Europe. Our primary exposures to institutional counterparty risk are with: (1) obligations of mortgage servicers that service the loans we have as collateral on our credit obligations; (2) third-party providers of credit enhancements on the MBS that we hold in our investment portfolio, including mortgage insurers, bond insurers, and financial guarantors; (3) third-party providers of PMI and SMI for mortgage loans purchased under the MPF Program; (4) uncleared derivative counterparties; (5) third-party custodians and futures commission merchants associated with cleared derivatives; and (6) unsecured money market and Federal funds investment transactions. A default by a counterparty with significant obligations to us could adversely affect our ability to conduct operations efficiently and at cost-effective rates, which in turn could adversely affect our results of operations and financial condition.
A default by a derivatives clearinghouse on its obligations could adversely affect our results of operations or financial condition. The Dodd-Frank Act and implementing CFTC regulations require all clearable derivatives transactions to be cleared through a derivatives clearinghouse. As a result of such statutes and regulations, we are required to centralize our risk with the derivatives clearinghouses as opposed to the pre-Dodd-Frank Act methods of entering into derivatives transactions that allowed us to distribute our risk among various counterparties. A default by a derivatives clearinghouse: (1) could adversely affect our financial condition in the event the derivatives clearinghouse is unable to make payments owed to us or return our posted initial margin; (2) jeopardize the effectiveness of derivatives hedging transactions; and (3) adversely affect our operations as we may be unable to enter into certain derivatives transactions or do so at cost-effective rates.
Securities or loans pledged as collateral by our members or collateral securing mortgage loans or MBS investments could be adversely affected by the devaluation of, or inability to liquidate, the collateral in the event of a default. Although we seek to obtain sufficient collateral on our credit obligations to protect ourselves from credit losses, changes in market conditions, uninsured or underinsured natural disasters, or other factors may cause the collateral to deteriorate in value, which could lead to a credit loss in the event of a default by a member or a borrower and adversely affect our financial condition and results of operations. A reduction in liquidity in the financial markets or otherwise could have the same effect.
Our funding depends on our ability to access the capital markets. Our primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. Our ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets (including investor demand) at the time. Our counterparties in the capital markets are also subject to additional regulation following the financial crisis that ended in 2010. These regulations could alter the balance sheet composition, market activities, and behavior of our counterparties in a way that could be detrimental to our access to the capital markets and overall financial market liquidity, which could have a negative impact on our funding costs and results of operations. Further, we rely on the Office of Finance for the issuance of consolidated obligations, and a failure or interruption of services provided by the Office of Finance could hinder our ability to access the capital markets. Accordingly, we cannot make any assurance that we will be able to obtain funding on terms acceptable to us in the future, if we are able to obtain funding at all in the case of another severe financial, economic, or other disruption. If we cannot access funding when needed, our ability to support and continue our operations would be adversely affected, negatively affecting our financial condition and results of operations.
Changes in interest rates could significantly affect our earnings. Changes in interest rates that are detrimental to our investment and debt positions could negatively affect our financial condition and results of operations. Like many financial institutions, we realize income primarily from earnings on our invested capital as well as the spread between interest earned on our outstanding advances, mortgage loans, and investments and interest paid on our borrowings and other liabilities. Although we use various methods and procedures to monitor and manage our exposures to risk due to changes in interest rates, we may experience instances when 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 and extension risk, which is the risk that mortgage-related assets will be refinanced in low interest-rate environments or will remain outstanding at below-market yields when interest rates increase.
Changes to and replacement of the LIBOR benchmark interest rate could adversely affect our business, results of operations, and financial condition. In July 2017, the United Kingdom's Financial Conduct Authority announced that it plans to phase out the regulatory oversight of LIBOR interest rate indices by 2021. Other financial services regulators and industry groups are evaluating alternative interest rate indices or reference rates, but there is no definitive information regarding the future utilization of LIBOR or of any particular replacement rate. Many of our assets and liabilities are indexed to LIBOR, so the impact of such a transition could adversely affect our business, results of operations, and financial condition.
We rely on derivatives to lower our cost of funds and reduce our interest rate, option and prepayment risk, and we may not be able to enter into effective derivative instruments on acceptable terms; thus, these derivatives may adversely affect our results of operations. We use derivatives to: (1) obtain funding at more favorable rates; and (2) reduce our interest rate risk, option risk and mortgage prepayment risk. Management determines the nature and quantity of hedging transactions using derivatives based on various factors, including market conditions and the expected volume and terms of advances or other transactions. As a result, our effective use of derivatives depends on management’s ability to determine the appropriate hedging positions considering: (1) our assets and liabilities; and (2) prevailing and anticipated market conditions. In addition, the effectiveness of our hedging strategies depends on our ability to enter into derivatives with acceptable counterparties or through derivative clearinghouses, on terms desirable to us and in the quantities necessary to hedge our corresponding obligations, interest rate risk or other risks. The cost of entering into derivative instruments has increased as a result of: (1) consolidations, mergers and bankruptcy or insolvency of financial institutions, which have led to fewer counterparties, resulting in less liquidity in the derivatives market; and (2) increased uncertainty related to the potential changes in legislation and regulations regarding over-the-counter derivatives including increased margin and capital requirements, and increased regulatory costs and transaction fees associated with clearing and custodial arrangements. If we are unable to manage our hedging positions properly, or are unable to enter into derivative hedging instruments on desirable terms or at all, we may incur higher funding costs, be required to limit certain advance product offerings, and be unable to effectively manage our interest rate risk and other risks, which could negatively affect our financial condition and results of operations.
The use of derivatives also subjects us to earnings volatility caused primarily by the changes in the fair values of derivatives that do not qualify for hedge accounting and, to a lesser extent, by hedge ineffectiveness, which is the difference in the amounts recognized in our earnings for the changes in fair value of a derivative and the related hedged item. If we are unable to apply hedge accounting due to changes in standards or other changes in circumstances that impact our ability to utilize hedge accounting, the result could be an increase in the volatility of our earnings from period to period. Such increases in earnings volatility could affect our ability to pay dividends, our ability to meet our retained earnings threshold, and our members’ willingness to hold the capital stock necessary for membership and/or lending activities with us.
Lack of a public market and restrictions on transferring our stock could result in an illiquid investment for the holder. Under the GLB Act, FHFA regulations and our capital plan, our Class A Common Stock may be redeemed upon the expiration of a six-month redemption period and our Class B Common Stock after a five-year redemption period following our receipt of a redemption request. Only capital stock in excess of a member’s minimum investment requirement, capital stock held by a member that has submitted a notice to withdraw from membership, or capital stock held by a member whose membership has been terminated may be redeemed at the end of the redemption period. Further, we may elect to repurchase excess capital stock of a member at any time at our sole discretion.
We cannot guarantee, however, that we will be able to redeem capital stock even at the end of the redemption periods. The redemption or repurchase of our capital stock is prohibited by FHFA regulations and our capital plan if the redemption or repurchase of the capital stock would cause us to fail to meet our minimum regulatory capital requirements. Likewise, under such regulations and the terms of our capital plan, we could not honor a member’s capital stock redemption request if the redemption would cause the member to fail to maintain its minimum capital stock investment requirement. Moreover, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our capital plan requires our approval before a member may transfer any of its capital stock to another member, we can provide no assurance that a member would be allowed to sell or transfer any excess capital stock to another member at any point in time.
We may also suspend the redemption of capital stock if we reasonably believe that the redemption would prevent us from maintaining adequate capital against a potential risk, or would otherwise prevent us from operating in a safe and sound manner. In addition, approval from the FHFA for redemptions or repurchases is required if the FHFA or our Board of Directors were to determine that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, we cannot guarantee that the FHFA would grant such approval or, if it did, upon what terms it might do so. We may also be prohibited from repurchasing or redeeming our capital stock if the principal and interest due on any consolidated obligations that we issued through the Office of Finance has not been paid in full or if we become unable to comply with regulatory liquidity requirements to satisfy our current obligations.
Accordingly, there are a variety of circumstances that would preclude us from redeeming or repurchasing our capital stock that is held by a member. Since there is no public market for our capital stock and transfers require our approval, we cannot guarantee that a member’s purchase of our capital stock would not effectively become an illiquid investment.
We may not be able to meet our obligations as they come due or meet the credit and liquidity needs of our members in a timely and cost-effective manner. We seek to be in a position to meet our members’ credit and liquidity needs and to pay our obligations without maintaining excessive holdings of low-yielding liquid investments or being forced to incur unnecessarily high borrowing costs. In addition, in accordance with the FHFA’s requirement to maintain five calendar days of contingent liquidity, we maintain a contingency liquidity plan designed to protect against temporary disruptions in access to the FHLBank debt markets in response to a rise in capital market volatility. Our efforts to manage our liquidity position, including carrying out our contingency liquidity plan, may not enable us to meet our obligations and the credit and liquidity needs of our members, which could have an adverse effect on our net interest income, and thereby, our financial condition and results of operations.
We rely on financial models to manage our market and credit risk, to make business decisions, and for financial accounting and reporting purposes. The impact of financial models and the underlying assumptions used to value financial instruments may have an adverse impact on our financial condition and results of operations. We make significant use of financial models for managing risk. For example, we use models to measure and monitor exposures to interest rate and other market risks, including prepayment risk, as well as credit risk. We also use models in determining the fair value of financial instruments for which independent price quotations are not available or reliable. The degree of management judgment in determining the fair value of a financial instrument is dependent on 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 assumptions are based on management's best estimates for discount rates, prepayments, market volatility, and other factors. These assumptions may 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 regular validation by independent parties, rapid changes in market conditions could impact the value of our instruments. The use of different models and assumptions, as well as changes in market conditions, could impact our financial condition and results of operations.
The information provided by these models is also used in making business decisions relating to strategies, initiatives, transactions, and products, and in financial statement reporting. We have adopted policies, procedures, and controls to monitor and manage assumptions used in these models. However, models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. Changes in any models or in any of the assumptions, judgments, or estimates used in the models may cause the results generated by the model to be materially different. If the results are not reliable due to inaccurate assumptions, judgments, or estimates, we could make poor business decisions, including asset and liability management, or other decisions, which could result in an adverse financial impact. Furthermore, any strategies that we employ to attempt to manage the risks associated with the use of models may not be effective.
We rely heavily on information systems and other technology. We rely heavily on information systems and other technology to conduct and manage our business. If key technology platforms become obsolete, or if we experience disruptions, including difficulties in our ability to process transactions, our revenue and results of operations could be materially adversely affected. To the extent that we experience a failure or interruption in any of these systems or other technology, we may be unable to conduct and manage our business effectively, including, without limitation, our funding, hedging, and advance activities. Additionally, a failure in or breach of our operational or security systems or infrastructure, or those of third parties with which we do business, including as a result of cyber attacks, could disrupt our systems or data necessary for the operation of our business and/or result in the disclosure or misuse of confidential or proprietary information, or the unavailability of systems or data that are necessary for the operation of our business. While we have implemented disaster recovery, business continuity, and legacy software reduction plans, we can make no assurance that these plans will be able to prevent, timely and adequately address, or mitigate the negative effects of any such failure or interruption. A failure to maintain current technology, systems, and facilities or an operational failure or interruption could significantly harm our customer relations, risk management, and profitability, which could negatively affect our financial condition and results of operations.
Our controls and procedures may fail or be circumvented, and risk management policies and procedures may be inadequate. We may fail to identify and manage risks related to a variety of aspects of our business, including without limitation, operational risk, legal and compliance risk, human capital risk, liquidity risk, market risk, and credit risk. We have adopted controls, procedures, policies, and systems to monitor and manage these risks. Our management cannot provide complete assurance that such controls, procedures, policies, and systems are adequate to identify and manage the risks inherent in our business and because our business continues to evolve, we may fail to fully understand the implications of changes in our business, and therefore, we may fail to enhance our risk governance framework to timely or adequately address those changes. Failed or inadequate controls and risk management practices could have an adverse effect on our financial condition, results of operations or reputation.
We may be unable to attract and retain a highly qualified and diverse workforce, including key management. Our success depends on the talents and efforts of our employees, and particularly our management. We may be unable to retain key management or to attract other highly qualified employees, particularly if we do not offer employment terms that are competitive with the rest of the market. Failure to attract and retain highly qualified and diverse employees, or failure to develop and implement an adequate succession plan for key members of management, could adversely affect our financial condition and results of operations.
Reliance on FHLBank of Chicago as MPF Provider could have a negative impact on our business if FHLBank of Chicago were to default on its contractual obligations owed to us. As part of our business, we participate in the MPF Program with FHLBank of Chicago. In its role as MPF Provider, FHLBank of Chicago provides the infrastructure, operational support, and maintenance of investor relations for the MPF Program and is also responsible for publishing and maintaining the MPF Guides, which include the requirements PFIs must follow in originating or selling and servicing MPF mortgage loans. If FHLBank of Chicago changes its MPF Provider role, ceases to operate the MPF Program, or experiences a failure or interruption in its information systems and other technology, our mortgage loan assets could be adversely affected, and we could experience a related decrease in our net interest margin and profitability. In the same way, we could be adversely affected if any of FHLBank of Chicago's third-party vendors engaged in the operation of the MPF Program, or investors that purchase mortgages under the MPF Program, were to experience operational or other difficulties that prevent the fulfillment of their contractual obligations.
We face competition for loan demand, purchases of mortgage loans and access to funding, which could adversely affect our earnings. Our primary business is making advances to our members. We compete with other suppliers of wholesale funding, both secured and unsecured, including investment banks, commercial banks, and, in certain circumstances, other FHLBanks. Our members have access to alternative funding sources that may offer more favorable terms than we offer on our advances, including more flexible credit or collateral standards. In addition, many of our competitors are not subject to the same regulations that are applicable to us. This enables those competitors to offer products and terms that we are not able to offer.
The availability of alternative funding sources to our members may significantly decrease the demand for our advances. Any change we might make in pricing our advances, in order to compete more effectively with competitive funding sources, may decrease our profitability on advances. A decrease in the demand for our advances or a decrease in our profitability on advances, would negatively affect our financial condition and results of operations.
Likewise, our acquisition of mortgage loans is subject to competition. The most direct competition for purchases of mortgage loans comes from other buyers of conventional, conforming, fixed rate mortgage loans, such as Fannie Mae and Freddie Mac. Increased competition can result in the acquisition of a smaller market share of the mortgage loans available for purchase and, therefore, lower income from this business activity.
We also compete in the capital markets with Fannie Mae, Freddie Mac, and other GSEs, as well as corporate, sovereign, and supranational entities for funds raised through the issuance of consolidated obligations and other debt instruments. Our ability to obtain funds through the issuance of debt depends in part on prevailing market conditions in the capital markets (including investor demand), such as effects on the reduction in liquidity in financial markets, which are beyond our control. Accordingly, we may not be able to obtain funding on terms that are acceptable to us. Increases in the supply of competing debt products in the capital markets may, in the absence of increases in demand, result in higher debt costs to us or lesser amounts of debt issued at the same cost than otherwise would be the case. Although our supply of funds through issuance of consolidated obligations has always kept pace with our funding needs, we cannot guarantee that this will continue in the future, especially in the case of financial market disruptions when the demand for advances by our members typically increases.
Member mergers or consolidations, failures, or other changes in member business with us may adversely affect our financial condition and results of operations. The financial services industry periodically experiences consolidation, which may occur as a result of various factors including adjustments in business strategies and increasing expense and compliance burdens. If future consolidation occurs within our district, it may reduce the number of current and potential members in our district, resulting in a loss of business to us and a potential reduction in our profitability. Member failures and out-of-district consolidations also can reduce the number of current and potential members in our district. The resulting loss of business could negatively impact our financial condition and the results of operations, as well as our operations generally. If our advances are concentrated in a smaller number of members, our risk of loss resulting from a single event (such as the loss of a member’s business due to the member’s acquisition by a non-member) would become proportionately greater.
Further, while member failures may cause us to liquidate pledged collateral if the outstanding advances are not repaid, historically, failures have been resolved either through repayment directly from the FDIC or through the purchase and assumption of the advances by another surviving financial institution. Liquidation of pledged collateral by us may cause financial statement losses. Additionally, if members become financially distressed, we may, at the request of their regulators, decrease lending limits or, in certain circumstances, cease lending activities to certain members if they do not have adequate eligible collateral to support additional borrowings. If members are unable to obtain sufficient liquidity from us, that member's financial position may continue to deteriorate. This may negatively impact our reputation and, therefore, negatively impact our financial condition and results of operations.
A high proportion of advances and capital is concentrated with a few members, and a loss of, or change in business activities with, such institutions could adversely affect us. We have a high concentration of advances (see Table 27) and capital with a few institutions. A reduction in advances by such institutions, or the loss of membership by such institutions, whether through merger, consolidation, withdrawal, or other action, may result in a reduction in our total assets and a possible reduction of capital as a result of the repurchase or redemption of capital stock. The reduction in assets and capital may also reduce our net income.
Item 1B:
Item 1B: Unresolved Staff Comments
Not applicable.
Item 2:
Item 2: Properties
Construction of our new 95,000 square foot facility was completed during January 2018. We own this property and have relocated our operations to this facility located at 500 SW Wanamaker Road, Topeka, Kansas. We also maintain in Topeka a leased off-site back-up facility with approximately 3,000 square feet.
Item 3:
Item 3: Legal Proceedings
We are subject to various pending legal proceedings arising in the normal course of business. After consultation with legal counsel, management does 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. Additionally, management does not believe that we are subject to any material pending legal proceedings outside of ordinary litigation incidental to our business.
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
As a cooperative, members own almost all of our Class A Common Stock and Class B Common Stock with the remainder of the capital stock held by former members that are required to retain capital stock ownership to support outstanding advance and mortgage loan activity the former members executed while they were members. Note, however, that the portion of our capital stock subject to mandatory redemption is treated as a liability and not as capital, including the capital stock of former members. There is no public trading market for our capital stock.
All of our member directors are elected by and from the membership, and we conduct our business in advances and mortgage loan acquisitions almost exclusively with our members. Depending on the class of capital stock, it may be redeemed at par value either six months (Class A Common Stock) or five years (Class B Common Stock) after we receive a written request by a member, subject to regulatory limits and to the satisfaction of any ongoing stock investment requirements applying to the member under our capital plan. We may repurchase shares held by members in excess of the members’ required stock holdings at our discretion at any time at par value. Par value of all common stock is $100 per share. As of March 13, 2018, we had 740 stockholders of record and 2,383,024 shares of Class A Common Stock and 14,952,521 shares of Class B Common Stock outstanding, including 19,748 shares of Class A Common Stock and 32,280 shares of Class B Common Stock subject to mandatory redemption by members or former members. "Classes" of stock are not registered under the Securities Act of 1933 (as amended). The Recovery Act amended the Exchange Act to require the registration of a class of common stock of each FHLBank under Section 12(g) and for each FHLBank to maintain such registration and to be treated as an “issuer” under the Exchange Act, regardless of the number of members holding such a class of stock at any given time. Pursuant to an FHFA regulation, we voluntarily registered one of our classes of stock pursuant to Section 12(g)(1) of the Exchange Act.
We paid quarterly stock dividends during the years ended December 31, 2017 and 2016, which excludes dividends treated as interest expense for mandatorily redeemable shares. Dividends paid on capital stock are outlined in Table 7 (dollar amounts in thousands):
Table 7
The cash dividends listed are cash dividends paid for partial shares and dividends paid to former members. Stock dividends are paid in whole shares.
Excludes dividends paid on mandatorily redeemable capital stock classified as interest expense.
Dividends may be paid in cash or shares of Class B Common Stock as authorized under our capital plan and approved by our Board of Directors. FHFA regulation prohibits any FHLBank from paying a stock dividend if excess stock outstanding will exceed one percent of its total assets after payment of the stock dividend. We were able to manage our excess capital stock position in the past two years in order to pay stock dividends.
We anticipate paying a 1.25 percent dividend on Class A Common Stock and a 6.50 percent dividend on Class B Common Stock for the first quarter of 2018. Historically, dividend levels have been influenced by several factors, including: (1) an objective of moving dividend rates gradually over time; (2) an objective of having dividends reflective of the level of current short-term interest rates; and (3) an objective of managing the balance of retained earnings to appropriate levels as set forth in the retained earnings policy. See Item 1 - “Business - Capital, Capital Rules and Dividends” for more information regarding our retained earnings policy, and also see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital” for a discussion of restrictions on dividend payments in the form of capital stock.
Our retained earnings balances have been significantly above the threshold set forth in the retained earnings policy and were not a factor in determining dividend declarations in 2017 and 2016. There is a possibility that the retained earnings threshold level could change and be a greater consideration for dividend levels in the future because the threshold is a function of the size and composition of our balance sheet.
Item 6:
Item 6: Selected Financial Data
Table 8 presents Selected Financial Data for the periods indicated (dollar amounts in thousands):
Table 8
Includes trading securities, available-for-sale securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell, and Federal funds sold.
The allowance for credit losses on mortgage loans was $1,208,000, $1,674,000, $1,972,000, $4,550,000, and $6,748,000 as of December 31, 2017, 2016, 2015, 2014, and 2013, respectively.
Consolidated obligations are bonds and discount notes that we are primarily liable to repay. See Note 17 to the financial statements for a description of the total consolidated obligations of all FHLBanks for which we are jointly and severally liable.
Dividends reclassified as interest expense on mandatorily redeemable capital stock and not included as dividends recorded in accordance with GAAP were $195,000, $79,000, $39,000, $40,000, and $25,000 for the years ended December 31, 2017, 2016, 2015, 2014, and 2013, respectively.
Dividends paid in cash and stock on both classes of stock as a percentage of average capital stock eligible for dividends.
Ratio disclosed represents dividends declared and paid during the year as a percentage of net income for the period presented, although the FHFA regulation requires dividends be paid out of known income prior to declaration date.
Net interest income as a percentage of average earning assets.
GAAP capital stock, which excludes mandatorily redeemable capital stock, plus retained earnings and AOCI as a percentage of total assets.
Regulatory capital (i.e., permanent capital and Class A Common Stock) as a percentage of total assets.
Total earnings divided by fixed charges (interest expense including amortization/accretion of premiums, discounts and capitalized expenses related to indebtedness).
Item 7:
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our audited financial statements and related notes presented under Item 8 of this annual report on Form 10-K. Our MD&A includes the following sections:
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Executive Level Overview - a general description of our business and financial highlights;
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Financial Market Trends - a discussion of current trends in the financial markets and overall economic environment, including the related impact on our operations;
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Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical estimates and assumptions;
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Results of Operations - an analysis of our operating results, including disclosures about the sustainability of our earnings;
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Financial Condition - an analysis of our financial position;
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Liquidity and Capital Resources - an analysis of our cash flows and capital position;
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Risk Management - a discussion of our risk management strategies; and
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Recently Issued Accounting Standards.
Executive Level Overview
We are a regional wholesale bank that makes advances (loans) to, purchases mortgage loans from, and provides limited other financial services primarily to our members. The FHLBanks, together with the Office of Finance, a joint office of the FHLBanks, make up the FHLBank System, which consists of 11 district FHLBanks. As independent, member-owned cooperatives, the FHLBanks seek to maintain a balance between their public purpose and their ability to provide adequate returns on the capital supplied by their members. The FHLBanks are supervised and regulated by the FHFA, an independent agency in the executive branch of the U.S. government. The FHFA’s mission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.
Our primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance that facilitates the issuance and servicing of the consolidated obligations. The FHFA and the U.S. Secretary of the Treasury oversee the issuance of FHLBank debt. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally viewed the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, the FHLBanks have historically had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings, and the issuance of capital stock.
We serve eligible financial institutions in Colorado, Kansas, Nebraska, and Oklahoma (collectively, the Tenth District of the FHLBank System), who are also the member-owners of the FHLBank. Initially, a member is required to purchase shares of Class A Common Stock based on the member’s total assets subject to a per member cap of $500 thousand. Each member may be required to purchase activity-based capital stock (Class B Common Stock) as it engages in certain business activities with the FHLBank, including advances, standby letters of credit, and AMA, at levels determined by management with the Board of Director’s approval and within the ranges stipulated in the Capital Stock Plan. Currently, our capital increases when members are required to purchase additional capital stock in the form of Class B Common Stock to support an increase in their advance borrowings. In the past, capital stock also increased when members sold additional mortgage loans to us; however, members are no longer required to purchase capital stock for AMA activity, as the mortgage loans are supported by the retained earnings of the FHLBank (former members previously required to purchase AMA activity-based stock are subject to the prior requirement as long as there are UPBs outstanding). At our discretion, we may repurchase excess stock if there is a decline in a member’s advances. We believe it is important to manage our business and the associated risks so that we strive to provide franchise value by maintaining a core mission asset focus and meeting the following objectives: (1) achieve our liquidity, housing finance and community development missions by meeting member credit needs by offering advances, supporting residential mortgage lending through the MPF Program and through other products; (2) periodically repurchase excess capital stock in order to appropriately manage the size of our balance sheet; and (3) pay acceptable dividends.
Net income for the year ended December 31, 2017 was $197.2 million compared to $161.8 million for the year ended December 31, 2016. The $35.4 million increase in net income was driven primarily by fair value fluctuations on derivatives and hedging activities and trading securities, which resulted in a net increase of $31.0 million compared to the prior year period. The increase in the LIBOR swap curve between periods had a positive impact on the net interest settlements on interest rate swaps, which accounted for a large part of the net increase in unrealized gains on derivatives and hedging activities for year ended December 31, 2017 when compared to the prior year. The positive fair value fluctuations on trading securities were generally due to changes in the relative level of interest rates. Net interest income increased $12.8 million for the year ended December 31, 2017 as a result of continued growth in advances and mortgage loans, along with the corresponding increase in investments. Further, the replacement of matured and called consolidated obligations at a lower cost during the last half of 2016 partially offset the increase in the cost of debt resulting from the increase in market interest rates in 2017. Despite the increase in net interest income, net interest margin decreased slightly for the year ended December 31, 2017 due to increases in the average rate on borrowings between periods, which was largely offset by increases in the average yield on interest-earning assets between periods. Increases to net income were partially offset by increases in compensation and benefits, software expenses, and AHP funds available to members. Detailed discussion relating to the fluctuations in net gains (losses) on derivatives and hedging activities, net gains (losses) on trading securities, net interest income, and operating expenses can be found under this Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations.”
Total assets increased $2.9 billion, or 6.3 percent from December 31, 2016 to December 31, 2017, resulting primarily from continued strong demand for advances and growth in our mortgage loan portfolio, which allowed for additional growth in our investments. The average balance of advances increased by $2.1 billion, or 7.1 percent, during 2017 compared to 2016 (see Table 12 under this Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations”). We have been increasing dividends incrementally since 2014; the weighted average dividend rate increased to 5.77 percent in 2017, compared to 2.42 percent in 2013. The increase in dividends lowers the effective borrowing cost of advances, which has contributed to increased utilization of advances, especially the line of credit product, which increased $2.0 billion between December 31, 2016 and December 31, 2017. Our mortgage loan portfolio increased $0.6 billion, or 9.7 percent, from December 31, 2016 to December 31, 2017, to $7.3 billion, with recent growth attributed to the addition of high-production PFIs and program enhancements that provide PFIs with additional funding opportunities. The average balance of mortgage loans increased $0.4 billion from December 31, 2016 to December 31, 2017. We strive to maintain a ratio of average advances and average mortgage loans to average consolidated obligations (CMA ratio), based on par balances, of 70 to 80 percent, so increases in the average balance of both advances and mortgages allows for growth in non-mission assets while maintaining our desired CMA ratio. Although our investments represent non-mission assets, they are utilized to provide liquidity and primary and secondary market support for the U.S. housing securities market.
Total liabilities increased $2.3 billion, or 5.4 percent, from December 31, 2016 to December 31, 2017. This increase was attributable to a $3.8 billion increase in consolidated obligation bonds, partially offset by a $1.4 billion decrease in discount notes. Our funding mix generally is driven by asset composition, but we may also shift our debt composition as a result of market conditions that impact the cost of consolidated obligations swapped or indexed to LIBOR. Short-term advances, including line of credit advances, represent the majority of the assets funded by term discount notes. We also use term discount notes to fund overnight investments to maintain liquidity sufficient to meet the advance needs of members. During the last half of 2016, the spread to LIBOR began to improve and as a result, we began increasing our allocation of floating rate consolidated obligation bonds and decreased our allocation of discount notes. During the last half of 2017, we increased our allocation of floating rate consolidated obligation bonds to increase liquidity in response to uncertainty surrounding the pending Congressional budget resolution and debt ceiling deadline. For additional information, see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition.”
Return on average equity (ROE) increased to 8.18 percent for the year ended December 31, 2017 compared to 7.45 percent for the prior year period. The increase in net income resulted in an increase in ROE for the year ended December 31, 2017 despite the increase in average capital caused by the increase in advances.
Dividends paid to members totaled $92.0 million for the year ended December 31, 2017 compared to $78.4 million for the prior year. The dividend rate for Class A Common Stock increased to 1.25 percent from 1.00 percent for the last two quarters of 2017, and the dividend rate for Class B Common Stock increased to 6.50 percent from 6.00 percent for all of 2017. Differences in the weighted average dividend rates between the last five years are due to the difference in the mix of outstanding Class A Common Stock and Class B Common Stock between those periods and the increases in the dividend rates. Other factors impacting the outstanding stock class mix and, therefore, the average dividend rates, include weekly exchanges of excess Class B Common Stock to Class A Common Stock and periodic repurchases of excess Class A Common Stock (see “Liquidity and Capital Resources - Capital” under this Item 7 and Item 5 - “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”).
Our strategic business plan is structured in such a way that our business activities are intended to achieve our mission consistent with the FHFA’s CMA guidance. Our CMA ratio was 77 percent for 2017. We intend to manage our balance sheet with an emphasis towards maintaining a CMA ratio within the range of 70 to 80 percent during 2018. However, this ratio is dependent on several variables such as member demand for our advance and mortgage loan products, so it is possible that we will be unable to maintain this level indefinitely.
Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy.
General discussion of the level of market interest rates:
Table 9 presents selected market interest rates as of the dates or for the periods shown.
Table 9
Source is Bloomberg.
Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate obtained from Bloomberg.
During 2017, the cost of FHLBank consolidated obligations as measured by the spread to comparative U.S. Treasury rates remained relatively stable; however, the Congressional budget agreement reached in early 2018 includes an increase in spending which will be financed primarily by debt, which could increase the cost of issuing consolidated obligations. Funding spreads relative to LIBOR have been deteriorating on the short end of the curve since the beginning of 2017, while spreads on longer tenors have improved. The Federal Open Market Committee (FOMC) raised the target rate for overnight Federal funds in March, June and December of 2017, amid positive economic indicators. Many market participants are assigning a high probability of additional increases in 2018 amidst a backdrop of accelerated economic conditions. During the January 2018 meeting, the FOMC reaffirmed its plan to reinvest reduced amounts of principal payments from its holdings of GSE debt, GSE MBS, and U.S. Treasury securities. We issue debt at a spread above U.S. Treasury securities; as a result, higher interest rates increase the cost of issuing FHLBank consolidated obligations and increase the cost of advances to our members and housing associates. For further discussion, see this Item 7 - “Financial Condition - Consolidated Obligations.”
Other factors impacting FHLBank consolidated obligations:
Investors continue to view FHLBank consolidated obligations as carrying a relatively strong credit profile. Historically, our strong credit profile has resulted in steady investor demand for FHLBank discount notes and short-term bonds. Recent regulatory changes to money market funds has intensified demand for our debt. Several market events continue to have the potential to impact the demand for our consolidated obligations including geopolitical events and/or disruptions; potential policy changes under the current administration; pending regulatory changes in liquidity requirements; changes in interest rates and the shape of the yield curve as the FOMC contemplates additional increases in short-term interest rates; the replacement of LIBOR with another index; and a decline in dealer demand due to regulatory changes related to capital.
Critical Accounting Policies and Estimates
The preparation of our financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect our reported results and disclosures. Several of our accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to results. These assumptions and assessments include the following:
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Accounting related to derivatives and hedging activities;
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Fair value determinations;
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Accounting for deferred premium/discount associated with MBS; and
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Determining the adequacy of the allowance for credit losses.
Changes in any of the estimates and assumptions underlying critical accounting policies could have a material effect on our financial statements.
The accounting policies that management believes are the most critical to an understanding of our financial condition and results of operations and require complex management judgment are described below.
Accounting for Derivatives and Hedging Activities: Derivative instruments are carried at fair value on the Statements of Condition. Any change in the fair value of a derivative is recorded each period in current period earnings or other comprehensive income (OCI), depending upon whether the derivative is designated as part of a hedging relationship and, if it is, the type of hedging relationship. A majority of our derivatives are structured to offset some or all of the risk exposure inherent in our lending, mortgage purchase, investment, and funding activities. We are required to recognize unrealized gains or losses on derivative positions, regardless of whether offsetting gains or losses on the hedged assets or liabilities are recognized simultaneously. Therefore, the accounting framework introduces the potential for considerable income variability from period to period. Specifically, a mismatch can exist between the timing of income and expense recognition from assets or liabilities and the income effects of derivative instruments positioned to mitigate market risk and cash flow variability. Therefore, during periods of significant changes in interest rates and other market factors, reported earnings may exhibit considerable variability. We seek to utilize hedging techniques that are effective under the hedge accounting requirements; however, in some cases, we have elected to enter into derivatives that are economically effective at reducing risk but do not meet hedge accounting requirements, either because it was more cost effective to use a derivative hedge compared to a non-derivative hedging alternative, or because a non-derivative hedging alternative was not available. As required by FHFA regulation and our RMP, derivative instruments that do not qualify as hedging instruments may be used only if we document a non-speculative purpose at the inception of the derivative transaction.
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 financial instrument or changes in future cash flows attributable to a balance sheet financial instrument or anticipated transaction. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut hedge accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. If the hedge is not designated for shortcut hedge accounting, it is treated as a “long haul” fair value hedge, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances. If the hedge fails effectiveness testing, the hedge no longer qualifies for hedge accounting and the derivative is marked to estimated fair value through current period earnings without any offsetting change in estimated fair value related to the hedged item. We had previously discontinued using shortcut hedge accounting for derivative transactions entered into on or after July 1, 2008 but resumed using shortcut hedge accounting during the fourth quarter of 2017.
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 offsetting changes in the estimated fair values attributable to the risks being hedged in the hedged items. Hedge effectiveness testing is performed at the inception of the hedging relationship and on an ongoing basis for long haul fair value hedges. We perform testing at hedge inception based on regression analysis of the hypothetical performance of the hedging 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 employs a sample of 30 historical interest rate environments and includes an R-squared test (commonly used statistic to measure correlation of the data), a slope test, and an F-statistic test (commonly used statistic to measure how well the regression model describes the collection of data). 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, results must fall within established tolerances.
Given that a derivative qualifies for long haul fair value hedge accounting treatment, the most important element of effectiveness testing is the price sensitivity of the derivative and the hedged item in response to changes in interest rates and volatility as expressed by their effective durations. The effective duration will be influenced mostly by the final maturity and any option characteristics. In general, the shorter the effective duration, the more likely it is that effectiveness testing would fail because of the impact of the short-term LIBOR side of the interest rate swap. In this circumstance, the slope criterion is the more likely factor to cause the effectiveness test to fail.
The estimated 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 contain mutual optional termination provisions at par. Since these fair values fluctuate throughout the hedge period and eventually return to zero (derivative) or par value (hedged item) on the maturity or option exercise date, the earnings impact of fair value changes is only a timing issue for hedging relationships that remain outstanding to maturity or the call termination date.
For derivative instruments and hedged items that meet the requirements as described above, we do not anticipate any significant impact on our financial condition or operating performance. For derivative instruments where no identified hedged item qualifies for hedge accounting, changes in the market value of the derivative are reflected in income. As of December 31, 2017 and 2016, we held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio of economic derivatives consisted primarily of: (1) interest rate swaps hedging fixed rate MBS and non-MBS trading investments; (2) interest rate caps hedging adjustable rate MBS with embedded caps; and (3) interest rate swaps hedging variable rate consolidated obligation bonds. While the fair value of these derivative instruments, with no offsetting qualifying hedged item, will fluctuate with changes in interest rates and the impact on our earnings can be material, the change in fair value of trading securities being hedged by economic hedges is expected to partially offset that impact. The change in fair value of the derivatives classified as economic hedges is only partially offset by the change in the fair value of trading securities being hedged by economic hedges because the amount of economic hedges exceeds the amount of swapped trading securities and because of the relationship between mortgage rates relative to the interest rate swap curve for the swapped MBS trading securities. See Tables 61 and 62 under Item 7A
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk Management
We measure interest rate risk exposure by various methods, including the calculation of DOE and MVE in different interest rate scenarios.
Duration of Equity: DOE aggregates the estimated sensitivity of market value for each of our financial assets and liabilities to changes in interest rates. In essence, DOE indicates the sensitivity of theoretical MVE to changes in interest rates. However, MVE should not be considered indicative of our market value as a going concern or our value in a liquidation scenario. A positive DOE results when the duration of assets and designated derivatives is greater than the duration of liabilities and designated derivatives. A positive DOE generally indicates a degree of interest rate risk exposure in a rising interest rate environment. A negative DOE indicates a degree of interest rate risk exposure in a declining interest rate environment. Higher DOE numbers, whether positive or negative, indicate greater volatility of MVE in response to changing interest rates. That is, if we have a DOE of 3.0, a 100 basis point (one percent) increase in interest rates would cause our MVE to decline by approximately three percent whereas a 100 basis point decrease in interest rates would cause our MVE to increase by approximately three percent. It should be noted that a decline in MVE does not necessarily translate directly into a decline in near-term income, especially for entities that do not trade financial instruments. Changes in market value may indicate trends in income over longer periods, and knowing the sensitivity of our market value to changes in interest rates provides a measure of the interest rate risk we take.
Under the RMP approved by our Board of Directors, our DOE is generally limited to a range of ±5.0 assuming current interest rates. In addition, our DOE is generally limited to a range of ±7.0 assuming an instantaneous parallel increase or decrease in interest rates of 200 basis points. During periods of extremely low interest rates, such as the current interest rate environment, the FHFA requires that FHLBanks employ a constrained down shock analysis to limit the evolution of forward interest rates to positive non-zero values. Since our market risk model imposes a positive non-zero boundary on post-shock interest rates, no additional calculations are necessary in order to meet this FHFA requirement.
The DOE parameters established by our Board of Directors represent one way to establish general limits on the amount of interest rate risk that we find acceptable. If our DOE exceeds the policy limits established by the Board of Directors, we either: (1) take asset/liability actions to bring the DOE back within the ranges established in our RMP; or (2) review and discuss potential asset/liability management actions with the Board of Directors at the next regularly scheduled meeting that could bring the DOE back within the ranges established in the RMP and ascertain a course of action, which can include a determination that no asset/liability management actions are necessary. A determination that no asset/liability management actions are necessary can be made only if the Board of Directors agrees with management’s recommendations. All of our DOE measurements were inside Board of Director established policy limits (discussed in previous paragraph) and operating ranges (discussed in next paragraph) as of December 31, 2017. On an ongoing basis, we actively monitor portfolio relationships and overall DOE dynamics as a part of our evaluation processes for determining acceptable future asset/liability management actions.
We typically maintain DOE within the above ranges through management of the durations of our assets, liabilities and derivatives. Significant resources in terms of staffing, software and equipment are continuously devoted to assuring that the level of interest rate risk existing in our balance sheet is properly measured and limited to prudent and reasonable levels. The DOE that management and the Board of Directors consider prudent and reasonable is somewhat lower than the RMP limits mentioned above and can change depending upon market conditions and other factors. As set forth in our Risk Appetite Metrics approved by the Board of Directors, we typically manage our DOE in the current base scenario to remain in the range of ±2.5 and in the ±200 basis point interest rate shock scenarios to remain in the range of ±4.0. When DOE exceeds either the limits established by the RMP or the more narrowly-defined ranges to which we manage DOE, corrective actions taken may include: (1) the purchase of interest rate caps, interest rate floors, swaptions or other derivatives; (2) the sale of assets; and/or (3) the addition to the balance sheet of assets or liabilities having characteristics that are such that they counterbalance the excessive duration observed. For example, if our DOE has become more positive than desired due to variable rate MBS that have reached interest rate cap limits, we may purchase interest rate caps that have the effect of removing those MBS cap limits. We would be short caps in the MBS investments and long caps in the offsetting derivative positions, thus reducing our DOE. Further, if an increase in our DOE were due to the extension of mortgage loans, MBS or new advances to members, the more appropriate action would be to add new long-term liabilities, whether callable or non-callable, to the balance sheet to offset the lengthening asset position.
Table 59 presents our DOE in the base and the up and down 200 basis point interest rate shock scenarios:
Table 59
All DOE results continue to remain inside our operating range of ±2.5 in the base scenario and ±4.0 in the ±200 basis point interest rate shock scenarios. Our DOE as of December 31, 2017 decreased in the up 200 and down 200 basis point shock scenarios and increased (more negative) in the base scenario from December 31, 2016. The primary factors contributing to these net changes in duration during the period were: (1) the decrease in long-term interest rates and the relative level of mortgage rates during the period; (2) the increase in the fixed rate mortgage loan portfolio during the period, including increasing prepayment projections based on the decrease in long-term interest rates; and (3) asset/liability actions taken by management throughout the period, including the continued call and re-issuance of long-term unswapped callable consolidated obligation bonds with short lock-out periods as conditions permitted and the continued issuance of discount notes funding the growth in short-term advances.
The decrease in longer-term interest rates from December 31, 2016 generally shortens the duration profile for both the fixed rate mortgage loan portfolio and the associated unswapped callable consolidated obligation bonds funding these assets. With the increase in our mortgage loan portfolio during this period, as discussed in Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - MPF Program,” the duration profile changed as expected since a general decrease in long-term interest rates typically generates faster prepayments for both new production mortgage loans, as well as the outstanding fixed rate mortgage loan portfolio. Generally, lower interest rates indicate a relative increase in refinancing incentive for borrowers.
The fixed rate mortgage loan portfolio increased in net outstanding balance, and increased as an overall percentage of total assets, increasing from 14.7 percent of total assets as of December 31, 2016 to 15.2 percent as of December 31, 2017 as the balance sheet remained relatively stable. With this weighting increase, the mortgage loan portfolio remains a sizable portion of our balance sheet and changes occurring with this portfolio tend to be magnified in terms of DOE. Since the DOE calculation is a market value based measurement and as portfolio market values increase or decrease, they become larger or smaller contributors to the overall market value of total assets. With the mortgage loan portfolio continuing to comprise a significant percentage of overall assets, its behavior is quite visible in the duration risk profile and changes in this portfolio are typically magnified as interest rates change.
This magnification occurs when a portfolio market value weighting as a percent of the overall net market value of the balance sheet changes, causing the remaining portfolios to be a smaller or larger component of the total balance sheet composition. For example, when our advance balances increase, as they did during 2017, our mortgage loan portfolio effectively decreases as a proportion of our total assets, assuming all other asset portfolios and interest rates remain constant. This relationship then causes the duration of the mortgage loan portfolio to have a somewhat smaller contribution impact to the overall DOE since DOE is a market value weighted measurement. With the absolute growth in the mortgage loan portfolio during the period, and with the associated long-term interest rate decrease, the mortgage loan portfolio increased slightly as a percentage of the market value of the net balance sheet, causing the DOE profile to have a marginally larger impact from the mortgage loan duration profile. With these balance sheet dynamics, we continue to actively manage and monitor the contributing factors of our market risk profile, including DOE. As the relationship of the fixed rate mortgage loan assets and the associated callable liabilities vary based on market conditions, we evaluate and manage these market driven sensitivities as both portfolios change in balance level and overall proportion.
New mortgage loans were continually added to the mortgage loan portfolio to replace mortgage loans that were prepaid during the period and we continue to actively manage this ongoing growth to position the balance sheet sensitivity to perform within our established risk tolerances. To effectively manage these changes in the mortgage loan portfolio (including new production and prepaid loans) and related sensitivity to changes in market conditions, a continued calling and reissuance of unswapped callable consolidated obligation bonds with short lock-out periods (generally three months) favorably positioned us for potential declines in the interest rate environment. Generally, the call of higher rate callable bonds and reissuance of these bonds when interest rates are lower generally extends the duration profile of this portfolio as bonds are called that are in-the-money (above market rates) and subsequently reissued at lower interest rates (at market rates). This liability extension corresponds with the expected longer duration profile of the new fixed rate mortgage loans, all else being equal.
As long-term interest rates decreased during 2017, we continued to experience prepayments of the fixed rate mortgage loan portfolio. As interest rates fluctuated during the period, the short lock-out periods of the callable bonds plus some maturities of non-callable bonds provided the opportunity to refinance a measured amount of our liabilities during this period. The overall decrease in long-term interest rates caused the duration profile of the existing portfolio of unswapped callable bonds to shorten as expected. In addition, the unswapped callable bond portfolio became a slightly larger percentage of the balance sheet as the portfolio expanded during the period and based on the elevated issuance of discount notes in response to the growth in short-term advances and associated capital stock activity. The discount note portfolio level naturally diluted the percentage of outstanding unswapped callable bonds and impacts the weighting of this portfolio as an overall percentage of liabilities. As discussed previously, a portfolio weighting change can alter the impact of a portfolio's overall contribution to net DOE. While the unswapped callable bonds relative weighting led to a slightly larger contribution to DOE, the overall shortening of the absolute portfolio duration served to limit the impact of the weighting change. This liability behavior includes the inherent convexity (discussed below) profile of these portfolios and demonstrates the specific duration sensitivity to changes in interest rates in certain shock scenarios. Further discussion of the unswapped callable bond calls, maturities on non-callable bonds and reissuance of callable bonds in relation to the mortgage portfolios is discussed in Item 7 - "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Consolidated Obligations.” The combination of these factors contributed to the net DOE increase (more negative) in the base scenario.
These factors also contributed to the net DOE decrease in the up 200 basis point interest rate shock scenario. As mentioned previously, as interest rates decreased during the period and the unswapped callable bond portfolio shortened in duration in the base scenario, shocking interest rates by increasing 200 basis points generated only a marginal increase in duration shortening. In other words, while the options of the longer dated unswapped callable bonds were trending more in-the-money with the decrease in rates, shocking rates by increasing 200 basis points caused the options to be significantly out-of-the-money and quite insensitive to interest rate shocks and relates to the convexity profile mentioned below. Again, this insensitivity to interest rate shocks generates only marginal change in values causing the duration of the portfolio to be quite stable. As the mortgage loan portfolio contributed only slightly more impact in the up 200 basis point shock scenario, the overall DOE become less positive, or less asset sensitive.
In addition, we purchased $0.3 billion of variable rate multi-family GSE MBS throughout the year as allowable according to FHFA regulations. The variable rate GSE MBS purchased were without embedded interest rate caps. We also purchased $0.4 billion of fixed rate multi-family GSE MBS during the period. These fixed rate securities were effectively swapped to LIBOR and impact DOE only slightly since they are reflected as variable rate instruments and are further described in Item 7 - "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Net Gain (Loss) on Trading Securities." As mentioned previously, the addition of mortgage securities, whether fixed or variable rate, typically lengthens the duration profile of the respective portfolios and generally lengthens our DOE. The relationship of the variable rate GSE MBS/CMOs and the purchased interest rate cap portfolio provides a measured impact on the positively shocked duration results as well. We did not purchase additional interest rate caps during 2017.
We generally purchase interest rate caps to offset the impact of embedded caps in variable rate GSE MBS/CMOs in rising interest rate scenarios. As expected, these interest rate caps are a satisfactory interest rate risk hedge to rising interest rates and provide an off-setting risk response to the risk profile changes in variable rate GSE CMOs with embedded caps. We periodically assess derivative strategies to ensure that overall balance sheet risk is appropriately hedged within our established risk appetite and make adjustments to the derivative portfolio as needed. This evaluation is completed considering not only the par value of the variable rate MBS/CMO investments with embedded caps being hedged with purchased interest rate caps, but also the composition of the purchased cap portfolio and expected prepayments of the variable rate MBS/CMO investments with embedded caps. This evaluation of the relative relationship between the variable rate investment portfolio and the purchased cap portfolio continues to indicate a sufficient hedging relationship, including a convexity profile that continues to perform well within our expectations. Our purchases of interest rate caps tend to partially offset the negative convexity of our mortgage assets and the effects of any interest rate caps embedded in the variable rate MBS/CMOs.
Convexity is the measure of the exponential change in prices for a given change in interest rates; or more simply stated, it measures the rate of change in duration as interest rates change. When an instrument is negatively convex, price generally increases at a slower pace as interest rates decline. When an instrument’s convexity profile approaches zero, it simply demonstrates that the duration profile is flattening or that the duration is changing at an increasingly slower rate. When an instrument’s convexity profile moves further from zero, the duration profile is steepening and is changing in price at an increasingly faster rate. Duration is a measure of the relative risk of a financial instrument, and the more rapidly duration changes as interest rates change, the riskier the instrument. The variable rate MBS/CMOs have negative convexity as a result of the embedded caps and prepayment options. Additionally, all of our mortgage loans are fixed rate, so they have negative convexity as a result of the prepayment options. We seek to mitigate this negative convexity with purchased options that have positive convexity (interest rate caps) and callable liabilities that have negative convexity (unswapped callable bonds), which offset some or all of the negative convexity risk in our assets. With the changes in current capital market conditions, the extremely low level of interest rates and the general shape of the yield curve, all of which make it challenging to manage our market risk position, we continue to take measured asset/liability actions to stay within established policy limits.
With respect to the down instantaneous shock scenarios, the sensitivities of both the assets and liabilities are impacted to a large extent by the absolute level of rates and the positive non-zero boundary methodology as discussed previously. Since the term structure of interest rates is at or near historically low levels, an instantaneous parallel shock of down 100 basis points or 200 basis points will effectively produce a flattened term structure of interest rates near zero for much of the interest rate term structure. This flattened term structure will produce slight, if any, variations in valuations, which generate near zero duration results since the duration measurement captures the sensitivity of valuations to changes in rates. These near zero duration results should be viewed in the context of the broader risk profile of the base and positive interest rate shock scenarios to establish a sufficient vantage point for helping discern the overall sensitivity of our balance sheet and of DOE. The net DOE decrease in the down 200 basis point interest rate shock scenario during the period is generally a function of related factors noted previously, including the impact of the changing term structure of interest rates. As with all scenario changes that occurred during the period, the impact from various sensitivities was expected and discussed during our regular interest-rate risk profile review process.
As noted previously, if at any point a risk measurement nears or exceeds an operating range or policy limit established by the Board of Directors, certain actions may be implemented both by management and the Board of Directors. We typically manage a DOE measurement that exceeds the established limits with various asset/liability management actions. Whenever an established limit is exceeded the Board of Directors is advised by management and the issue is discussed at the next regularly scheduled Board of Directors’ meeting. If after discussion, the Board of Directors determines that asset/liability management action is required, management implements the Board-approved approach to address the situation. Even though all of our DOE measurements are inside management’s operating range as of December 31, 2017, active monitoring of portfolio relationships and overall DOE dynamics continues as do evaluation processes for acceptable future asset/liability management actions.
In calculating DOE, we also calculate our duration gap, which is the difference between the duration of our assets and the duration of our liabilities. Our base duration gap was -1.0 months and -0.6 months for December 31, 2017 and 2016, respectively. Again, as discussed previously, the relatively stable performance of the duration gap was primarily the result of the changes in the fixed rate mortgage loan portfolio and the associated funding decisions made by management in response to the interest rate environment. All FHLBanks are required to submit this base duration gap number to the Office of Finance as part of the quarterly reporting process created by the FHFA.
Matching the duration of assets with the duration of liabilities funding those assets is accomplished through the use of different debt maturities and embedded option characteristics, as well as the use of derivatives, primarily interest rate swaps, caps, floors and swaptions as discussed previously. Interest rate swaps increase the flexibility of our funding alternatives by providing desirable cash flows or characteristics that might not be as readily available or cost-effective if obtained in the standard GSE debt market. FHFA regulation prohibits the speculative use of derivatives, and we do not engage in derivatives trading for short-term profit. Because we do not engage in the speculative use of derivatives through trading or other activities, the primary risk posed by derivative transactions is credit risk in that a counterparty may fail to meet its contractual obligations on a transaction and thereby force us to replace the derivative at market price (see Item 7 - “Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Management - Credit Risk Management” for additional information).
As discussed earlier, the funding of mortgage loans and prepayable assets with liabilities that have similar duration or average cash flow patterns over time is our primary strategy for and means of managing the interest rate risk for these assets. To achieve the desired liability durations, we issue debt across a broad spectrum of final maturities. Because the durations of mortgage loans and other prepayable assets change as interest rates change, callable consolidated obligation bonds with similar duration characteristics, on average, are frequently issued. The duration of callable bonds shortens when interest rates decrease and lengthens when interest rates increase, allowing the duration of the debt to better match the typical duration of mortgage loans and other prepayable assets as interest rates change. In addition to actively monitoring this relationship, the funding and hedging profile and process are continually measured and reevaluated. We may also use purchased interest rate caps, floors and swaptions to manage the duration of our assets and liabilities. For example, in order to manage our interest-rate risk in rising interest rate environments, we may purchase out-of-the-money interest rate caps to help manage the duration extension of mortgage assets, especially variable rate MBS/CMOs with periodic and lifetime embedded interest rate caps. We may also purchase receive-fixed or pay-fixed swaptions (options to enter into receive-fixed rate or pay-fixed rate interest rate swaps) to manage our overall DOE in falling or rising interest rate environments, respectively. During times of falling interest rates, when mortgage assets are prepaying quickly and shortening in duration, we may also synthetically convert fixed rate debt to variable rate using interest rate swaps in order to shorten the duration of our liabilities to more closely match the shortening duration of mortgage assets. As we need to lengthen the liability duration, we terminate selected interest rate swaps to effectively extend the duration of the previously swapped debt.
Market Value of Equity: MVE is the net value of our assets and liabilities. Estimating sensitivity of MVE to changes in interest rates is another measure of interest rate risk. We generally maintain an MVE within limits specified by the Board of Directors in the RMP. The RMP measures our market value risk in terms of the MVE in relation to total regulatory capital stock outstanding (TRCS). TRCS includes all capital stock outstanding, including stock subject to mandatory redemption. As a cooperative, we believe using the TRCS results in an appropriate measure because it reflects our market value relative to the book value of our capital stock. Our RMP stipulates MVE shall not be less than: (1) 100 percent of TRCS under the base case scenario; or (2) 90 percent of TRCS under a ±200 basis point instantaneous parallel shock in interest rates. Table 60 presents MVE as a percent of TRCS. As of December 31, 2017, all scenarios are well above the specified limits and much of the relative level in the ratios during the periods covered by the table can be attributed to the relative level of the fixed rate mortgage loan market values as rates have continued to remain historically low, the general value impact of the refinancing activities of the associated unswapped callable consolidated obligation bonds and the relative level of outstanding capital.
The MVE to TRCS ratios can be greatly impacted by the level of capital outstanding based on our capital management approach. Typically, as advances increase and the associated capital level increases, the ratio will generally decline since the new advances are primarily short-term with market values at or near par. Conversely, as advance balances decrease and the capital level decreases as capital stock is repurchased, the ratio will generally increase. However, if excess capital stock is not repurchased, the capital level remains higher thereby causing a decrease in the ratio. The higher level of excess stock as of December 31, 2017 (see Table 47 under Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital”) contributed to the decrease in MVE from December 31, 2016 to December 31, 2017. These relationships primarily generate the changes in the MVE/TRCS levels and produce the changes in the ratios in all interest rate scenarios in the table below.
Table 60
Detail of Derivative Instruments by Type of Instrument by Type of Risk: Various types of derivative instruments are utilized to mitigate the interest rate risks described in the preceding sections as well as to better match the terms of assets and liabilities. We currently employ derivative instruments by designating them as either a fair value or cash flow hedge of an underlying financial instrument or a forecasted transaction or in asset/liability management (i.e., an economic hedge). An economic hedge is defined as a derivative hedging specific or non-specific underlying assets, liabilities or firm commitments that either does not qualify for hedge accounting, or for which we have not elected hedge accounting, but is an acceptable hedging strategy under our RMP. For hedging relationships that are not designated for shortcut hedge accounting, we formally assess (both at the hedge’s inception and monthly on an ongoing basis) whether the derivatives used have been highly effective in offsetting changes in the fair values or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. We typically use regression analyses or similar statistical analyses to assess the effectiveness of our long haul hedges. We determine the hedge accounting to be applied when the hedge is entered into by completing detailed documentation, which includes a checklist setting forth criteria that must be met to qualify for hedge accounting.
Tables 61 and 62 present the notional amount and fair value amount (fair value includes net accrued interest receivable or payable on the derivative) for derivative instruments by hedged item, hedging instrument, hedging objective and accounting designation (in thousands):
Table 61
Table 62
Item 8:
Item 8: Financial Statements and Supplementary Data
The following financial statements and accompanying notes, including the Report of Independent Registered Public Accounting Firm, are set forth on pages to of this Form 10-K.
Audited Financial Statements
Tables 63 and 64 present supplementary quarterly financial information (unaudited) for the years ended December 31, 2017 and 2016 (in thousands):
Table 63
Table 64
The significant fluctuations that have occurred in non-interest income (loss) are primarily the result of the recognition of net gains/losses on derivatives and hedging activities as well as the recording of fair value changes on our trading securities. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations” for additional information.
Item 9:
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There were no changes in or disagreements with our accountants on accounting and financial disclosure during the two most recent fiscal years.
Item 9A:
Item 9A: Controls and Procedures
Disclosure Controls and Procedures
Senior management is responsible for establishing and maintaining a system of disclosure controls and procedures designed to ensure that information required to be disclosed in the reports filed or submitted under the Exchange Act 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 in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our disclosure controls and procedures are designed to provide a reasonable level of assurance in achieving their desired objectives; however, in designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
Management, with the participation of the President and CEO, our principal executive officer, and Chief Financial Officer (CFO), our principal financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of December 31, 2017. Based upon that evaluation, the CEO and CFO have concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of December 31, 2017.
Management’s Report on Internal Control Over Financial Reporting
Management’s Report on Internal Control over Financial Reporting and the Report of Independent Registered Public Accounting Firm with respect to the FHLBank’s internal control over financial reporting are included under Item 8 - “Financial Statements and Supplementary Data.”
Changes in Internal Control Over Financial Reporting
There has been no change in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the last fiscal quarter of the fiscal year for which this annual report on Form 10-K is filed that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B:
Item 9B: Other Information
None.
Item 10:
Item 10: Directors, Executive Officers and Corporate Governance
Executive Officers
Table 67 sets forth certain information regarding each of our executive officers as of the date of this annual report on Form 10-K.
Table 67
No executive officer has any family relationship with any other executive officer or director. All executive officers, other than the Chief Compliance and Ethics Officer (CCEO) and General Counsel, the Chief Audit Executive, and the Chief Risk Officer (CRO), may be removed from office or discharged by the Board of Directors or the President and CEO with or without cause. The Chief Audit Executive may be removed from office, with or without cause, only with the approval of the Audit Committee. The CCEO and General Counsel and the CRO may be removed from office, with or without cause, only with the approval of the Risk Oversight Committee.
There are no arrangements or understandings between any executive officer and any other person pursuant to which the executive officer was or is to be selected as an officer of the FHLBank, including no employment agreement between any executive officer and the FHLBank.
Except as otherwise indicated below, each officer has been engaged in the principal occupation listed above for at least five years:
Mark E. Yardley became President and CEO in March 2017, after serving as Interim President and CEO starting in January 2017. From May 2010 through December 2016, he was Executive Vice President and CRO. Mr. Yardley previously served as Executive Vice President and Chief Financial Officer (CFO) from February 2005 to May 2010, First Senior Vice President and CFO from December 1999 through February 2005 and as First Senior Vice President, Director of Finance, from January 1999 to December 1999. Mr. Yardley joined the FHLBank in 1984 as Director of Internal Audit and was promoted to Assistant Vice President in 1990 and Vice President in 1991.
Patrick C. Doran became Executive Vice President, CCEO and General Counsel in December 2017. From March 2016 to December 2017, he served as Executive Vice President, Chief Compliance Officer and General Counsel, and from December 2015 to March 2016, he was Senior Vice President, General Counsel, Chief Compliance Officer and Corporate Secretary. He served as Senior Vice President, General Counsel and Corporate Secretary from May 2004 to December 2015.
Sonia R. Betsworth became Chief Administrative Officer (CAO) in March 2017, after serving as Interim Chief Administrative Officer starting in January 2017. From March 2013 through December 2016, she was Senior Vice President and Chief Credit Officer. She served as Senior Vice President, Director of Credit from July 2009 to March 2013; Senior Vice President, Director of Member Products from April 2006 through June 2009; Director of Sales, Lending and Collateral from 2002 to April 2006; and Director of Credit and Collateral from 1999 to 2002. She joined the FHLBank in 1983. Ms. Betsworth was named Assistant Vice President in 1994 and Vice President in 1998.
Denise L. Cauthon became Senior Vice President and Chief Accounting Officer in December 2010. Ms. Cauthon served as First Vice President and Chief Accounting Officer from May to December 2010, First Vice President and Controller from March 2007 to April 2010, and Vice President and Controller from January 2005 to March 2007. Ms. Cauthon joined the FHLBank in 1989 as a staff internal auditor and was promoted to Assistant Liability Manager and then Financial Reporting Accountant in 1998. Ms. Cauthon was promoted to Financial Reporting and Operations Manager in 1999 and was named Assistant Vice President in 2000. She was promoted to Assistant Controller-Financial Reporting in 2002 and became Vice President in 2004.
Joe B. Edwards became Senior Vice President and Chief Information Officer (CIO) in July 2013. Prior to joining the FHLBank in 2013, Mr. Edwards was Senior Vice President and CIO at ACE Cash Express, Inc., a multi-unit retailer of financial services, where he was responsible for IT development, operations, business intelligence and call center operations from January 1998 through his retirement in December 2012.
Dan J. Hess became Senior Vice President and Chief Business Officer in March 2013. Mr. Hess previously served as Senior Vice President, Director of Member Products from July 2009 to March 2013; First Vice President, Director of Sales from April 2002 to May 2009; and Senior Vice President, Director of Sales from May 2009 to July 2009. Mr. Hess joined the FHLBank in 1995 as a Correspondent Banking Account Manager for Kansas. He was promoted to Lending Officer in 1997, to Assistant Vice President and Lending Manager in 1999, and to Vice President in 2000.
Thomas E. Millburn became Senior Vice President, Chief Audit Executive in March 2016. Mr. Millburn previously served as Senior Vice President, Chief Internal Audit Officer from March 2011 to March 2016 and Senior Vice President, Director of Internal Audit from December 2010 to March 2011. Mr. Millburn joined the FHLBank in 1994 as a staff internal auditor and was promoted to Assistant Vice President, Director of Internal Audit in 1999, Vice President in 2000 and then to First Vice President in March 2004.
William W. Osborn became Senior Vice President and CFO in June 2010. Mr. Osborn joined the FHLBank in May 2006 as Director of Product Profitability and Pricing. He was promoted to Director of Banking Strategies in January 2008, to First Vice President in April 2008 and to Senior Vice President in April 2009.
Martin L. Schlossman, Jr. became CRO in March 2017, after serving as Interim CRO starting in January 2017. Mr. Schlossman previously served as Senior Vice President, Associate CRO from March 2012 through December 2016. He joined the FHLBank in November 2000 as an Enterprise Risk Analyst and was promoted to Planning Officer in December 2001, Assistant Vice President in March 2004, Vice President in June 2005, and First Vice President in March 2009. He was named Associate CRO in June 2010 and was promoted to Senior Vice President in March 2012.
Directors
The Bank Act (as amended by the Recovery Act) and FHFA regulations mandate that our Board of Directors consist of 13 directors or such other number as may be provided by the FHFA, a majority of whom are to be member directors and at least two-fifths of whom are to be independent directors. Due to the interplay of the “method of equal proportions,” which the FHFA uses to allocate member directorships to each state in our four-state district, the requirement that at least two-fifths of the directorate must be comprised of independent directors, and the requirement that the number of member directorships allocated to each of those four states must be at least equal to the number allocated to each state on December 31, 1960, the FHFA may require from time to time the allocation of additional member director seats. Currently our Board of Directors consists of 18 directors, 10 of whom are member directors and 8 of whom are independent directors. Under the FHFA regulations, new and re-elected directors serve four-year terms, subject to adjustment by the FHFA to establish staggering of the board. Directors cannot be elected to serve more than three consecutive full terms. A director may be re-elected to a directorship for a term that commences no earlier than two years after the expiration of the third full term. Each director must be: (1) a citizen of the United States; (2) either a resident in our district or serve as an officer or director of a member located in our district; and (3) elected by a vote of the members, in accordance with the Bank Act and FHFA regulations. Additionally, at least two of the independent directors must qualify as public interest directors. To qualify as a public interest director, an individual must have more than four years of experience in representing consumer or community interests in banking services, credit needs, housing, or consumer financial protections.
Member directorships are designated to each of the four states in our district and each of our members is entitled to nominate and vote for candidates representing the state in which the member’s principal place of business is located. To qualify as a nominee for a member directorship, a nominee must be an officer or director of a member located in the state to which the director of the FHFA has allocated the directorship, and such member must meet all minimum capital requirements established by its appropriate Federal banking agency or appropriate state regulator. Member directors are nominated by members located in the state to which the member directorship is assigned, based on a determination by the nominating institution that the nominee possesses the applicable experience, qualifications, attributes and skills to qualify the nominee to serve as an FHLBank director, without any participation from our Board of Directors. Following the nomination process, a member is entitled to cast, for each applicable member directorship, one vote for each share of capital stock that the member is required to hold, subject to a statutory limitation. Under this limitation, the total number of votes that each member may cast is limited to the average number of shares of capital stock that were required to be held by all members in that state as of the record date for voting.
Each of our member directors meets the required qualifications and, as such, each is an officer or director of a member in the respective state from which they were nominated and elected.
Independent directors are elected by ballot from among those eligible persons nominated by the Board of Directors after consultation with the Affordable Housing Advisory Council and after the nominee has been submitted to the FHFA for review. In nominating independent directors, our Board of Directors may consider an individual’s current and prior experience on the Board of Directors, the qualifications of nominees, and the skills and experience most likely to add strength to the Board of Directors, among other skills, qualifications and attributes. FHFA regulations require us to encourage the consideration of diversity in nominating or soliciting nominees for positions on our Board of Directors. Our Board of Directors will consider diversity in nominating independent directors and in electing member directors when the Board of Directors is permitted to elect member directors in the event of a vacancy. If our Board of Directors nominates only one individual for each independent directorship, then each nominee must receive at least 20 percent of the number of votes eligible to be cast in the election to be elected. If our Board of Directors nominates more persons for the type of independent directorship to be filled than there are directorships of that type to be filled in the election, then the nominee receiving the highest number of votes will be elected. Each member voting in the independent director election is entitled to cast one vote for each share of capital stock that the member is required to hold, subject to the statutory limitation discussed above. Our Board of Directors has adopted procedures for the nomination and election of independent directors, consistent with the requirements of the Bank Act and FHFA regulations.
There are no arrangements or understandings between any director and any other person pursuant to which the director was or is to be selected as a director or nominee. No director has any family relationship with any other director or executive officer. No director or executive officer of the FHLBank has been involved in any legal proceeding during the past ten years that would affect the integrity or ability of such director or nominee to serve in such capacity.
As of the date of this annual report on Form 10-K, we have 18 directors, 10 of whom are serving directorships as “member directors” (as such term is defined under the Bank Act) and 8 of whom are serving directorships as “independent directors” (as such term is also defined under the Bank Act).
On November 7, 2017, we elected Andrew C. Hove, Jr. and Richard S. Masinton as independent directors, as reported in our Current Report on Form 8-K filed with the SEC on November 7, 2017. Additionally, on September 26, 2017, we filed a Current Report on Form 8-K announcing that Mark J. O'Connor, from the state of Colorado, and Gregg L. Vandaveer, from the state of Oklahoma, were deemed elected as member directors of FHLBank’s Board of Directors. Each of the directors elected in 2017 will serve four-year terms expiring December 31, 2021.
Table 68 sets forth certain information regarding each of our directors as of the date of this annual report on Form 10-K.
Table 68
Board of Director committees are as follows: (a) Audit; (b) Compensation, Human Resources and Inclusion; (c) Executive; (d) Risk Oversight; (e) Housing and Governance; and (f) Operations.
The following describes the principal occupation, business experience, qualifications and skills, among other matters, of the 18 directors who currently serve on the Board of Directors. Except as otherwise indicated, each director has been engaged in the principal occupation described below for at least five years:
Donald R. Abernathy, Jr. has served as the President and CEO of The Bankers Bank, Oklahoma City, Oklahoma, since June 1993, and has served on the board of directors of Bankers Banc Investment Services, Inc., since December 2006. Although the Board of Directors did not participate in Mr. Abernathy's nomination since he is a member director, Mr. Abernathy possesses a Bachelors of Business Administration, has more than 38 years of banking experience, including 23 as President and CEO, and served on the board of directors of the Independent Community Bankers of America, that assists in his service as a director.
Milroy A. Alexander has been a housing, financial and business consultant since 2010, serving nonprofit housing organizations, local housing authorities and the City of Denver Housing and Neighborhood Redevelopment department. He also served his second and third terms as a director of the Municipal Securities Rulemaking Board from October 2010 through September 2012 and May 2013 through September 2013. He completed his second and final five-year term on the board of trustees of Rose Community Foundation in December 2017, and is board chair of the Lowry Redevelopment Authority. Mr. Alexander previously served as Executive Director and CEO of the Colorado Housing and Finance Authority in Denver, Colorado. The Board of Directors considered Mr. Alexander’s qualifications, skills and attributes, including his more than 21 years of service at a state HFA, including nine years as Executive Director and CEO and 12 years as CFO, his certification as a CPA, his more than 10 years as an auditor with Touche Ross & Co. (now Deloitte), his past service on the audit committees of many organizations and his ability to provide the Board of Directors with racial diversity, when making his nomination.
Robert E. Caldwell, II is the Vice Chair of our Board of Directors. Mr. Caldwell is currently Director of Corporate Development for Nebco, Inc., a supplier of materials to the construction industry to construct buildings, streets and highways, which he began in August 2014. Prior to his service at Nebco, Inc., Mr. Caldwell was the President and COO of WRK Real Estate, LLC, which he began in January 2014. He previously served as President and CEO of Hampton Enterprises, Inc., a commercial real estate development, general contracting, construction management and property management firm, since 2006, and General Counsel for Linweld, Inc., a large independent manufacturer and distributor of industrial/medical gases and welding supplies. The Board of Directors considered Mr. Caldwell’s qualifications, skills and attributes, including his B.S. in business administration, his J.D. and MBA, his experience as General Counsel for Linweld, Inc., a subsidiary of a Japanese public company, his service as President and CEO of a commercial real estate and construction company, and his prior service as an FHLBank director, when making his nomination.
G. Bridger Cox is the Chair of our Board of Directors. Mr. Cox has been Chairman and President of Citizens Bank & Trust Company, Ardmore, Oklahoma, since 1996. Although the Board of Directors did not participate in Mr. Cox’s nomination since he is a member director, Mr. Cox is a graduate of the Stonier Graduate School of Banking at Rutgers University, possesses more than 30 years of banking management experience, has served on the board of directors of the Oklahoma Industrial Finance Authority and the Oklahoma Development Finance Authority, and has prior experience as an FHLBank director, that assists in his service as a director. Prior to his current term, Mr. Cox served as a member director of the FHLBank from January 1998 through December 2006.
Holly Easterling has served the Chickasaw Nation in various roles since 1997 and presently serves as Secretary of the Department of Treasury for the Chickasaw Nation since October 2012. From October 2010 to September 2012, she served as the Administrator of Planning and Organizational Development for the Chickasaw Nation. From August 2003 to October 2010, she served as an Elected Tribal Legislator for the Pontotoc District. Ms. Easterling serves as a trustee of the Chickasaw Foundation, is a past trustee of the Ada City Schools Foundation, a current board member of the Ada Chamber of Commerce, and a current appointed commissioner of the Oklahoma Ethics Commission. The Board of Directors considered Ms. Easterling's qualifications, skills and attributes, including her role as Secretary for the Department of Treasury for the Chickasaw Nation, her experience as a CPA and at public accounting firms, her experience in and knowledge of auditing and accounting, financial management, organizational management, project development and risk management practices, and her ability to provide the Board of Directors with gender and racial diversity, when making her nomination.
Andrew C. Hove, Jr., now retired, previously served as Vice Chairman and Acting Chairman of the FDIC from 1991 to 2001, and prior to that he served as the Chairman and CEO of Minden Exchange Bank and Trust, Minden, Nebraska. Mr. Hove served on the boards of directors of NeighborWorks Lincoln from 2002 to 2016, Great Western Bank, Sioux Falls, South Dakota, from 2001 until February 2017, and Great Western Bancorp, Inc., a Delaware corporation and public company, from July 2014 until February 2017. Mr. Hove also previously served on the board of directors of Sovereign Bank, Wyomissing, Pennsylvania, a public company, until 2009. The Board of Directors considered Mr. Hove’s qualifications, skills and attributes, including his experience as Chairman and CEO of a community bank, his experience as Vice Chairman and Acting Chairman of the FDIC, his activities and affiliation with NeighborWorks Lincoln, and his prior service as an FHLBank director, when making his nomination.
Michael B. Jacobson has been Chairman, President and CEO of NebraskaLand National Bank, North Platte, Nebraska, since 1998. Although the Board of Directors did not participate in Mr. Jacobson’s nomination since he is a member director, Mr. Jacobson possesses a B.S. in agricultural economics, is a graduate of the Colorado Graduate School of Banking and possesses over 35 years of banking experience, including over 20 years as the CEO of a bank, that assists in his service as a director.
Jane C. Knight, now retired, served as Vice President of Site-based Strategies for Kansas Big Brothers Big Sisters from 2002 through 2005. Prior to that, she directed the Wichita office for Kansas Governor Bill Graves and was in charge of addressing constituent concerns, including housing issues. The Board of Directors considered Ms. Knight’s qualifications, skills and attributes, including her prior management skills, her service as Director of the Kansas Governor’s regional office, her experience with housing issues through the Governor’s office and Habitat for Humanity, her experience with not-for-profit organizations, her ability to provide the Board of Directors with gender diversity, and her prior service as an FHLBank director, when making her nomination.
Richard S. Masinton, now retired, was Executive Vice President of Quinn Capital, LLC, a private equity company in Leawood, Kansas from January 2009 through 2014. Mr. Masinton previously served as CFO, then Executive Vice President of Russell Stover Candies in Kansas City, Missouri, from 1996 until 2008. Mr. Masinton has served on the board of directors of No More Homeless Pets Kansas City, an animal welfare charity. He also sat on the boards of directors of Eco-Choice Springwater, LLC and CRB Biosoft, LLC. Mr. Masinton retired from the boards of directors of OneNeck IT Services Corp in 2008 and Enterprise Financial Services Corporation, a publicly owned bank holding company, in 2007. He has also served on the board of advisors of the University of Kansas School of Business and on an advisory board at the University of Oklahoma School of Business. The Board of Directors considered Mr. Masinton’s qualifications, skills and attributes, including his Master's Degree in Accounting, Finance and Economics, his certification as a CPA, his experience on the board of a publicly owned bank holding company, including his 7 years of experience as Chairman of the audit committee of such bank holding company, his 40 years of experience as a corporate executive, and his prior service as an FHLBank director, when making his nomination.
Neil F. M. McKay was CFO and Treasurer of Capitol Federal Savings in Topeka, Kansas, from 1994 through March 2006. Mr. McKay, now retired, has held significant executive positions in various financial institutions including Heartland Federal Savings in Ponca City, Oklahoma, and First Nationwide Bank (now part of Citibank) in San Francisco, California. He was also a CPA in public practice for 12 years. The Board of Directors considered Mr. McKay’s qualifications, skills and attributes, including his certification as a CPA, his 12 years of service as an audit manager of large, publicly traded banks, his experience as Controller of a $30 billion publicly traded bank, his experience as CFO of an $8 billion publicly traded bank, and his prior service as an FHLBank director, when making his nomination.
L. Kent Needham has served as Chairman, President and CEO of The First Security Bank, Overbrook, Kansas, since 2007. Although the Board of Directors did not participate in Mr. Needham’s nomination since he is a member director, Mr. Needham possesses an MBA, is a graduate of the Colorado Graduate School of Banking, and has over 40 years of banking experience, including more than 20 years as CEO, that assists in his service as a director.
Mark J. O’Connor currently serves as President of Investments of FirstBank Holding Company, Lakewood, Colorado, and has served as Vice President of FirstBank since 2002. Although the Board of Directors did not participate in Mr. O’Connor’s most recent nomination since he is a member director, Mr. O’Connor has more than 29 years of banking experience. He is a graduate of the Pacific Coast Banking School, currently serves as the President of Investments and Chairs the ALCO Committee of a large bank holding company and has over 15 years of investment portfolio management experience. Mr. O’Connor serves on the Foundation Board of a local university and sits on its Investment Committee. He has experience on the board, including service as chairman, of a state housing finance authority, and his prior experience as an FHLBank director assists in his service as a director.
Thomas H. Olson, Jr. has been CEO of Points West Community Bank, Windsor, Colorado, since 1998. Mr. Olson is currently also the chairman of Points West Community Bank, Windsor, Colorado, Chairman of Points West Community Bank, Sidney, Nebraska, Chairman of First Nebraska Bancs, Inc., Chairman of Bank of Estes Park, Chairman of First National Financial, Chairman of Fullerton National Bank, Chairman of Woodstock Land and Cattle, and Director of Rush Creek Land and Livestock. Although the Board of Directors did not participate in Mr. Olson's nomination since he is a member director, Mr. Olson has a B.S. in Finance and Accounting, is a graduate of the Colorado Graduate School of Banking, and has over 24 years of banking experience, including more than 19 years as CEO, that assists in his service as a director.
Donde L. Plowman serves as Executive Vice Chancellor and Chief Academic Officer at the University of Nebraska - Lincoln since January 2017. From July 2010 through December 2016, she served as the Dean of the College of Business Administration at the University of Nebraska - Lincoln. Ms. Plowman has also served on the board of directors of Ballantyne Strong, a publicly traded company, from June 2011 through May 2015, served on the board of directors of Cornerstone Bank, York, Nebraska, from 2011 to December 2016, and has served on the Board of Trustees of Bryan Health Systems from January 2012 to present. The Board of Directors considered Ms. Plowman's qualifications, skills and attributes, including her role as Dean of the College of Business Administration at the University of Nebraska - Lincoln, her M.Ed. in Higher Education, her Ph.D. in Strategic Management, her prior service on the board of directors of a publicly traded company, her experience in and knowledge of auditing and accounting, financial management, organizational management, project development, and risk management practices, and her ability to provide the Board of Directors with gender diversity, when making her nomination.
Mark W. Schifferdecker has been President and CEO of The Girard National Bank, Girard, Kansas, since 2003. Although the Board of Directors did not participate in Mr. Schifferdecker’s nomination since he is a member director, Mr. Schifferdecker has experience as a CPA, possesses more than 11 years of experience as the CEO of a community bank, served more than 10 years as an auditor with KPMG, served six years on the board of directors of the Federal Reserve Bank of Kansas City, including two years as Chairman of the Audit Committee, and served on the board of directors of Bankers’ Bank of Kansas, N.A., including one year as Chairman, that assists in his service as a director.
Bruce A. Schriefer joined Bankers’ Bank of Kansas, Wichita, Kansas, in 1996 and served as President, CEO until his retirement in February 2015. He remains a director of Bankers' Bank of Kansas and is a director of its parent BBOK Bancshares, Inc. Although the Board of Directors did not participate in Mr. Schriefer’s nomination since he is a member director, Mr. Schriefer possesses more than 40 years of experience at various levels of commercial banking, experience as a former director of the Federal Reserve Bank of Kansas City, experience on the boards of directors of various national and state trade associations, experience as a member of the FDIC Advisory Committee on Community Banking, and prior experience as an FHLBank director, that assists in his service as a director.
Douglas E. Tippens has served as Executive Vice President of BancFirst, Oklahoma City, Oklahoma, since December 2017. He served as Market President of BancFirst from November 2015 to December 2017. Before his service at BancFirst, Mr. Tippens served as President and CEO of Bank of Commerce, Yukon, Oklahoma, since 2006, and served on the board of directors of Bank of Commerce, Chelsea, Oklahoma, since 2013. Although the Board of Directors did not participate in Mr. Tippens’ nomination since he is a member director, Mr. Tippens possesses a B.S. in agriculture economics, an MBA, is a graduate of the Graduate School of Banking at the University of Wisconsin, has more than 35 years of banking experience, including nine years as president and CEO, and served on the board of directors of the Federal Reserve Bank of Kansas City, Oklahoma City Branch, that assists in his service as a director.
Gregg L. Vandaveer has served as President and CEO of Sooner State Bank, Tuttle, Oklahoma, since April 2001. Although the Board of Directors did not participate in Mr. Vandaveer's nomination since he is a member director, Mr. Vandaveer possesses a B.S. in journalism, is a graduate of the Southwest Graduate School of Banking at SMU, and has more than 36 years of banking experience, including 20 years as President and CEO, that assists in his service as a director.
Code of Ethics
We have adopted a Code of Ethics that applies to our directors, officers (including our principal executive officer, principal financial officer, principal accounting officer or controller and persons performing similar functions) and employees. Our Code of Ethics has been posted on our website at www.fhlbtopeka.com in the "Board Governance" page. We will also post on our website any amendments to, or waivers from, a provision of our Code of Ethics that applies to the principal executive officer, principal financial officer, principal accounting officer, or persons performing similar functions as required by applicable rules and regulations. Except for the documents specifically incorporated by reference into this Annual Report on Form 10-K, information contained on our website or that can be accessed through our website is not incorporated by reference into this Annual Report on Form 10-K. Reference to our website is made as an inactive textual reference. The Code of Ethics is available, in print, free of charge, upon request. Written requests may be made to the CCEO and General Counsel of the FHLBank at 500 SW Wanamaker, Topeka, Kansas, 66606.
Audit Committee Financial Expert
We have a separately-designated, standing audit committee, which consists of Mark W. Schifferdecker (chair), Milroy A. Alexander, Robert E. Caldwell, II, Holly Easterling, Michael B. Jacobson, Neil F. M. McKay, Thomas H. Olson, Jr. and Bruce A. Schriefer.
The Board of Directors has determined that each of Neil F. M. McKay and Mark W. Schifferdecker is an “audit committee financial expert” as that term is defined under SEC regulations. Mr. McKay and Mr. Schifferdecker are “independent” in accordance with the Nasdaq Independence Standards (defined under Item 13 below) for audit committee members, as those standards were applied by our Board of Directors.
The Compensation, Human Resources and Inclusion Committee Report is included following the Compensation Discussion and Analysis in Item 11
Item 11. Executive Compensation
Compensation Discussion and Analysis
Overview of Previous Year Performance and Compensation: Our overall executive compensation philosophy is to attract, retain, and motivate highly-qualified executive officers who will advance: (1) our business objectives to promote our long-term growth and profitability in accordance with achievement of our long-term strategic objectives; and (2) our mission of supporting our members’ interests.
We met or exceeded all of our short-term objectives in 2017, as discussed below. We believe FHLBank experienced strong performance against our long-term objectives as well. These objectives were designed to drive performance in key areas that align our incentive compensation with our members’ view of our performance and with our ongoing long-term financial stability.
The named executive officers in 2017 were comprised of the person who served as our President and CEO throughout 2017, the Executive Vice President and CCEO and General Counsel, the Senior Vice President and CFO, the Senior Vice President and CAO and the Senior Vice President and CIO (collectively, the Named Executive Officers).
In determining the appropriate total compensation package for our Named Executive Officers for 2017, we considered the principal objectives of our compensation program as: (1) attracting and retaining highly-qualified and talented individuals; and (2) motivating these individuals to achieve short- and long-term FHLBank-wide performance goals through incentive compensation.
In 2017, we provided competitive compensation opportunities for our Named Executive Officers based in part on adjustments to base salary and on incentive compensation achievable through our Executive Incentive Compensation Plan (EICP). The EICP provides cash-based annual incentives and deferred incentive awards, which promote the achievement of short- and long-term objectives. The achievement of both short- and long-term goals translated to incentive awards earned by our Named Executive Officers in recognition of their contribution to our overall performance and success.
Framework for Compensation Decisions: The Compensation, Human Resources and Inclusion Committee of the Board of Directors (Compensation Committee) oversees the compensation of the Named Executive Officers. The Compensation Committee’s responsibilities in 2017 included:
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Advising the Board of Directors on the establishment of appropriate compensation, incentive and benefits programs, including the recommendation of performance goals for the EICP;
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Approving the base salaries and salary adjustments of the CCEO and General Counsel, CFO, CAO, and CIO, as recommended by the CEO; and
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Recommending to the Board of Directors the base salary, including any salary adjustments, of the CEO.
Elements of Executive Compensation in 2017: To implement our compensation objectives, the elements of our 2017 compensation program for the Named Executive Officers included: (1) annual base salary; (2) annual and deferred cash incentive award opportunities under our EICP; (3) retirement and other benefits; (4) limited perquisites; and (5) potential payments upon termination or change in control.
Use of Benchmarks - We believe a key to attracting and retaining highly-qualified executive officers is the identification of the appropriate peer groups within which we compete for executive talent. We have historically recruited nationally, both within and outside of the FHLBank System, in our efforts to attract highly-qualified candidates for the Named Executive Officer positions. To ensure that we are offering and paying competitive compensation to retain our Named Executive Officers, the Board of Directors (and/or Compensation Committee) periodically retains compensation consultants to assist with comparative analyses of the Named Executive Officers’ total compensation through a review of survey data reflecting potential comparator benchmarks for total compensation. Our Compensation Committee has used such survey data as guideposts in considering and determining competitive levels of base salary and total compensation for our Named Executive Officers among other factors as described above.
In 2017, the Compensation Committee considered the competitiveness of the total compensation paid to our Named Executive Officers by reviewing comparative survey data obtained from the compensation consultant, McLagan Partners, Inc. (McLagan).
The Compensation Committee generally considers a market composite benchmark when making pay decisions regarding the Named Executive Officers. The market composite benchmark is created by McLagan pulled from a proprietary survey database and is calculated by considering three peer groups: (1) commercial banks with $20 billion or more in assets, including Federal Reserve Banks (excluding former "bulge bracket" investment banks); (2) other FHLBanks; and (3) publicly available proxy data for banks with assets between $10 billion and $20 billion. Additionally, in calculating the market composite benchmark, for the first peer group, the commercial banks, Divisional Heads are used as the relevant comparison (e.g., General Counsel) at the median. For the other FHLBanks peer group, Overall Functional Heads are used (e.g., CFO) at the median. For the third peer group, Salary Rank is used except for the CEO and CFO where the actual position is used; in addition, the low quartile is used.
The following is a list of survey participants of Commercial Banks, FHLBanks, and Fannie Mae and Freddie Mac that were included by McLagan in the 2017 FHLBank Custom Compensation Survey:
The following is a list of regional and community banks with $10 billion to $20 billion in assets, which is the peer group used for the 2017 compensation benchmarks:
The intent to remain competitive primarily with the other FHLBanks and to also consider the broader labor market of a limited group of financial services institutions reflects our belief that the knowledge and skills necessary to effectively perform our Named Executive Officers’ duties may be developed as a result of experience not only at other FHLBanks, but also at a variety of other financial services institutions. We recognize that Topeka’s geographic location may be a disadvantage in attracting executives, but generally is a positive factor in retaining executives.
Of the FHLBank-based survey data and the broader survey data utilized, the Compensation Committee considered the 25th percentile, 50th percentile (median) and 75th percentile compensation ranges for analyzing executive positions similar to those of our Named Executive Officers in considering the competitiveness of our total compensation for the Named Executive Officers. The Compensation Committee generally strives to establish annual base salary and incentive compensation opportunities for our Named Executive Officers in the median range of the survey data reviewed assuming target level performance would be achieved. The ultimate compensation determined appropriate in any given year, however, will depend on the scope of a Named Executive Officer’s responsibilities as compared to similar positions within our identified peer groups, the experience and performance of the individual Named Executive Officer, and our overall performance. Generally, the Compensation Committee and CEO recommend below median pay for poor performance and above median pay for superior performance. While survey information is one factor in setting compensation for our Named Executive Officers, we believe that surveys are not the sole governing factor and independent decisions by the Compensation Committee are necessary to make compensation consistent with our financial condition and future prospects.
Annual Base Salary - A significant element of each Named Executive Officer’s total compensation is annual base salary, which is designed to reward our Named Executive Officers for past performance and their commitment to future performance and to serve as the foundation for competitive total compensation. Adjustments to annual base salaries for the Named Executive Officers are considered annually and generally were made effective April 1st, following an analysis of our total compensation practices and the FHLBank’s performance. As of January 1, 2018, annual increases to the annual base salary of the Named Executive Officers will be effective each January 1st.
For 2017, the Compensation Committee determined that appropriate annual base salaries for each Named Executive Officer should be competitive with the salaries of comparable executive positions within financial institutions that are regarded as peers for purposes of providing guideposts for a competitive compensation analysis, as discussed in more detail previously under “Use of Benchmarks.” Adjustments to annual base salaries of the Named Executive Officers for 2017 were based on: (1) each Named Executive Officer’s scope of responsibility and accountability; (2) analysis of our comparator peer groups; (3) performance of the FHLBank based on achievement levels of FHLBank-wide goals in the prior year; (4) the perceived performance of each Named Executive Officer, as a subjective matter; and (5) other factors such as experience, time in position, general economic conditions, and labor supply and demand conditions.
A final factor that the Compensation Committee generally considers in determining base salary increases in its effort to retain our Named Executive Officers is the relative difference in compensation between the executive officers as well as the pay relationship between executive officers and other employees at the FHLBank. The Compensation Committee believes that internal pay equity provides an additional perspective to that of peer group survey compensation information. While comparisons to compensation levels of executive positions within our peer groups are the primary basis used to assess the overall competitiveness of our compensation program, we also believe that our executive compensation practices should be internally consistent and equitable.
The Compensation Committee also considered guidance and communications from FHLBank's regulator, the FHFA, in determining total compensation for the Named Executive Officers as more specifically addressed below under “FHFA Oversight.”
In 2017, the Compensation Committee and the CEO determined that, with respect to competitive pay positioning for purposes of retaining our Named Executive Officers, it was appropriate to increase the base salaries of the Named Executive Officers to maintain competitive total compensation. Consideration was also given to each Named Executive Officer’s scope of responsibility, market comparators, individual and FHLBank performance, and other factors as described above. Table 69 presents the total base salary and percentage of salary increase for the Named Executive Officers, effective January 1, 2017 for the CEO and effective April 1, 2017 for the other four Named Executive Officers:
Table 69
Salary increase recommended by the Compensation Committee and approved by the Board of Directors.
Salary increase recommended by the CEO and approved by the Compensation Committee.
Annual and Deferred Cash Incentive Awards - Effective January 1, 2012, we adopted the EICP as a cash-based annual incentive plan with a long-term deferral component that establishes individual incentive compensation award opportunities related to achievement of performance objectives during the performance periods. The EICP establishes two performance periods: (1) a Base Performance Period aligned with the calendar year; and (2) a Deferral Performance Period (or the long-term performance period), which is a three-year period commencing the calendar year following the Base Performance Period. Named Executive Officers may earn an annual cash incentive during a Base Performance Period and a deferred cash incentive during a Deferral Performance Period. For each Base Performance Period, the Board will establish a Total Base Opportunity for Named Executive Officers. The Total Base Opportunity is equal to a percentage of each Named Executive Officer’s annual base salary at the beginning of the Base Performance Period, and is composed of the Cash Incentive and the Deferred Incentive.
We believe that well-designed incentive compensation plans provide important opportunities to motivate our Named Executive Officers to accomplish financial, risk, and operational goals that promote our mission. Thus, motivating our Named Executive Officers to accomplish business and financial short- and long-term goals that promote a high level of performance for our members is a key objective of our total compensation program. Consequently, our compensation and benefits programs are designed to motivate our Named Executive Officers to engage in the behaviors and performance necessary to deliver our desired results.
To effectively motivate the Named Executive Officers to accomplish both short- and long-term goals that promote our performance, we believe that incentive awards must represent pay at risk. In other words, the administration of our incentive compensation plans must be such that awards are distributed only in exchange for accomplishing pre-established goals, recommended by the Compensation Committee and approved by the Board of Directors, and are distributed only in accordance with such achievement. In 2017, we achieved this compensation objective through attainment of objectives under our EICP.
Beginning in the fourth quarter of 2016, goal metrics, metric performance ranges and metric weights for award opportunities under the 2017 EICP were developed. The proposed performance objectives reflected the drivers of our business and mission and were based upon the Compensation Committee’s and management’s discussions with respect to our primary mission and stockholder perceptions of success. The Compensation Committee and management took steps intended to align the performance objectives to the Strategic Business Plan. The Compensation Committee reviewed and analyzed the proposed 2017 performance objectives, as appropriate, before submitting the objectives to the Board of Directors for approval in January 2017.
For the Base Performance Period of January 1, 2017 to December 31, 2017, the Board of Directors approved a Total Base Opportunity equal to a percentage of each Named Executive Officer’s annual base salary at the beginning of the Base Performance Period. Certain Named Executive Officers have a greater and more direct impact than others on the success of the FHLBank; therefore, these differences are recognized by varying the Total Base Opportunity for each Named Executive Officer. The Total Base Opportunity is the amount that may be earned for achieving performance levels under established Performance Measures and is comprised of the Cash Incentive and the Deferred Incentive. In the event the FHLBank’s performance during the Base Performance Period results in the achievement of a Total Base Opportunity that exceeds 100 percent of a Participant’s base salary at the start of the Base Performance Period, the Target Document provides that the Total Base Opportunity shall be capped at 100 percent of the Participant’s base salary in accordance with regulatory restrictions. The Deferred Incentive is 50 percent of the Total Base Opportunity, which shall be deferred for the Deferral Performance Period, which is the three-year period from January 1, 2018 to December 31, 2020, over which the FHLBank’s performance is measured based on specific parameters, and becomes payable after the end of the Deferral Performance Period, subject to review by the Director of the FHFA. The Cash Incentive is the portion of the Total Base Opportunity that is not the Deferred Incentive and becomes payable after the end of the Base Performance Period upon achievement of established Performance Measures, subject to review by the Director of the FHFA.
Awards under the EICP may be granted for achievement of Performance Measures corresponding to achievement levels, from threshold, to target, to optimum performance for each goal metric. Threshold represents the minimum achievement level; target represents the expected achievement level; and optimum represents the achievement level that substantially exceeds the target level. Awards may be earned for performance attainment within these achievement levels as a percentage of base salary that corresponds to actual performance. For performance that falls between any two levels of achievement, linear interpolation is used to ensure that the award is consistent with the level of performance achieved. Named Executive Officers may earn annual awards expressed as a percent of their base salary at the beginning of the Performance Period. Table 70 presents the Total Base Opportunity for each Named Executive Officer for each achievement level for the Base Performance Period:
Table 70
The Total Base Opportunity Goal Metrics for 2017 are described in Table 71:
Table 71
As part of evaluating our financial performance and measuring EICP performance, we begin with the components of “adjusted income” and “adjusted ROE,” non-GAAP financial measures defined in Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations.” We adjust net income reported in accordance with GAAP for the impact of: (1) AHP assessments (equivalent to an effective minimum income tax rate of 10 percent); (2) fair value changes on derivatives and hedging activities (excludes net interest settlements related to derivatives not qualifying for hedge accounting); and (3) prepayment fees on terminated advances; and (4) other items excluded because they are not considered a part of our routine operations, such as gains/losses on retirement of debt, gains/losses on mortgage loans held for sale, and gains/losses on securities. For measuring our EICP performance, we further adjust for other items excluded because they are not considered a part of our routine operations or ongoing business model, such as interest expense on mandatorily redeemable capital stock, amortization of derivative option costs and amortization/accretion of premium/discount on unswapped MBS classified as trading. This resulting EICP adjusted income, also a non-GAAP financial measure of income, is used to compute an EICP adjusted ROE that is then compared to the average overnight Federal funds effective rate with the difference referred to as EICP adjusted ROE spread.
The profit-oriented objectives of “Adjusted Return Spread on Total Regulatory Capital” and “Net Income after Capital Charge” (non-GAAP financial measures) were based on the belief that profitability is critical to the long-term viability of the organization. The “Risk Management” objectives were included in recognition of the impact that the Named Executive Officers have on management of business, compliance, credit, liquidity, market and operations risks and an effort to reward positive risk management performance as determined by the Board of Directors. We divided the risk management objectives to provide balance and focus in the amount of risk exposure we are willing to accept/retain in pursuit of stakeholder value. The “Retained Earnings” objective reflects our desire to ensure we operate from a position of capital strength and take appropriate steps to protect our members from the potential impairment of the par value of our capital stock. Finally, the performance objective for “Diversity and Inclusion” establishes our commitment to the advancement of Diversity and Inclusion awareness.
Award levels were set at threshold, target and optimum percentages of annual base salary. Table 72 sets forth the specific annual goal performance ranges and the actual achievement levels for each of our Total Base Opportunity Goal Metrics in 2017:
Table 72
As a minimum requirement to achieving this goal, FHLBank management prepared and the Board of Directors adopted a long-term Diversity and Inclusion strategic plan to incorporate cultural diversity into all of FHLBank's business activities by December 31, 2017.
As reflected in Table 72, 2017 was a strong year regarding the achievement of our EICP base opportunity performance objectives, which is indicative of FHLBank's balanced approach to profitability and risk management. We exceeded Target performance for each goal in 2017 with the exception of the Adjusted Return Spread on Total Regulatory Capital.
Table 73 provides the metric weight for each Total Base Opportunity Goal Metric as a percent of the Total Base Opportunity for each Named Executive Officer in 2017:
Table 73
Table 74 presents the base salary, aggregate goal achievement, Total Base Opportunity, Cash Incentive and Deferred Incentive for each Named Executive Officer as calculated under the EICP for the Base Performance Period of January 1, 2017 to December 31, 2017 and the Deferral Performance Period, which is the three-year period from January 1, 2018 to December 31, 2020:
Table 74
Cash Incentive is included as non-equity incentive plan compensation in Table 80 for all Named Executive Officers.
The final value of the Deferred Incentive portion of the Total Base Opportunity is measured by evaluating Performance Measures as presented in Table 75, which provides a template of how amounts will be calculated for the calendar year 2018 to calendar year 2020, as long as the minimum requirement for receiving a Final Deferred Incentive Award of having an MVE of not less than 100 percent of our TRCS outstanding, as of the last day of the Deferral Performance Period, is met:
Table 75
Total Return equals the Total Dividends, plus the Change in Retained Earnings, divided by the Average TRC over the three-year period. Total Dividends is defined as all dividends paid on all capital stock during the three-year period; Change in Retained Earnings is defined as the change in retained earnings from 12/31/2017 to 12/31/2020; and Average TRC is defined as the average daily ending balance of regulatory capital for dates starting with 01/01/2018 and ending 12/31/2020. TRC is defined as total capital stock plus retained earnings plus subordinated debt plus mandatorily redeemable capital stock. TRC will also include any additional capital from mergers that will be reported in the FHFA Call Report System (CRS) statement of condition. For performance comparison purposes, FHLBank Topeka will be ranked against the other FHLBanks, with the highest total return being the best performance, and ranking 1st out of the 11 FHLBanks.
Using amounts reported on the Trendbook Analysis from the CRS, MVE/TRC is calculated by dividing base case MVE by TRC (as defined above) calculated at the end of the Deferral Performance Period. For performance comparison purposes, FHLBank Topeka will be ranked against the other FHLBanks, with the highest MVE/TRC being the best performance, and ranking 1st out of the 11 FHLBanks.
We believe our long-term goals effectively motivate our Named Executive Officers to develop strategies and policies to achieve long-term growth and provide increased value to members while taking future risk into account.
For any Performance Period, an award will not be payable if we fail to achieve performance at or above the Performance Measure(s) set by the Compensation Committee. The Compensation Committee may, in its discretion, reduce or eliminate an award payable under the EICP under any of the following circumstances: (1) we receive a composite “4” or “5” rating in our FHFA examination in any single year in any single Base Performance Period or Deferral Performance Period; (2) the Board of Directors finds a serious, material safety or soundness problem or a serious, material risk management deficiency exists, or if: (a) operational errors or omissions result in material revisions to the financial results, information submitted to the FHFA, or to data used to determine incentive payouts; (b) submission of material information to the SEC, Office of Finance, and/or FHFA is significantly past due; or (c) we fail to make sufficient progress, as determined by the Board of Directors, in the timely remediation of significant examination, monitoring or other supervisory findings; (3) during the most recent FHFA examination, the FHFA identified an unsafe or unsound practice or condition that is material to the financial operation of the FHLBank within a Named Executive Officer’s area(s) of responsibility and such unsafe or unsound practice or condition is not subsequently resolved in favor of the FHLBank by the last day of the Base Performance Period or Deferral Performance Period; or (4) a given participant does not achieve satisfactory individual achievement levels (as determined in the sole discretion of the Compensation Committee) during the Deferral Performance Period. Additionally, Deferred Incentive awards shall be reduced by one-third for each year during the Deferral Performance Period in which we have negative net income, as defined and in accordance with GAAP. As noted above, for Deferral Performance Periods beginning 2015 and later in order for Participants to be eligible to receive a Final Deferred Incentive Award, the FHLBank must have an MVE of not less than 100 percent of FHLBank’s TRCS outstanding, as of the last day of the Deferral Performance Period.
Under the EICP Targets for the 2015-2017 Deferral Performance Period, the achievement of base award opportunities is measured over a three-year performance period. The metric weight for the 2015-2017 performance goals as a percent of the total EICP award opportunity for all Named Executive Officers and the 2015-2017 goal achievement percentage is included in Table 76:
Table 76
Based on the performance results, Table 77 presents the Final Deferred Incentive Award for the 2015-2017 Deferral Performance Period for each Named Executive Officer:
Table 77
Final Deferred Incentive Award is included as non-equity incentive plan compensation in Table 80 for all Named Executive Officers.
A Named Executive Officer, in the discretion of the Compensation Committee, may be required to forfeit an award earned under the EICP if the Named Executive Officer is: (1) terminated from employment with the FHLBank for Cause as defined under the EICP; (2) engages in competition with the FHLBank or interferes with the business relationships of the FHLBank during his or her employment or for a period of one year following his or her termination; or (3) discloses confidential information of the FHLBank.
Bonuses - On occasion, the Compensation Committee may elect to award a Named Executive Officer additional compensation in the form of a bonus in recognition of that Named Executive Officer's performance. On January 24, 2017, the Compensation Committee determined to award Mr. Doran a bonus in the amount of $50,000 for his work in overseeing and managing the FHLBank's significant legal and governance projects in 2016.
Retirement and Other Benefits - We maintain a comprehensive retirement program for our eligible employees comprised of two qualified retirement plans: (1) the Pentegra Defined Benefit Plan for Financial Institutions, a tax-qualified multiple-employer defined-benefit plan (DB Plan); and (2) the Pentegra Financial Institutions Thrift Plan, a defined contribution retirement savings plan qualified under the Internal Revenue Code (IRC) for employees of the FHLBank (DC Plan). In response to federal legislation, which imposed restrictions on the pension benefits payable to our executives, we subsequently established a third retirement plan, the Benefit Equalization Plan (BEP) in order to maintain the competitive level of our total compensation for executive officers, including the Named Executive Officers. Generally, the BEP is characterized as a non-qualified “excess benefit” plan, which restores those retirement benefits that exceed the IRC limits applicable to the qualified DB Plan and DC Plan. In this respect, the BEP is an extension of our retirement commitment to our Named Executive Officers and other eligible highly compensated employees that preserves and restores the full pension benefits that, due to IRC limitations, are not payable from the qualified pension plans.
DB Plan - Our DB Plan covers all full-time employees of the FHLBank as of January 1, 2009 who have met the eligibility requirements of: (1) attainment of age 21; (2) completion of twelve months of employment; and (3) employed by the FHLBank as of December 31, 2008, including the Named Executive Officers. Employees are not fully vested until they have completed five years of employment. The regular form of retirement benefits provides a single life annuity; a lump-sum payment or other additional payment options are also available to a limited degree for those Named Executive Officers who were employed prior to a plan change in 2003. The benefits are not subject to offset for social security or any other retirement benefits received. In 2017, four of the Named Executive Officers (the CEO, CCEO and General Counsel, CFO, and CAO) participated in the DB Plan, which required no contribution from those four Named Executive Officers.
The DB Plan provides a normal retirement benefit at or after age 65 where a Named Executive Officer participant has met the vesting requirement of completing five years of employment equal to 2.0 percent of his/her highest three-year average salary multiplied by his/her years of benefit service, up to 30 years. Two Named Executive Officer participants (Mr. Yardley and Ms. Betsworth) are eligible to receive benefits in excess of 2.0 percent because of a plan change in 2003. The amount in excess of 2.0 percent is a calculated “frozen add-on” determined at the time of the plan change. The formula for this “frozen add-on” is the old benefit formula as of August 31, 2003 minus the new benefit formula as of September 1, 2003. Earnings are defined as base salary plus overtime and bonuses, subject to an annual IRC Section 401(a)(17) limit of $270,000 on earnings for 2017. Annual benefits provided under the DB Plan also are subject to IRC limits, which vary by age and benefit option selected. The annual IRC Section 415(b)(1)(A) benefit limit is $215,000 for 2017. Benefits are payable in the event of retirement, death, disability, or termination of employment if vested. Only the portion of the benefit accrued before September 1, 2003 is payable as a lump sum to employees who have attained age 50; otherwise, benefits are paid in installments.
Early retirement benefits are payable at a reduced rate. Upon termination of employment prior to age 65, Named Executive Officer participants meeting the 5-year vesting and age 45 early retirement eligibility criteria are entitled to an early retirement benefit. Each of the Named Executive Officers is eligible for early retirement. The early retirement benefit amount is calculated by taking the normal retirement benefit amount and reducing it by 3.0 percent times the difference between the age of the early retiree and age 65. If the Named Executive Officer was employed prior to September 1, 2003 and his/her age and benefit service added together totaled 70 (Rule of 70), the normal retirement benefit amount would be reduced by 1.5 percent for each year between the age of the early retiree and age 65 for the portion of the normal retirement benefit accrued prior to September 1, 2003.
The measurement date used to determine the current year’s benefit obligation was December 31, 2017. The present value of the accrued benefit of the DB Plan, calculated through September 1, 2003, was valued at 50 percent of benefit value using the 2000 RP Mortality table (generational table for annuities) and 50 percent of benefit value using the 2000 RP Mortality table (statistical mortality table for lump sums), discounted to the current age of each Named Executive Officer at 3.60 percent interest. The present value of benefits accrued after September 1, 2003 is multiplied by a present value factor which uses the 2000 RP Mortality table (generational table for annuities) discounted to the current age of each Named Executive Officer at 3.60 percent. As of December 31, 2017, the actuary’s calculations utilized: (1) the projected unit credit valuation method; (2) the 2014 RP white collar worker annuitant tables (with Scale MP-2017); (3) an average salary increase adjustment; and (4) a 3.50 percent discount rate as the primary assumptions attributable to valuation of benefits under the DB portion of the BEP (see "BEP" below).
DC Plan - The DC Plan is a tax-qualified, defined contribution pension plan. Substantially all officers and employees of the FHLBank are covered by the plan. The FHLBank contributes a matching amount equal to a percentage of voluntary employee contributions, subject to certain limitations (see "BEP" below).
All employees who have met the eligibility requirements can choose to participate in the DC Plan. We match employee contributions based on the length of service and the amount of an employee’s contribution. These employer contributions are immediately 100 percent vested. Matching ratios for all employees, including the Named Executive Officers, under the DC Plan are as follows:
For an employee hired on or after January 1, 2009, we also make a monthly basic contribution in an amount equal to two percent of that employee's monthly eligible compensation.
BEP - The BEP is an unfunded, nonqualified supplemental executive retirement plan that permits Named Executive Officers and certain other participants in the BEP to defer compensation and to receive matching contributions and pension accruals that would otherwise have been made or accrued under the FHLBank’s DC Plan or DB Plan, as appropriate, but for the limitations imposed by the IRC. Effective January 1, 2018, the Board of Directors approved participation of the CIO in the BEP.
The BEP allows the Named Executive Officers to receive a rate of return based on our return on equity calculated for EICP purposes for the previous year. For 2017, the rate of return earned on the defined contribution portion of the BEP was 6.52 percent, which was our return on equity calculated for EICP purposes for 2016.
Named Executive Officers are at all times 100 percent vested in their defined contribution account balances of the BEP. In the event of unforeseen emergencies, they may request withdrawals equal to the lesser of the amounts necessary to meet their financial hardships or the amount of their account balances. As of December 31, 2017, each of the Named Executive Officers would be entitled to receive his or her respective balance of compensation deferred through participation under the BEP within ninety days of any such Named Executive Officer’s termination of employment due to death, disability or retirement and upon a change in control as defined in the BEP and in accordance with IRC Section 409A and applicable regulations. For each Named Executive Officer, these amounts are listed in Table 84 under the column titled “Aggregate Balance at Last FYE.”
Other benefits - We are also committed to providing competitive benefits designed to promote health and welfare for all employees (including their families), including the Named Executive Officers. We offer all employees a variety of benefits including insurance (medical, dental, vision, prescription drug, life, long-term disability and travel accident), short-term disability salary continuation, flexible spending accounts, employee assistance program and education benefits. The Named Executive Officers participate in these benefit programs on the same basis as all other eligible employees.
Perquisites - The Board of Directors views limited perquisites afforded to the Named Executive Officers as an element of the total compensation program. Any perquisites provided, however, are not intended to materially add to any Named Executive Officer’s compensation package and, as such, are provided to them primarily as a convenience associated with their respective duties and responsibilities. Examples of perquisites that were provided to the Named Executive Officers in 2017 are limited cell phone reimbursement and limited spousal travel.
Categorical types of perquisites provided to the Named Executive Officers in 2017 are presented and detailed in the All Other Compensation Table (see Table 81 under this Item 11) and are more specifically described in the case that aggregate perquisites to any single Named Executive Officer exceeded $10,000.
Potential payments upon termination or change in control
Severance Benefits - We provide severance benefits to the Named Executive Officers pursuant to our Executive Officer Severance Policy. The policy’s primary objective is to provide a level of protection to officers from loss of income during a period of unemployment. These officers are eligible to receive severance pay under the policy if we terminate the officer’s employment with or without cause, subject to certain limitations. These limitations include: (1) the officer voluntarily terminates employment, including disability or death; or (2) the officer’s employment is terminated by us for misconduct.
Provided the requirements of the policy are met and the Named Executive Officer provides us an enforceable release, Table 78 presents the term and amounts that would have been payable to the Named Executive Officer under the Named Executive Officers Severance Policy as of December 31, 2017, or other effective policy, absent a qualifying event that would result in payments under the Change in Control Plan (see "Change in Control Plan" below):
Table 78
Severance Amount equals the number of months of base salary as described under the Severance Policy.
COBRA equals the number of months of medical, dental and vision coverage cost as described under the Severance Policy.
The amounts above do not include accrued incentive plan payments as presented in the Summary Compensation Table; the aggregate balance of the DC Plan as presented in the Nonqualified Deferred Compensation Table; or the present value of accumulated benefits of the BEP as presented in the Pension Benefits Table.
Change in Control Plan - The Change in Control Plan provides that, upon both a change in control and the termination of a participant that qualifies as a Change in Control Termination, a participant will be entitled to a cash lump sum payment. A Change in Control means the occurrence of any of the following events, provided it shall not include any reorganization that is mandated by any Federal statute, rule, regulations or directive: (1) the merger, reorganization, or consolidation of FHLBank Topeka with or into another FHLBank or other entity; (2) the sale or transfer of all or substantially all of the business or assets of FHLBank Topeka to another FHLBank or other entity; (3) the purchase by FHLBank Topeka or transfer to FHLBank Topeka of substantially all of the business or assets of another FHLBank; (4) a change in the composition of the Board of Directors, as a result of one or a series of related transactions, that causes the combined number of member directors from the states of Colorado, Kansas, Nebraska and Oklahoma to cease to constitute a majority of the directors of FHLBank Topeka; or (5) the liquidation or dissolution of FHLBank Topeka. We provide for payments under a Change in Control to: (1) promote key employee loyalty and to assure continued dedication to FHLBank Topeka, notwithstanding the possibility, threat or occurrence of a Change in Control; and (2) to reduce the personal uncertainties to key employees who are vital to FHLBank Topeka's future success associated with a pending or possible Change in Control, and to encourage those key employees' continued dedication to FHLBank Topeka.
A Participant in the Change in Control Plan will receive in a cash lump sum, an amount that, when combined with any amount payable under an FHLBank severance policy, equals a compensation multiplier times the sum of: (1) the Participant’s then annualized base salary; and (2) an amount equal to the target Total Base Opportunity as reflected in FHLBank’s EICP Targets document for the year in which the change in control occurs. Participants at Tier 1 are subject to a compensation multiplier of 2.99, participants at Tier 2 are subject to a compensation multiplier of 2.0, and participants at Tier 3 are subject to a compensation multiplier of 1.0. A Participant is also eligible to receive the continuation of certain group health care benefits for a period of years equal to his or her compensation multiplier. On June 19, 2015, FHLBank’s board approved the Change in Control Plan. Subsequently on June 22, 2017, the Compensation Committee approved the following Participants in the Change in Control Plan and their effective Tiers: CEO, at Tier 1; CCEO and General Counsel, at Tier 2; and CFO and CAO at Tier 3.
Table 79 represents the elements of potential payments upon a Change in Control and the total amount that would be payable to the participating Named Executive Officers as of December 31, 2017 subject to FHLBank’s Change in Control Plan, as currently in effect:
Table 79
Compensation multiplier times the annual base salary at year end as described under the Change in Control Plan.
Compensation multiplier times target Total Base Opportunity reflected in the 2017 EICP Targets as described in under the Change in Control Plan.
COBRA equals the number of months of medical, dental and vision coverage cost as described under the Change in Control Plan.
The amounts above do not include accrued incentive plan payments as presented in the Summary Compensation Table; the aggregate balance of the DC Plan as presented in the Nonqualified Deferred Compensation Table; or the present value of accumulated benefits of the BEP as presented in the Pension Benefits Table.
Why We Choose to Pay These Elements: We believe the Compensation Committee’s analyses described above provided an appropriate process to determine 2017 compensation levels for each Named Executive Officer that reasonably positions us to competitively manage our operations for success and to accomplish our mission.
The mix of compensation elements that comprised the total compensation of our Named Executive Officers in 2017 particularly allowed us to provide total compensation that we believe appropriately balanced reasonable guaranteed pay through carefully considered base salary determinations with additional at-risk cash compensation opportunities for the Named Executive Officers. This means that while we strived to match an appropriate level of compensation comparable to that reflected by our perceived peer groups and internal pay analysis through annual base salary and retirement benefits components, we also strived to provide a component of compensation that is at-risk in both the shorter term and the longer term. These at-risk awards represent an opportunity to reward our Named Executive Officers based on the achievement of both our annual and long-term performance goals and the discretion vested in our Compensation Committee.
FHFA Oversight: Section 1113 of the Recovery Act requires that the Director of the FHFA prevent 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 2009, the FHFA issued an advisory bulletin establishing certain principles for executive compensation at the FHLBanks and the Office of Finance that include: (1) such compensation must be reasonable and comparable to that offered to executives in similar positions at comparable financial institutions; (2) such compensation should be consistent with sound risk management and preservation of the par value of FHLBank capital stock; (3) a significant percentage of an executive’s incentive based compensation should be tied to longer-term performance and outcome-indicators and be deferred and made contingent upon performance over several years; and (4) the Board of Directors should promote accountability and transparency in the process of setting compensation. On January 28, 2014, the FHFA issued a final rule on executive compensation, which defines “reasonable” and “comparable” compensation and establishes the review and approval process for certain compensation payments and agreements.
The FHLBanks have been directed to provide all compensation actions affecting their Named Executive Officers to the FHFA for review.
Compensation, Human Resources and Inclusion Committee Report: The Compensation, Human Resources and Inclusion Committee of our Board of Directors has reviewed and discussed the Compensation Discussion and Analysis with management. Based on its review and discussions with management, the Compensation, Human Resources and Inclusion Committee has recommended to the Board of Directors that the Compensation Discussion and Analysis be included in our annual report on Form 10-K.
The Compensation, Human Resources and Inclusion Committee
of the Board of Directors
Richard S. Masinton, Chair
Milroy A. Alexander
Robert E. Caldwell, II
G. Bridger Cox
Donde L. Plowman
Mark W. Schifferdecker
Bruce A. Schriefer
Douglas E. Tippens
Table 80 presents the Summary Compensation Table for the Named Executive Officers.
Table 80
All compensation reported under “non-equity incentive plan compensation” represents performance awards earned pursuant to achievement of performance objectives under the FHLBank’s EICP.
The change in pension value will fluctuate with changes in discount rates used to calculate the present value of accumulated benefits and can result in decreases. However, per SEC rules, any net actuarial decreases in pension plan values have been excluded from this column. Nonqualified deferred compensation earnings include above market earnings attributable to the BEP, which are calculated by multiplying the nonqualified deferred compensation balance as of January 1 of the applicable year by the average rate of return in excess of the long-term applicable Federal rate (120 percent compounded quarterly) published by the IRS.
The 2017 components of All Other Compensation are provided in Table 81.
Above market earnings attributable to the BEP for Mr. Yardley were $36,561, $28,745, and $30,175 for 2017, 2016, and 2015, respectively. The aggregate change in the value of Mr. Yardley’s accumulated benefit under the FHLBank’s DB Plan was $264,000, $155,000, and $30,000 for 2017, 2016, and 2015, respectively. The aggregate change in the value of his accumulated benefit under the defined benefit portion of the BEP was $997,000, $21,000, and $(16,000) for 2017, 2016, and 2015, respectively.
Above market earnings attributable to the BEP for Mr. Doran were $6,590, $4,310, and $4,565 for 2017, 2016, and 2015, respectively. The aggregate change in the value of Mr. Doran’s accumulated benefit under the FHLBank’s DB Plan was $157,000, $97,000, and $34,000 for 2017, 2016, and 2015, respectively. The aggregate change in the value of his accumulated benefit under the defined benefit portion of the BEP was $161,000, $73,000, and $25,000 in 2017, 2016, and 2015, respectively.
Above market earnings attributable to the BEP for Mr. Osborn were $542, $0, and $241 for 2017, 2016, and 2015, respectively. The aggregate change in the value of Mr. Osborn's accumulated benefit under the FHLBank’s DB Plan was $132,000, $78,000 and $26,000 for 2017, 2016, and 2015, respectively. The aggregate change in the value of his accumulated benefit under the defined benefit portion of the BEP was $119,000, $61,000 and $28,000 for 2017, 2016, and 2015, respectively.
Above market earnings attributable to the BEP for Ms. Betsworth were $7,768 for 2017. The aggregate change in the value of Ms. Betsworth's accumulated benefit under the FHLBank’s DB Plan was $280,000 for 2017. The aggregate change in the value of her accumulated benefit under the defined benefit portion of the BEP was $238,000 in 2017.
Mr. Edwards was not a participant in the BEP during 2017.
Table 81 presents the components of “All Other Compensation” for 2017 as summarized in Table 80.
Table 81
Perquisites and personal benefits are only included if more than $10,000 in aggregate for an individual. Mr. Yardley's perquisites and personal benefits consist of professional and tax fee reimbursement, cellular phone reimbursement and expenses for spousal travel.
Table 82 presents the Grants of Plan Based Awards Table for the Named Executive Officers.
Table 82
Amounts reflected for the EICP represent the applicable range of estimated future payouts and do not represent amounts actually earned or awarded for the fiscal year ended December 31, 2017. Award amounts are calculated using the base salaries in effect on January 1 at the beginning of the performance period. The EICP-Cash Incentive, if any, are earned and vested at year end. Awards, if any, under the EICP-Deferred Incentive Opportunity are payable in the year following the end of the three-year performance period. See discussion under Annual and Deferred Cash Incentive Awards under this Item 11 for a description of the terms of the EICP and future payouts.
The final value of the EICP-Deferred Incentive Opportunity may be $0 if threshold metrics are not met, 75 percent of initial deferral at threshold, 100 percent at target and 125 percent at optimum.
Pension Benefits: Table 83 presents the 2017 Pension Benefits Table for the participating Named Executive Officers.
Table 83
Deferred Compensation: Table 84 presents the 2017 Nonqualified Deferred Compensation Table for the participating Named Executive Officers. Our fiscal year (FY) is 2017, with a fiscal year end (FYE) of December 31, 2017.
Table 84
All amounts are also included in the salary column of Table 80.
The total amount reported as preferential (above market) earnings in the aggregate balance at last FYE reported as compensation to each Named Executive Officer in the Executive Group in our Summary Compensation Tables for previous years (2006-2016) was $164,565 for Mr. Yardley, $23,622 for Mr. Doran, $783 for Mr. Osborn, and $9,065 for Ms. Betsworth. The amounts reported as preferential (above market) earnings for the current year are presented in Table 80.
CEO Pay Ratio: As required by Section 953(b) of the Dodd-Frank Act and Item 402(u) of Regulation S-K, we are providing the following information about the relationship of the median of the annual Total Compensation of all our employees except our CEO, who is our principal executive officer (the "Median Employee"), and the annual total compensation of Mr. Yardley, our CEO. We identified the Median Employee by comparing the 2017 compensation (i.e., 2017 annual salary and incentive earned for 2016 paid in 2017) for each of the employees who were employed by the FHLBank on October 1, 2017, and ranking all 235 employees by that consistently applied compensation measure from lowest to highest, excluding the CEO. We next identified the initial median employee based on that calculation, and identified the five employees with 2017 compensation higher than that initial median employee and the five employees with 2017 compensation lower than that initial median employee, constituting a total pool of 11 employees (the "Identified Pool"). We then calculated the 2017 Total Compensation for each employee in the Identified Pool for 2017 in the same manner “Total Compensation” for 2017 is shown for our CEO in the Summary Compensation Table (see Table 80), which includes among other things, amounts attributable to the change in pension value, which will vary among employees based upon their tenure at the FHLBank. We ranked the 2017 Total Compensation for each employee in the Identified Pool from lowest to highest, and the median employee from the Identified Pool based on 2017 Total Compensation was identified as our Median Employee. The employees in the calculation included all full-time and part-time employees, and we annualized all such employees who were not employed by us for all of 2017.
For the year ended December 31, 2017, the ratio of our CEO’s Total Compensation to the Total Compensation of our Median Employee was approximately 21:1. For the year ended December 31, 2017, the Total Compensation of the CEO, as reported in the Summary Compensation Table, was $2,262,054, and the Total Compensation of the Median Employee was $106,947. As a result of our methodology for determining the pay ratio, the estimated pay ratio reported above may not be comparable to the pay ratio of other companies in our industry or in other industries because other companies may rely on different methodologies or assumptions to determine an estimate of their pay ratio, or may make adjustments that we do not make. In addition, no two companies have identical employee populations or compensation programs. As such, our pay ratio should not be used as a basis for comparison between companies.
Director Compensation: Table 85 presents the Director Compensation Table for our 2017 Board of Directors.
Table 85
Director Fees - The Board of Directors establishes on an annual basis a Board of Directors Compensation Policy governing compensation for Board meeting attendance. Our 2017 Board of Directors Compensation Policy (2017 Policy) was adopted October 28, 2016 and became effective January 1, 2017. This policy was established in accordance with the Bank Act and FHFA regulations that were amended in 2008 to remove the statutory cap on director compensation. The applicable statutes and regulations allow each FHLBank to pay its directors reasonable compensation and expenses, subject to the authority of the Director of the FHFA to object to, and to prohibit prospectively, compensation and/or expenses that the Director of the FHFA determines are not reasonable. In order to compensate them for their time while serving as directors, our 2017 Policy provided that each director shall be paid one-fourth of his or her maximum annual compensation provided for in the policy following the end of each calendar quarter. The quarterly payment can be reduced for reasons specified in the policy.
In determining reasonable compensation for our directors, we participated in an FHLBank System review of director compensation, which included a study prepared by McLagan. FHLBank director compensation that was established by the Board under the 2017 Policy reflected this analysis. The 2017 Policy established annual compensation limits of $130,000 for the Chairman, $110,000 for the Vice-Chairman and Committee Chairs and $100,000 for all other directors. Additionally, an individual serving as a Vice Chair of the Board was also entitled to an increase of $5,000 in his or her Maximum Annual Compensation in the event the individual served as both Vice Chair of the Board and a Committee Chair.
The Board of Directors adopted a 2018 Board of Directors Compensation Policy (2018 Policy) governing compensation for board meeting attendance on October 27, 2017. The 2018 Policy is similar to the 2017 Policy, except that the 2018 Policy reflects increases in the established annual compensation limits to $133,750 for the Chairman, $113,750 for the Vice-Chairman and Committee Chairs and $103,750 for all other directors. Additionally, an individual serving as a Vice Chair of the Board shall be entitled to an increase of $5,000 in his or her Maximum Annual Compensation in the event the individual serves as both Vice Chair of the Board and a Committee Chair. In addition to the Maximum Annual Compensation reflected in the policy, a director may also realize the benefit of reasonable spousal or guest travel expenses that qualify as perquisites as set forth in the Directors and Executive Officers Travel Policy, for one meeting per calendar year, as designated by the Chair of the Board of Directors. The Board of Directors also adopted revisions to the BEP effective January 1, 2018, discussed above and as disclosed in the Form 8-K filed on February 5, 2018, which allows Directors the opportunity to defer Director compensation, up to 100 percent.
Director Expenses - Directors are also reimbursed for all necessary and reasonable travel, subsistence and other related expenses incurred in connection with the performance of their duties. For expense reimbursement purposes, directors’ official duties can include:
▪
Meetings of the Board and Board Committees;
▪
Meetings requested by the FHFA;
▪
Meetings of FHLBank System committees;
▪
FHLBank System director meetings;
▪
Meetings of the Council of Federal Home Loan Banks and Council committees; and
▪
Attendance at other events on behalf of the FHLBank.
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. A majority of our directors are elected from our membership. One of the voting rights of members is for the election of member and independent directors. Each member is eligible to vote for those open member director seats in the state in which its principal place of business is located and for all open independent director seats, which are elected by members of the entire FHLBank district. Membership is voluntary; however, members must give notice of their intent to withdraw from membership. A member that withdraws from membership may not be readmitted to membership for five years after the date upon which its required membership stock (Class A Common Stock) is redeemed by us.
Management cannot legally and, therefore, does not, own our capital stock. We do not offer any compensation plan to our employees under which equity securities of the FHLBank are authorized for issuance.
Table 86 presents information on member institutions holding five percent or more of the total outstanding capital stock, which includes mandatorily redeemable capital stock, of the FHLBank as of March 13, 2018. Of these stockholders, no affiliated officer or director currently serves on our Board of Directors.
Table 86
Additionally, because of the fact that a majority of our Board of Directors is nominated and elected from our membership (“member directors”), these member directors are officers or directors of member institutions that own our capital stock. Table 87 presents total outstanding capital stock, which includes mandatorily redeemable capital stock, held as of March 13, 2018, for member institutions whose affiliated officers or directors served as our directors as of March 13, 2018:
Table 87
Item 13:
Item 13: Certain Relationships and Related Transactions, and Director Independence
Certain Relationships and Related Transactions
Since we are a cooperative, ownership of our capital stock is a prerequisite for our members to transact business with us. In recognition of this organizational structure, the SEC granted us an accommodation pursuant to a “no action letter,” dated May 23, 2006, which relieves us from the requirement to make disclosures under Item 404(a) of Regulation S-K for transactions with related persons, such as our members and directors, which occur in the ordinary course of business. Further, the Recovery Act codified this accommodation.
Members with beneficial ownership of more than five percent of our total outstanding capital stock and all of our directors are classified as related persons under SEC regulations. Transactions with members deemed related persons of the FHLBank occur in the ordinary course of our business since we conduct our advance and mortgage loan business almost exclusively with our members. Our member directors are officers or directors of members that own our capital stock and conduct business with us.
Information with respect to the directors who are officers or directors of our members is set forth under Item 10 - “Directors, Executive Officers and Corporate Governance - Directors.” Additional information regarding members that are beneficial owners of more than five percent of our total outstanding capital stock is provided in Item 12 - “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
See Item 11 - "Executive Compensation" for a discussion of the compensation of our Named Executive Officers and directors.
We have a written “Related Person Transactions Policy” (Policy) that provides for the review and approval or ratification by our Audit Committee of any transaction with a related person that is outside the ordinary course of business. Under the Policy, transactions with related persons that are in the ordinary course of business are deemed pre-approved.
A “Related Person” under the Policy is:
▪
Any person who is, or at any time since the beginning of our last fiscal year was, a director or an executive officer of the FHLBank;
▪
Any immediate family member of any of the foregoing persons and any person (other than a tenant or employee) sharing the household of such director or executive officer;
▪
Any firm, corporation, or other entity in which any of the foregoing persons is an executive officer, a general partner or principal or in a similar position; or
▪
Any member institution (or successor) of the FHLBank that is known to be the beneficial owner of more than five percent of our voting securities.
“Ordinary course of business” is defined in the Policy as activities conducted with members, including but not limited to providing our products and services to the extent such product and service transactions are conducted on terms no more favorable than the terms of comparable transactions with similarly situated members or housing associates, as applicable, or transactions between the FHLBank and a Related Person where the rates and charges involved in the transactions are subject to competitive bidding. Our products and services include: (1) credit products (i.e., line of credit, advances, forward settling advance commitments, letters of credit, standby credit facility and derivative transactions); (2) MPF Program mortgage loan products; (3) housing and CDP products; and (4) other services (i.e., deposit accounts, wire transfer services, safekeeping services, consolidated obligation direct placement and unsecured credit transactions permissible under the RMP).
Transactions outside the ordinary course of business, with Related Persons that have a direct or indirect material interest, and exceed $120,000 are subject to Audit Committee review and approval under the Policy and include situations in which: (1) we obtain products or services from a Related Person of a nature, quantity or quality, or on terms that are not readily available from alternative sources; (2) we provide products or services to a Related Person on terms not comparable to those provided to unrelated parties; or (3) the rates or charges involved in the transactions are not subject to competitive bidding.
Director Independence
Board Operating Guidelines and Nasdaq Standards: The Board Operating Guidelines of the FHLBank (Guidelines), available at www.fhlbtopeka.com, require that the Board of Directors make an annual affirmative determination as to the independence of each director, as that term is defined by Rule 5605(a)(2) of the Nasdaq Marketplace Rules (the “Nasdaq Independence Standards”).
The Board of Directors has affirmatively determined that each one of its directors, both independent and member directors (each of whom is listed in Item 10 of this Form 10-K), is independent in accordance with the Nasdaq Independence Standards.
In order to assist the Board of Directors in making an affirmative determination of each director’s independence under the Nasdaq Independence Standards, the Board of Directors: (1) applied categorical standards for independence contained in the Guidelines and under the Nasdaq Independence Standards; (2) determined subjectively the independence of each director; and (3) considered the recommendation of the Audit Committee following its assessment of the independence of each director. The Board of Directors’ determination of independence under the Nasdaq Independence Standards rested upon a finding that each director has no relationship which, in the opinion of the Board of Directors, would interfere with that director’s exercise of independent judgment in carrying out the responsibilities of the director. Since under FHFA regulations, each independent director must be a bona fide resident of our district, and each member director must be an officer or director of one of our members, the Board of Directors included in its consideration whether any of these relationships would interfere with the exercise of independent judgment of a particular director.
Committee Independence
Audit Committee: In addition to the Nasdaq Independence Standards for committee members, our Audit Committee members are subject to the independence standards of the FHFA. FHFA regulations state that a director will be considered sufficiently independent to serve as an Audit Committee member if that director does not have a disqualifying relationship with the FHLBank or its management that would interfere with the exercise of that director’s independent judgment. Disqualifying relationships include but are not limited to:
▪
Being employed by the FHLBank in the current year or any of the past five years;
▪
Accepting compensation from the FHLBank other than compensation for service as a director;
▪
Serving or having served in any of the past five years as a consultant, advisor, promoter, underwriter, or legal counsel of the FHLBank; or
▪
Being an immediate family member of an individual who is, or has been in any of the past five years, employed by the FHLBank as an executive officer.
In addition to the independence standards for Audit Committee members required under the FHFA regulations, Section 10A(m) of the Exchange Act sets forth the independence requirements of directors serving on the Audit Committee of a listed company under the Exchange Act. Under Section 10A(m), in order to be considered independent, a member of the Audit Committee may not, other than in his or her capacity as a member of the Board of Directors or any other Board Committee: (1) accept any consulting, advisory, or other compensation from the FHLBank; or (2) be an affiliated person of the FHLBank.
All members of our Audit Committee were independent under the FHFA’s audit committee independence criteria and under the independence criteria of Section 10A(m) of the Exchange Act throughout the period covered by this annual report.
The FHFA’s criteria for audit committee independence are posted on the corporate governance page of our website at www.fhlbtopeka.com. Except for the documents specifically incorporated by reference into this Annual Report on Form 10-K, information contained on our website or that can be accessed through our website is not incorporated by reference into this Annual Report on Form 10-K. Reference to our website is made as an inactive textual reference.
Compensation, Human Resources and Inclusion Committee: FHLBank’s Board of Directors has established a Compensation, Human Resources and Inclusion committee. Under NASDAQ rules, in order to be considered an independent Compensation committee member, the Board of Directors must affirmatively determine the independence of each director on the Compensation committee and must consider all factors specifically relevant to determine whether a director has a relationship to FHLBank which is material to that director’s ability to be independent from management in connection with the duties of a Compensation committee member, including the source of the compensation of the director and whether the director is affiliated with FHLBank. The Board of Directors has affirmatively determined that each member of the Compensation, Human Resources and Inclusion committee is independent in accordance with the NASDAQ Independence Standards for Compensation committee members.
Item 14:
Item 14: Principal Accounting Fees and Services
Prior to approving PricewaterhouseCoopers LLP as our independent accountants for 2017, the Audit Committee considered whether PricewaterhouseCoopers LLP’s provision of services other than audit services is compatible with maintaining the accountants’ independence. The Audit Committee’s policy is to pre-approve all audit, audit-related, and permissible non-audit services provided by our independent accountants. The Audit Committee pre-approved all such services provided by the independent accountants during 2017 and 2016. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services and is generally subject to a specific budget. The independent accountants and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent accountants in accordance with its pre-approval and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.
Table 88 sets forth the aggregate fees we were billed for the years ended December 31, 2017 and 2016 by our external accounting firm, PricewaterhouseCoopers LLP (in thousands):
Table 88
Audit fees during the years ended December 31, 2017 and 2016 were for professional services rendered for the audits of our annual financial statements and review of financial statements included in our annual reports on Form 10-K and quarterly reports on Form 10-Q.
Audit-related fees during the years ended December 31, 2017 and 2016 were for discussions regarding miscellaneous accounting-related matters.
We are assessed our proportionate share of the costs of operating the Office of Finance, which includes the expenses associated with the annual audits of the combined financial statements of the 11 FHLBanks. The audit fees for the combined financial statements are billed directly by PricewaterhouseCoopers LLP to the Office of Finance and we are assessed our proportionate share of these expenses. In 2017 and 2016, we were assessed $30,000 and $31,000, respectively, for the costs associated with PricewaterhouseCoopers LLP’s audits of the combined financial statements for those years. These assessments are not included in the table above.
We are exempt from all federal, state and local taxation, with the exception of real property tax. Therefore, no tax consultation fees were paid during the years ended December 31, 2017 and 2016.
All other fees during the year ended December 31, 2016 were for consulting fees related to a private health care exchange feasibility study on behalf of all FHLBanks.
PART IV
Item 15:
Item 15: Exhibits, Financial Statement Schedules
a)
The financial statements included as part of this Form 10-K are identified in the index to Audited Financial Statements appearing in Item 8 of this Form 10-K and which index is incorporated in this Item 15 by reference.
b)
Exhibits.
We have incorporated by reference certain exhibits as specified below pursuant to Rule 12b-32 under the Exchange Act.
*
Represents a management contract or a compensatory plan or arrangement.
**
The financial information contained in these XBRL documents is unaudited.
***
FHLBank has requested confidential treatment of the redacted portions of this exhibit pursuant to Rule 246-2 under the Exchange Act.
Item 16: Form 10-K Summary
None.
SIGNATURES
Pursuant to the requirements 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 indicated on the dates indicated.
Pursuant to Power of Attorney
Management’s Report on Internal Control over Financial Reporting
Management of the Federal Home Loan Bank of Topeka (FHLBank) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. The FHLBank’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the financial statements in accordance with generally accepted accounting principles. 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 FHLBank’s assets; (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 FHLBank are being made only in accordance with authorizations of the FHLBank’s management and board of directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the FHLBank’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 and even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. 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 of the FHLBank assessed the effectiveness of the FHLBank’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework (2013). Based on this evaluation under the COSO framework, management has concluded that the FHLBank’s internal control over financial reporting was effective as of December 31, 2017.
The effectiveness of the FHLBank’s internal control over financial reporting as of December 31, 2017 has been audited by PricewaterhouseCoopers LLP, the FHLBank’s independent registered public accounting firm, as stated in their accompanying report.
/s/Mark E. Yardley
Mark E. Yardley
President and Chief Executive Officer
/s/William W. Osborn
William W. Osborn
Senior Vice President and Chief Financial Officer
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of the
Federal Home Loan Bank of Topeka
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying statements of condition of the Federal Home Loan Bank of Topeka (the “FHLBank”) as of December 31, 2017 and 2016, and the related statements of income, comprehensive income, capital, and cash flows for each of the three years in the period ended December 31, 2017, including the related notes (collectively referred to as the “financial statements”). We also have audited the FHLBank's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the FHLBank as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the FHLBank maintained, in all material respects, effective internal control over financial reporting as of December 31, 2o17, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Basis for Opinions
The FHLBank'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 the FHLBank’s financial statements and on the FHLBank's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the FHLBank in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. 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.
Definition and Limitations of Internal Control over Financial Reporting
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.
/s/PricewaterhouseCoopers LLP
Kansas City, Missouri
March 15, 2018
We have served as the FHLBank’s auditor since 1990.
1 Fair value: $4,856,996 and $4,487,252 as of December 31, 2017 and 2016, 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.
1 Putable
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 TOPEKA
Notes to Financial Statements
For the years ended December 31, 2017, 2016 and 2015
BACKGROUND INFORMATION
The Federal Home Loan Bank of Topeka (FHLBank or FHLBank Topeka), a federally chartered corporation, is one of 11 district Federal Home Loan Banks (FHLBanks). The FHLBanks are government-sponsored enterprises (GSE) that were organized under the Federal Home Loan Bank Act of 1932, as amended (Bank Act), to serve the public by enhancing the availability of credit for residential mortgages and targeted community development and provide a readily available, competitively-priced source of funds to their members. The FHLBank is a cooperative whose member institutions own substantially all of the outstanding capital stock of the FHLBank and generally receive dividends on their stock investments. Regulated financial depositories, insurance companies and community development financial institutions engaged in residential housing finance whose principal place of business is located in Colorado, Kansas, Nebraska or Oklahoma are eligible to apply for membership. State and local housing authorities that meet certain statutory requirements may become housing associates of the FHLBank and also be eligible to borrow from the FHLBank. While eligible to borrow, housing associates are not members of the FHLBank and therefore are not permitted or required to hold capital stock.
All members are required to purchase stock in the FHLBank located in their district in accordance with the capital plan of that particular FHLBank. Under FHLBank Topeka’s capital plan, members must own capital stock in the FHLBank based on the amount of their total assets. Each member is also required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank, including advances. Former members that still have outstanding business transactions with the FHLBank are also required to maintain their investments in FHLBank capital stock until the transactions mature or are paid off. As a result of these requirements, the FHLBank conducts business with members in the ordinary course of its business. For financial reporting purposes, the FHLBank defines related parties as those members: (1) with investments in excess of 10 percent of the FHLBank’s total regulatory capital stock outstanding, which includes mandatorily redeemable capital stock; or (2) with an officer or director serving on the FHLBank’s board of directors. See Note 18 for more information on related party transactions.
The FHLBanks are supervised and regulated by the Federal Housing Finance Agency (FHFA), an independent agency in the executive branch of the U.S. government. The FHFA’s stated mission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment. Each FHLBank is operated as a separate entity and has its own management, employees and board of directors. The FHLBanks do not have any special purpose entities or any other type of off-balance sheet conduits.
The FHLBanks have established a joint office called the Office of Finance to facilitate the issuance and servicing of the debt instruments of the FHLBanks, known as consolidated obligation bonds and consolidated obligation discount notes (collectively referred to as consolidated obligations) and to prepare the combined quarterly and annual financial reports of the FHLBanks. As provided by the Bank Act, and applicable regulations, consolidated obligations are backed only by the financial resources of the FHLBanks. Consolidated obligations are the primary source of funds for the FHLBanks in addition to deposits, other borrowings and capital stock issued to members. The FHLBank primarily uses these funds to provide advances to members and to acquire mortgage loans from members through the Mortgage Partnership Finance® (MPF®) Program. "Mortgage Partnership Finance" and "MPF" are registered trademarks of the FHLBank of Chicago. In addition, the FHLBank also offers correspondent services such as wire transfer, security safekeeping and settlement services.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation: The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).
Use of Estimates: The preparation of financial statements under GAAP requires management to make estimates and assumptions as of the date of the financial statements in determining the reported amounts of assets, liabilities and estimated fair values and in determining the disclosure of any contingent assets or liabilities. Estimates and assumptions by management also affect the reported amounts of income and expense during the reporting period. The most significant of these estimates include the fair value of trading and available-for-sale securities, the fair value of derivatives and the allowance for credit losses. Many of the estimates and assumptions, including those used in financial models, are based on financial market conditions as of the date of the financial statements. Because of the volatility of the financial markets, as well as other factors that affect management estimates, actual results may vary from these estimates.
Fair Values: The fair value amounts, recorded on the Statements of Condition and presented in the note disclosures for the periods presented, have been determined by the FHLBank using available market and other pertinent information and reflect the FHLBank’s best judgment of appropriate valuation methods. Although the FHLBank uses its 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 16 for more information.
Financial Instruments Meeting Netting Requirements: The FHLBank presents certain financial instruments, including derivatives, repurchase agreements and securities purchased under agreements to resell, on a net basis when it has a legal right of offset and all other requirements for netting are met (collectively referred to as the netting requirements). For these financial instruments, the FHLBank has elected to offset its asset and liability positions, as well as cash collateral received or pledged, when it has 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. See Note 12 for additional information regarding these financial instruments.
For derivative instruments that meet the netting requirements, any excess cash collateral received or pledged is recognized as a derivative liability or derivative asset. See Note 8 for additional information regarding these agreements.
Cash Flows: For purposes of the Statements of Cash Flows, the FHLBank considers cash on hand and non-interest-bearing deposits in banks as cash and cash equivalents.
Interest-bearing Deposits, Securities Purchased Under Agreements to Resell and Federal Funds Sold: Interest-bearing deposits, securities purchased under agreements to resell and Federal funds sold provide short-term liquidity and are carried at cost. The FHLBank treats securities purchased under agreements to resell as short-term collateralized loans, which are classified as assets on the Statements of Condition. Securities purchased under agreements to resell are held in safekeeping in the FHLBank’s name by third-party custodians approved by the FHLBank. If the fair value of the underlying securities decreases below the fair value required as collateral, the counterparty has the option to: (1) place an equivalent amount of additional securities in safekeeping in the FHLBank’s name; or (2) remit an equivalent amount of cash; otherwise, the dollar value of the resale agreement will be decreased accordingly. Federal funds sold consist of short-term unsecured loans generally transacted with counterparties that are considered by the FHLBank to be of investment quality.
Investment Securities: The FHLBank classifies investments as trading, available-for-sale and 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 either: (1) held for liquidity purposes; (2) swapped and classified as trading to provide a fair value offset to the gains (losses) on the interest rate swaps tied to the securities; or (3) acquired as asset/liability management tools and carried at fair value. The FHLBank records changes in the fair value of these securities through other income (loss) as net gains (losses) on trading securities. FHFA regulation and the FHLBank’s Risk Management Policy (RMP) prohibit trading in or the speculative use of these instruments and limits credit risk arising from these instruments. While the FHLBank classifies certain securities as trading for financial reporting purposes, it does not actively trade any of these securities with the intent of realizing gains and holds these investments indefinitely as management periodically evaluates its asset/liability and liquidity needs. Short-term money market investments with maturities of three months or less are acquired and classified as trading securities primarily for liquidity purposes. These short-term money market investments are periodically sold to meet the FHLBank’s cash flow needs.
Available-for-Sale: Securities that are not classified as trading or held-to-maturity are classified as available-for-sale and are carried at fair value. The change in fair value of available-for-sale securities is recorded in other comprehensive income (loss) (OCI) as net unrealized gains (losses) on available-for-sale securities. For available-for-sale securities that have been hedged and the hedge relationships qualify as benchmark fair value hedges, the FHLBank records the portion of the change in the fair value of the investment related to the risk being hedged in non-interest income as net gains (losses) on derivatives and hedging activities together with the related change in the fair value of the derivative, and records the remainder of the change in the fair value of the investment in OCI as net unrealized gains (losses) on available-for-sale securities.
Held-to-Maturity: Securities that the FHLBank has 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, accretion of discounts and other-than-temporary impairment (OTTI) recognized in net income and OCI.
Certain changes in circumstances may cause the FHLBank to change its intent to hold a security to maturity without calling into question its intent to hold other debt securities to maturity in the future, including: (1) evidence of a significant deterioration in the issuer’s creditworthiness; (2) a change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of investments, thereby causing the FHLBank to dispose of a held-to-maturity investment; (3) a significant increase by a regulator in the FHLBank’s capital requirements that causes the FHLBank to downsize by selling held-to-maturity investments; or (4) a significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes. The FHLBank considers the following situations to be maturities for purposes of assessing ability and intent to hold to maturity:
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The sale of the security is near enough to maturity (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 the FHLBank has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition either due 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: The FHLBank computes the amortization of purchased premiums and accretion of purchased discounts on mortgage-backed securities (MBS) using the level-yield method over the estimated cash flows of the securities. This method requires a retrospective adjustment of the effective yield each time the FHLBank receives a principal repayment or changes the estimated remaining cash flows as if the actual principal repayments and new estimated cash flows had been known since the original acquisition dates of the securities. The FHLBank uses nationally recognized, market-based third-party prepayment models to estimate future cash flows. The FHLBank computes the amortization of premiums and accretion of discounts on other investments using the level-yield method to the contractual maturities of the securities.
Gains and Losses on Sales: Gains and losses on the sales of investment securities are computed using the specific identification method and are included in other income (loss).
Investment Securities - Other-than-temporary Impairment: The FHLBank evaluates its individual available-for-sale and held-to-maturity investment securities in an unrealized loss position for OTTI at least quarterly, or more frequently if events or changes in circumstances indicate that these investments may be other-than-temporarily impaired. An investment is considered impaired when its fair value is less than its amortized cost basis. The FHLBank considers an OTTI to have occurred under any of the following circumstances:
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The FHLBank has the intent to sell the impaired debt security;
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The FHLBank believes, based on available evidence, it is more likely than not that it will be required to sell the debt security before the recovery of its amortized cost basis; or
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The FHLBank does not expect to recover the entire amortized cost basis of the impaired debt security.
Recognition of OTTI: If either of the first two conditions above is met, the FHLBank recognizes an OTTI charge in earnings equal to the entire difference between the security’s amortized cost basis 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, the entire loss position, or total OTTI, is evaluated to determine the extent and amount of credit loss.
To determine whether a credit loss exists, the FHLBank performs an analysis, which includes a cash flow analysis for private-label MBS, to determine if it will recover the entire amortized cost basis of each of these securities. The present value of the cash flows expected to be collected is compared to the amortized cost basis of the security to determine if a credit loss exists. If there is a credit loss, the carrying value of the security is adjusted to its fair value. However, rather than recognizing the entire difference between the amortized cost basis and the fair value in earnings, only the amount of the impairment representing the credit loss (i.e., the credit component) is recognized in earnings, while the amount related to all other factors (i.e., the non-credit component) is recognized in OCI. The credit loss on a debt security is limited to the amount of that security’s unrealized losses.
The total OTTI is presented in the Statements of Income with an offset for the amount of the non-credit portion of OTTI that is recognized in OCI. The remaining amount in the Statements of Income represents the credit loss for the period.
Accounting for OTTI Recognized in OCI: For subsequent accounting of other-than-temporarily impaired securities, the FHLBank records an additional OTTI if the present value of cash flows expected to be collected is less than the amortized cost basis. The total amount of this additional OTTI is determined as the difference between its carrying amount prior to the determination of this additional OTTI and its fair value. Additional credit losses related to previously other-than-temporarily impaired securities are reclassified out of OCI into the Statements of Income, but only to the extent of a security’s unrealized losses (i.e., difference between the security’s amortized cost and its fair value). The OTTI recognized in OCI is accreted to the carrying value of each held-to-maturity 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).
Interest Income Recognition: The FHLBank recognizes subsequent interest income in accordance with the method described in accounting guidance for beneficial interests in securitized financial assets. As of the impairment measurement date, a new accretable yield is calculated for the impaired investment security. 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 change the accretable yield on a prospective basis. The estimated cash flows and accretable yield are re-evaluated on a quarterly basis.
Advances: The FHLBank presents advances (secured loans to members, former members or housing associates) net of unearned commitment fees, premiums, discounts and fair value basis adjustments. The FHLBank amortizes the premiums and accretes the discounts on advances to interest income using the level-yield method. The FHLBank records interest on advances to interest income as earned.
Advance Modifications: In cases in which the FHLBank funds a new advance concurrently with or within a short period of time before or after the prepayment of an existing advance, the FHLBank evaluates whether the new advance meets the accounting criteria to qualify as a modification of an existing advance or whether it constitutes a new advance. The FHLBank compares the present value of cash flows on the new advance to the present value of cash flows remaining on the existing advance. If there is at least a 10 percent difference in the cash flows or if the FHLBank concludes the differences between the advances are more than minor based on qualitative factors, the advance is accounted for as a new advance. In all other instances, the new advance is accounted for as a modification.
Prepayment Fees: The FHLBank charges prepayment fees to its borrowers when certain advances are repaid before their original maturities. The FHLBank records prepayment fees net of hedging fair value basis adjustments included in the carrying value of the advance, as prepayment fees on terminated advances in the interest income section of its Statements of Income.
If a new advance does not qualify as a modification of an existing advance, it is treated as an advance termination and any prepayment fee, net of hedging adjustments, is recorded to prepayment fees on terminated advances in the interest income section of the Statements of Income.
If the new advance qualifies as a modification, the net prepayment fee received on the prepaid advance is deferred as a discount and included in the basis of the modified advance. The basis adjustment is amortized over the life of the modified advance to advance interest income. If the modified advance is hedged, the fair value gain or loss on the advance and the prepayment fee are included in the carrying amount of the modified advance, and any prior gains or losses and prepayment fees are amortized to interest income over the life of the modified advance using the level-yield method. Modified hedged advances are marked to benchmark fair value after the modification, and subsequent fair value changes are recorded in net gains (losses) on derivatives and hedging activities in other income (loss).
Mortgage Loans Held for Portfolio: The FHLBank carries mortgage loans classified as held for investment at their principal amount outstanding, net of unamortized premiums, unaccreted discounts, deferred loan fees associated with table funded loans, hedging adjustments, unrealized gains and losses from mortgage purchase commitments, charge-offs, and other fees. The FHLBank has the intent and ability to hold these mortgage loans to maturity.
Premiums and Discounts: The FHLBank defers and amortizes/accretes mortgage loan origination fees (agent fees) and premiums and discounts paid to and received from participating financial institutions (PFI) as interest income using the level-yield method over the contractual lives of the loans. This method uses the cash flows required by the loan contracts, as adjusted for actual prepayments, to apply the interest method. The contractual method does not utilize estimates of future prepayments of principal.
Credit Enhancement Fees: The credit enhancement obligation (CE obligation) is an obligation on the part of the PFI that ensures the retention of credit risk on loans it originates on behalf of or sells to the FHLBank. The amount of the CE obligation is determined at the time of purchase so that any losses in excess of the CE obligation for each pool of mortgage loans purchased approximate those experienced by an investor in either a double-A or triple-B rated MBS. As a part of our methodology to determine the amount of credit enhancement necessary, we analyze the risk characteristics of each mortgage loan using a model licensed from a Nationally Recognized Statistical Rating Organization (NRSRO). We use the model to evaluate loan data provided by the PFI as well as other relevant information.
The FHLBank pays the PFI a credit enhancement fee (CE fee) for managing this portion of the credit risk in the pool of loans. CE fees are paid monthly based on the remaining unpaid principal balance (UPB) of the loans in a master commitment, or a one-time upfront CE fee is paid at purchase. The upfront CE fee is based upon the present value of the monthly CE fee payments, with consideration for expected prepayments, and amortized as interest income using the level-yield method over the contractual lives of the loans. The required CE obligation amount may vary depending on the various product alternatives selected by the PFI. CE fees are recorded as an offset to mortgage loan interest income. To the extent the FHLBank experiences a loss in a master commitment, the FHLBank may be able to recapture future performance-based CE fees paid to the PFIs to offset these losses.
Other Fees: The FHLBank may receive other non-origination fees, such as delivery commitment extension fees and pair-off fees as part of the mark-to-market on derivatives to which they are related or as part of the loan basis, as applicable. Delivery commitment extension fees are received when a PFI requires an extension of the delivery commitment period beyond the original stated expiration. These fees compensate the FHLBank for lost interest as a result of late funding and represent the member purchasing a derivative from the FHLBank. Pair-off fees are received from the PFI when the amount funded is more than or less than a specific percentage range of the delivery commitment amount. These fees compensate the FHLBank for hedge costs associated with the under-delivery or over-delivery. To the extent that pair off fees relate to under-deliveries of loans, they are included in the mark-to-market of the related delivery commitment derivative. If they relate to over-deliveries, they represent purchase price adjustments to the related loans acquired and are recorded as a part of the carrying value of the loan.
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 the FHLBank’s portfolios as of the Statement of Condition date. To the extent necessary, an allowance for credit losses for off-balance sheet credit exposures is recorded as a liability. See Note 7 for details on each allowance methodology.
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. The FHLBank has developed and documented a systematic methodology for determining an allowance for credit losses, where applicable, for: (1) credit products (advances, letters of credit and other extensions of credit to members); (2) government-guaranteed or -insured mortgage loans held for portfolio; (3) conventional mortgage loans held for portfolio; (4) the direct financing lease receivable; (5) term Federal funds sold; and (6) term securities purchased under agreements to resell.
Classes of Financing Receivables: Classes of financing receivables generally are a disaggregation of a portfolio segment to the extent that it is needed to understand the exposure to credit risk arising from these financing receivables. The FHLBank has determined that no further disaggregation of portfolio segments identified previously is needed as the credit risk arising from these financing receivables is assessed and measured at the portfolio segment level.
Non-accrual Loans: The FHLBank places a conventional mortgage loan on non-accrual status if it is determined that either: (1) the collection of interest or principal is doubtful; or (2) interest or principal is past due for 90 days or more, except when the loan is well-secured (e.g., through credit enhancements) and in the process of collection. The FHLBank does not place government-guaranteed or -insured mortgage loans on non-accrual status due to the U.S. government guarantee or insurance on these loans and the contractual obligation of the loan servicer to repurchase the loans when certain criteria are met. For those mortgage loans placed on non-accrual status, accrued but uncollected interest is reversed against interest income. The FHLBank records cash payments received on non-accrual loans first as interest income and then as a reduction of principal as specified in the contractual agreement, unless the collection of the remaining principal amount due is considered doubtful. If the collection of the remaining principal amount due is considered doubtful then cash payments received would be 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 non-accrual status may be restored to accrual status when: (1) none of its contractual principal and interest is due and unpaid, and the FHLBank expects repayment of the remaining contractual principal and interest; or (2) it otherwise becomes well secured and in the process of collection.
Troubled Debt Restructuring: The FHLBank considers a troubled debt restructuring to have occurred when a concession is granted to a borrower for economic or legal reasons related to the borrower’s financial difficulties and that concession would not have been considered otherwise. Loans that are discharged in Chapter 7 bankruptcy and have not been reaffirmed by the borrowers are also considered to be troubled debt restructurings, except in certain cases where supplemental mortgage insurance (SMI) policies are held or where all contractual amounts due are still expected to be collected as a result of certain credit enhancements or government guarantees.
Impairment Methodology: A loan is considered impaired when, based on current information and events, it is probable that the FHLBank will be unable to collect all amounts due according to the contractual terms of the loan agreement.
Loans that are on non-accrual 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 is insufficient to recover the recorded investment on the loan. Interest income on impaired loans is recognized in the same manner as non-accrual loans.
Charge-off Policy: A charge-off is recorded if it is estimated that the recorded investment in a loan will not be recovered. The FHLBank evaluates 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. The FHLBank charges off the portion of outstanding conventional mortgage loan balances in excess of fair value of the underlying property, less estimated cost to sell, for loans that are 180 days or more delinquent and certain loans that the borrower has filed for bankruptcy.
Real Estate Owned: Real estate owned (REO) includes assets that have been received in satisfaction of debt through foreclosures. REO is initially recorded at fair value less estimated selling costs and is subsequently carried at the lower of that amount or current fair value less estimated selling costs. The FHLBank recognizes a charge-off to the allowance for credit losses if the fair value of the REO less estimated selling costs is less than the recorded investment in the loan at the date of transfer from loans to REO. Any subsequent gains, losses and carrying costs are included in other expense in the Statements of Income. REO is recorded in other assets on the Statements of Condition.
Derivatives: All derivatives are recognized on the Statements of Condition at their fair values and are reported as either derivative assets or derivative liabilities, net of cash collateral, including initial and certain variation margin, and accrued interest receivable from or pledged by clearing agents and/or counterparties. The fair values of derivatives are netted by clearing agent 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. Cash flows associated with derivatives are reflected as cash flows from operating activities in the Statements of Cash Flows unless the derivative meets the criteria to be a financing derivative.
The FHLBank utilizes two Derivative Clearing Organizations (Clearinghouses) for all cleared derivative transactions, LCH.Clearnet LLC and CME Clearing. Effective January 3, 2017, CME Clearing made certain amendments to its rulebook changing the legal characterization of variation margin payments to be daily settlement payments rather than collateral. Variation margin related to LCH.Clearnet LLC contracts was characterized as cash collateral as of December 31, 2017 as amendments to its rulebook were not effective until January 16, 2018. At both Clearinghouses, initial margin is considered cash collateral.
Derivative Designations: Each derivative is designated as one of the following:
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a qualifying fair value hedge of the change in fair value of: (1) a recognized asset or liability; or (2) an unrecognized firm commitment;
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a qualifying cash flow hedge of: (1) a forecasted transaction; or (2) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability;
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a non-qualifying hedge of an asset or liability (an economic hedge) for asset/liability management purposes; or
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a non-qualifying hedge of another derivative (an intermediary hedge) that is offered as a product to members.
Accounting for Qualifying 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 hedge accounting and the offsetting changes in fair value of the hedged items attributable to the hedged risk may be recorded in earnings (fair value hedges) or OCI (cash flow hedges). Two approaches to hedge accounting include:
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Long haul hedge accounting - The application of long haul hedge accounting requires the FHLBank to formally assess (both at the hedge's inception and at least quarterly) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items or forecasted transactions attributable to the hedged risk and whether those derivatives may be expected to remain highly effective in future periods; and
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Shortcut hedge accounting - Transactions that meet more stringent criteria qualify for the shortcut method of hedge accounting in which an 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 shortcut method, the entire change in fair value of the interest rate swap is considered to be highly effective at achieving offsetting changes in fair values or cash flows of the hedged asset or liability.
Derivatives are typically executed at the same time as the hedged item, and the FHLBank designates the hedged item in a qualifying hedge relationship at the trade date. In many hedging relationships, the FHLBank may designate the hedging relationship upon its commitment to disburse an advance or trade a consolidated obligation in which settlement occurs within the shortest period of time possible for the type of instrument based on market settlement conventions. The FHLBank defines market settlement conventions for advances to be five business days or less and for consolidated obligations to be thirty calendar days or less, using a next business day convention. The FHLBank then records 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 gains (losses) 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 highly effective, are recorded in accumulated OCI (AOCI), a component of capital, until earnings are affected by the variability of the cash flows of the hedged transaction (i.e., until the recognition of interest on a variable rate asset or liability is recorded in earnings). For both fair value and cash flow hedges, any hedge ineffectiveness (which represents the amount by which the change in the fair value of the derivative differs from the change in fair value of the hedged item or the variability in the cash flows of the forecasted transaction attributable to the hedged risk) is recorded in other income (loss) as net gains (losses) on derivatives and hedging activities.
Accounting for Non-Qualifying Hedges: An economic hedge is defined as a derivative hedging specific or non-specific underlying assets, liabilities or firm commitments that does not qualify for hedge accounting but is an acceptable hedging strategy under the FHLBank’s RMP. 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 changes in fair value on the derivatives that are recorded in the FHLBank’s income but not offset by corresponding changes in the fair value of the economically hedged assets, liabilities or firm commitments being recorded simultaneously in income. As a result, the FHLBank recognizes only the net interest and the change in fair value of these derivatives in other income (loss) as net gains (losses) on derivatives and hedging activities with no offsetting fair value adjustments for the assets, liabilities or firm commitments.
The derivatives used in intermediary activities do not qualify for hedge accounting treatment and are separately marked-to-market through earnings. The net result of the accounting for these derivatives does not significantly affect the operating results of the FHLBank. These amounts are recorded in other income (loss) as net gains (losses) on derivatives and hedging activities.
Accrued Interest Receivables and Payables: The net settlements of interest receivables and payables on derivatives designated as fair value or cash flow hedges are recognized as adjustments to the interest income or expense of the designated underlying investment securities, advances, consolidated obligations or other financial instruments, thereby affecting the reported amount of net interest income on the Statements of Income. The net settlements of interest receivables and payables on intermediated derivatives for members and other economic hedges are recognized in other income (loss) as net gains (losses) on derivatives and hedging activities.
Discontinuance of Hedge Accounting: The FHLBank discontinues hedge accounting prospectively when: (1) it determines 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); (2) the derivative and/or the hedged item expires or is sold, terminated or exercised; (3) it is no longer probable that the forecasted transaction will occur in the originally expected period; (4) a hedged firm commitment no longer meets the definition of a firm commitment; or (5) management determines that designating the derivative as a hedging instrument is no longer appropriate.
When hedge accounting is discontinued because the FHLBank determines that the derivative no longer qualifies as an effective fair value hedge of an existing hedged item, the FHLBank continues to carry the derivative on its Statements of Condition at fair value, ceases to adjust the hedged asset or liability for changes in fair value, and begins amortizing 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 the FHLBank determines that the derivative no longer qualifies as an effective cash flow hedge of an existing hedged item, the FHLBank continues to carry the derivative on its Statements of Condition at fair value and amortizes the cumulative OCI adjustment to earnings when earnings are affected by the original forecasted transaction. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, the FHLBank carries the derivative at fair value on its Statements of Condition, recognizing changes in the fair value of the derivative in current period earnings. When the FHLBank discontinues hedge accounting because it is probable that a forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter, the gains and losses in AOCI will be recognized immediately in earnings. When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, the FHLBank continues to carry the derivative on its Statements of Condition at fair value, removing 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: The FHLBank may issue debt, make advances, or purchase financial instruments in which a derivative instrument is embedded. Upon execution of these transactions, the FHLBank assesses 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 or purchased financial instrument (the host contract) and whether a separate, non-embedded instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When the FHLBank determines 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 pursuant to an economic hedge. However, 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 period earnings (such as an investment security classified as trading), or if the FHLBank 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 Statements of Condition at fair value and no portion of the contract is designated as a hedging instrument.
Premises, Software and Equipment: The FHLBank records premises, software, and equipment at cost less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets ranging from 3 to 40 years. Leasehold improvements are amortized on the straight-line basis over the shorter of the estimated useful life of the improvement or the remaining term of the lease. Improvements and major renewals are capitalized, and ordinary maintenance and repairs are expensed as incurred. As of December 31, 2017 and 2016, the accumulated depreciation and amortization related to premises, software and equipment was $31,482,000 and $30,175,000, respectively. Depreciation and amortization expense was $2,282,000, $2,031,000 and $2,193,000 for the years ended December 31, 2017, 2016, and 2015, respectively. Gains and losses on disposals are included in other income (loss).
The cost of purchased software and certain costs incurred in developing computer software for internal use is capitalized and amortized over future periods. Amortization is computed on the straight-line method over the estimated useful lives ranging from five to seven years for purchased and developed software. As of December 31, 2017 and 2016, the FHLBank had $7,295,000 and $4,433,000, respectively, in unamortized computer software costs included in premises, software and equipment on its Statements of Condition. Amortization of computer software costs charged to expense was $936,000, $834,000 and $1,064,000 for the years ended December 31, 2017, 2016, and 2015, respectively.
Consolidated Obligations: Consolidated obligations are recorded at amortized cost.
Discounts and Premiums: Consolidated obligation discounts are accreted and premiums are amortized to interest expense using the level-yield method over the contractual maturities of the corresponding debt.
Concessions: Amounts paid to dealers in connection with sales of consolidated obligations are deferred and amortized using the level-yield method over the contractual terms of the consolidated obligations. Concession amounts are prorated to the FHLBank by the Office of Finance based on the percentage of each consolidated obligation issued by the Office of Finance on behalf of the FHLBank. The FHLBank records concessions paid on consolidated obligations as a direct deduction from their carrying amounts, consistent with the presentation of discounts on consolidated obligations. The amortization of those concessions is included in consolidated obligation interest expense.
Mandatorily Redeemable Capital Stock: The FHLBank reclassifies all stock subject to redemption from capital to liability once a member submits a written redemption request, gives notice of intent to withdraw from membership, or attains non-member status by merger or acquisition, charter termination or involuntary termination from membership, since the member shares will then meet the definition of a mandatorily redeemable financial instrument. There is no distinction as to treatment for reclassification from capital to liability between in-district redemption requests and those redemption requests triggered by out-of-district acquisitions. The FHLBank does not take into consideration its members’ right to cancel a redemption request in determining when shares of capital stock should be classified as a liability because the cancellation would be subject to a substantial cancellation fee. Member and non-member shares of capital stock meeting the definition of mandatorily redeemable capital stock are reclassified to a liability at fair value, which has been determined to be par value ($100) plus any estimated accrued but unpaid dividends. The FHLBank’s dividends are declared and paid at each quarter-end; therefore, the fair value reclassified equals par value. Dividends declared on a member's shares of capital stock for the time after classification as a liability are accrued at the expected dividend rate and reflected as interest expense in the Statements of Income. The repurchase of these mandatorily redeemable financial instruments by the FHLBank are reflected as financing cash outflows in the Statements of Cash Flows once settled.
If a member submits a written request to cancel a previously submitted written redemption request, the capital stock covered by the written cancellation request is reclassified from a liability to capital at fair value. After the reclassification, dividends on the capital stock are no longer classified as interest expense.
Restricted Retained Earnings: The FHLBank allocates 20 percent of its quarterly net income to a separate restricted retained earnings account until the account balance equals at least 1 percent of its average balance of outstanding consolidated obligations for the previous quarter. These restricted retained earnings are not available to pay dividends and are presented separately on the Statements of Condition.
FHFA Expenses: A portion of the FHFA’s expenses and working capital fund are allocated among the FHLBanks based on the pro rata share of the annual assessments based on the ratio between each FHLBank’s minimum required regulatory capital and the aggregate minimum required regulatory capital of every FHLBank.
Office of Finance Expenses: Each FHLBank’s proportionate share of Office of Finance operating and capital expenditures is calculated using a formula that is based upon the following components: (1) two-thirds based upon each FHLBank’s share of total consolidated obligations outstanding; and (2) one-third based upon an equal pro rata allocation.
Affordable Housing Program (AHP) Assessments: The FHLBank is required to establish, fund and administer an AHP. The AHP funds provide subsidies to members to assist in the purchase, construction or rehabilitation of housing for very low-, low- and moderate-income households. The required annual AHP funding is charged to earnings, and an offsetting liability is established.
NOTE 2 - RECENTLY ISSUED ACCOUNTING STANDARDS AND INTERPRETATIONS AND CHANGES IN AND ADOPTIONS OF ACCOUNTING PRINCIPLES
Targeted Improvements to Accounting for Hedging Activities (Accounting Standards Update (ASU) 2017-12). In August 2017, Financial Accounting Standards Board (FASB) issued an amendment to simplify the application of hedge accounting guidance in current GAAP and to improve the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements. This guidance requires that, for fair value hedges, the entire change in the fair value of the hedging instrument included in the assessment of hedge effectiveness be presented in the same income statement line that is used to present the earnings effect of the hedged item. For cash flow hedges, the entire change in the fair value of the hedging instrument included in the assessment of hedge effectiveness must be recorded in OCI. In addition, the amendments include certain targeted improvements to the assessment of hedge effectiveness and permit, among other things, the following:
•
Measurement of the change in fair value of the hedged item on the basis of the benchmark rate component of the contractual coupon cash flows determined at hedge inception;
•
Measurement of the hedged item in a partial-term fair value hedge of interest rate risk by assuming the hedged item has a term that reflects only the designated cash flows being hedged;
•
Consideration only of how changes in the benchmark interest rate affect a decision to settle a prepayable instrument before its scheduled maturity in calculating the change in the fair value of the hedged item attributable to interest rate risk; and
•
For a cash flow hedge of interest rate risk of a variable rate financial instrument, an entity could designate the variability in cash flows attributable to the contractually specified interest rate as the hedged risk.
The amendment will be effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, which is January 1, 2019 for the FHLBank, and early adoption is permitted in any interim period or fiscal year prior to the effective date. The FHLBank does not plan on early adoption. This guidance should be applied through a cumulative-effect adjustment directly to retained earnings as of the beginning of the fiscal year of adoption. The FHLBank is in the process of evaluating this guidance and its effect on the FHLBank's financial condition, results of operations and cash flows.
Premium Amortization on Purchased Callable Debt Securities (ASU 2017-08). In March 2017, FASB issued an amendment to shorten the amortization period of any premium on callable debt securities to the first call date instead of over the contractual life of the instrument. The amendment does not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The guidance is intended to reduce diversity in practice in the amortization of premiums and the consideration of how the potential of a security being called is factored into current impairment assessments. The amendment also intends to more closely align the amortization of premiums and discounts to the expectations incorporated into the market pricing of the instrument. The amendment will be effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, which is January 1, 2019 for the FHLBank, and early adoption is permitted. The FHLBank does not plan on early adoption. This guidance should be applied using a modified retrospective method through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The adoption of this guidance is not expected to have a material effect on the FHLBank's financial condition, results of operations or cash flows.
Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (ASU 2017-07). In March 2017, FASB issued an amendment to improve the presentation of net periodic pension cost and net periodic postretirement benefit cost. The amendment requires that the employer disaggregate the service cost component and the other components of net benefit cost and allow only the service cost component of net benefit cost to be eligible for capitalization. The amendment is intended to provide transparency, consistency, and usefulness to users of financial statements. The amendment became effective for annual periods, and interim periods within those annual periods, beginning on January 1, 2018 for the FHLBank. This guidance was applied retrospectively for the presentation of the service cost component and the other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement and prospectively, on and after the effective date, for the capitalization of the service cost component of net periodic pension cost and net periodic postretirement benefit in assets. The adoption of this guidance did not have a material effect on the FHLBank's financial condition, results of operations or cash flows.
Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15). In August 2016, FASB issued amendments to clarify guidance on the classification of certain cash receipts and payments in the statement of cash flows. This guidance is intended to reduce existing diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. This guidance became effective for the FHLBank for interim and annual periods and applied retrospectively, beginning on January 1, 2018. The adoption of this guidance did not have an impact on the FHLBank's financial condition, results of operations or cash flows.
Measurement of Credit Losses on Financial Instruments (ASU 2016-13). In June 2016, FASB issued amended guidance for the accounting of credit losses on financial instruments. The amendments require entities to measure expected credit losses based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. An entity must use judgment in determining the relevant information and estimation methods that are appropriate in its circumstances. Additionally, under the new guidance, a financial asset, or a group of financial assets, measured at amortized cost basis is required to be presented at the net amount expected to be collected.
The guidance also requires:
•
The statement of income to reflect the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period;
•
The entities to determine the allowance for credit losses for purchased financial assets with a more-than-insignificant amount of credit deterioration since origination that are measured at amortized cost basis in a similar manner to other financial assets measured at amortized cost basis. The initial allowance for credit losses is required to be added to the purchase price;
•
Credit losses relating to available-for-sale debt securities to be recorded through an allowance for credit losses. The amendments limit the allowance for credit losses to the amount by which fair value is below amortized cost; and
•
Public entities to further disaggregate the current disclosure of credit quality indicators in relation to the amortized cost of financing receivables by the year of origination (i.e., vintage).
The guidance is effective for the FHLBank for interim and annual periods beginning on January 1, 2020. Early application is permitted as of the interim and annual reporting periods beginning after December 15, 2018. The FHLBank does not plan on early adoption. The guidance should be applied using a modified-retrospective approach, through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. In addition, entities are required to use a prospective transition approach for debt securities for which an OTTI charge had been recognized before the effective date. The FHLBank has formed an internal working group that has begun its implementation efforts by identifying key interpretive issues and potential impacts to processes and systems that will eventually determine the magnitude of the impact on the FHLBank's financial condition, results of operations and cash flows.
Leases (ASU 2016-02). In February 2016, FASB issued amendments to lease accounting guidance. Under the new guidance, lessees will be required to recognize a lease liability and a right-of-use asset for all leases in the statement of financial condition, which effectively removes a source of off-balance sheet financing for operating leases. A distinction remains between finance leases and operating leases, but the assets and liabilities arising from operating leases are now also required to be recognized in the statement of financial condition. Lessor accounting is largely unchanged. The amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, which is January 1, 2019 for the FHLBank. The FHLBank does not plan on early adoption. The FHLBank has a limited number of lease agreements and has concluded that the impact of the guidance is not expected to have a material effect on the FHLBank's financial condition, results of operations or cash flows.
Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01). In January 2016, FASB issued amendments to improve the recognition, measurement, presentation and disclosure of financial instruments through changes to existing GAAP. The provisions impacting the FHLBank include the elimination of the requirement to disclose the method and significant assumptions used to estimate the fair value of financial instruments carried at amortized cost, the requirement to use the notion of exit price when measuring the fair value of financial instruments for disclosure purposes, and the separate presentation of financial assets and financial liabilities by measurement category and form of asset (i.e., securities or loans and receivables) on the statement of financial condition or in the notes to financial statements. The amendments became effective for annual periods, and interim periods within those annual periods, beginning on January 1, 2018 for the FHLBank. This guidance will impact disclosures related to the fair value of financial instruments. However, this guidance did not have an impact on the FHLBank's financial condition, results of operations or cash flows.
Revenue Recognition (ASU 2014-09). In May 2014, FASB issued guidance to introduce a new revenue recognition model in which an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This guidance also requires disclosures sufficient to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. In July 2015, FASB voted to defer the effective date of the new standard by one year. In addition, in March 2016, FASB issued amendments to clarify the implementation guidance on principal versus agent considerations, in particular, relating to how an entity should determine whether the entity is a principal or an agent for each specified good or service promised to the customer and the nature of each specified good or service. The amendments do not change the core principle in the new revenue standard. The standard became effective for fiscal years, including interim periods within those fiscal years, beginning on January 1, 2018 for the FHLBank. Because the guidance does not apply to revenue associated with financial instruments, including loans and securities that are accounted for under other GAAP, the adoption of this guidance did not have a material impact on its financial condition, results of operations or cash flows.
NOTE 3 - CASH AND DUE FROM BANKS
Cash and due from banks represents non-interest-bearing deposits in banks.
Pass-through Deposit Reserves: The FHLBank acts as a pass-through correspondent for members required to deposit reserves with the Federal Reserve Banks (FRB). The amount shown as cash and due from banks includes pass-through reserves deposited with the FRB of $9,513,000 and $1,726,000 as of December 31, 2017 and 2016, respectively.
NOTE 4 - INVESTMENT SECURITIES
Trading Securities: Trading securities by major security type as of December 31, 2017 and 2016 are summarized in Table 4.1 (in thousands):
Table 4.1
Represents debentures issued by other FHLBanks, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal Farm Credit Bank (Farm Credit) and Federal Agricultural Mortgage Corporation (Farmer Mac). GSE securities are not guaranteed by the U.S. government.
Represents single-family MBS issued by Government National Mortgage Association (Ginnie Mae), which are guaranteed by the U.S. government.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Net gains (losses) on trading securities during the years ended December 31, 2017, 2016, and 2015 are shown in Table 4.2 (in thousands):
Table 4.2
Available-for-sale Securities: Available-for-sale securities by major security type as of December 31, 2017 are summarized in Table 4.3 (in thousands):
Table 4.3
Represents fixed rate multi-family MBS issued by Fannie Mae.
Available-for-sale securities by major security type as of December 31, 2016 are summarized in Table 4.4 (in thousands):
Table 4.4
Represents fixed rate multi-family MBS issued by Fannie Mae.
Table 4.5 summarizes the available-for-sale securities with unrealized losses as of December 31, 2017 (in thousands). The unrealized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position.
Table 4.5
Represents fixed rate multi-family MBS issued by Fannie Mae.
Table 4.6 summarizes the available-for-sale securities with unrealized losses as of December 31, 2016 (in thousands). The unrealized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position.
Table 4.6
Represents fixed rate multi-family MBS issued by Fannie Mae.
All available-for-sale securities are GSE MBS and as such do not have a single maturity date. The expected maturities of these securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
Held-to-maturity Securities: Held-to-maturity securities by major security type as of December 31, 2017 are summarized in Table 4.7 (in thousands):
Table 4.7
Represents single-family MBS issued by Ginnie Mae.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Held-to-maturity securities by major security type as of December 31, 2016 are summarized in Table 4.8 (in thousands):
Table 4.8
Represents single-family MBS issued by Ginnie Mae.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Table 4.9 summarizes the held-to-maturity securities with unrealized losses as of December 31, 2017 (in thousands). The unrealized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position.
Table 4.9
Total unrealized losses in Table 4.9 will not agree to total gross unrecognized losses in Table 4.7. Total unrealized losses in Table 4.9 include non-credit-related OTTI recognized in AOCI and gross unrecognized gains on previously other-than-temporarily impaired securities.
Represents single-family MBS issued by Ginnie Mae.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Table 4.10 summarizes the held-to-maturity securities with unrealized losses as of December 31, 2016 (in thousands). The unrealized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position.
Table 4.10
Total unrealized losses in Table 4.10 will not agree to total gross unrecognized losses in Table 4.8. Total unrealized losses in Table 4.10 include non-credit-related OTTI recognized in AOCI and gross unrecognized gains on previously other-than-temporarily impaired securities.
Represents single-family MBS issued by Ginnie Mae.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
The amortized cost, carrying value and fair values of held-to-maturity securities by contractual maturity as of December 31, 2017 and 2016 are shown in Table 4.11 (in thousands). Expected maturities of certain securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
Table 4.11
Net gains (losses) were realized on the sale of long-term held-to-maturity securities during the year ended December 31, 2015 and are recorded as net gains (losses) on sale of held-to-maturity securities in other income (loss) on the Statements of Income. All securities sold had paid down below 15 percent of the principal outstanding at acquisition. Table 4.12 presents details of the sales (in thousands). No held-to-maturity securities were sold during the years ended December 31, 2017 and 2016.
Table 4.12
Other-than-temporary Impairment: For the 21 outstanding private-label residential MBS with OTTI during the lives of the securities, the FHLBank’s reported balances as of December 31, 2017 are presented in Table 4.13 (in thousands):
Table 4.13
Table 4.14 presents a roll-forward of OTTI activity for the years ended December 31, 2017, 2016, and 2015 related to credit losses recognized in earnings (in thousands):
Table 4.14
For the years ended December 31, 2017, 2016 and 2015, securities previously impaired represent all securities that were impaired prior to January 1, 2017, 2016 and 2015, respectively.
The FHLBank amortizes the credit component based on estimated cash flows prospectively up to the amount of expected principal to be recovered. The discounted cash flows will move from the discounted loss value to the ultimate principal to be written off at the projected date of loss. If the expected cash flows improve, the amount of expected loss decreases which causes a corresponding decrease in the calculated amortization. Based on the level of improvement in the cash flows, the amortization could become a positive adjustment to income.
As of December 31, 2017, the fair value of a portion of the FHLBank's available-for-sale and held-to-maturity MBS were below the amortized cost of the securities due to interest rate volatility and/or illiquidity. However, the decline in fair value of these securities is considered temporary as the FHLBank expects to recover the entire amortized cost basis on the remaining securities in unrecognized loss positions and neither intends to sell these securities nor is it more likely than not that the FHLBank will be required to sell these securities before its anticipated recovery of the remaining amortized cost basis. For state and local housing agency obligations, the FHLBank determined that all of the gross unrealized losses on these bonds were temporary because the strength of the underlying collateral and credit enhancements was sufficient to protect the FHLBank from losses based on current expectations.
NOTE 5 - ADVANCES
General Terms: The FHLBank offers a wide range of fixed and variable rate advance products with different maturities, interest rates, payment characteristics and optionality. As of December 31, 2017 and 2016, the FHLBank had advances outstanding at interest rates ranging from 0.66 percent to 7.41 percent and 0.46 percent to 7.41 percent, respectively. Table 5.1 presents advances summarized by year of contractual maturity as of December 31, 2017 and 2016 (dollar amounts in thousands):
Table 5.1
The FHLBank’s advances outstanding include advances that contain call options that may be exercised with or without prepayment fees at the borrower’s discretion on specific dates (call dates) before the stated advance maturities (callable advances). In exchange for receiving the right to call the advance on a predetermined call schedule, the borrower may pay a higher fixed rate for the advance relative to an equivalent maturity, non-callable, fixed rate advance. The borrower normally exercises its call options on these advances when interest rates decline (fixed rate advances) or spreads change (adjustable rate advances).
Convertible advances allow the FHLBank to convert an advance from one interest payment term structure to another. When issuing convertible advances, the FHLBank purchases put options from a member that allow the FHLBank to convert the fixed rate advance to a variable rate advance at the current market rate or another structure after an agreed-upon lockout period. A convertible advance carries a lower interest rate than a comparable-maturity fixed rate advance without the conversion feature.
Table 5.2 presents advances summarized by contractual maturity or next call date (for callable advances) and by contractual maturity or next conversion date (for convertible advances) as of December 31, 2017 and 2016 (in thousands):
Table 5.2
Interest Rate Payment Terms: Table 5.3 details additional interest rate payment terms for advances as of December 31, 2017 and 2016 (in thousands):
Table 5.3
Credit Risk Exposure and Security Terms: The FHLBank’s potential credit risk from advances is concentrated in commercial banks and savings institutions. As of December 31, 2017 and 2016, the FHLBank had outstanding advances of $10,200,000,000 and $9,140,000,000, respectively, to two members that individually held 10 percent or more of the FHLBank’s advances, which represents 38.8 percent and 38.1 percent, respectively, of total outstanding advances. The members were the same each year.
See Note 7 for information related to the FHLBank’s credit risk on advances and allowance for credit losses.
See Note 18 for detailed information on transactions with related parties.
See Note 16 for information about the fair value of advances.
NOTE 6 - MORTGAGE LOANS
The MPF Program involves the FHLBank investing in mortgage loans, which have been funded by the FHLBank through or purchased from PFIs. These mortgage loans are government-guaranteed or -insured loans (by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service of the Department of Agriculture (RHS) and/or the Department of Housing and Urban Development (HUD)) and conventional residential loans credit-enhanced by PFIs. Depending upon a member’s product selection, the servicing rights can be retained or sold by the participating member. The FHLBank does not buy or own any mortgage servicing rights.
Mortgage Loans Held for Portfolio: Table 6.1 presents information as of December 31, 2017 and 2016 on mortgage loans held for portfolio (in thousands):
Table 6.1
Medium-term defined as a term of 15 years or less at origination.
Table 6.2 presents information as of December 31, 2017 and 2016 on the outstanding UPB of mortgage loans held for portfolio (in thousands):
Table 6.2
See Note 7 for information related to the FHLBank’s credit risk on mortgage loans and allowance for credit losses.
See Note 18 for detailed information on transactions with related parties.
See Note 16 for information about the fair value of mortgage loans held for portfolio.
NOTE 7 - ALLOWANCE FOR CREDIT LOSSES
The FHLBank has established an allowance methodology for each of its portfolio segments: credit products (advances, letters of credit and other extensions of credit to borrowers); government mortgage loans held for portfolio; conventional mortgage loans held for portfolio; the direct financing lease receivable; term Federal funds sold; and term securities purchased under agreements to resell. Based on management's analyses of each portfolio segment, the FHLBank has only established an allowance for credit losses on its conventional mortgage loans held for portfolio.
Credit Products: The FHLBank manages its credit exposure to credit products through an integrated approach that generally includes establishing a credit limit for each member. This approach includes an ongoing review of each member’s financial condition, in conjunction with conservative collateral/lending policies to limit risk of loss, while balancing members’ needs for a reliable source of funding. In addition, the FHLBank lends to its members in accordance with federal law and FHFA regulations. Specifically, the FHLBank is required to obtain sufficient collateral to fully secure credit products. The estimated value of the collateral required to secure each member’s credit products is calculated by applying collateral discounts, or haircuts, to the market value or UPB of the collateral, as applicable. The FHLBank accepts certain investment securities, residential mortgage loans, deposits, and other real estate related assets as collateral. In addition, community financial institutions are eligible to utilize expanded statutory collateral provisions for small business loans, small farm loans, small agri-business loans and community development loans. The FHLBank’s capital stock owned by borrowing members is held by the FHLBank as further collateral security for all indebtedness of the member to the FHLBank. Collateral arrangements may vary depending upon member credit quality, financial condition and performance; borrowing capacity; and overall credit exposure to the member. The FHLBank can also require additional or substitute collateral to protect its security interest. FHLBank management believes that these policies are effectively applied to manage the FHLBank’s credit risk from credit products.
The FHLBank either allows a member to retain physical possession of the collateral assigned to an advance, or requires the member to specifically assign or place physical possession of the collateral with the FHLBank or its safekeeping agent. The FHLBank perfects its security interest in all pledged collateral. The Bank Act affords any security interest granted to the FHLBank by a member priority over the claims or rights of any other party except for claims or rights of a third party that would be entitled to priority under otherwise applicable law and are held by a bona fide purchaser for value or by a secured party holding a prior perfected security interest.
Using a risk-based approach and taking into consideration each member’s financial strength, the FHLBank considers the type of collateral to be the primary indicator of credit quality on its credit products. As of December 31, 2017 and 2016, the FHLBank had rights to collateral on a member-by-member basis with an estimated value in excess of its outstanding extensions of credit. The FHLBank continues to evaluate and make changes to its collateral guidelines, as necessary, based on current market conditions. Based upon the collateral held as security, management’s credit extension and collateral policies, management’s credit analysis and the repayment history on credit products, the FHLBank currently does not anticipate any credit losses on its credit products.
Government Mortgage Loans Held for Portfolio: The FHLBank invests in government-guaranteed or -insured (by FHA, VA, RHA and/or HUD) fixed rate mortgage loans secured by one-to-four family residential properties. 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 guarantee with respect to defaulted government mortgage loans. Any losses on these loans that are not recovered from the issuer or guarantor are absorbed by the servicers. Therefore, the FHLBank only has credit risk for these loans if the servicer fails to pay for losses not covered by the insurance or guarantee. Based on the FHLBank’s assessment of its servicers, the FHLBank has not established an allowance for credit losses on government mortgage loans.
Conventional Mortgage Loans Held for Portfolio: The allowance for conventional loans is determined by a formula analysis based upon loss factors predominantly calculated using a historical analysis of loan performance. Delinquent loan migration analysis is performed to determine default probability rates, and historical loss analysis is performed to determine loss severity rates, both of which are then utilized as loss factors within the formula analysis. These analyses include consideration of various data observations, such as past performance, current performance, loan portfolio characteristics, collateral-related characteristics, industry data, and prevailing economic conditions. The measurement of the allowance for conventional mortgage loan losses may consist of: (1) reviewing all residential mortgage loans at the individual master commitment level; (2) reviewing specifically identified collateral-dependent loans for impairment; (3) reviewing homogeneous pools of residential mortgage loans; and/or (4) estimating credit losses in the remaining portfolio. The formula analysis is consistently applied, but loss factors may be adjusted in response to changing conditions, as a result of management’s assessment of the adequacy of the allowance to absorb losses inherent in the portfolio.
The FHLBank’s management of credit risk in the MPF Program involves several layers of loss protection that are defined in agreements among the FHLBank and its PFIs. The availability of loss protection may differ slightly among MPF products. The FHLBank’s loss protection consists of the following loss layers, in order of priority:
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Homeowner Equity.
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Private Mortgage Insurance (PMI). PMI is required on all conventional loans with homeowner equity of less than 20 percent of the original purchase price or appraised value.
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First Loss Account (FLA). The FLA functions as a tracking mechanism for determining the FHLBank’s potential loss exposure under each master commitment prior to the PFI’s CE obligation. If the FHLBank experiences losses in a master commitment, these losses will be: (1) absorbed by the FHLBank's FLA; and (2) recovered through the withholding of future performance-based CE fees from the PFI, if applicable.
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CE Obligation. PFIs have a CE obligation to absorb losses in excess of the FLA in order to limit the FHLBank’s loss exposure to that of an investor in an MBS that is rated the equivalent of triple-B by an NRSRO (effective December 2016). For master commitments with loans funded prior to December 2016, the CE obligation makes the risk equivalent to a double-A rated asset, unless the PFI has requested a realignment of the CE obligation. PFIs must either fully collateralize their CE obligation with assets considered acceptable by the FHLBank’s Member Products Policy (MPP) or purchase SMI from mortgage insurers, as applicable. Any incurred losses that would be absorbed by the CE obligation are not reserved as part of the FHLBank’s allowance for loan losses.
The FHLBank pays the PFI a fee, a portion of which may be based on the credit performance of the mortgage loans, in exchange for absorbing the CE obligation loss layer up to an agreed-upon amount. For some products, losses incurred under the FLA may be recovered by withholding future performance-based CE fees otherwise paid to our PFIs. The FHLBank records CE fees paid to the participating members as a reduction to mortgage interest income. Table 7.1 presents net CE fees paid to PFIs for the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 7.1
CE fees paid to PFIs excludes the amortization of CE fees paid upfront, which is included with premium amortization as a reduction to mortgage interest income.
Mortgage Loans Evaluated at the Individual Master Commitment Level: The credit risk analysis of all conventional loans is performed at the individual master commitment level to properly determine the credit enhancements available to recover losses on mortgage loans under each individual master commitment.
Collectively Evaluated Mortgage Loans: The credit risk analysis of conventional loans evaluated collectively for impairment considers loan pool specific attribute data, including historical delinquency migration, applies estimated loss severities, and incorporates the associated credit enhancements in order to determine the FHLBank’s best estimate of probable incurred losses. Migration analysis is a methodology for determining, through the FHLBank’s experience over a historical period, the rate of default on pools of similar loans. The FHLBank applies migration analysis to loans based on the following categories: (1) loans in foreclosure; (2) nonaccrual loans; (3) delinquent loans; and (4) all other remaining loans. The FHLBank then estimates how many loans in these categories may migrate to a realized loss position and applies a loss severity factor to estimate losses incurred as of the Statement of Condition date.
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 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 not sufficient CE obligation from a PFI to offset all 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 for these loans on an individual loan basis. The FHLBank estimates the fair value of this collateral by applying an appropriate loss severity rate or using third party estimates or property valuation models. The incurred loss of an individually evaluated mortgage loan is equal to the difference between the carrying value of the loan and the estimated fair value of the collateral, less estimated selling costs, and may include expected proceeds from PMI and other applicable credit enhancements.
Direct Financing Lease Receivable: The FHLBank has a recorded investment in a direct financing lease receivable with a member for a building complex and property. Under the office complex agreement, the FHLBank has all rights and remedies under the lease agreement as well as all rights and remedies available under the member’s Advance, Pledge and Security Agreement. Consequently, the FHLBank can apply any excess collateral securing credit products to any shortfall in the leasing arrangement.
Term Federal Funds Sold: Term Federal funds sold are short-term unsecured loans conducted with investment-grade counterparties. We only evaluate these investments for purposes of an allowance for credit losses if the investment is not paid when due. There were no investments in term Federal funds sold outstanding at any time during the years ended December 31, 2017 and 2016.
Term Securities Purchased Under Agreements to Resell: Term securities purchased under agreements to resell are considered collateralized financing arrangements and effectively represent short-term loans to investment-grade counterparties. 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, or the FHLBank will decrease the dollar value of the agreement to resell accordingly. If the FHLBank determines 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. There were no investments in term securities purchased under agreements to resell outstanding at any time during the years ended December 31, 2017 and 2016.
Roll-forward of Allowance for Credit Losses: Table 7.2 presents a roll-forward of the allowance for credit losses for the years ended December 31, 2017, 2016, and 2015 (in thousands).
Table 7.2
Table 7.3 presents the allowance for credit losses and the recorded investment as well as the method used to evaluate impairment relating to all portfolio segments regardless of whether or not an estimated credit loss has been recorded as of December 31, 2017 (in thousands). The recorded investment in a financing receivable is the UPB, adjusted for accrued interest, net deferred loan fees or costs, unamortized premiums or discounts, fair value hedging adjustments and direct write-downs. The recorded investment is not net of any valuation allowance.
Table 7.3
The recorded investment for credit products includes only advances. The recorded investment for all other credit products is insignificant.
Table 7.4 presents the allowance for credit losses and the recorded investment as well as the method used to evaluate impairment relating to all portfolio segments regardless of whether or not an estimated credit loss has been recorded as of December 31, 2016 (in thousands):
Table 7.4
The recorded investment for credit products includes only advances. The recorded investment for all other credit products is insignificant.
Credit Quality Indicators: The FHLBank’s key credit quality indicators include the migration of: (1) past due loans; (2) non-accrual loans; (3) loans in process of foreclosure; and (4) impaired loans, all of which are used either on an individual or pool basis to determine the allowance for credit losses.
Table 7.5 summarizes the delinquency aging and key credit quality indicators for all of the FHLBank’s portfolio segments as of December 31, 2017 (dollar amounts in thousands):
Table 7.5
The recorded investment for credit products includes only advances. The recorded investment for all other credit products is insignificant.
Includes loans where the decision of foreclosure or similar alternative such as pursuit of deed-in-lieu has been reported. Loans in process of foreclosure are included in past due or current loans dependent on their delinquency status.
Loans that are 90 days or more past due or in the process of foreclosure expressed as a percentage of the total recorded investment for the portfolio class.
Loans on non-accrual status include $1,398,000 of troubled debt restructurings. Troubled debt restructurings are restructurings in which the FHLBank, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider.
Table 7.6 summarizes the key credit quality indicators for all of the FHLBank’s portfolio segments as of December 31, 2016 (dollar amounts in thousands):
Table 7.6
The recorded investment for credit products includes only advances. The recorded investment for all other credit products is insignificant.
Includes loans where the decision of foreclosure or similar alternative such as pursuit of deed-in-lieu has been reported. Loans in process of foreclosure are included in past due or current loans dependent on their delinquency status.
Loans that are 90 days or more past due or in the process of foreclosure expressed as a percentage of the total recorded investment for the portfolio class.
Loans on non-accrual status include $1,327,000 of troubled debt restructurings. Troubled debt restructurings are restructurings in which the FHLBank, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider.
Individually Evaluated Impaired Loans: Table 7.7 presents the recorded investment, UPB, and related allowance of impaired conventional mortgage loans individually assessed for impairment as of December 31, 2017 and 2016 (in thousands):
Table 7.7
Table 7.8 presents the average recorded investment and related interest income recognized on these individually evaluated impaired loans during the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 7.8
The FHLBank had $2,539,000 and $2,608,000 classified as REO recorded in other assets as of December 31, 2017 and 2016, respectively.
NOTE 8 - DERIVATIVES AND HEDGING ACTIVITIES
Nature of Business Activity: The FHLBank is exposed to interest rate risk primarily from the effect of interest rate changes on its interest-earning assets and its interest-bearing liabilities that finance these assets. The goal of the FHLBank’s interest-rate risk management strategy is not to eliminate interest rate risk, but to manage it within appropriate limits. To mitigate the risk of loss, the FHLBank has established policies and procedures, which include guidelines on the amount of exposure to interest rate changes it is willing to accept. In addition, the FHLBank monitors the risk to its interest income, net interest margin and average maturity of interest-earning assets and interest-bearing liabilities.
Consistent with FHFA regulation, the FHLBank enters into derivatives to: (1) reduce the interest rate risk exposures inherent in otherwise unhedged assets and funding positions; (2) achieve risk management objectives; and (3) act as an intermediary between its members and counterparties. FHFA regulation and the FHLBank’s RMP prohibit trading in or the speculative use of these derivative instruments and limit credit risk arising from these instruments. The use of derivatives is an integral part of the FHLBank’s financial and risk management strategy.
The FHLBank reevaluates its hedging strategies from time to time and may change the hedging techniques it uses or may adopt new strategies. The most common ways in which the FHLBank uses derivatives are to:
▪
Reduce funding costs by combining an interest rate swap with a consolidated obligation because the cost of a combined funding structure can be lower than the cost of a comparable consolidated obligation;
▪
Reduce the interest rate sensitivity and repricing gaps of assets and liabilities;
▪
Preserve a favorable interest rate spread between the yield of an asset (e.g., an advance) and the cost of the related liability (e.g., the consolidated obligation used to fund the advance). Without the use of derivatives, this interest rate spread could be reduced or eliminated when a change in the interest rate on the advance does not match a change in the interest rate on the consolidated obligation;
▪
Mitigate the adverse earnings effects of the shortening or extension of certain assets (e.g., advances or mortgage assets) and liabilities;
▪
Manage embedded options in assets and liabilities; and
▪
Manage its overall asset/liability portfolio.
Application of Derivatives: At the inception of every hedge transaction, the FHLBank documents all hedging relationships between derivatives designated as hedging instruments and the hedged items, its risk management objectives and strategies for undertaking various hedge transactions, and its method of assessing effectiveness. This process includes linking all derivatives that are designated as fair value or cash flow hedges to: (1) assets and/or liabilities on the Statements of Condition; (2) firm commitments; or (3) forecasted transactions.
Derivative instruments are designated by the FHLBank as:
▪
A qualifying fair value or cash flow hedge of an associated financial instrument, a firm commitment or an anticipated transaction;
▪
A non-qualifying economic hedge to manage certain defined risks in the statement of condition. These hedges are primarily used to: (1) manage mismatches between the coupon features of assets and liabilities; (2) offset prepayment risks in certain assets; (3) mitigate the income statement volatility that occurs when financial instruments are recorded at fair value and hedge accounting is not permitted; or (4) reduce exposure to reset risk; or
▪
A non-qualifying intermediary hedge to meet the asset/liability management needs of its members. The FHLBank acts as an intermediary by entering into derivatives with its members and offsetting derivatives with other counterparties. This intermediation grants smaller members indirect access to the derivatives market. The derivatives used in intermediary activities do not receive hedge accounting treatment and are separately marked-to-market through earnings. The net result of the accounting for these derivatives does not significantly affect the operating results of the FHLBank. As of December 31, 2017 and 2016, the FHLBank did not have any intermediary hedges outstanding, and the FHLBank does not currently offer this service to its members.
The FHLBank transacts most of its derivatives with large banks and major broker/dealers. Some of these banks and broker/dealers or their affiliates buy, sell and distribute consolidated obligations. Over-the-counter derivative transactions may be either executed through a bilateral agreement with a counterparty (uncleared derivatives) or cleared through a Futures Commission Merchant (i.e., clearing agent) with a Clearinghouse (cleared derivatives). Once a derivative transaction has been accepted for clearing by a Clearinghouse the executing counterparty is replaced with that Clearinghouse. The FHLBank is not a derivatives dealer and thus, does not trade derivatives for short-term profit.
Types of Derivatives: The FHLBank primarily uses the following derivative instruments:
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 exchanged 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 principal 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 principal amount at a variable interest rate index for the same period of time. The variable interest rate received or paid by the FHLBank in most derivative transactions is the London Interbank Offered Rate (LIBOR).
Swaptions - A swaption is an option 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 the FHLBank against future interest rate changes. The FHLBank may enter into both payer swaptions and receiver swaptions to decrease its interest rate risk exposure related to the prepayment of certain assets. 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.
Interest Rate Caps and Floors - In an interest rate cap agreement, a cash flow is generated if the price or interest rate of an underlying variable rises above a certain threshold (or cap) price or interest rate. In an interest rate floor agreement, a cash flow is generated if the price or interest rate of an underlying variable falls below a certain threshold (or floor) price or interest rate. Interest rate caps and floors are designed as protection against the interest rate on a variable rate asset or liability rising or falling below a certain level. The FHLBank purchases interest rate caps and floors to hedge option risk on variable rate MBS held in the FHLBank’s trading and held-to-maturity portfolios and to hedge embedded caps or floors in the FHLBank’s advances.
Types of Hedged Items: The FHLBank may have the following types of hedged items:
Investments - The FHLBank invests in U.S. Treasury securities, U.S. Agency securities, GSE securities, MBS and state or local housing finance agency securities. The interest rate and prepayment risk associated with these investment securities is managed through a combination of debt issuance and derivatives. The FHLBank may manage the prepayment and interest rate risk by funding investment securities with consolidated obligations that have call features or by economically hedging the prepayment risk with interest rate caps or floors, callable swaps or swaptions. The FHLBank may manage against prepayment and duration risks by funding investment securities with consolidated obligations that have call features. The FHLBank may also manage the risk arising from changing market prices and volatility of investment securities by entering into economic derivatives that generally offset the changes in fair value or cash flows of the securities. The FHLBank’s derivatives associated with trading and held-to-maturity securities are designated as economic hedges, and the FHLBank's derivatives associated with available-for-sale securities are designated and qualify as fair value hedges.
Interest rate caps and floors, swaptions and callable swaps may also be used to hedge prepayment and option risk on the MBS held in the FHLBank’s trading, available-for-sale and held-to-maturity portfolios. Many of these derivatives are purchased interest rate caps that hedge interest rate caps embedded in the FHLBank’s trading and held-to-maturity variable rate Agency MBS. Although these derivatives are valid economic hedges against the prepayment and option risk of the portfolio of MBS, they are not specifically linked to individual investment securities and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings.
Advances - With the issuance of a convertible advance, the FHLBank purchases from the member an option that enables the FHLBank to convert an advance from fixed rate to variable rate if interest rates increase. Once the FHLBank exercises its option to convert an advance to an at-the-market variable rate, the member then owns the option to terminate the converted advance without fee or penalty on the conversion date and each interest rate reset date thereafter. The FHLBank hedges a convertible advance by entering into a cancelable derivative with a non-member counterparty where the FHLBank pays a fixed rate and receives a variable rate. The derivative counterparty may cancel the derivative on a put date. This type of hedge is designated as a fair value hedge. The counterparty’s decision to cancel the derivative would normally occur in a rising rate environment. If the option is in-the-money, the derivative is cancelled by the derivative counterparty at par (i.e., without any premium or other payment to the FHLBank). When the derivative is cancelled, the FHLBank exercises its option to convert the advance to a variable rate. If a convertible advance is not prepaid by the member upon conversion to an at-the-market variable rate advance (i.e., callable variable rate advance), any hedge-related unamortized basis adjustment is amortized as a yield adjustment.
When fixed rate advances are issued to one or more borrowers, the FHLBank can either fund the advances with fixed rate consolidated obligations with the same tenor or simultaneously enter into a matching derivative in which the clearing agent or derivative counterparty receives fixed cash flows from the FHLBank designed to mirror in timing and amount the cash inflows the FHLBank receives on the advance. These transactions are designated as fair value hedges. In this type of transaction, the FHLBank typically receives from the clearing agent or derivative counterparty a variable cash flow that closely matches the interest payments on short-term discount notes or swapped consolidated obligation bonds.
The repricing characteristics and optionality embedded in certain financial instruments held by the FHLBank can create interest rate risk. For example, when a member prepays an advance, the FHLBank 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, the FHLBank generally charges a prepayment fee on an advance that makes it financially indifferent to a member’s decision to prepay the advance. When the FHLBank offers advances (other than short-term advances) that a member may prepay without a prepayment fee, it usually finances these advances with callable debt or otherwise hedges the option being sold to the member.
Mortgage Loans - The FHLBank invests in fixed rate mortgage loans through the MPF Program. The prepayment options embedded in mortgage loans can result in extensions or contractions in the expected lives of these investments, depending on changes in estimated future cash flows, which usually occur as a result of interest rate changes. The FHLBank may manage the interest rate and prepayment risk associated with mortgage loans through a combination of debt issuance and derivatives. The FHLBank issues both callable and non-callable debt to achieve cash flow patterns and liability durations similar to those expected on the mortgage loans. The FHLBank may use derivatives in conjunction with debt issuance to better match the expected prepayment characteristics of its mortgage loan portfolio.
Interest rate caps and floors, swaptions and callable swaps may also be used to hedge prepayment risk on the mortgage loans. Although these derivatives are valid economic hedges against the prepayment risk of the portfolio of mortgage loans, they are not specifically linked to individual loans and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings.
Consolidated Obligations - The FHLBank may enter into derivatives to hedge the interest rate risk associated with its debt issuances. The FHLBank manages the risk arising from changing market prices and volatility of a consolidated obligation by matching the cash inflow on the derivative with the cash outflow on the consolidated obligation.
For instance, the FHLBank may issue a fixed rate consolidated obligation and simultaneously enter into a matching derivative in which the FHLBank received a fixed cash flow designed to mirror in timing and amount the cash outflows the FHLBank pays on the consolidated obligation. In this type of transaction, the FHLBank typically pays a variable cash flow that closely matches the interest payments it receives on short-term or variable rate advances (typically one- or three-month LIBOR). These transactions are designated as fair value hedges. The FHLBank may issue variable rate consolidated obligations indexed to the Federal funds effective rate, LIBOR or other rate and simultaneously execute interest rate swaps to hedge the basis risk of the variable rate debt. This type of hedge is treated as an economic hedge and is market-to-market through earnings.
This strategy of issuing consolidated obligations while simultaneously entering into derivatives is intended to enable the FHLBank to offer a wider range of attractively priced advances to its members and may allow the FHLBank to reduce its funding costs. The continued attractiveness of this debt depends on yield relationships between the consolidated obligations and the derivative markets. If conditions change, the FHLBank may alter consolidated obligations that it issues.
Firm Commitments - Commitments that obligate the FHLBank to purchase closed fixed rate mortgage loans from its members are considered derivatives. Accordingly, each mortgage loan purchase commitment is recorded as a derivative asset or derivative liability at fair value, with changes in fair value recognized in current period earnings. When a mortgage loan purchase commitment derivative settles, the current market value of the commitment is included with the basis of the mortgage loan and amortized accordingly.
The FHLBank may also hedge a firm commitment for a forward starting advance or consolidated obligation bond through the use of an interest rate swap. In this case, the swap functions as the hedging instrument for both the hedging relationship involving the firm commitment and the subsequent hedging relationship involving the advance or bond. The basis movement associated with the firm commitment is recorded as a basis adjustment of the advance or bond at the time the commitment is terminated and the advance or bond is issued. The basis adjustment is then amortized into interest income or expense over the life of the advance or bond. In addition, if a hedged firm commitment no longer qualifies as a fair value hedge, the hedge would be terminated and net gains and losses would be recognized in current period earnings. There were no gains or losses recognized due to disqualification of firm commitment hedges during the years ended December 31, 2017, 2016, and 2015.
Anticipated Debt Issuance - The FHLBank enters into interest rate swaps for the anticipated issuance of fixed rate consolidated obligation bonds to hedge the variability in forecasted interest payments associated with fixed rate debt that has not yet been issued. The interest rate swap is terminated upon issuance of the fixed rate bond, with the realized gain or loss on the interest rate swap recorded in OCI. Realized gains and losses reported in AOCI are recognized as earnings in the periods in which earnings are affected by the cash flows of the fixed rate bonds.
Financial Statement Impact and Additional Financial Information: Derivative instruments are recorded at fair value and reported in derivative assets or derivative liabilities on the Statements of Condition. Premiums paid at acquisition are accounted for as the basis of the derivative at inception of the hedge. The notional amount in derivative contracts serves as a factor in determining periodic interest payments or cash flows received and paid. However, the notional amount of derivatives reflects the FHLBank’s involvement in the various classes of financial instruments and represents neither the actual amounts exchanged nor the overall exposure of the FHLBank 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 clearing agents, counterparties, the types of derivatives, the items being hedged and any offsets between the derivatives and the items being hedged.
The FHLBank considers accrued interest receivables and payables and the legal right to offset derivative assets and liabilities by clearing agent or derivative counterparty. Consequently, derivative assets and liabilities reported on the Statements of Condition generally include the net cash collateral, including initial or certain variation margin, and accrued interest received or pledged by clearing agents and/or derivative counterparties. Therefore, an individual derivative may be in an asset position (clearing agent or derivative counterparty would owe the FHLBank the current fair value, which includes net accrued interest receivable or payable on the derivative, if the derivative was settled as of the Statement of Condition date) but when the derivative fair value and cash collateral fair value (includes accrued interest on the collateral) are netted by clearing agent by Clearinghouse, or by derivative counterparty, the derivative may be recorded on the Statements of Condition as a derivative liability. Conversely, a derivative may be in a liability position (FHLBank would owe the clearing agent or derivative counterparty the fair value if settled as of the Statement of Condition date) but may be recorded on the Statements of Condition as a derivative asset after netting.
Table 8.1 presents outstanding notional amounts and fair values of the derivatives outstanding by type of derivative and by hedge designation as of December 31, 2017 and 2016 (in thousands). Total derivative assets and liabilities include the effect of netting adjustments and cash collateral.
Table 8.1
Amounts represent the application of the netting requirements that allow the FHLBank to settle positive and negative positions cash collateral, including initial or certain variation margin, and related accrued interest held or placed with the same clearing agent and/or derivative counterparty. Cash collateral posted was $56,508,000 and $105,481,000 as of December 31, 2017 and 2016, respectively. Cash collateral received was $40,695,000 and $21,490,000 as of December 31, 2017 and 2016, respectively.
The following tables provide information regarding gains and losses on derivatives and hedging activities by type of hedge and type of derivative and gains and losses by hedged item for fair value hedges.
For the years ended December 31, 2017, 2016, and 2015, the FHLBank recorded net gains (losses) on derivatives and hedging activities as presented in Table 8.2 (in thousands):
Table 8.2
Amount represents price alignment amount on derivatives for which variation margin is characterized as a daily settled contract.
The FHLBank carries derivative instruments at fair value on its Statements of Condition. Any change in the fair value of derivatives designated under a fair value hedging relationship is recorded each period in current period earnings. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. For the years ended December 31, 2017, 2016, and 2015, the FHLBank recorded net gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the FHLBank’s net interest income as presented in Table 8.3 (in thousands):
Table 8.3
The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.
Managing Credit Risk on Derivatives: The FHLBank is subject to credit risk due to the risk of nonperformance by counterparties to its derivative transactions and manages credit risk through credit analyses, collateral requirements and adherence to the requirements set forth in its RMP, U.S. Commodity Futures Trading Commission regulations and FHFA regulations.
Uncleared derivatives. For uncleared derivatives, the degree of credit risk depends on the extent to which master netting arrangements are included in these contracts to mitigate the risk. The FHLBank requires collateral agreements with collateral delivery thresholds on all uncleared derivatives. Additionally, collateral related to derivatives with member institutions includes collateral assigned to the FHLBank, as evidenced by a written security agreement.
Based on credit analyses and collateral requirements, FHLBank management does not anticipate any credit losses on its derivative agreements. The maximum credit risk applicable to a single counterparty was $19,118,000 and $21,112,000 as of December 31, 2017 and 2016, respectively. The counterparty was the same for both periods.
The FHLBank recently entered into updated bilateral security agreements with its non-member counterparties with bilateral-collateral-exchange provisions that require all credit exposures be collateralized, subject to minimum transfer amounts. Previously, certain of the FHLBank’s uncleared derivative instruments contained provisions that required the FHLBank to post additional collateral with its counterparties if there was deterioration in the FHLBank’s credit rating.
Cleared derivatives. For cleared derivatives, the Clearinghouse is the FHLBank’s counterparty. The Clearinghouse notifies the clearing agent of the required initial and variation margin, and the clearing agent in turn notifies the FHLBank. The FHLBank utilizes two Clearinghouses for all cleared derivative transactions, LCH.Clearnet LLC and CME Clearing. Effective January 3, 2017, CME Clearing made certain amendments to its rulebook changing the legal characterization of variation margin payments to represent daily settlement payments rather than collateral. Variation margin related to LCH.Clearnet LLC contracts was characterized as cash collateral as of December 31, 2017 because amendments to its rulebook were not effective until January 16, 2018. At both Clearinghouses, initial margin is considered cash collateral. The requirement that the FHLBank posts initial and variation margin through the clearing agent, to the Clearinghouse, exposes the FHLBank to institutional credit risk if the clearing agent or the Clearinghouse fails to meet its obligations. The use of cleared derivatives is intended to mitigate credit risk exposure because a central counterparty is substituted for individual counterparties and collateral/payments for changes in the value of cleared derivatives is posted daily through a clearing agent.
The Clearinghouse determines initial margin requirements and generally, credit ratings are not factored into the initial margin. However, clearing agents may require additional initial margin to be posted based on credit considerations, including but not limited to credit rating downgrades. The FHLBank was not required to post additional initial margin by its clearing agents as of December 31, 2017 and 2016.
The FHLBank’s net exposure on derivative agreements is presented in Note 12.
NOTE 9 - DEPOSITS
The FHLBank offers demand, overnight and short-term deposit programs to its members and to other qualifying non-members. Table 9.1 details the types of deposits held by the FHLBank as of December 31, 2017 and 2016 (in thousands):
Table 9.1
Deposits classified as demand and overnight 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 weighted-average interest rate paid on interest-bearing deposits was 0.69 percent, 0.17 percent and 0.09 percent for the years ended December 31, 2017, 2016, and 2015, respectively.
There were no term deposits as of December 31, 2017 and 2016.
NOTE 10 - CONSOLIDATED OBLIGATIONS
Consolidated obligations consist of consolidated bonds and discount notes and, as provided by the Bank Act or FHFA regulation, are backed only by the financial resources of the FHLBanks. The FHLBanks jointly issue consolidated obligations with the Office of Finance acting as their agent. The Office of Finance tracks the amounts of debt issued on behalf of each FHLBank. In addition, the FHLBank records as a liability its specific portion of consolidated obligations for which it is the primary obligor. The FHLBank utilizes a debt issuance process to provide a scheduled monthly issuance of global bullet consolidated obligation bonds. As part of this process, management from each of the FHLBanks determines and communicates a firm commitment to the Office of Finance for an amount of scheduled global debt to be issued on its behalf. If the FHLBanks’ commitments do not meet the minimum debt issue size, the proceeds are allocated to all FHLBanks based on the larger of the FHLBank’s commitment or allocated proceeds based on the individual FHLBank’s regulatory capital to total system regulatory capital. If the FHLBanks’ commitments exceed the minimum debt issue size, the proceeds are allocated based on relative regulatory capital of the FHLBanks with the allocation limited to the lesser of the allocation amount or actual commitment amount.
The FHFA and the U.S. Secretary of the Treasury oversee the issuance of FHLBank debt through the Office of Finance. The FHLBanks can, however, pass on any scheduled calendar slot and not issue any global bullet consolidated obligation bonds upon agreement of 8 of the 11 FHLBanks. Consolidated obligation bonds may be issued to raise short-, intermediate-, and long-term funds for the FHLBanks and are not subject to any statutory or regulatory limits as to maturities. Consolidated obligation discount notes, which are issued to raise short-term funds, are generally issued at less than their face amounts and redeemed at par when they mature.
Although the FHLBank is primarily liable for its portion of consolidated obligations, the FHLBank is also jointly and severally liable with the other 10 FHLBanks for the payment of principal and interest on all consolidated obligations of each of the FHLBanks. The FHFA, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the FHFA determines that the non-complying FHLBank is unable to satisfy its obligations, then the FHFA may allocate the non-complying FHLBank’s outstanding consolidated obligation debt among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis the FHFA may determine to ensure that the FHLBanks operate in a safe and sound manner.
The par value of outstanding consolidated obligations of all FHLBanks, including outstanding consolidated obligations issued on behalf of the FHLBank, was approximately $1,034,259,761,000 and $989,311,064,000 as of December 31, 2017 and 2016, respectively. See Note 19 for FHLBank obligations acquired by FHLBank Topeka as investments. FHFA regulations require that each FHLBank maintain unpledged qualifying assets equal to its participation in the total consolidated obligations outstanding. Qualifying assets are defined as cash; secured advances; obligations of or fully guaranteed by the United States; obligations, participations or other instruments of or issued by Fannie Mae or Ginnie Mae; mortgages, obligations or other securities, which are or have ever been sold by Freddie Mac under the Bank Act; and such securities as fiduciary and trust funds may invest in under the laws of the state in which the FHLBank is located.
Consolidated Obligation Bonds: Table 10.1 presents the FHLBank’s participation in consolidated obligation bonds outstanding as of December 31, 2017 and 2016 (dollar amounts in thousands):
Table 10.1
The FHLBank issues optional principal redemption bonds (callable bonds) that may be redeemed in whole or in part at the discretion of the FHLBank on predetermined call dates in accordance with terms of bond offerings. The FHLBank’s participation in consolidated obligation bonds outstanding as of December 31, 2017 and 2016 includes callable bonds totaling $6,452,000,000 and $6,097,000,000, respectively. The FHLBank uses the unswapped callable bonds for financing its callable fixed rate advances (Note 5), MBS (Note 4) and mortgage loans (Note 6). Contemporaneous with a portion of its fixed rate callable bond issuances, the FHLBank also enters into interest rate swap agreements (in which the FHLBank generally pays a variable rate and receives a fixed rate) with call features that mirror the options in the callable bonds (a sold callable swap). The combined sold callable swap and callable debt transaction allows the FHLBank to obtain attractively priced variable rate financing. Table 10.2 summarizes the FHLBank’s participation in consolidated obligation bonds outstanding by year of maturity, or by the next call date for callable bonds as of December 31, 2017 and 2016 (in thousands):
Table 10.2
In addition to having fixed rate or simple variable rate coupon payment terms, consolidated obligation bonds may also have the following broad terms, regarding the coupon payment:
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Range bonds that have coupon rates at fixed or variable rates and pay the fixed or variable rate as long as the index rate is within the established range, but generally pay zero percent or a minimal interest rate if the specified index rate is outside the established range;
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Conversion bonds that have coupon rates that convert from fixed to variable, or variable to fixed, rates or from one index to another, on predetermined dates according to the terms of the bond offerings; and
▪
Step bonds that have coupon rates at fixed or variable rates for specified intervals over the lives of the bonds. At the end of each specified interval, the coupon rate or variable rate spread increases (decreases) or steps up (steps down). These bond issues generally contain call provisions enabling the bonds to be called at the FHLBank’s discretion on the step dates.
Table 10.3 summarizes interest rate payment terms for consolidated obligation bonds as of December 31, 2017 and 2016 (in thousands):
Table 10.3
Consolidated Discount Notes: Table 10.4 summarizes the FHLBank’s participation in consolidated obligation discount notes, all of which are due within one year (dollar amounts in thousands):
Table 10.4
Represents yield to maturity excluding concession fees.
Information about the fair value of the consolidated obligations is included in Note 16.
NOTE 11 - AFFORDABLE HOUSING PROGRAM
The Bank Act, as amended by the Financial Institutions Reform, Recovery and Enforcement Act of 1989, requires each FHLBank to establish an AHP. As a part of its AHP, the FHLBank provides subsidies in the form of direct grants or below-market interest rate advances to members that use the funds to assist in the purchase, construction or rehabilitation of housing for very low-, low- and moderate-income households. By regulation, to fund the AHP, the FHLBanks as a group must annually set aside the greater of $100,000,000 or 10 percent of the current year’s net earnings. For purposes of the AHP calculation, the term “net earnings” is defined as income before interest expense related to mandatorily redeemable capital stock and the assessment for AHP. The FHLBank accrues this expense monthly based on its net earnings.
The amount set aside for AHP is charged to expense and recognized as a liability. As subsidies are provided through the disbursement of grants or issuance of subsidized advances, the AHP liability is reduced accordingly. If the FHLBank’s net earnings before AHP would ever be zero or less, the amount of AHP liability would generally be equal to zero. However, if the result of the aggregate 10 percent calculation described above is less than the $100,000,000 minimum for all FHLBanks as a group, then the Bank Act requires the shortfall to be allocated among the FHLBanks based on the ratio of each FHLBank’s income for the previous year. If an FHLBank determines that its required AHP contributions are exacerbating any financial instability of that FHLBank, it may apply to the FHFA for a temporary suspension of its AHP contributions. The FHLBank has never applied to the FHFA for a temporary suspension of its AHP contributions.
Table 11.1 details the change in the AHP liability for the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 11.1
Recaptured funds are direct grants returned to the FHLBank in those instances where the commitments associated with the approved use of funds are not met and repayment to the FHLBank is required by regulation. Recaptured funds are returned as a result of: (1) AHP-assisted homeowner’s transfer or sale of property within the five-year retention period that the assisted homeowner is required to occupy the property; (2) homeowner’s failure to acquire sufficient loan funding (funds previously approved and disbursed cannot be used); (3) over-subsidized projects; or (4) previously disbursed but unused grants.
As of December 31, 2017, the FHLBank’s AHP accrual on its Statements of Condition consisted of $23,408,000 for the 2018 AHP (uncommitted, including amounts recaptured and reallocated from prior years) and $19,597,000 for prior years’ AHP (committed but undisbursed).
NOTE 12 - ASSETS AND LIABILITIES SUBJECT TO OFFSETTING
The FHLBank presents certain financial instruments, including derivatives, repurchase agreements and securities purchased under agreements to resell, on a net basis by clearing agent by Clearinghouse, or by counterparty, when it has met the netting requirements. For these financial instruments, the FHLBank has elected to offset its asset and liability positions, as well as cash collateral, including initial and certain variation margin, received or pledged, and associated accrued interest.
The FHLBank has analyzed the enforceability of offsetting rights incorporated in its cleared derivative transactions and determined that the exercise of those offsetting rights by a non-defaulting party under these transactions should be upheld under applicable law upon an event of default including a bankruptcy, insolvency, or similar proceeding involving the Clearinghouse or clearing agent, or both. Based on this analysis, the FHLBank presents a net derivative receivable or payable for all of its transactions through a particular clearing agent with a particular Clearinghouse.
Tables 12.1 and 12.2 present the fair value of financial assets, including the related collateral received from or pledged to clearing agents or counterparties, based on the terms of the FHLBank’s master netting arrangements or similar agreements as of December 31, 2017 and 2016 (in thousands):
Table 12.1
Represents noncash collateral received on financial instruments that: (1) do not qualify for netting on the Statement of Condition; or (2) are not subject to an enforceable netting agreement (e.g., mortgage delivery commitments).
Table 12.2
Represents noncash collateral received on financial instruments that: (1) do not qualify for netting on the Statement of Condition; or (2) are not subject to an enforceable netting agreement (e.g., mortgage delivery commitments).
Tables 12.3 and 12.4 present the fair value of financial liabilities, including the related collateral received from or pledged to counterparties, based on the terms of the FHLBank’s master netting arrangements or similar agreements as of December 31, 2017 and 2016 (in thousands):
Table 12.3
Represents noncash collateral received on financial instruments that: (1) do not qualify for netting on the Statement of Condition; or (2) are not subject to an enforceable netting agreement (e.g., mortgage delivery commitments).
Table 12.4
Represents noncash collateral received on financial instruments that: (1) do not qualify for netting on the Statement of Condition; or (2) are not subject to an enforceable netting agreement (e.g., mortgage delivery commitments).
NOTE 13 - CAPITAL
Capital Requirements: The FHLBank is subject to three capital requirements under the provisions of the Gramm-Leach-Bliley Act (GLB Act) and the FHFA's capital structure regulation. Regulatory capital does not include AOCI but does include mandatorily redeemable capital stock.
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Risk-based capital. The FHLBank must maintain at all times permanent capital in an amount at least equal to the sum of its credit risk, market risk and operations risk capital requirements. The risk-based capital requirements are all calculated in accordance with the rules and regulations of the FHFA. Only permanent capital, defined as Class B Common Stock and retained earnings, can be used by the FHLBank to satisfy its risk-based capital requirement. The FHFA may require the FHLBank to maintain a greater amount of permanent capital than is required by the risk-based capital requirement as defined, but the FHFA has not placed any such requirement on the FHLBank to date.
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Total regulatory capital. The GLB Act requires the FHLBank to maintain at all times at least a 4.0 percent total capital-to-asset ratio. Total regulatory capital is defined as the sum of permanent capital, Class A Common Stock, 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.
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Leverage capital. The FHLBank is required to maintain at all times a leverage capital-to-assets ratio of at least 5.0 percent, with the leverage capital ratio defined as the sum of permanent capital weighted 1.5 times and non-permanent capital (currently only Class A Common Stock) weighted 1.0 times, divided by total assets.
Table 13.1 illustrates that the FHLBank was in compliance with its regulatory capital requirements as of December 31, 2017 and 2016 (dollar amounts in thousands):
Table 13.1
Capital Stock: The FHLBank offers two classes of stock, Class A Common Stock and Class B Common Stock. Each member is required to hold capital stock to become and remain a member of the FHLBank (Asset-based Stock Purchase Requirement; Class A Common Stock) and enter into specified activities with the FHLBank including, but not limited to, access to the FHLBank’s credit products and selling Acquired Member Assets (AMA) to the FHLBank (Activity-based Stock Purchase Requirement; Class A Common Stock to the extent of a member’s Asset-based Stock Purchase Requirement, then Class B Common Stock for the remainder). The amount of Class A Common Stock a member must acquire and maintain is the Asset-based Stock Purchase Requirement, which is currently equal to 0.1 percent of a member’s total assets as of December 31 of the preceding calendar year, with a minimum requirement of $1,000, and a maximum requirement of $500,000. The amount of Class B Common Stock a member must acquire and maintain is the Activity-based Stock Purchase Requirement, which is currently equal to 4.5 percent of the principal amount of advances outstanding to the member less the member’s Asset-based Stock Purchase Requirement. There are currently no Activity-based Stock Purchase Requirements for AMA, letters of credit or derivatives.
The percentages listed above are subject to change by the FHLBank within ranges established in its capital plan. Changes to the percentages outside of the capital plan percentages require the FHLBank to request FHFA approval of an amended capital plan. See Note 18 for detailed information on transactions with related parties.
Any member may make a written request not in connection with a notice of withdrawal or attaining non-member status for the redemption of a part of its Class A Common Stock or all or part of its Class B Common Stock (i.e., excess stock redemption request). Within five business days of receipt of a member’s written redemption request, the FHLBank may notify the member that it declines to repurchase the excess stock before the end of that five business day period, at which time the applicable redemption period shall commence. Otherwise, the FHLBank will repurchase any excess stock within the five business day period. The redemption periods are six months for Class A Common Stock and five years for Class B Common Stock. Subject to certain limitations, the FHLBank may choose to repurchase a member’s excess stock on or before the end of the applicable redemption period.
Under FHFA regulations, members that withdraw from membership may not be readmitted to membership, or acquire any capital stock of any FHLBank, for a period of five years from the date on which the institution's membership terminated and it divested all of its shares of FHLBank stock.
Stock Dividends: The FHLBank’s board of directors may declare and pay non-cumulative dividends, expressed as a percentage rate per annum based upon the par value of capital stock on shares of Class A Common Stock outstanding and on shares of Class B Common Stock outstanding, out of previously unrestricted retained earnings and current earnings in either cash or Class B Common Stock. There is no dividend preference between Class A Common Stockholders and Class B Common Stockholders up to the Dividend Parity Threshold (DPT). Dividend rates in excess of the DPT may be paid on Class A Common Stock or Class B Common Stock at the discretion of the board of directors, provided, however, that the dividend rate paid per annum on the Class B Common Stock equals or exceeds the dividend rate per annum paid on the Class A Common Stock for any dividend period. The DPT can be changed at any time by the board of directors but will only be effective for dividends paid at least 90 days after the date members are notified by the FHLBank. The DPT effective for dividends paid during 2017, 2016, and 2015 was equal to the average overnight Federal funds effective rate minus 100 basis points. This DPT will continue to be effective until such time as it may be changed by the FHLBank’s board of directors. When the overnight Federal funds effective rate is below 1.00 percent, the DPT is zero percent for that dividend period (DPT is floored at zero).
The board of directors cannot declare a dividend if: (1) the FHLBank’s capital position is below its minimum regulatory capital requirements; (2) the FHLBank’s capital position will be below its minimum regulatory capital requirements after paying the dividend; (3) the principal or interest due on any consolidated obligation of the FHLBank has not been paid in full; (4) the FHLBank fails to provide the FHFA the quarterly certification prior to declaring or paying dividends for a quarter; or (5) the FHLBank fails to provide notification upon its inability to provide such certification or upon a projection that it will fail to comply with statutory or regulatory liquidity requirements or will be unable to timely and fully meet all of its current obligations.
Mandatorily Redeemable Capital Stock: The FHLBank is a cooperative whose members own most of the FHLBank’s capital stock. Former members (including certain non-members that own FHLBank capital stock as a result of merger or acquisition, relocation, charter termination, or involuntary termination of an FHLBank member) own the remaining capital stock to support business transactions still carried on an FHLBank's statement of condition. Shares cannot be purchased or sold except between the FHLBank and its members at a price equal to the $100 per share par value. If a member cancels its written notice of redemption or notice of withdrawal, the FHLBank 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.
Table 13.2 presents a roll-forward of mandatorily redeemable capital stock for the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 13.2
Table 13.3 shows the amount of mandatorily redeemable capital stock by contractual year of redemption as of December 31, 2017 and 2016 (in thousands). The year of redemption in Table 13.3 is the end of the redemption period in accordance with the FHLBank’s capital plan. The FHLBank is not required to redeem or repurchase membership stock until six months (for Class A Common Stock) or five years (for Class B Common Stock) after the FHLBank receives notice for withdrawal. Additionally, the FHLBank is not required to redeem or repurchase activity-based stock until any activity-based stock becomes excess stock as a result of an activity no longer remaining outstanding. However, the FHLBank intends to repurchase the excess activity-based stock of non-members to the extent that it can do so and still meet its regulatory capital requirements.
Table 13.3
Represents mandatorily redeemable capital stock that is past the end of the contractual redemption period because there is activity outstanding to which the mandatorily redeemable capital stock relates.
Assuming the FHLBank did not elect to redeem a member's Class A Common Stock or Class B Common Stock within five business days of its receipt of a redemption request, a member may cancel or revoke its written redemption request prior to the end of the redemption period (six months for Class A Common Stock and five years for Class B Common Stock) or its written notice of withdrawal from membership prior to the end of a six-month period starting on the date the FHLBank received the member’s written notice of withdrawal from membership. At the end of the six-month period, the member’s membership is terminated and the Class A Common Stock held to meet its Asset-based Stock Purchase Requirement will be redeemed by the FHLBank, as long as the FHLBank will continue to meet its regulatory capital requirements and as long as the Class A Common Stock is not needed to meet the former member’s Activity-based Stock Purchase Requirements. The FHLBank’s capital plan provides that the FHLBank will charge the member a cancellation fee in accordance with a schedule where the amount of the fee increases with the passage of time, the fee being 1.0 percent for any Class A Common Stock cancellation and starting at 1.0 percent in year one for Class B Common Stock and increasing by 1.0 percent each year to a maximum of 5.0 percent for cancellations in the fifth year for Class B Common Stock.
The FHFA issued a regulatory interpretation confirming that the mandatorily redeemable capital stock accounting treatment for certain shares of FHLBank capital stock does not affect the definition of regulatory capital for purposes of determining the FHLBank’s compliance with its regulatory capital requirements, calculating its mortgage securities investment authority (various percentages of total FHLBank capital depending on the date acquired), calculating its unsecured credit exposure to other GSEs (100 percent of total FHLBank capital) or calculating its unsecured credit limits to other counterparties (various percentages of total FHLBank capital depending on the rating of the counterparty).
Excess Capital Stock: Excess capital stock is defined as the amount of stock held by a member (or former member) in excess of that institution’s minimum stock purchase requirement. FHFA rules limit the ability of the FHLBank to create excess member stock under certain circumstances. For example, the FHLBank may not pay dividends in the form of capital stock or issue new excess stock to members if the FHLBank’s excess stock exceeds one percent of its total assets or if the issuance of excess stock would cause the FHLBank’s excess stock to exceed one percent of its total assets. As of December 31, 2017, the FHLBank’s excess stock was less than one percent of total assets.
Capital Classification Determination: The FHFA determines each FHLBank’s capital classification on at least a quarterly basis. If an FHLBank is determined to be other than adequately capitalized, the FHLBank becomes subject to additional supervisory authority by the FHFA. Before implementing a reclassification, the Director of the FHFA is required to provide the FHLBank with written notice of the proposed action and an opportunity to submit a response. As of the most recent review by the FHFA for the fourth quarter of 2017, the FHLBank was classified as adequately capitalized.
NOTE 14 - ACCUMULATED OTHER COMPREHENSIVE INCOME
Table 14.1 summarizes the changes in AOCI for the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 14.1
Recorded in “Net other-than-temporary impairment losses on held-to-maturity securities” on the Statements of Income. Amount represents a debit (decrease to other income (loss)).
Recorded in “Compensation and benefits” on the Statements of Income. Amount represents a debit (increase to other expenses).
NOTE 15 - PENSION AND POSTRETIREMENT BENEFIT PLANS
Qualified Defined Benefit Multiemployer Plan: The FHLBank participates in the Pentegra Defined Benefit Plan for Financial Institutions (Pentegra Defined Benefit Plan), a tax-qualified 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 (ERISA) and the Internal Revenue Code. As a result, 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 because 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 Pentegra Defined Benefit Plan covers all officers and employees of the FHLBank who began employment prior to January 1, 2009.
The Pentegra Defined Benefit Plan operates on a fiscal year from July 1 through June 30 and files one Form 5500 on behalf of all employers who participate in the plan. The Employer Identification Number is 135645888 and the three-digit plan number is 333. There are no collective bargaining agreements in place at the FHLBank.
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. As a result, 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 year ended June 30, 2016. For the Pentegra Defined Benefit Plan years ended June 30, 2016 and 2015, the FHLBank’s contributions did not represent more than five percent of the total contributions to the Pentegra Defined Benefit Plan. The pension provisions under Moving Ahead for Progress in the 21st Century (MAP-21), enacted July 6, 2012, changed the discount rate to be used in the valuation of future benefits. The increased rates will decrease the valuation as well as the minimum required contributions. By maintaining a level of funding comparative to prior periods (contributing more than the minimum required contribution), the FHLBank is effectively increasing its funded status in the short-term. Table 15.1 presents the net pension cost and funded status of the FHLBank relating to the Pentegra Defined Benefit Plan (dollar amounts in thousands):
Table 15.1
The funded status as of July 1, 2017 is preliminary and may increase because the plan’s participants are permitted to make contributions for the plan year ended June 30, 2017 through March 15, 2018. Contributions made on or before March 15, 2018, and designated for the plan year ended June 30, 2017, will be included in the final valuation as of July 1, 2017. The final funded status as of July 1, 2017 will not be available until the Form 5500 for the plan year July 1, 2017 through June 30, 2018 is filed (this Form 5500 is due to be filed no later than April 2019). The funded status as of July 1, 2016 is preliminary and may increase because the plan’s participants were permitted to make contributions for the plan year ended June 30, 2016 through March 15, 2017. Contributions made on or before March 15, 2017, and designated for the plan year ended June 30, 2016, will be included in the final valuation as of July 1, 2016. The final funded status as of July 1, 2016 will not be available until the Form 5500 for the plan year July 1, 2016 through June 30, 2017 is filed (this Form 5500 is due to be filed no later than April 2018).
Qualified Defined Contribution Plans: The FHLBank also participates in the Pentegra Defined Contribution Plan for Financial Institutions, a tax-qualified, defined contribution pension plan. Substantially all officers and employees of the FHLBank are covered by the plan. The FHLBank contributes a matching amount equal to a percentage of voluntary employee contributions, subject to certain limitations. The FHLBank’s contributions of $1,343,000, $1,184,000 and $1,129,000 to the Pentegra Defined Contribution Plan in 2017, 2016, and 2015, respectively, were charged to compensation and benefits expense.
Nonqualified Supplemental Retirement Plan: The FHLBank maintains a benefit equalization plan (BEP) covering certain senior officers. This non-qualified plan contains provisions for a deferred compensation component and a defined benefit pension component. The BEP is, in substance, an unfunded supplemental retirement plan. The cost of the defined benefit pension component of the BEP charged to compensation and benefits expense was $1,568,000, $1,212,000 and $1,452,000 in 2017, 2016, and 2015, respectively. Compensation and benefits expense and other interest expense include deferred compensation and accrued earnings under the BEP of $962,000, $708,000 and $555,000 in 2017, 2016, and 2015, respectively.
As indicated, the BEP is a supplemental retirement plan for covered retirees. There are no funded plan assets that have been designated to provide for the deferred compensation component or defined benefit pension component of the BEP. The obligations and funding status of the defined benefit portion of the FHLBank’s BEP as of December 31, 2017 and 2016 are presented in Table 15.2 (in thousands):
Table 15.2
Table 15.3 presents the components of the net periodic pension cost for the defined benefit portion of the FHLBank’s BEP for the years ended December 31, 2017, 2016, and 2015 (in thousands):
Table 15.3
The estimated actuarial (gain) loss that will be amortized from AOCI into net periodic pension cost over the next fiscal year is $23,000.
The measurement date used to determine the current year’s benefit obligation was December 31, 2017.
Table 15.4 presents the key assumptions and other information for the actuarial calculations for the defined benefit portion of the FHLBank’s BEP for the years ended December 31, 2017, 2016, and 2015 (dollar amounts in thousands):
Table 15.4
The FHLBank estimates that its required contributions to the defined benefit portion of the FHLBank’s BEP for the year ended December 31, 2018 will be $965,000.
The FHLBank’s estimated future benefit payments are presented in Table 15.5 (in thousands):
Table 15.5
NOTE 16 - FAIR VALUES
The fair value amounts recorded on the Statements of Condition and presented in the note disclosures have been determined by the FHLBank using available market and other pertinent information and reflect the FHLBank’s best judgment of appropriate valuation methods. Although the FHLBank uses its best judgment in estimating the fair value of its financial instruments, there are inherent limitations in any valuation technique. Therefore, the fair values may not be indicative of the amounts that would have been realized in market transactions as of December 31, 2017 and 2016.
Subjectivity of Estimates: Estimates of the fair value of advances with options, mortgage instruments, derivatives with embedded options and consolidated obligation bonds with options 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, methods to determine 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.
Fair Value Hierarchy: The FHLBank records trading securities, available-for-sale securities, derivative assets and derivative liabilities at fair value on a recurring basis and on occasion, certain private-label MBS, impaired mortgage loans held for portfolio and non-financial assets on a non-recurring basis. The fair value hierarchy requires the FHLBank 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 the market observability of the fair value measurement for the asset or liability. The FHLBank must disclose the level within the fair value hierarchy in which the measurements are classified for all assets and liabilities.
The fair value hierarchy prioritizes the inputs used to measure fair value into three broad levels:
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Level 1 Inputs - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the FHLBank can access on the measurement date.
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Level 2 Inputs - Inputs other than quoted prices within Level 1 that are observable inputs for the asset or liability, either directly or indirectly. If the asset or liability has a specified (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 and liabilities in active markets; (2) quoted prices for similar assets and 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 and implied volatilities); and (4) inputs that are derived principally from or corroborated by observable market data by correlation or other means.
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Level 3 Inputs - Unobservable inputs for the asset or liability.
The FHLBank reviews its 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. There were no reclassifications of assets or liabilities recorded at fair value on a recurring basis during the years ended December 31, 2017 and 2016.
The carrying value and fair value of the FHLBank’s financial assets and liabilities as of December 31, 2017 and 2016 are summarized in Tables 16.1 and 16.2 (in thousands):
Table 16.1
Represents the effect of legally enforceable master netting agreements that allow the FHLBank to net settle positive and negative positions and also derivative cash collateral and related accrued interest held or placed with the same clearing agent or derivative counterparty.
Table 16.2
Represents the effect of legally enforceable master netting agreements that allow the FHLBank to net settle positive and negative positions and also derivative cash collateral and related accrued interest held or placed with the same clearing agent or derivative counterparty.
Fair Value Methodologies and Techniques and Significant Inputs:
Cash and Due from Banks: The fair values approximate the carrying values.
Interest-bearing Deposits: The balance is comprised of interest-bearing deposits in banks. Based on the nature of the accounts, the carrying value approximates the fair value.
Securities Purchased Under Agreements to Resell: The fair values are determined by calculating the present value of the future cash flows. The discount rates used in the calculations are rates for securities with similar terms. For overnight borrowings, the carrying value approximates fair value.
Federal Funds Sold: The carrying value of overnight Federal funds approximates fair value, and term Federal funds are valued using projected future cash flows discounted at the current replacement rate.
Investment Securities - Non-MBS: The fair values of short-term non-MBS investments are determined using an income approach derived from representative publicly available curves based on the short-term non-MBS investment type.
For long-term (as determined by original issuance date) non-MBS securities, the FHLBank obtains prices from multiple designated third-party pricing vendors when available. The pricing vendors use various proprietary models to price investments. The inputs to those models are derived from various sources including, but not limited to: benchmark yields, reported trades, dealer estimates, issuer spreads, benchmark securities, bids, offers and other market-related data. Each pricing vendor has an established challenge process in place for all valuations, which facilitates resolution of potentially erroneous prices identified by the FHLBank. The use of multiple pricing vendors provides the FHLBank with additional data points regarding levels of inputs and final prices that are used to validate final pricing of investment securities. The utilization of the average of available vendor prices within a cluster tolerance and the evaluation of reasonableness of outlier prices described below does not discard available information.
Annually, the FHLBank conducts reviews of the multiple pricing vendors to confirm and further augment its understanding of the vendors’ pricing processes, methodologies and control procedures. The FHLBank’s review process includes obtaining available vendors’ independent auditors’ reports regarding the internal controls over their valuation process, although the availability of pertinent reports varies by vendor.
The FHLBank utilizes a valuation technique for estimating the fair values of long-term non-MBS securities as follows:
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The FHLBank’s valuation technique first requires the establishment of a median price for each security. 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.
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All prices that are within a specified tolerance threshold of the median price are included in the cluster of prices that are averaged to compute a default price.
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Prices that are outside the threshold (outliers) are subject to further analysis (including, but not limited to, comparison to prices provided by an additional third-party valuation service, prices for similar securities, and/or non-binding dealer estimates) to determine if an outlier is a better estimate of fair value.
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If an outlier (or some other price identified in the analysis) is determined to be a better estimate of fair value, then the outlier (or the other price as appropriate) is used as the final price rather than the default price.
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If, on the other hand, the analysis confirms that an outlier (or outliers) is (are) in fact not representative of fair value and the default price is the best estimate, then the default price is used as the final price. In all cases, the final price is used to determine the fair value of the security.
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If all prices received for a security are outside the tolerance threshold level of the median price, then there is no default price, and the final price is determined by an evaluation of all outlier prices as described above.
As of December 31, 2017, multiple prices were received for substantially all of the FHLBank’s long-term non-MBS holdings with most vendor prices falling within the tolerances so the final prices for those securities were computed by averaging the prices received. Based on the FHLBank’s reviews 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, the FHLBank’s additional analyses), the FHLBank has concluded that its final prices result in reasonable estimates of fair value and that the fair value measurements are classified appropriately in the fair value hierarchy. Based on the significant lack of market activity for state or local housing agency obligations, the fair value measurements for those securities were classified as Level 3 within the fair value hierarchy as of December 31, 2017 and 2016.
Investment Securities - MBS: For MBS securities, the FHLBank obtains prices from multiple designated third-party pricing vendors when available. These pricing vendors use various proprietary models to price investments. The inputs to those models are derived from various sources including, but not limited to: benchmark yields, reported trades, dealer estimates, issuer spreads, benchmark securities, bids, offers and other market-related data (certain inputs are actively quoted and can be validated to external sources). Since many MBS are not traded daily, the pricing vendors use available information as applicable 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 valuations, which facilitates resolution of potentially erroneous prices identified by the FHLBank. The use of multiple pricing vendors provides the FHLBank with additional data points regarding levels of inputs and final prices that are used to validate final pricing of investment securities. The utilization of the average of available vendor prices within a cluster tolerance and the evaluation of reasonableness of outlier prices does not discard available information.
As of December 31, 2017, multiple prices were received for substantially all of the FHLBank’s MBS holdings with most vendor prices falling within the tolerances so the final prices for those securities were computed by averaging the prices received. Based on the FHLBank’s reviews 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, the FHLBank’s additional analyses), the FHLBank has concluded that its final prices result in reasonable estimates of fair value and that the fair value measurements are classified appropriately in the fair value hierarchy. Based on the significant lack of market activity for private-label MBS, the fair value measurements for those securities were classified as Level 3 within the fair value hierarchy as of December 31, 2017 and 2016.
Advances: The fair values of advances are determined by calculating the present values of the expected future cash flows from the advances, excluding the amount of accrued interest receivable. The discount rates used in these calculations are equivalent to the replacement advance rates for advances with similar terms.
The inputs used to determine the fair values of advances are as follows:
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Consolidated Obligation curve (CO curve) and LIBOR curve. The Office of Finance constructs an internal curve, referred to as the CO curve, using the U.S. Treasury curve as a base 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 trades and secondary market activity. The CO curve is used for fixed rate callable and non-callable advances. The LIBOR curve is used for variable rate advances and certain fixed rate advances with other optionality.
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Volatility assumption. To estimate the fair values of advances with optionality, the FHLBank uses market-based expectations of future interest rate volatility implied from current market prices for similar options.
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Spread adjustment. The spread adjustment represents an adjustment to the CO curve or LIBOR curve.
In accordance with FHFA regulations, an advance with a maturity or repricing period greater than six months requires a prepayment fee sufficient to make the FHLBank financially indifferent to the borrower’s decision to prepay the advance. Therefore, the fair value of an advance does not assume prepayment risk. The FHLBank did not adjust the fair value measurement for creditworthiness primarily because advances were fully collateralized.
Mortgage Loans Held for Portfolio: The fair values of mortgage loans are determined based on quoted market prices of similar mortgage loans. These prices, however, can change rapidly based upon market conditions and are highly dependent upon the underlying prepayment assumptions.
Overnight Loans to Other FHLBanks: The carrying value of overnight loans to other FHLBanks approximates fair value.
Accrued Interest Receivable and Payable: The fair values approximate the carrying values.
Derivative Assets/Liabilities: The FHLBank bases the fair values of derivatives on instruments with similar terms or market prices, when available. However, active markets do not exist for many of the FHLBank’s derivatives. Consequently, fair values for these instruments are generally estimated using standard valuation techniques such as discounted cash flow analysis and comparisons to similar instruments. The FHLBank is subject to credit risk due to the risk of nonperformance by counterparties to its derivative transactions. For uncleared derivatives, the degree of credit risk depends on the extent to which master netting arrangements are included in these contracts to mitigate the risk. In addition, the FHLBank requires collateral agreements with collateral delivery thresholds on the majority of its uncleared derivatives. The use of cleared derivatives is intended to mitigate credit risk exposure because a central counterparty is substituted for individual counterparties and collateral is posted daily through a clearing agent for changes in the value of cleared derivatives. The FHLBank has evaluated the potential for the fair value of the instruments to be impacted by counterparty credit risk and its own credit risk and has determined that no adjustments were significant or necessary to the overall fair value measurements of derivatives.
The fair values of the FHLBank’s derivative assets and liabilities include accrued interest receivable/payable and cash collateral, including initial and certain variation margin, remitted to/received from counterparties. The estimated fair values of the accrued interest receivable/payable and cash collateral approximate their carrying values due to their short-term nature. Derivatives are presented on a net basis by clearing agent by Clearinghouse or by counterparty when it has met the netting requirements. If these netted amounts are positive, they are classified as an asset and, if negative, a liability.
The discounted cash flow model uses market-observable inputs. Inputs by class of derivative are as follows:
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Interest-rate related:
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Discount rate assumption - Overnight Index Swap (OIS) curve;
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Forward interest rate assumption for rate resets - LIBOR swap curve;
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Volatility assumptions - market-based expectations of future interest rate volatility implied from current market prices for similar options; and
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Prepayment assumptions.
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Mortgage delivery commitments:
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To be announced (TBA) price - market-based prices of TBAs by coupon class and expected term until settlement.
Deposits: The fair values of term deposits are determined by calculating the present values of the expected future cash flows from the deposits. The calculated present values are reduced by the accrued interest payable. The discount rates used in these calculations are the cost of deposits with similar terms. The carrying value of demand and overnight deposits approximates fair value.
Consolidated Obligations: The fair values for consolidated obligation bonds and discount notes are determined by using standard valuation techniques and inputs based on the cost of raising comparable term debt.
The inputs used to determine the fair values of consolidated obligations are as follows:
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CO curve and LIBOR curve. Fixed rate consolidated obligations that do not contain options are discounted using a replacement rate based on the CO curve. Variable rate consolidated obligations that do not contain options are discounted using LIBOR. Consolidated obligations that contain optionality are discounted using LIBOR.
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Volatility assumption. To estimate the fair values of consolidated obligations with optionality, the FHLBank uses 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 par value. Fair value also includes estimated dividends earned at the time of reclassification from equity to liabilities, until such amount is paid, and any subsequently declared stock dividend. The FHLBank’s dividends are declared and paid at each quarter end; therefore, fair value equaled par value as of the end of the periods presented. Stock can only be acquired by members at par value and redeemed or repurchased at par value. Stock is not traded and no market mechanism exists for the exchange of stock outside the cooperative structure.
Industrial Revenue Bonds and Financing Obligation Payable: The fair values for the industrial revenue bonds and the financing obligation payable are estimated using the present value of future payments discounted using the CO curve.
Standby Letters of Credit: The fair values of standby letters of credit are based on the present value of fees currently charged for similar agreements. The value of these guarantees is recognized and recorded in other liabilities.
Standby Bond Purchase Agreements: The fair values of the standby bond purchase agreements are estimated using the present value of the future fees on existing agreements with fees determined using rates currently charged for similar agreements.
Advance Commitments: The fair values of advance commitments are based on the present value of fees currently charged for similar agreements, taking into account the remaining terms of the agreement and the difference between current levels of interest rates and the committed rates.
Fair Value Measurements: Tables 16.3 and 16.4 present, for each hierarchy level, the FHLBank’s assets and liabilities that are measured at fair value on a recurring or nonrecurring basis on the Statements of Condition as of or for the periods ended December 31, 2017 and 2016 (in thousands). The FHLBank measures certain held-to-maturity securities at fair value on a nonrecurring basis due to the recognition of a credit loss. For held-to-maturity securities that had credit impairment recorded during a period for which no total impairment was recorded (the full amount of additional credit impairment was a reclassification from non-credit impairment previously recorded in AOCI), these securities were recorded at their carrying values and not fair value. The FHLBank measures certain impaired mortgage loans held for portfolio at fair value on a nonrecurring basis when, upon individual evaluation for impairment, the estimated fair value less costs to sell is lower than the recorded investment. REO is measured at fair value when the asset’s fair value less costs to sell is lower than its carrying amount.
Table 16.3
Represents the effect of legally enforceable master netting agreements that allow the FHLBank to net settle positive and negative positions and also derivative cash collateral, related accrued interest held or placed with the same clearing agent or derivative counterparty.
Represents debentures issued by other FHLBanks, Fannie Mae, Farm Credit and Farmer Mac. GSE securities are not guaranteed by the U.S. government.
Represents single-family MBS issued by Ginnie Mae, which are guaranteed by the U.S. government.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Represents multi-family MBS issued by Fannie Mae.
Includes assets adjusted to fair value during the year ended December 31, 2017 and still outstanding as of December 31, 2017.
Table 16.4
Represents the effect of legally enforceable master netting agreements that allow the FHLBank to net settle positive and negative positions and also derivative cash collateral and related accrued interest held or placed with the same clearing agent or derivative counterparty.
Represents debentures issued by other FHLBanks, Fannie Mae, Freddie Mac, Farm Credit and Farmer Mac.
Represents single-family MBS issued by Ginnie Mae.
Represents single-family and multi-family MBS issued by Fannie Mae and Freddie Mac.
Represents multi-family MBS issued by Fannie Mae.
Includes assets adjusted to fair value during the year ended December 31, 2016 and still outstanding as of December 31, 2016.
NOTE 17 - COMMITMENTS AND CONTINGENCIES
Joint and Several Liability: As provided in the Bank Act or in FHFA regulations, consolidated obligations are backed only by the financial resources of the FHLBanks. FHLBank Topeka is jointly and severally liable with the other FHLBanks for the payment of principal and interest on all of the consolidated obligations issued by the FHLBanks. The par amounts for which FHLBank Topeka is jointly and severally liable were approximately $989,306,996,000 and $946,829,735,000 as of December 31, 2017 and 2016, respectively.
The joint and several obligations are mandated by FHFA regulations and are not the result of arms-length transactions among the FHLBanks. As described above, 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 liability. 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 all FHLBanks' consolidated obligations, FHLBank Topeka regularly monitors the financial condition of the other FHLBanks to determine whether it should expect a loss to arise from its joint and several obligations. If the FHLBank were to determine that a loss was probable and the amount of the loss could be reasonably estimated, the FHLBank would charge to income the amount of the expected loss. Based upon the creditworthiness of the other FHLBanks as of December 31, 2017, FHLBank Topeka has concluded that a loss accrual is not necessary at this time.
Off-balance Sheet Commitments: As of December 31, 2017 and 2016, off-balance sheet commitments are presented in Table 17.1 (in thousands):
Table 17.1
Commitments to Extend Credit: The FHLBank issues standby letters of credit on behalf of its members to support certain obligations of the members to third-party beneficiaries. These standby letters of credit are subject to the same collateralization and borrowing limits that are applicable to advances and are fully collateralized with assets allowed by the FHLBank’s MPP. Standby letters of credit may be offered to assist members in facilitating residential housing finance, community lending, and asset-liability management, and to provide liquidity. In particular, members often use standby letters of credit as collateral for deposits from federal and state government agencies. Standby letters of credit are executed for members for a fee. If the FHLBank is required to make payment for a beneficiary's draw, the member either reimburses the FHLBank for the amount drawn or, subject to the FHLBank's discretion, the amount drawn may be converted into a collateralized advance to the member. However, standby letters of credit usually expire without being drawn upon. Standby letters of credit have original expiration periods of up to 10 years, currently expiring no later than 2023. Unearned fees as well as the value of the guarantees related to standby letters of credit are recorded in other liabilities and amounted to $1,246,000 and $1,151,000 as of December 31, 2017 and 2016, respectively. Advance commitments legally bind and unconditionally obligate the FHLBank for additional advances up to 24 months in the future. Based upon management’s credit analysis of members and collateral requirements under the MPP, the FHLBank does not expect to incur any credit losses on the outstanding letters of credit or advance commitments.
Standby Bond-Purchase Agreements: The FHLBank has entered into standby bond purchase agreements with state housing authorities whereby the FHLBank, for a fee, agrees to purchase and hold the authorities’ bonds until the designated marketing agent can find a suitable investor or the housing authority repurchases the bond according to a schedule established by the standby agreement. Each standby agreement dictates the specific terms that would require the FHLBank to purchase the bond. The bond purchase commitments entered into by the FHLBank expire no later than 2020, though some are renewable at the option of the FHLBank. As of December 31, 2017 and 2016, the total commitments for bond purchases included agreements with two in-district state housing authorities. Additionally, as of December 31, 2016, the total commitments for bond purchases included agreements with one out-of-district state housing authority. The FHLBank was not required to purchase any bonds under any agreements during the years ended December 31, 2017 and 2016.
Commitments to Purchase Mortgage Loans: These commitments that unconditionally obligate the FHLBank to purchase mortgage loans from participating FHLBank Topeka members in the MPF Program are generally for periods not to exceed 60 calendar days. Certain commitments are recorded as derivatives at their fair values on the Statements of Condition. The FHLBank recorded mortgage delivery commitment net derivative asset (liability) balances of $30,000 and $(158,000) as of December 31, 2017 and 2016, respectively.
Commitments to Issue Consolidated Obligations: The FHLBank enters into commitments to issue consolidated obligation bonds and discount notes outstanding in the normal course of its business. All settle within the shortest period possible and are considered regular way trades; thus, the commitments are appropriately not recorded as derivatives.
Other Commitments: On June 28, 2017, the FHLBank completed an industrial revenue bond financing transaction with Shawnee County, Kansas (County) that will provide property tax savings for 10 years on the FHLBank's new headquarters. In the transaction, the County acquired an interest in the land, improvements, building and equipment (collectively, the Project) by issuing up to $36,000,000 of industrial revenue bonds due December 31, 2027 (IRBs) and leased the Project to the FHLBank for an identical 127-month term under a financing lease. The IRBs are collateralized by the Project and the lease revenues for the related leasing transaction with the County. The IRBs were purchased by the FHLBank. The County assigned the lease to the bond trustee for the FHLBank's benefit as the sole holder of the IRBs. The FHLBank can prepay the IRBs at any time, but would forfeit its property tax benefit in the event the IRBs were to be prepaid. As a result, the land and building will remain a component of the property, plant and equipment in the FHLBank's statement of financial condition. The IRBs and the equivalent liability are included in the FHLBank's statement of financial condition in other assets and other liabilities, respectively. The FHLBank, as holder of the IRBs, is due interest at 2.0 percent per annum with interest payable annually in arrears on December 1, beginning December 1, 2018. This interest income is directly offset by the financing interest expense payments on the land and building, which are due at the same time and in the same amount as the interest income. The bond trustee for the transaction is BOKF, N.A., a related party disclosed in Note 18. As bond trustee, BOKF, N.A. received trustee fees of $11,000 during the year ended December 31, 2017. As of December 31, 2017, $29,000,000 of the IRBs were issued and outstanding.
Lease Commitments: Net rental costs under operating leases of approximately $81,000, $81,000 and $73,000 in 2017, 2016, and 2015, respectively, for premises and equipment have been charged to other operating expenses. Total future minimum net rentals, which extend no later than 2020, are $186,000.
Safekeeping Custodial Arrangements: The FHLBank acts as a securities safekeeping custodian on behalf of participating members. Actual securities are held by a third-party custodian acting as agent for the FHLBank. As of December 31, 2017, the total original par value of customer securities held by the FHLBank under this arrangement was $46,269,500,000.
Other commitments and contingencies are discussed in Notes 1, 5, 6, 7, 8, 10, 11, 13 and 15.
NOTE 18 - TRANSACTIONS WITH STOCKHOLDERS
The FHLBank is a cooperative whose members own most of the capital stock of the FHLBank and generally receive dividends on their investments. In addition, certain former members that still have outstanding transactions are also required to maintain their investments in FHLBank capital stock until the transactions mature or are paid off. Nearly all outstanding advances are with current members, and the majority of outstanding mortgage loans held for portfolio were purchased from current or former members. The FHLBank also maintains demand deposit accounts for members primarily to facilitate settlement activities that are directly related to advances and mortgage loan purchases.
As provided by statute, the FHLBank’s members have the right to vote on the election of directors. In accordance with the Bank Act and FHFA regulations, members elect all of the FHLBank’s board of directors. Under the statute and regulations, each member directorship is designated to one of the four states in the FHLBank’s district, and a member is entitled to vote only for candidates for the state in which the member’s principal place of business is located. Each independent director is elected by the members at large from among individuals nominated by the FHLBank’s board of directors. A member is entitled to cast, for each applicable directorship, one vote for each share of capital stock that the member is required to hold as of the record date for voting, subject to a statutory limitation. Under this limitation, the total number of votes that a member may cast is limited to the average number of shares of the FHLBank’s capital stock that were required to be held by all members in that state as of the record date for voting. Non-member stockholders are not entitled to cast votes for the election of directors. As of December 31, 2017 and 2016, no member owned more than 10 percent of the voting interests of the FHLBank due to the statutory limitation on members’ voting rights as discussed above.
Transactions with members are entered into in the ordinary course of business. In instances where members also have officers or directors who are directors of the FHLBank, transactions with those members are subject to the same eligibility and credit criteria, as well as the same terms and conditions, as other transactions with members. For financial reporting and disclosure purposes, the FHLBank defines related parties as FHLBank directors’ financial institutions and members with capital stock investments in excess of 10 percent of the FHLBank’s total regulatory capital stock outstanding, which includes mandatorily redeemable capital stock.
Activity with Members that Exceed a 10 Percent Ownership in FHLBank Capital Stock: Tables 18.1 and 18.2 present information on members that owned more than 10 percent of outstanding FHLBank regulatory capital stock as of December 31, 2017 and 2016 (dollar amounts in thousands). None of the officers or directors of these members currently serve on the FHLBank’s board of directors.
Table 18.1
Table 18.2
Advance and deposit balances with members that owned more than 10 percent of outstanding FHLBank regulatory capital stock as of December 31, 2017 and 2016 are summarized in Table 18.3 (dollar amounts in thousands). Information is only listed for the period in which the member owned more than 10 percent of outstanding FHLBank regulatory stock.
Table 18.3
BOKF, N.A. and MidFirst Bank did not sell any mortgage loans into the MPF Program during the years ended December 31, 2017 and 2016. Capitol Federal Savings Bank did not sell any mortgage loans into the MPF Program during the year ended December 31, 2017.
Transactions with FHLBank Directors’ Financial Institutions: Table 18.4 presents information as of December 31, 2017 and 2016 for members that had an officer or director serving on the FHLBank’s board of directors (dollar amounts in thousands). Information is only included for the period in which the officer or director served on the FHLBank’s board of directors. Capital stock listed is regulatory capital stock, which includes mandatorily redeemable capital stock.
Table 18.4
Table 18.5 presents mortgage loans acquired during the years ended December 31, 2017 and 2016 for members that had an officer or director serving on the FHLBank’s board of directors in 2017 or 2016 (dollar amounts in thousands). Information is only included for the period in which the officer or director served on the FHLBank’s board of directors.
Table 18.5
Direct Financing Lease: During 2002, the FHLBank entered into a 20-year direct financing lease with a member for a building complex and property. Either party has the option to terminate this lease after 15 years. The net investment in the direct financing lease with the member is recorded in other assets. The FHLBank’s $7,896,000 up-front payment for its portion of the building complex is recorded in premises, software and equipment. On October 31, 2005, the FHLBank amended its lease to occupy additional building space, thereby reducing the portion of the property previously leased back to the member and decreasing the member’s future lease payments. All other provisions of the original lease remained in effect. The net reduction in the lease receivable is recorded in premises, software and equipment. On March 31, 2015, the FHLBank provided a Notice of Termination of FHLBank Occupancy (Notice) to the member stating that the FHLBank plans to terminate its occupancy of the space currently occupied by the FHLBank as its headquarters on March 31, 2018. The Notice was further amended to reflect the termination of occupancy and initiate the sale of its space to the member on January 31, 2018. The 20-year direct financing lease will remain in place for the member's space being leased thereafter. Beginning February 1, 2018, the member's future lease payments will revert back to the initial amount prior to the October 31, 2005 amendment. The direct financing lease has been adjusted accordingly.
See Note 7 for additional information on the direct financing lease.
NOTE 19 - TRANSACTIONS WITH OTHER FHLBANKS
FHLBank Topeka had the following business transactions with other FHLBanks during the years ended December 31, 2017, 2016, and 2015 as presented in Table 19.1 (in thousands). All transactions occurred at market prices.
Table 19.1
_________
Occasionally, the FHLBank loans (or borrows) short-term funds to (from) other FHLBanks. Interest income on loans to other FHLBanks is included in Other Interest Income and interest expense on borrowings from other FHLBanks is included in Other Interest Expense on the Statements of Income.
Balances are interest bearing and are classified on the Statements of Condition as interest-bearing deposits.
Fees are calculated monthly based on outstanding loans at the per annum rate in effect at origination.
Purchases of consolidated obligations issued on behalf of one FHLBank and purchased by the FHLBank occur at market prices with third parties and are accounted for in the same manner as similarly classified investments. Outstanding fair value balances totaling $110,641,000 and $219,931,000 as of December 31, 2017 and 2016, respectively, are included in the non-MBS GSE obligations totals presented in Note 4. Interest income earned on these securities totaled $5,817,000, $9,011,000, and $9,011,000 for the years ended December 31, 2017, 2016, and 2015, respectively.