This document contains forward-looking statements that describe the objectives, expectations, estimates, and assessments of the Federal Home Loan Bank of Cincinnati (the FHLB). These statements use words such as “anticipates,” “expects,” “believes,” “could,” “estimates,” “may,” and “should.” By their nature, forward-looking statements relate to matters involving risks or uncertainties, some of which we may not be able to know, control, or completely manage. Actual future results could differ materially from those expressed or implied in forward-looking statements or could affect the extent to which we are able to realize an objective, expectation, estimate, or assessment. Some of the risks and uncertainties that could affect our forward-looking statements include the following:
We do not undertake any obligation to update any forward-looking statements made in this document.
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Item 1.Business.
COMPANY INFORMATION
Company Background
The FHLB is a regional wholesale bank that serves the public interest by providing financial products and services to our members to fulfill a public-policy mission of supporting housing finance and community investment. We are part of the FHLBank System. Each of the 11 FHLBanks operates as a separate entity with its own stockholders, employees, Board of Directors, and business model. Our region, known as the Fifth District, comprises Kentucky, Ohio and Tennessee.
The U.S. Congress chartered the FHLBank System in the Federal Home Loan Bank Act of 1932 (the FHLBank Act) as a GSE to help provide liquidity and credit to the U.S. housing market and support home ownership. Promoting home ownership is a long-standing central theme of U.S. government policy. The System has a critical public-policy role as important national liquidity providers to mortgage lenders, particularly during stressful conditions when private-sector liquidity often proves unreliable.
The FHLBanks are not government agencies and the U.S. government does not guarantee, directly or indirectly, the debt securities or other obligations of the FHLBank System. Rather, the FHLBanks are GSEs, which combine private sector ownership with public sector sponsorship. In addition, the FHLBanks are cooperative institutions, privately and wholly owned by stockholders who are also the primary customers.
The FHLBank System also includes the Federal Housing Finance Agency (Finance Agency) and the Office of Finance. The Finance Agency is an independent agency in the executive branch of the U.S. government that regulates the FHLBanks, the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Office of Finance. The Office of Finance is a joint office of the FHLBanks that facilitates the issuance and servicing of the FHLBank System's Consolidated Obligations.
All federally insured depository institutions, certain insurance companies, and community development financial institutions chartered in the Fifth District may voluntarily apply for membership in our FHLB. Applicants must satisfy membership requirements in accordance with statutes and Finance Agency regulations. These requirements deal primarily with home financing activities, satisfactory financial condition such that Advances may be made safely, and matters related to the regulatory, supervisory and management oversight of the applicant. By law, an institution is permitted to apply for membership in only one FHLBank, although a holding company may have memberships in more than one FHLBank through its subsidiaries. At December 31, 2020, we had 628 members.
The combination of public sponsorship and private ownership that drives our business model is reflected in the composition of our 18-member17-member Board of Directors, all of whom members elect. Ten directors are officers and/or directors of our member institutions, while the remaining directors are Independent directors who represent the public interest.
At December 31, 2018, we had 646 members, 225 full-time employees, and four part-time employees. Our employees are not represented by a collective bargaining unit. We consider our relationship with our employees to be good.
Our internet address is www.fhlbcin.com. Information on our website is not incorporated by reference into this report.
Mission and Corporate Objectives
Our mission is to provide member-stockholders with financial services and a competitive return on their capital investment to help them facilitate and expand housing finance and community investment and achieve their objectives for liquidity and asset liability management.
How We Achieve the Mission
We achieve our mission through a cooperative business model. We raise private-sector capital from member stockholders and issue low-cost high-quality debt in the global capital markets jointly with other FHLBanks. The capital and proceeds from debt issuance enable us to provide members services—primarily, access to liquidity via reliable, readily available, and low-cost sources of funding to support their business activities including affordable housing and community investment. Another
important member service is that we offer a program to purchase certain mortgage loans, which provides members liquidity and helps them reduce market risk. Additionally, we provide a competitive return on members' capital investment in our company.
Our ability to best perform our mission depends on having a membership base that is an essential component of the nation’s housing and mortgage finance systems. We focus closely on fulfilling our mission for members who are community financial institutions, who we believe typically rely more on us for access to liquidity and mortgage markets compared with larger members. At the same time, we value having large members who are active borrowers because they provide the System the ability to consistently issue large amounts of debt, which helps ensure the debt has a relatively low cost, benefiting all members.
The primary products we offer, which we call Mission Assets, are readily available low-cost loans called Advances, purchases of certain whole mortgage loans sold by qualifying members through the Mortgage Purchase Program (MPP), and Letters of Credit. We also offer affordable housing programs and related activities to support members in their efforts to assist very low-, low- and moderate-income households and their local communities. To a more limited extent, we also have several correspondent services that assist members in operational administration.
The primary way we obtain funding is through participation in the issuance of the FHLBank System's Consolidated Obligations in the global capital markets. Secondary sources of funding are capital and deposits we accept from our members. A critical component of the success of the FHLBank System is its ability to maintain a comparative advantage in funding, which due to its GSE status, confers an implied guarantee from the U.S. federal government, low risk operations, and joint and several liability across the 11 FHLBanks. We regularly issue Obligations with a wide range of maturities, structures, and amounts, and at relatively favorable spreads to benchmark market interest rates (such as U.S. Treasury securities, the London InterBank Offered Rate (LIBOR)LIBOR, Federal funds effective, and the Secured Overnight Financing Rate (SOFR)) compared with many other financial institutions.
Because we are a cooperative organization with some members using our products more heavily than others and members having different percentages of capital stock, we must achieve a balance in generating membership value from product prices and characteristics and paying a competitive dividend rate. We attempt to achieve this balance by pricing Mission Asset ActivityAssets at relatively narrow spreads over funding costs, compared with other financial institutions, while still achieving acceptable profitability. Our cooperative ownership structure and deep access to debt markets allow our business to be scalable and self-capitalizing without jeopardizing profitability, taking undue risks, or diminishing capital adequacy.adequacy, or jeopardizing profitability.
Our franchise value is derived from the synergies brought by the various components of our business model, including the public-policy mandate, GSE status, cooperative ownership structure, consistent ability to issue large amounts of debt at favorable funding costs, and mechanisms of providing housing finance liquidity through products and services to financial institutions rather than directly to homeowners.
Corporate Objectives
Our corporate objectives, listed below, are intended to promote housing finance among members and ensure our operations and governance are effective and efficient.
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▪ | Mission Asset Activity:Implement strategies and tactics and effectively manage operations to promote members’ usage of Mission Assets and stand ready at all times to provide liquidity to members.
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▪ | Stock Return: Earn adequate profitability so that members receive a competitive long-term dividend on their capital stock investment.
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▪ | Housing and Community Investment Programs: Maintain effective housing and community investment programs and offer targeted voluntary assistance programs.
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▪ | Safe and Sound Operations:Optimize our counterparty and deposit ratings, achieve an acceptable rating on annual examinations, and have an adequate amount and composition of capital.
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▪ | Risk Management: Employ effective risk optimization management practices and maintain risk exposures at low to moderate levels.
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▪ | Governance: Operate in accordance with effective corporate governance processes that emphasize compliance and consider the interest of all stakeholders (members, stockholders, employees, creditors, housing partners, and regulators).
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▪Mission Asset Activity:Implement strategies and tactics and effectively manage operations to promote members’ usage of Mission Assets and stand ready at all times to provide liquidity to members.
▪Stock Return: Earn adequate profitability so that members receive a competitive long-term dividend on their capital stock investment.
▪Housing and Community Investment Programs: Maintain effective housing and community investment programs and offer targeted voluntary assistance programs.
▪Safe and Sound Operations:Optimize our counterparty and deposit ratings, achieve an acceptable rating on annual examinations, and have an adequate amount and composition of capital.
▪Risk Management: Employ effective risk optimization management practices and maintain risk exposures at low to moderate levels.
▪Governance: Operate in accordance with effective corporate governance processes that emphasize compliance and consider the interest of all stakeholders (members, stockholders, employees, creditors, housing partners, and regulators).
Business Activities
Mission Asset Activity
The following are our principal business activities with members:
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▪ | We lend readily-available, competitively-priced, and fully-collateralized Advances. |
▪We lend readily-available, competitively-priced, and fully-collateralized Advances.
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▪ | We issue collateralized Letters of Credit. |
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▪ | We purchase qualifying residential mortgage loans through the MPP and hold them on our balance sheet. |
▪We issue collateralized Letters of Credit.
▪We purchase qualifying residential mortgage loans through the MPP and hold them on our balance sheet.
Together, these product offerings constitute “Mission Asset Activity.” We refer to Advances and Letters of Credit as Credit Services.
Affordable Housing and Community Investment
In addition, through various Housing and Community Investment programs, we assist members in serving very low-, low-, and moderate-income households and community economic development. These programs provide Advances at below-market rates of interest, as well as direct grants.
Investments
To help us achieve our mission and corporate objectives, we invest in highly-rated debt instruments of financial institutions and the U.S. government and in mortgage-related securities. In practice, these investments normally include liquidity instruments and longer-term mortgage-backed securities (MBS),MBS, as permitted by Finance Agency regulation. Investments provide liquidity, help us manage market risk exposure, enhance earnings, and through the purchase of mortgage-related securities, support the housing market.
Sources of Earnings
Our major source of revenue is interest income earned on Advances, MPP loans, and investments.
Major items of expense are:
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▪ | interest paid on Consolidated Obligations and deposits to fund assets; |
▪interest paid on Consolidated Obligations and deposits to fund assets;
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▪ | costs of providing below-market-cost Advances and direct grants and subsidies under the Affordable Housing Program; and |
▪costs of providing below-market-cost Advances and direct grants and subsidies under the Affordable Housing Program; and
▪non-interest expenses.
The largest component of earnings is net interest income, which equals interest income minus interest expense. We derive net interest income from the interest rate spread earned on assets versus funding costs and the use of financial leverage.earnings from funding assets with capital. Each of these can vary over time with changes in market conditions, including most importantly interest rates, business conditions and our risk management activities.
We believe members' capital investment is comparable to investing in adjustable-rate preferred equity instruments. Therefore, we structure our balance sheet risk exposures so that earnings tend to move in the same direction as changes in short-term market rates, which can help provide a degree of predictability for dividend returns.
Capital
Due to our cooperative structure, we obtain capital from members. Each member must own capital stock as a condition of membership and normally must acquire additional stock above the membership stock amount in order to gain access to Mission Assets. Acquiring capital in connection with growth in Mission Assets ensures that these assets are self-capitalizing. We issue, redeem, and repurchase capital stock only at its stated par value of $100 per share. By law, our stock is not publicly traded.
We also maintain an amount of capital to ensure we meet all of our regulatory and business requirements relating to capital adequacy and protection of creditors against losses. We hold retained earnings to protect members' stock investment against impairment risk and to help stabilize dividend payments when earnings may be volatile.
Tax Status
We are exempt from all federal, state, and local taxation other than real property taxes. Any cash dividends we issue are taxable to members and do not benefit from the corporate dividends received exclusion. Notes 1 and 1410 of the Notes to Financial Statements provide additional details regarding the assessment for the Affordable Housing Program.
Ratings of Nationally Recognized Statistical Rating Organizations
The FHLBank System's comparative advantage in funding is acknowledged in its excellent credit ratings from nationally recognized statistical rating organizations (NRSROs). Moody's Investors Service (Moody's) currently assigns, and historically has assigned, the System's Consolidated Obligations the highest ratings available: long-term debt is rated Aaa and short-term debt is rated P-1. It also assigns a Prime-1 short-term bond rating on each FHLBank. It affirmed these ratings in 20182020 and maintained a stable outlook. In 2018,2020, Standard & Poor's affirmed its issuer credit ratings on each FHLBank and its AA+ ratings on the System's senior debt and also maintained a stable outlook. The ratings closely follow the U.S. sovereign ratings from both agencies.
The agencies' rationales for their ratings of the System and our FHLB include the System's status as a GSE; the joint and several liability for Obligations; excellent overall asset quality; extremely strong capacity to meet commitments to pay timely principal and interest on debt; strong liquidity; conservative use of derivatives; adequate capitalization relative to our risk profile; a stable capital structure; and the fact that no FHLBank has ever defaulted on repayment of, or delayed return of principal or interest on, any Obligation.
A credit rating is not a recommendation to buy, sell or hold securities. A rating organization may revise or withdraw its ratings at any time, and each rating should be evaluated independently of any other rating. We cannot predict what future actions, if any, a rating organization may take regarding the System's or our ratings.
Regulatory Oversight
Our business is subject to extensive regulation and supervision. The laws and regulations to which we are subject cover all key aspects of our business, and directly and indirectly affect our product and service offerings, pricing, competitive position and strategic plan, relationship with members and third parties, capital structure, cash needs and uses, and information security. As discussed throughout this document, such laws and regulations can have a significant effect on key drivers of our results of operations, including, for example, our capital and liquidity, product and service offerings, risk management, and costs of compliance.
The Finance Agency is headed by a Director who has regulatory authority to promulgate regulationsover the FHLBanks and to make other decisions. The Finance Agency is charged with ensuring that each FHLBank carries out its housing and community development finance mission, remains adequately capitalized, operates in a safe and sound manner, and complies with Finance Agency regulations. The Finance Agency is headed by a Director who has authority to promulgate regulations and to make other decisions.
To carry out these responsibilities, the Finance Agency conducts on-site examinations of each FHLBank at least annually, as well as periodic on- and off-site reviews, and receives monthly information on each FHLBank's financial condition and operating results. While an individual FHLBank has substantial discretion in governance and operational structure, the Finance Agency maintains broad supervisory and regulatory authority. In addition, the Comptroller General has authority to audit or examine the Finance Agency and the FHLBanks, to decide the extent to which the FHLBanks fairly and effectively fulfill the purposes of the FHLBank Act, and to review any audit, or conduct its own audit, of the financial statements of an FHLBank.
BUSINESS SEGMENTS
We manage the development, resource allocation, product delivery, pricing, credit risk management, and operational administration of our Mission Asset Activity in two business segments: Traditional Member Finance and the MPP. Traditional Member Finance includes Credit Services, Housing and Community Investment, Investments, some correspondent and deposit services, and other financial products of the FHLB. See the “Segment Information” section of “Results of Operations” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 1814 of the Notes to Financial Statements for more information on our business segments, including their results of operations.
Traditional Member Finance
Credit Services
Advances.Advances are competitively priced sources of funds available for members to help manage their asset/liability and liquidity needs. Advances can both complement and be alternatives to retail deposits, other wholesale funding sources, and corporate debt issuance. We strive to facilitate efficient, fast, and continuous member access to funds. In most cases, members can access funds on a same-day basis.
We price a variety of standard Advance programs every business day and several other standard programs on demand. We also offer customized, non-standard Advances. Having diverse programs gives members the flexibility to choose and customize their borrowings according to size, maturity, interest rate, interest rate index (for adjustable-rate coupons), interest rate options, and other features.
Repurchase based (REPO) Advances are short-term, fixed-rate instruments structured similarly to repurchase agreements from investment banks, with one principal difference. Members collateralize their REPO Advances through our normal collateralization process, instead of being required to pledge specific securities as would be required in a typical repurchase agreement. A majority of REPO Advances outstanding have overnight maturities.
Adjustable-rate Advances have interest rates typically priced off benchmark rate indices such as LIBORSOFR, or SOFR.historically LIBOR. Adjustable-rate Advances may be structured at the member's option as either prepayable with a fee or prepayable without a fee if the prepayment is made on a repricing date.
Regular Fixed-Rate Advances have terms of 3 months to 30 years, with interest normally paid monthly and principal repayment normally at maturity. Members may choose to purchase call options on these Advances, although in the last several years, balances with call options have been at or close to zero.
Putable Advances are fixed-rate Advances that provide us an option to terminate the Advance, usually after an initial “lockout” period. Most have long-term original maturities. Selling us these options enables members to secure lower rates on Putable Advances compared to Regular Fixed-Rate Advances with the same final maturity.
Mortgage-Related Advances are fixed-rate, amortizing Advances with final maturities of 5 to 30 years. Some of these Advances, at the choice of the member, provide members with prepayment options without fees.
We also offer various other Advance programs that have smaller outstanding balances.
Letters of Credit. Letters of Credit are collateralized contractual commitments we issue on a member's behalf to guarantee its performance to third parties. A Letter of Credit may obligate us to make direct payments to a third party, in which case it is treated as an Advance to the member. The most popular use of Letters of Credit is as collateral supporting public unit deposits, which are deposits held by governmental units at financial institutions. We normally earn fees on Letters of Credit based on the actual average amount of the Letters utilized, which generally is less than the notional amount issued.
How We Manage Risks of Credit Services. We manage market risk from Advances by funding them with Consolidated Obligations and interest rate swaps that have similar interest rate risk characteristics as the Advances. The net effect is that in practice we mitigate nearly all of the market risk exposure associated with Advances.
In addition, for many, but not all, Advance programs, Finance Agency regulations require us to charge members prepayment fees for early termination of principal when the early termination results in an economic loss to us. We determine prepayment fees using standard present-value calculations that make us economically indifferent to the prepayment. The prepayment fee equals the present value of the estimated profit that we would have earned over the remaining life of the prepaid Advance. If a member prepays principal on an Advance that we have hedged with an interest rate swap, we may also assess the member a fee to compensate us for the cost we incur in terminating the swap before its stated final maturity. Some Advance programs are structured as non-prepayable and may have additional restrictions in order to terminate.
We manage credit risk on Advances by requiring each member to supply us with a security interest in eligible collateral that in the aggregate has estimated value in excess of the total Advances and Letters of Credit. Collateral is comprised mostly of single-family loans,single- and multi-family residential loans, commercial real estate loans, home equity loans, government guaranteed loans and bond securities. The combination of conservative collateral policies and risk-based credit underwriting activities mitigates virtually all potential credit risk associated with Advances and Letters of Credit. We have never experienced a credit loss on
Advances, nor have we ever
determined it necessary to establish a loan loss reserve for Advances. "Quantitative and Qualitative Disclosures About Risk Management” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 8 and 10Note 5 of the Notes to Financial Statements haveprovide more detail on our credit risk management of member borrowings.
Housing and Community Investment
Our Housing and Community Investment Programs include the Affordable Housing Program and various housing and community economic development-related Advance and grant programs. We fund the Affordable Housing Program with an accrual equal to 10 percent of our previous year's net earnings, mandated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989. See Note 1410 of the Notes to Financial Statements for a complete description of the Affordable Housing Program calculation.
The Affordable Housing Program provides funding for the development of affordable housing. The Program consists of a Competitive Program and a homeownership program called Welcome Home, which assists homebuyers with down payments and closing costs. Under the Competitive Program, we currently distribute funds in the form of grants to members that apply and successfully compete in an annual offering. Under Welcome Home, we make funds available beginning in March until they have been fully committed. For both programs, the income of qualifying individuals or households must be 80 percent or less of the area median income. We set aside up to 35 percent of the Affordable Housing Program accrual for Welcome Home and allocate the remainder to the Competitive Program.
Our Board of Directors also may allocate funds to voluntary housing programs. In 2018,2020, the Board re-authorized an additional $1.5$2.0 million to the Carol M. Peterson Housing Fund for use during the year. In January 2019, the Board authorized an increase in this fund to $2.1 million for use in 2019. These funds are primarily used as grants to pay for accessibility rehabilitation and emergency repairs for special needs and elderly homeowners. In 2012, the Board of Directors also established the Disaster Reconstruction Program, a voluntary housing program that provides grants for purchase or rehabilitation of a home within the Fifth District for residents that have suffered loss or damage to their primary residence as a result of a state or federally declared disaster. In December 2018,Since the Board approved an additional $3.6program's inception, we have disbursed over $4.7 million to continueassist 378 households. Furthermore, in support of our members during the Disaster Reconstruction Program. When combinedCOVID-19 pandemic, we created a new Advance program that offered Advances with the existing $1.4terms up to six months at zero percent interest to members between May 1, 2020 and September 30, 2020. These Advances supported COVID-19 related assistance made by all Fifth District members. In 2020, we issued a total of $183 million available under the original authorization, the total disaster funds available were $5.0of these Advances of which $34 million remained outstanding at December 31, 2018.2020.
Two other housing programs that fall outside the auspices of the Affordable Housing Program are the Community Investment Program and the Economic Development Program. Advances under the former program have rates equal to our cost of funds, while Advances under the latter program have rates equal to our cost of funds plus three basis points.reasonable administrative costs. Members use the Community Investment Program to serve housing needs of low- and moderate-income households and, under certain conditions, community economic development projects. The Economic Development Program is a discounted Advance program used to promote economic development and job creation and retention.
Investments
Types of Investments. A primary reason we hold investments is to carry sufficient asset liquidity. Permissible liquidity investments include Federal funds, certificates of deposit, bank notes, bankers' acceptances, commercial paper, securities purchased under agreements to resell, and debt securities issued by the U.S. government, its agencies, or other GSE's. The first five categories represent unsecured lending to private counterparties. We also may place deposits with the Federal Reserve Bank. We are prohibited by Finance Agency regulations from investing (secured or unsecured) in financial investments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks. Many liquidity investments have short-term maturities.
Subject to regulatory limitations on purchases of new LIBOR-based investments, we are also permitted by regulation to purchase the following other investments, which have longer original maturities than liquidity investments:
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▪ | MBS and collateralized mortgage obligations (together, referred to as MBS) issued by GSEs or private issuers; |
▪MBS and collateralized mortgage obligations (together, referred to as MBS) issued by GSEs, other U.S. government agencies or private issuers;
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▪ | asset-backed securities collateralized by manufactured housing loans or home equity loans issued by GSEs or private issuers; and |
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▪ | marketable direct obligations of certain government units and agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital. |
▪asset-backed securities collateralized by manufactured housing loans or home equity loans issued by GSEs or private issuers; and
▪marketable direct obligations of certain government units and agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital.
We have never purchased asset-backed securities and do not own any privately-issued MBS. We have historically held small amounts of obligations of government units and agencies.
Per Finance Agency regulations, the total investment in MBS and asset-backed securities may not exceed on a book value basis, 300 percent of previous month-end regulatory capital on the day we purchase the securities. See the “Capital Resources” section below for the definition of regulatory capital.
Purposes of Having Investments. The investments portfolio helps achieve corporate objectives in the following ways:
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▪ | Liquidity management. Liquidity investments support the ability to fund assets on a timely basis, especially Advances, and when it may be more difficult to issue new debt. These investments supply liquidity because we normally fund them with longer-term debt than asset maturities. We also may be able to obtain liquidity by selling certain investments for cash without a significant loss of value.
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▪ | Earnings enhancement. The investments portfolio, especially MBS, assists with earning a competitive return on capital, and increasing funding for Housing and Community Investment programs. In addition, liquidity investments help stabilize earnings because they typically earn a relatively stable spread to the cost of debt issued to fund them.
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▪ | Management of debt issuance. Maintaining a short-term liquidity investment portfolio can help us participate in attractively priced debt issuances, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
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▪ | Support of housing market. Investment in MBS and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
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▪Liquidity management. Liquidity investments support the ability to fund assets on a timely basis, especially Advances, and when it may be more difficult to issue new debt. These investments supply liquidity because we normally fund them with longer-term debt than asset maturities. We also may be able to obtain liquidity by selling certain investments for cash without a significant loss of value.
▪Earnings enhancement. The investments portfolio, especially MBS, assists with earning a competitive return on capital, and increasing funding for Housing and Community Investment programs. In addition, liquidity investments help stabilize earnings because they typically earn a relatively stable spread to the cost of debt issued to fund them.
▪Management of debt issuance. Maintaining a short-term liquidity investment portfolio can help us participate in attractively priced debt issuances, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
▪Support of housing market. Investment in MBS and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
How We Manage Risks of Investments. We strive to ensure our investment holdings have a moderate degree of market risk and limited credit risk, which tends to lower the returns we can expect to earn on these securities. We believe that a philosophy of purchasing investments with a high amount of market or credit risk would be inconsistent with our GSE status and corporate objectives.
Market risk associated with short-term investments tends to be minimal because of their short maturities and because we typically fund them with short-term Consolidated Obligations having similar maturities. We mitigate much of the market risk of MBS, which exists primarily from changes in mortgage prepayment speeds, by limiting their balances to 300 percent of regulatory capital and by funding them with a portfolio of long-term fixed-rate callable and non-callable Obligations,Obligations. Additionally, we mitigate much of the market risk of longer-term non-MBS securities, and a portion of our MBS, by managingusing interest rate swaps to effectively convert the fixed rate investments to adjustable-rate investments. We also manage the market risk exposure of the entire balance sheet within prudent policy limits.
Finance Agency regulations and internal policies also provide controls on market risk exposure by restricting the types of mortgage loans, MBS and other investments we can hold. These restrictions prohibit, among others, the purchase of interest only or principal only stripped MBS and MBS whose average life varies more than six years under a 300 basis points interest rate shock.
Our internal policies specify guidelines for, and relatively tight constraints on, the types and amounts of short-term investments we are permitted to hold and the maximum amount of credit risk exposure we are permitted to have with eligible counterparties. We are permitted to invest only in the instruments of counterparties with high credit ratings, and because of our conservative
investment policies and practices, we believe all of our investments have high credit quality. We have never had a credit loss or credit-related write down of any investment security.
Deposits
We provide a variety of deposit programs, including demand, overnight, term and Federal funds, which enable depositors to invest funds in short-term liquid assets. We accept deposits from members, other FHLBanks, any institution to which we offer correspondent services, and other government instrumentalities. The rates of interest we pay on deposits are subject to change daily based on comparable money market interest rates. The balances in deposit programs tend to vary positively with the amount of idle funds members have available to invest, as well as the level of short-term interest rates. Deposits have typically represented a small component of our funding in recent years, typically less than one to two percent of our funding sources.sources in recent years.
Mortgage Purchase Program (MPP or Mortgage Loans Held for Portfolio)
Description of the MPP
Types of Loans and Benefits. Finance Agency regulations permit FHLBanks to purchase and hold specified whole mortgage loans from their members, which offers members a competitive alternative to the traditional secondary mortgage market and directly supports housing finance. We account for MPP loans as mortgage loans held for portfolio. By selling mortgage loans to us, members can increase their balance sheet liquidity and lower interest rate and mortgage prepayment risks. The MPP particularly enables small- and medium-sized community-based financial institutions to use their existing relationship with us to participate more effectively in the secondary mortgage market.
We purchase two types of mortgage loans: qualifying conforming fixed-rate conventional 1-4 family residential mortgages and residential mortgages fully insured by the Federal Housing Administration (FHA). Members approved to sell us these loans are referred to as Participating Financial Institutions (PFIs).
A “conventional” mortgage refers to a non-government-guaranteed mortgage. A “conforming” mortgage refers to the maximum amount permissible to be lent as a regular prime (i.e., non-jumbo, non-subprime) mortgage. For 2019,2021, the Finance Agency established the conforming limit at $484,350$548,250 with loans originated in a limited number of high-cost cities and counties receiving higher conforming limits. We dohave elected not to purchase mortgages subject to these higher amounts.conforming limits.
Loan Purchase Process. A Master Commitment Contract is negotiated with each PFI, in which the PFI agrees to make a best efforts attempt to sell us a specific dollar amount of mortgage loans generally over a period of up to 12 months. We purchase loans pursuant to a Mandatory Delivery Contract, which is a legal commitment we make to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of note rates and prices.
Shortly before delivering the loans that will fill the Mandatory Delivery Contract, the PFI must submit loan level detail including underwriting information. We apply procedures through thean automated Loan Acquisition Systemsystem designed to screen loans that do not comply with our policies. Our underwriting guidelines generally mirror those of Fannie Mae and Freddie Mac for conforming conventional loans, although our guidelines and pool composition requirements are more conservative in a number of ways in order to further limit credit risk exposure. PFIs are required to make certain representations and warranties against our underwriting guidelines on the loans they sell to us. If a PFI sells us a loan in breach of those representations and warranties, we have the contractual right to require the PFI to repurchase the loan.
How We Manage Risks of the MPP
Market Risk. We mitigate the MPP's market risk similarly to how we mitigate market risk from MBS.
Credit Risk - Conventional Mortgage Loans. A unique feature of the MPP is that it separates the various activities and risks associated with residential mortgage lending for conventional loans and allows these risks and activities to be taken on by different entities. We manage the market risk (including interest rate risk and prepayment risk) and liquidity risk. PFIs manage marketing, originating and, in most cases, servicing the loans. PFIs may either retain servicing or sell it to a qualified and approved third-party servicer (also referred to as a PFI). Because PFIs manage and bear most of the credit risk, they do not pay us a guarantee fee to transfer credit risk.
We manage credit risk exposure for conventional loans primarily through underwriting and pool composition requirements and by applying layered credit enhancements. These enhancements, which apply after a homeowner's equity is exhausted, include available primary mortgage insurance, the Lender Risk Account (discussed below), and Supplemental Mortgage Insurance. Supplemental Mortgage Insurance is applicable to loans acquired before February 2011 and was purchased by the PFI from one
of our approved third-party providers naming us as the beneficiary. These credit enhancements are designed to protect us against credit losses in scenarios of severe downward movements in housing prices and unfavorable changes in other factors that can affect loan delinquencies and defaults.
The Lender Risk Account is a key component of how we manage residual credit risk. It is a holdback of a portion of the initial purchase price. Starting after five years from the loan purchase date, we may return the holdback to PFIs if they manage credit risk to pre-defined acceptable levels of exposure on the loan pools they sell to us. Actual loan losses are deducted from the amount of the purchase-price holdback we return to the PFI. The Lender Risk Account provides PFIs with a strong incentive to sell us high quality performing mortgage loans.
Credit Risk - FHA Mortgage Loans. Because the FHA makes an explicit guarantee on FHA loans, we do not require any credit enhancements on these loans beyond primary mortgage insurance.
"Quantitative and Qualitative Disclosures About Risk Management” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations provides more detail on how we manage market and credit risks for the MPP.
Earnings from the MPP
The MPP enhances long-term profitability on a risk-adjusted basis and augments the return on member stockholders' capital investment. We generate earnings in the MPP from monthly interest payments minus the cost of funding and the cost of hedging the MPP's interest rate risk. Interest income on each loan is computed as the mortgage note rate multiplied by the loan's principal balance:
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▪ | minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans); |
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▪ | minus the cost of Supplemental Mortgage Insurance (for applicable loans); and |
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▪ | adjusted for the amortization of purchase premiums or the accretion of purchase discounts and for the amortization or accretion of fair value adjustments on loans initially classified as mortgage loan commitments. |
▪minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans);
▪minus the cost of Supplemental Mortgage Insurance (for applicable loans); and
▪adjusted for the amortization of purchase premiums or the accretion of purchase discounts and for the amortization or accretion of fair value adjustments on loans initially classified as mortgage loan commitments.
For new loan purchases, we consider the cost of the Lender Risk Account when we set conventional loan prices and evaluate the MPP's potential return on investment. The pricing of each structure depends on a number of factors and is specific to the PFI and to the loan pool. We do not receive fees or income for retaining the risk of losses in excess of any credit enhancements.
FUNDING - CONSOLIDATED OBLIGATIONS
Our primary source of funding and hedging market risk exposure is through participation in the sale of Consolidated Obligation debt securities to global investors. Obligations are the joint and several obligations of all the FHLBanks, backed only by the financial resources of these institutions.
There are two types of Consolidated Obligations: Consolidated Bonds (Bonds) and Consolidated Discount Notes (Discount Notes).
We participate in the issuance of Bonds for three purposes:
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▪ | to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets; |
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▪ | to finance and hedge short-term, adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate funding through the execution of interest rate swaps; and |
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▪ | to acquire liquidity investments. |
▪to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets;
▪to finance and hedge short-term, adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate funding through the execution of interest rate swaps; and
▪to acquire liquidity investments.
Bonds may have fixed or adjustable rates of interest. Fixed-rate Bonds are either non-callable or callable. A callable Bond is one that we are able to redeem in whole or in part at our discretion on one or more predetermined call dates according to the Bond's offering notice. The maturity of Bonds typically ranges from one1 year to 20 years. Adjustable-rate Bonds use a benchmark market interest rate, typically LIBOR or SOFR, for interest rate resets. We do not participate in the issuance of range Bonds, zero coupon Bonds, or indexed principal redemption Bonds.
We use fixed-rate Bonds to fund longer-term fixed-rate Advances and longer-term fixed-rate mortgage assets, and use adjustable-rate Bonds to fund adjustable-rate Advances and certain longer-term fixed rate investments that have been swapped to an adjustable-rate.
We transact in interest rate swaps to synthetically convert some fixed-rate Bonds to adjustable-rate terms. These are used to hedge adjustable-rate Advances.
We participate in the issuance of Discount Notes to fund short-term Advances, adjustable-rate Advances, putable Advances (which we normally swap to an adjustable-rate), liquidity investments, and a portion of longer-term fixed-rate assets. Discount Notes have maturities from one day to one year, with most of ours normally maturing within three months.
The mix of Obligations fluctuates in response to relative changes in short-term versus long-term assets, relative changes in fixed-rate versus adjustable-rate assets, decisions on market risk management (particularly the amount of funding of longer-term assets with short-term Obligations), and differences in relative costs of various Obligations.
Interest rates on Obligations are affected by a multitude of factors such as: overall economic and credit conditions; credit ratings of the FHLBank System; investor demand and preferences for our debt securities; the level of interest rates and the shape of the U.S. Treasury curve, and the SOFR swap curve or LIBOR swap curve; and the supply, volume, timing, and characteristics of debt issuances by the FHLBanks, other GSEs, and other highly rated issuers.
Finance Agency regulations govern the issuance of Obligations. An FHLBank may not issue individual debt securities without Finance Agency approval, and we have never done so. The Office of Finance services Obligations, prepares the FHLBank System's quarterly and annual combined financial statements, and serves as a source of information for the FHLBanks on capital market developments.
We have the primary liability for our portion of Obligations, i.e., those issued on our behalf for which we received the proceeds. However, we also are jointly and severally liable with the other FHLBanks for the payment of principal and interest on all Obligations. If we do not pay the principal or interest in full when due on any Obligation issued on our FHLB's behalf, we are prohibited from paying dividends or redeeming or repurchasing shares of capital stock. If another FHLBank were unable to repay its participation in an Obligation for which it is the primary obligor, the Finance Agency could call on each of the other FHLBanks to repay all or part of the Obligation. The Finance Agency has never invoked this authority.
LIQUIDITY
Our business requires a substantial and continual amount of liquidity to satisfy financial obligations (primarily maturing Consolidated Obligations) in a timely and cost-efficient manner and to provide members access to timely Advance funding and mortgage loan sales in all financial environments. We obtain liquidity by issuing debt, holding short-term assets that mature before their associated funding, and having the ability to sell certain investments without significant accounting or economic consequences. Sources of asset liquidity include cash, maturing Advances, maturing investments, principal paydowns of mortgage assets, the ability to sell certain investments, and interest payments received. Uses of liquidity primarily include repayments of Obligations, issuances of new Advances, purchases of loans under the MPP, purchases of investments, and payments of interest.
Liquidity requirements are significant because Advance balances can be volatile, many have short-term maturities, and we strive to allow members to borrow Advances on the same day they request them. We regularly monitor liquidity risks and the investment and cash resources available to meet liquidity needs, as well as statutory and regulatory liquidity requirements.
Because Obligations have favorable credit ratings and because the FHLBank System is one of the largest sellers of debt in the worldwide capital markets, the System historically has been able to satisfy its liquidity needs through debt issuance across a wide range of structures at relatively favorable spreads to benchmark market interest rates, such as U.S. Treasury securities.
CAPITAL RESOURCES
Capital Requirements
Statutory and Regulatory Requirements
Under Finance Agency regulations, regulatory capital is composed of all capital stock (including stock classified as mandatorily redeemable), retained earnings, general loss allowances, and other amounts from sources the Finance Agency determines are available to absorb losses. Under the Gramm-Leach-Bliley Act of 1999 (GLB Act), permanent capital equals Class B stock plus retained earnings and is available to absorb financial losses.
Finance Agency regulations stipulate that we must comply with three limits on capital leverage and risk-based capital. These ensure a low amount of capital risk while providing for competitive profitability. We have always complied with these regulatory capital requirements.
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▪ | We must maintain at least a four percent minimum regulatory capital-to-assets ratio. This requirement historically has been closest to affecting our operations. |
▪We must maintain at least a four percent minimum regulatory capital-to-assets ratio. This requirement historically has been closest to affecting our operations.
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▪ | We must maintain at least a five percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the four percent unweighted capital requirement. |
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▪ | We are subject to a risk-based capital rule in which we must hold an amount of "permanent" capital that exceeds the amount of exposure to market risk, credit risk, and operational risk. How we determine the amount of these risk exposures is stipulated by Finance Agency regulation. Permanent capital includes retained earnings and the regulatory amount of Class B capital stock. |
▪We must maintain at least a five percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the four percent unweighted capital requirement.
▪We are subject to a risk-based capital rule in which we must hold an amount of "permanent" capital that exceeds the amount of exposure to market risk, credit risk, and operational risk. How we determine the amount of these risk exposures is stipulated by Finance Agency regulation. Permanent capital includes retained earnings and the regulatory amount of Class B capital stock.
In addition to the minimum capital requirements, the GLB Act and our Capital Plan promote the adequacy of our capital to absorb financial losses in three ways. These combine to give member stockholders a clear incentive to require us to minimize our risk profile:
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▪ | the five-year redemption period for Class B stock; |
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▪ | the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and |
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▪ | the limitations, described below, on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations. |
▪the five-year redemption period for Class B stock;
▪the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and
▪the limitations, described below, on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations.
In accordance with the GLB Act, our stock is also putable by members. There are statutory and regulatory restrictions on our obligation or right to redeem or repurchase outstanding stock, including, but not limited to, the following:
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▪ | We may not redeem any capital stock if, following the redemption, we would fail to satisfy any regulatory capital requirements. By law, we may not redeem any stock if we become undercapitalized. |
▪We may not redeem any capital stock if, following the redemption, we would fail to satisfy any regulatory capital requirements. By law, we may not redeem any stock if we become undercapitalized.
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▪ | We may not redeem any capital stock without approval of the Finance Agency if either our Board of Directors or the Finance Agency determines that we have incurred or are likely to incur losses resulting or expected to result in a charge against capital. |
▪We may not redeem any capital stock without approval of the Finance Agency if either our Board of Directors or the Finance Agency determines that we have incurred or are likely to incur losses resulting or expected to result in a charge against capital.
If we were to be liquidated, stockholders would be entitled to receive the par value of their capital stock after payment in full to our creditors. In addition, each stockholder would be entitled to any retained earnings in an amount proportional to the stockholder's share of the total shares of capital stock. In the event of a merger or consolidation of the FHLB, the Board of Directors would determine the rights and preferences of the FHLB's stockholders, subject to any terms and conditions imposed by the Finance Agency.
Capital Plan
Our Capital Plan ties the amount of each member's required capital stock to the amount of the member's assets and the amount and type of its Mission Asset Activity with us. The Capital Plan has the following basic characteristics:
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▪ | We offer only one class of capital stock, Class B, which is generally redeemable upon a member's five-year advance written notice. We strive to manage capital risks to be able to safely and soundly satisfy redemption requests sooner than five years, although we may elect to wait up to five years (or longer under certain conditions). |
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▪ | We issue shares of capital stock as required for an institution to become a member or maintain membership (membership stock), as required for members to capitalize Mission Asset Activity (activity stock), and if we pay dividends in the form of additional shares of stock. |
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▪ | We may, subject to the restrictions described above, repurchase certain capital stock (i.e., "excess" capital stock). |
▪We offer only one class of capital stock, Class B, which is generally redeemable upon a member's five-year advance written notice. We strive to manage capital risks to be able to safely and soundly satisfy redemption requests sooner than five years, although we may elect to wait up to five years (or longer under certain conditions).
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▪ | The concept of “cooperative capital,” explained below, better aligns the interests of heavy users of our products with light users by enhancing the dividend return and providing a more stable base of capital. |
▪We issue shares of capital stock as required for an institution to become a member or maintain membership (membership stock), as required for members to capitalize Mission Asset Activity (activity stock), and if we pay dividends in the form of additional shares of stock.
▪We may, subject to the restrictions described above, repurchase certain capital stock (i.e., "excess" capital stock).
We believe the Capital Plan enables us to efficiently increase and decrease capital stock needed to capitalize assets in response to changes in the membership base and demand for Mission Asset Activity. This enables us to maintain a prudent amount of financial leverage and consistently generate a competitive dividend return.
At December 31, 2018,2020, the amount of membership stock required for each member ranged from a minimum of $1,000 to a maximum of $25$30 million, with the amount within that range determined as a percentage of member assets. Beginning in April 2019, the maximum amount of membership stock required for each member was increased to $30 million. Separate from its
membership stock, each member is required to purchase and hold activity stock to capitalize its Mission Asset Activity. For purposes of the Capital Plan, Mission Asset Activity includes the principal balance of Advances, guaranteed funds and rate Advance commitments, and the principal balance of loans and commitments in the MPP.MPP, and beginning January 1, 2021, the notional balance of Letters of Credit.
The FHLB must capitalize all Mission Asset Activity with capital stockits total assets at a rate of at least four percent. However, eachThe Capital Plan supports the memberships' stock component towards this overall requirement. Each member is permittedrequired to maintain an amount of activity stock within thea range of a minimum and maximum percentagespercentage for each type of Mission Asset Activity. The Capital Plan amendment that went into effect on January 1, 2021 changed the activity percentages and set these minimums and maximums to be equal. As a result, the current percentages are as follows:
| | | Mission Asset Activity | | Minimum Activity Percentage | | Maximum Activity Percentage | Mission Asset Activity | | Minimum Activity Percentage | | Maximum Activity Percentage |
| Advances | | 2% | | 4% | Advances | | 4.50% | | 4.50% |
| Advance Commitments | | 2 | | 4 | Advance Commitments | | 4.50 | | 4.50 |
| MPP | | 0 | | 4 | MPP | | 3.00 | | 3.00 |
| Letters of Credit | | Letters of Credit | | 0.10 | | 0.10 |
If a member owns more stock than is needed to satisfy both its membership stock requirement and the maximum activity stock percentages for its Mission Asset Activity, we designate the remaining stock as the member's excess capital stock. The member may utilize its excess stock to capitalize additional Mission Asset Activity.
IfPrior to 2021, if an individual member's excess stock reachesreached zero, the Capital Plan normally permitshad permitted us, with certain limits, to capitalize additional Mission Asset Activity of that member with excess stock owned by other members at the maximum percentage rate. This feature, called “cooperative capital,” enablesenabled us to more effectively utilize our excess capital stock. The limitstock holdings. However, with the most recently amended Capital Plan, by setting the minimum and maximum activity requirements to how muchbe equal, members are no longer able to utilize this cooperative capital a member may use is currently set at $100 million. A member's use of cooperative capital reduces the ratio of its activity stock to its Mission Asset Activity for each type of Mission Asset Activity. When a member's ratio of activity stock to its Mission Asset Activity reaches the minimum activity stock percentage for all types of Mission Asset Activity, the member must capitalize additional Mission Asset Activity of a given type by purchasing capital stock at that asset type's minimum percentage rate, assuming availability of cooperative capital.marginal new business.
Retained Earnings
Purposes and Amount of Retained Earnings
Retained earnings are important to protect members' capital stock investment against the risk of impairment and to enhance our ability to pay stable and competitive dividends when earnings may be volatile. Impairment risk is the risk that members would have to write down the par value of their capital stock investment in our FHLB as a result of their analysis of ultimate recoverability. An extreme situation of earnings instability, in which other-than-temporary losses were experienced and expected for a period of time, could result in members determining that the value of their capital stock investment was impaired.
We have a policy that sets forth a range for theminimum amount of retained earnings we believe is needed to mitigate impairment risk and facilitate dividend stability in light of the risks we face. At December 31, 2018,2020, the minimum retained earnings requirement ranges from $400 million to $600was approximately $290 million, based on mitigating quantifiable risks under very stressed business and market scenarios to a 99
percent confidence level. At the end of 2018,2020, our retained earnings totaled $1,023 million.$1.3 billion. We believe the current amount of retained earnings is fully sufficient to protect our capital stock against impairment risk and to provide for dividend stability.
Joint Capital Agreement to Augment Retained Earnings
The FHLBanks entered into a Joint Capital Enhancement Agreement (the “Capital Agreement”) in February 2011. The Capital Agreement provides that each FHLBank will, on a quarterly basis, allocate quarterly at least 20 percent of its net income to a restricted retained earnings account (the “Account”). until the balance of the Account, calculated as of the last day of each calendar quarter, equals at least one percent of that FHLBank's average balance of outstanding Consolidated Obligations for the calendar quarter. The Account is not available to be distributed as dividends except under certain limited circumstances. The Capital Agreement does not limit our ability to use retained earnings held outside of the Account to pay dividends. Although we have always maintained compliance with our capital requirements, we believe the Capital Agreement enhances risk mitigation by building a larger capital buffer over time to absorb unexpected losses, if any, that we may experience.
USE OF DERIVATIVES
Finance Agency regulations and our policies establish guidelines for the execution and use of derivative transactions. We are prohibited from trading in, or the speculative use of, derivatives and have limits on the amount of credit risk to which we may be exposed. Most of our derivatives activity involves interest rate swaps, some of which may include options. We account for all derivatives at fair value.
Similar to our participation in debt issuances, use of derivatives is integral to hedging market risk created by Advances, certain longer-term fixed-rate investments and mortgage assets, including commitments. Derivatives related to Advances most commonly hedge either:
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▪ | below-market rates and/or the market risk exposure on Putable Advances, and certain other Advances, for which members have sold us options embedded within the Advances; or |
▪below-market rates and/or the market risk exposure on Putable Advances, and certain other Advances, for which members have sold us options embedded within the Advances; or
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▪ | Regular Fixed-Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management. |
▪Regular Fixed-Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.
The derivatives we transact related to investments hedge market risk exposure by effectively converting the fixed-rate investment to an adjustable-rate investment. The derivatives we transact related to mortgage assets primarily hedge interest rate risk and prepayment risk. Such derivatives include options on interest rates swaps (swaptions) and sales of to-be-announced MBS for forward settlement.
Derivatives transactions related to Bonds help us intermediate between the preference of capital market investors for intermediate- and long-term fixed-rate debt securities and the preference of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
We may also transact derivatives to reduce the repricing risk of Discount Notes that fund certain overnight and shorter-term assets.
Use of derivatives can result in a substantial amount of volatility of accounting and economic earnings. We strive to maintain a low amount of earnings volatility from realized gains and losses on derivatives. We accept a higher amount of earnings volatility from unrealized gains and losses on recording derivatives at fair values, to the extent our use of derivatives effectively hedge market risk exposure.
COMPETITION
Advances
Members' demand for our Advances is affected by, among other things, the cost of other sources of funding available, including our members' customer deposits. We compete with other suppliers of wholesale funding, both secured and unsecured, including the federal government, commercial banks, investment banking divisions of commercial banks, brokered deposits and other FHLBanks when our members' affiliated institutions are members of other FHLBanks. In addition, competition is often more significant when originating Advances to larger members, which have greater access to the national and global capital markets.
Our ability to compete successfully with other suppliers of wholesale funding, including other FHLBanks, depends primarily on the total cost of our products to members, which include the rates we charge, earnings and dividend performance, collateral policies, capital stock requirements, product features and members' perceptions of our relative safety and soundness. In addition, our competitive environment continues to be impacted by the Federal Reserve's low interest-rate environment.environment and actions to provide liquidity in the financial markets. See Item 1A. Risk Factors below for further discussion.
Mortgage Purchase Program
The primary competitors for mortgage loans we purchase in the MPP are Fannie Mae and Freddie Mac, government agencies such as the Government National Mortgage Association (Ginnie Mae), and other secondary mortgage market conduits. Fannie Mae and Freddie Mac, in particular, have long-established and efficient programs and are the dominant purchasers of fixed-rate conventional mortgages. In addition, a number of private financial institutions have well-established securitization programs, although they may not currently be as active as they were historically. The MPP also competes with the Federal Reserve to the extent it purchases MBS and affects market prices and the availability of supply.
Debt Issuance
The FHLBank System primarily competes with the U.S. government and other GSEs for funds raised through the issuance of unsecured debt in the national and global debt markets. Increases in the supply of competing debt products may, in the absence of increases in demand, result in higher debt costs.
HUMAN CAPITAL RESOURCES
Our human capital is a significant contributor to the success of our strategic business objectives. As such, we are committed to the health, safety and wellness of our employees. In response to the COVID-19 pandemic, we implemented significant operating environment changes, safety protocols and procedures that we determined were in the best interest of our employees and members, and which comply with government regulations. This includes having nearly all employees work remotely, while implementing additional safety measures for employees continuing any on-site work.
In managing human capital, we focus on our workforce profile and the various programs and philosophies described below.
Workforce Profile
Our workforce is primarily comprised of corporate employees, with one location of principal operations. As of December 31, 2020, we had 241 employees. As of December 31, 2020, approximately 37 percent of our workforce was female, 63 percent male, 85 percent non-minority and 15 percent minority. Our workforce is leanly staffed, and historically has included a number of longer-tenured employees. As of December 31, 2020, the average tenure of our employees was 10 years. We strive to both develop talent from within the organization and supplement with external hires. We believe that developing talent internally results in institutional strength and continuity and promotes loyalty and commitment in our employee base, which furthers our success. However, adding new employees contributes to new ideas, continuous improvement, and our goals of a diverse and inclusive workforce. Our employees are not represented by a collective bargaining unit.
Total Rewards
We seek to attract, develop and retain talented employees to achieve our strategic business initiatives, enhance business performance and provide members with financial services and a competitive return on their capital investment. We strive to
achieve this objective through a combination of development programs, benefits and employee wellness programs, and recognizing and rewarding performance. Specifically, our programs include:
▪Cash compensation – provides competitive salary, transportation and other cash subsidies, and performance based incentives.
▪Benefits – offers health insurance with a health savings account contribution, dental and vision insurance, life and AD&D insurance, supplemental life insurance, long-term disability insurance, employee assistance program, 401(k) retirement savings plan with employer match, and defined benefit pension benefits.
▪Recognition programs – sponsors peer-to-peer recognition program, department recognition program and company-wide recognition.
▪Work / life balance – provides flexible scheduling and time off programs for vacation, illness, personal, holiday, bereavement, jury duty, and paid leave programs for times when caring for a sick family member, bonding with a newborn or recovering from childbirth.
▪Culture – promotes the five core values of dependable, customer focused, inclusive, change oriented and results driven and encourages employee resource groups and other culture and inclusion initiatives.
▪Development programs and training – offers tuition assistance programs, internal educational and development opportunities, and fee reimbursement for external educational and development programs.
▪Management succession planning – assesses talent annually with our leadership and Board of Directors with, at a minimum, a defined plan for positions at Vice President and above.
Diversity and Inclusion Program
Diversity and inclusion is a strategic business priority. Our diversity and inclusion officer reports to the President and Chief Executive Officer, serves as a liaison to the Board of Directors, and is a member of the senior management strategy council. We recognize that diversity increases capacity for innovation and creativity and that inclusion allows us to leverage the unique perspectives of all employees and strengthen retention efforts. We operationalize our commitment through the development and execution of a three-year diversity and inclusion strategic plan that includes quantifiable metrics to measure its success. Our diversity and inclusion officer and team reports regularly on performance against the strategic plan to management and the Board of Directors. We offer a range of opportunities for our employees to connect, and grow personally and professionally through employee resource groups and community outreach. We consider learning an important component of our diversity and inclusion strategic plan and regularly offer educational opportunities to our employees. Employee job descriptions contain inclusive behavior expectations that increase with increasing responsibilities in the organization, and also are included as part of our annual performance management process.
Item 1A.Risk Factors.
The following are the most importantdiscussion summarizes risks and uncertainties we currently face. The realization of one or more of the risks could negatively affect our results of operations, financial condition, safety and soundness, and, at the extreme, the viability of our business franchise. The effects could include reductions in Mission Asset Activity, lower earnings and dividends, and, at the extreme, impairment of our capital or an inability to participate in issuances of Consolidated Obligations. The risks identified below are not the only risks we face. Other risks not presently known or which we deem to be currently immaterial may also impact our business. Additionally, the risks identified may adversely affect our business in ways we do not expect or anticipate.
Economy. An
BUSINESS AND REGULATORY RISK
A prolonged economic downturn could further lower Mission Asset Activity and profitability.
Member demand for Mission Asset Activity depends in large part on the general health of the economy and overall business conditions. Numerous external factors can affect our Mission Asset Activity and earnings including:
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▪ | the general state and trends of the economy and financial institutions, especially in the Fifth District; |
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▪ | conditions in the financial, credit, mortgage, and housing markets; |
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▪ | competitive alternatives to our products, such as retail deposits and other sources of wholesale funding; |
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▪ | actions of the Federal Reserve to affect liquidity reserves of financial institutions and the money supply; and |
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▪ | the willingness and ability of financial institutions to expand lending. |
A recessionary▪the general state and trends of the economy can lowerand financial institutions, especially in the demand for Mission Asset Activity, can decrease profitability,Fifth District;
▪conditions in the financial, credit, mortgage, and canhousing markets;
▪interest rates;
▪actions of the Federal Reserve to affect liquidity reserves of financial institutions and the money supply;
▪competitive alternatives to our products, such as retail deposits and other sources of wholesale funding;
▪regulations affecting our members' liquidity requirements;
▪the willingness and ability of financial institutions to expand lending; and
▪natural disasters, pandemics or other widespread health emergencies (see the separate Risk Factor on the COVID-19 pandemic), terrorist attacks, civil unrest, or other unanticipated or catastrophic events could create economic and financial disruptions and uncertainties.
These external factors, some of which were experienced in 2020, are likely to have a more severe impact if a prolonged economic downturn is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or actual or potential changes in the legislative and regulatory environment. Any of these factors, or a combination of factors, could adversely affect our business activities and results of operations and may ultimately cause stockholders to request redemption of a portion of their capital or request withdrawal from membership (both referred to in this document as “request withdrawal of capital”). These unfavorable effects are more likely to occur and be more severe if a weak economy is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or actual or potential changes in the legislative and regulatory environment.
The economy has grown at a measured pace in recent years, a major reason for tempered overall demand for Mission Asset Activity. In addition,For example, we believe overall Advance demand has been and continues to be unfavorably affected by the substantial amount of deposit-based liquidity provided to financial institutions through the monetary actions of the Federal Reserve.Reserve and changes in our members' ability to manage their regulatory liquidity requirements. The Federal Reserve’s policies facilitate liquidity and support stability in the fixed-income markets, which in turn has generally led to substantial deposit growth for our members and decreases in their demand for Advances. See the "Competition" risk factor"Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for further discussion.additional information on recent market activity.
Competition.The competitive environment for our products could adversely affect business activities, including decreasing the level and utilization rates of Mission Asset Activity, earnings, and capitalization.
Our primary business is providing liquidity to our members by making Advances to, and purchasing mortgage loans from, our members. Members have access to alternative funding sources, including their customers' deposits and wholesale funding, which may offer more favorable terms than we offer, such as lower rates or more flexible credit or collateral standards. Some of our competitors are not subject to the same body of regulations applicable to us, which enables those competitors to offer products and terms that we are not able to offer. In addition, state and federal regulators’ perception of the stability and reliability of our Advances can also directly impact the amount of Advances used by members.
In connection with purchasing mortgage loans from our members, we face competition in the areas of customer service, purchase prices for the MPP loans and ancillary services such as automated underwriting and loan servicing options. Our primary competitors are Fannie Mae, Freddie Mac, government agencies such as Ginnie Mae, and other secondary mortgage market conduits. In addition, our members continue to face increased competition in mortgage origination competition from originatorsnon-bank financial institutions that are not members of aneligible for FHLBank membership, which could reduce the amount of mortgage loans that members can make available to us to purchase.
Increased competition could decrease the amount of Advances and mortgage loans and narrow profitability, on those products, both of which could cause stockholders to request withdrawals of capital.capital and ultimately result in a failure to meet our capital adequacy requirements.
In addition, the FHLBank System's offerings of debt compete with the U.S. Treasury, Fannie Mae, Freddie Mac, other GSEs, and corporate, state, and sovereign entities, among others. Increases in the supply and types of competing debt products or other regulatory factors could adversely affect the System's ability to access funding or increase the cost of our debt issuance. Either of these effects could in turn adversely affect our financial condition and results of operations and the value of FHLB membership.
Business Concentration and Consolidation and Composition of the Financial Industry.Sharp reductions in Mission Asset Activity resulting from lower usage by large members, consolidation of large members, or continued shift in mortgage lending activities towards entities not eligible for FHLB membership could adversely impact our net income and dividends.
The amount of Mission Asset Activity and capital is concentrated among a small number of our large members. Additionally, the financial industry continues to consolidate and in recent years there has been a systemic trend of financial institutions that are currently ineligible for FHLB membership gaining an increasing market share, especially related to mortgage finance. However, the legislative and regulatory environment faced by the FHLBanks has not changed in response to this trend. Our members could decrease their Mission Asset Activity and the amount of their capital stock as a result of merger and acquisition activity or continued loss of market share to ineligible entities. At December 31, 2018,2020, one member, JPMorgan ChaseU.S. Bank, N.A., held over 4015 percent of our Advances and one member PFI, Union Savings Bank, accounted for over 30 percent of the outstanding MPP principal balance. Our business model is structured to be able to absorb sharp changes in Mission Asset Activity because we can undertake commensurate reductions in liability balances and capital and because of our relatively modest operating expenses. However, an extremely large and sustained reduction in Mission Asset Activity could affect our profitability and ability to pay competitive dividends, as well as, at the FHLBank System level, raise policy questions about the relevance of the FHLBank System in its traditional mission of supporting housing finance.
GSE Reform.Replacement of the LIBOR benchmark interest rate could adversely affect our business, financial condition, and results of operations.
In July 2017, the United Kingdom's Financial Conduct Authority (FCA), which regulates LIBOR, announced that after 2021 it will no longer persuade or compel banks to submit rates for the calculation of LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR, and immediately after June 30, 2023, in the case of the remaining U.S. dollar LIBOR settings. In response, the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to 1) develop a robust alternative to U.S. dollar LIBOR and 2) develop a plan to encourage its use in derivatives and other transactions as appropriate. The ARRC has settled on the establishment of SOFR as its recommended alternative to U.S. dollar LIBOR. SOFR is based on a broad segment of the overnight Treasury repurchase market and is intended to be a measure of the cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR in April 2018 and since then, the market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated Obligations and SOFR-linked Advances on an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk. As many of our assets and derivatives are indexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management.
In September 2019, the Finance Agency issued a supervisory letter providing LIBOR transition guidance. Under the supervisory letter, the FHLBanks were directed, by December 31, 2019, to cease purchasing investments that reference LIBOR and mature after December 31, 2021, and, by March 31, 2020, to no longer enter into any other new LIBOR
referenced financial assets, liabilities and derivatives with maturities beyond December 31, 2021. Except for investments and option embedded products, the ability to enter into new LIBOR referenced transactions was extended to June 30, 2020. As a result of the limitations introduced by the Finance Agency, we may experience less flexibility in our access to funding, higher funding costs, increased basis risk, lower overall demand or increased costs of Advances, and a lack of suitable investment alternatives. Accordingly, the composition of our balance sheet, capital stock level, primary mission assets ratio and net income may be negatively impacted. Additionally, the limitations within the supervisory letter may impact our ability to manage interest-rate risk, which may have a negative effect on our financial condition and results of operations.
During the market transition away from LIBOR, LIBOR may experience increased volatility, and the overnight Treasury repurchase market underlying SOFR may also experience disruptions from time to time, which may result in unexpected fluctuations in SOFR. While market activity in SOFR-linked financial instruments has continued to develop, the progress has been uneven and there can be no guarantee that SOFR will become widely accepted and used across market segments and financial products in a timely manner or that any other alternative reference rate will be developed. Any disruption in the market transition away from LIBOR towards SOFR or another alternate reference rate could result in increased financial, operational, legal, reputational or compliance risks. We are not currently able to predict the ultimate impact the market transition away from LIBOR towards SOFR may have on our business, financial condition, and results of operations. See "Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about the replacement of LIBOR.
The COVID-19 pandemic and related developments have created substantial economic and financial disruptions and uncertainties as well as significant operational changes, which could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
The COVID-19 pandemic, and governmental and public actions taken in response (such as stay-at-home or similar orders, travel restrictions, and business closures), have reduced economic activity and created substantial uncertainty about the future economic environment. There are no comparable recent events that provide guidance as to the long-term effect that the COVID-19 pandemic may have and, as a result, the ultimate impact of the pandemic, including the depth of the economic downturn and the timing and shape of the economic recovery, is highly uncertain. This could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
Prolonged periods of significant economic and financial disruptions and uncertainties resulting from the COVID-19 pandemic, may lead to an increased risk of credit losses, in particular due to decreases in the value of our mortgage loans held for portfolio or collateral securing our Advances or due to member financial difficulties or member failures, and may lead to an increased risk of counterparty defaults. The risk of credit losses may be exacerbated by a prolonged downturn in the residential and commercial real estate markets, including higher mortgage defaults or delinquencies due to rising unemployment and the effect of mortgage forbearance and other relief as well as financial difficulties or failures of mortgage servicers.
Additionally, a prolonged economic downturn resulting from the COVID-19 pandemic may lead to further reduced demand for Advances. Beginning in the second quarter of 2020, demand for Advances decreased significantly as a number of emergency actions taken by the Federal Reserve helped facilitate liquidity and support stability in the fixed-income markets and as members experienced substantial deposit growth. We believe that reduced demand for Advances from many of our members will, or is likely to, continue in the near future.
Overall, the effects of the COVID-19 pandemic have contributed to, and may continue to cause, compression in our net interest income and net interest margin. To the extent interest rates continue to be low, or negative interest rates arise, our business and profitability may be further adversely affected.
Furthermore, stay-at-home or similar orders, travel restrictions, and business shutdowns as a result of the COVID-19 pandemic have led to substantial changes in normal business practices, such as the implementation of widespread work-from-home arrangements for us, as well as many of our members, dealers, investors, and third-party service providers. These changes have increased the risk of operational errors, disruptions and failures, and cybersecurity breaches. It is uncertain when and in what manner normal business operations may return, which could adversely affect our ability to conduct and manage our business.
The extent to which the COVID-19 pandemic may continue to impact our business, financial condition, and results of operations will depend on many factors that remain highly uncertain and difficult to predict, including, but not limited to:
the duration, spread, and severity of the pandemic; additional fiscal stimulus and other measures taken in response to the pandemic; the actions taken to contain the pandemic, including the effectiveness of related vaccines and therapeutics; and how quickly and to what extent normal economic and operating conditions can resume.
Potential GSE reform could unfavorably affect our business model, financial condition, and results of operations.
Due to our GSE status, the ultimate resolution to the conservatorship of Fannie Mae and Freddie Mac could affect the FHLBanks. While there appears to be consensus that a permanent financial and political solution to the current conservatorship status should be implemented, which could include maintaining the current structure, no consensus has evolved to date around any of the various legislative proposals. Some policy proposals directed towards Fannie Mae and Freddie Mac have included provisions applicable to the FHLBank System, such as limitations on Advances and portfolio investments, and development of a covered bond market.investments. Other proposals have included broader changes in GSE mortgage finance, such as the FHLBank System being a greater participant in the secondary mortgage market, which could affect the FHLBank System's long-standing business model.
There are significant differences between the FHLBank System and Fannie Mae and Freddie Mac, including the System's focus on lending as opposed to guaranteeing mortgages and its distinctive cooperative business model. GSE legislation could inadequately account for these differences. This could jeopardize the ability of the FHLBank System to continue operating effectively within its current business model, including by adversely changing the perceptions of the capital markets about the risk associated with the debt of housing GSEs. We cannot predict the effects on the System if GSE reform were to be enacted.
FHLB Regulatory Environment.Changes in the regulatory and legislative environment could unfavorably affect our business model, financial condition, and results of operations.
In addition to potential GSE reform, the legislative and regulatory environment in which the System operates continues to undergo change. Recently-promulgated and future legislative and regulatory actions could significantly affect our business model, financial condition, or results of operations. Furthermore, the overall increase in demand for short-term funding due to the effects of reform in the money markets in the last few years combined with our growing role as a market liquidity provider for large financial institutions have resulted in heightened regulatory scrutiny.
We believe that, taken as a whole, legislativeLegislative and regulatory actions have also raised our operating costs and imparted added uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. We
are unable at this time to predict the ultimate effects the regulatory environment could have on the FHLBank System's business model, our members' view on the value of the FHLBank membership, or on our financial condition and results of operations.
LiquidityFailure to meet capital adequacy requirements mandated by Finance Agency regulations and supervisory guidance and by our internal policies, or not being able to pay dividends or repurchase or redeem capital stock, may lower demand for Mission Asset Activity, harm results of operations, and lower membership value.
To ensure safe and sound operations, we must hold a minimum amount of capital relative to our asset levels. We must also hold a sufficient amount of retained earnings to help protect members' capital stock investment against impairment risk. If our capital levels fall significantly, we may be unable to pay dividends or redeem and repurchase capital stock in a timely manner (or at all). Such events could adversely affect the value of membership including causing impairment in the value of members' capital investment in our company. Outcomes could be: reduced demand for Mission Asset Activity, decreased profitability, requests from members to redeem a portion of their capital or to withdraw from membership, or increased investors' perception of the riskiness of our FHLB.
MARKET AND LIQUIDITY RISK
Changes in interest rates and mortgage prepayment speeds (together referred to as market risk exposure or interest rate risk exposure) could significantly affect our financial condition and results of operations.
Exposure of earnings to unhedged changes in interest rates and mortgage prepayment speeds is one of our largest ongoing residual risks. We derive most of our income from the interest earned on assets less the interest paid on Consolidated Obligations and deposits used to fund the assets. Spreads on our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model. Market Access.conditions, yield curve shape, competitive forces, and market risk exposure could cause these already narrow asset spreads to decline, which could substantially reduce our
profitability. A key spread relationship is that we tend to utilize Consolidated Discount Notes to fund a significant amount of assets that have adjustable-rates tied to a benchmark interest rate, such as LIBOR or SOFR. Because rates on Discount Notes do not perfectly correlate with other adjustable benchmark interest rates, a narrowing of this spread, for example from investors changing perceptions about the quality of our debt, could lower income and reduce balances of Mission Asset Activity.
We hedge mortgage assets with a combination of Consolidated Obligations and derivatives transactions. Interest rate movements can lower profitability in two primary ways: 1) directly due to their impact on earnings from cash flow mismatches between assets and liabilities; and 2) indirectly via their impact on prepayment speeds on our MBS investments and mortgages purchased under our MPP, which can unfavorably affect the cash flow mismatches. The effects on income can also include acceleration in the amortization of purchased premiums on mortgage assets.
Because it is normally cost-prohibitive to completely mitigate market risk exposure, a residual amount of market risk normally remains after incorporating risk management activities. Sharp increases or decreases in interest rates could adversely affect us and our stockholders by making dividend rates less competitive relative to the returns available to members on alternative investments.
In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders' expectations for an extended period of time and/or market capitalization ratios falling below par which could indicate potential impairment of member stock. In such a situation, members could engage in less Mission Asset Activity and could request a withdrawal of capital. See "Quantitative and Qualitative Disclosures About Risk Management" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about market risk exposure.
Impaired access to the capital markets for debt issuance could decrease the amount of Mission Asset Activity, lower earnings by raising debt costs and, at the extreme, prevent the System from meeting its financial obligations.
Our principal long-term source of funding, liquidity, and market risk management is through access on favorable terms to the capital markets for participation in the issuances of debt securities and execution of derivative transactions at prices and yields that are adequate to support our business model. Our ability to obtain funds through the sale of Consolidated Obligations depends in part on prevailing conditions in the capital markets, particularly the short-term capital markets, because we and the System normally have a large reliance on short-term funding. The System's strong debt ratings, the implicit U.S. government backing of our debt, strong investor demand for FHLBank System debt, and effective funding management are instrumental in ensuring satisfactory access to the capital markets.
We are exposed to liquidity risk if significant disruptions in the capital markets occur. Although the System was able to maintain access to the capital markets for debt issuances on acceptable terms during 2018,2020, there is no assurance this will continue to be the case. Future ability to effectively access the capital markets on acceptable terms could be adversely affected by external events (such as general economic and financial instabilities, political instability, wars, and natural disasters)disasters, pandemics or other widespread health emergencies, civil unrest or other unanticipated or catastrophic events), deterioration in the perception of financial market participants about the financial strength of Consolidated Obligations, or downgrades to the System's credit ratings. The System could also be affected by the continued changes in the capital markets in response to financial regulations and by the joint and several liability for Consolidated Obligations, which exposes the System as a whole to events at individual FHLBanks. If access to capital markets were to be impaired for an extended period, the effect on our financial condition and results of operations could be material. At the extreme, the System's ability to achieve its mission and satisfy its financial obligations could be threatened.
Credit and Counterparty Risk.
CREDIT RISK
We are exposed to credit risk that, if realized, could materially affect our financial condition and results of operations.
We believe we have a de minimis overall amount of residual credit risk exposure related to Credit Services, purchases of investments, and transactions in derivatives, and a minimal amount of credit risk exposure related to the MPP. However, we can make no assurances that credit losses could not materially affect our financial condition or results of operations in all scenarios. An extremely severe and prolonged economic downturn, especially if combined with continued significant disruptions in housing or mortgage markets, could result in credit losses on assets that could impair our financial condition or results
The FHLB is an asset-based lender for Advances and Letters of Credit. Advances and Letters of Credit are over-collateralized and we have a perfected first lien position on collateral. However, we do not have full information on the characteristics of, nor do we estimate current market values on, a large portion of collateral. This results in a degree of uncertainty as to the precise amount of over-collateralization.
Our MPP consists of mortgage loans considered to have high credit quality and conservative underwriting and loan characteristics with additional credit enhancements in place designed to protect us against credit losses. The result has been a minimal amount of credit losses historically.
Although Advances and Letters of Credit are over-collateralized and mortgage loans in the MPP are of high credit quality with various credit enhancements, credit risk could increase under a number adverse scenarios, such as damage or destruction of collateral that members pledge to secure Advances or mortgages that we hold in the MPP as a result of natural disasters, which may be caused by the effects of climate change or other catastrophic events. Significant declines in the value of collateral pledged to secure Advances could lead to greater exposure to credit losses in the MPP have historically been minimal, they could increase under adverse economic scenarios involvingevent of a member default. Additionally, significant and sustained reductions in home prices and sustained elevated levels of unemployment and other factors that influence delinquencies and defaults.defaults could increase the risk of credit losses in the MPP.
Some of our liquidity investments are unsecured, as are uncollateralized portions of certain derivatives. We make unsecured liquidity investments in and transact derivatives with highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices. Failure of an investment or derivative counterparty with which we have a large unsecured position could have a material adverse effect on our financial conditions and results of operations. To the extent we engage in derivative transactions required to be cleared under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), we may be exposed to nonperformance from central clearinghouses and Futures Commission Merchants.
Financial institutions are increasingly inter-related as a result of trading, clearing, counterparty, and other relationships. As a result, actual or potential defaults of one or more financial institutions could lead to market-wide disruptions making it difficult for us to find qualified counterparties for transactions.
Market Risk. Changes in interest rates and mortgage prepayment speeds (together referred to as market risk exposure or interest rate risk exposure) could significantly affect our financial condition and results of operations.
Exposure of earnings to unhedged changes in interest rates and mortgage prepayment speeds is one of our largest ongoing residual risks. We derive most of our income from the interest earned on assets less the interest paid on Consolidated Obligations and deposits used to fund the assets. We hedge mortgage assets with a combination of Consolidated Obligations and derivatives transactions. Interest rate movements can lower profitability in two ways: 1) directly due to their impact on earnings from cash flow mismatches between assets and liabilities; and 2) indirectly via their impact on prepayment speeds, which can unfavorably affect the cash flow mismatches. The effects on income can also include acceleration in the amortization of purchased premiums on mortgage assets.
Because it is normally cost-prohibitive to completely mitigate market risk exposure, a residual amount of market risk normally remains after incorporating risk management activities. Sharp increases or decreases in interest rates could adversely affect us and our stockholders by making dividend rates less competitive relative to the returns available to members on alternative investments.
In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders' expectations for an extended period of time and/or market capitalization ratios falling below par which could indicate potential impairment of member stock. In such a situation, members could engage in less Mission Asset Activity and could request a withdrawal of capital. See "Quantitative and Qualitative Disclosures About Risk Management" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about market risk exposure.
Asset Profitability. Spreads on assets to funding costs may narrow because of changes in other risk factors such as the economy, interest rates, and competition, resulting in lower profitability.
Spreads on our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model. Market conditions, yield curve shape, competitive forces, and, as discussed above, market risk exposure could cause these already narrow asset spreads to decline, which could substantially reduce our profitability. A key spread relationship is that we tend to utilize Consolidated Discount Notes to fund a significant amount of assets that have adjustable-rates tied to a benchmark interest rate, such as LIBOR. Because rates on Discount Notes do not perfectly correlate with other adjustable benchmark interest rates, a narrowing of this spread, for example from investors changing perceptions about the quality of our debt, could lower income and reduce balances of Mission Asset Activity.
Capital Adequacy. Failure to meet capital adequacy requirements mandated by Finance Agency regulations and by our internal policies, or not being able to pay dividends or repurchase or redeem capital stock, may lower demand for Mission Asset Activity, harm results of operations, and lower membership value.
To ensure safe and sound operations, we must hold a minimum amount of capital relative to our asset levels. We must also hold a sufficient amount of retained earnings to help protect members' capital stock investment against impairment risk. If our capital levels fall significantly, we may be unable to pay dividends or redeem and repurchase capital stock in a timely manner (or at all). Such events could adversely affect the value of membership including causing impairment in the value of members' capital investment in our company. Outcomes could be reduced demand for Mission Asset Activity, decreased profitability, requests from members to redeem a portion of their capital or to withdraw from membership, or increased investors' perception of the riskiness of our FHLB.
LIBOR Replacement. Replacement of the LIBOR benchmark interest rate could adversely affect our business, financial condition, and results of operations.
The United Kingdom's Financial Conduct Authority (FCA), which has regulated LIBOR since April 2013, has made significant improvements to the index since LIBOR began to face scrutiny in 2009. However, the LIBOR index is now expected to be phased out no later than the end of 2021. The Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to 1) develop a robust alternative to U.S. dollar LIBOR and 2) develop a plan to encourage its use in derivatives and other transactions as appropriate. The ARRC has settled on the establishment of the Secured Overnight Financing Rate (SOFR) as its recommended alternative to U.S. dollar LIBOR. SOFR is based on a broad segment of the overnight Treasuries repurchase market and is intended to be a measure of the cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR in April
2018. During the third quarter of 2018, several market participants began utilizing SOFR through the issuance of variable-rate debt securities indexed to SOFR. In the fourth quarter of 2018, we participated in the FHLBank System's first issuance of SOFR-linked Consolidated Bonds and have continued to participate in subsequent issuances. However, many of our assets and liabilities still remain indexed to LIBOR. Therefore, we are planning for the eventual replacement of our LIBOR-indexed instruments away from the LIBOR benchmark interest rate, including the possibility of SOFR as the dominant replacement. We are not currently able to predict whether LIBOR will remain as an available rate index, whether and when an alternative rate such as SOFR will become a robust market benchmark rate in place of LIBOR, or what the impact of such a transition may be on our business, financial condition, and results of operations.
Exposure to Other FHLBanks.Financial difficulties at other FHLBanks could require us to provide financial assistance to another FHLBank, which could adversely affect our results of operations or our financial condition.
Each FHLBank has a joint and several liability for principal and interest payments on Consolidated Obligations, which are backed only by the financial resources of the FHLBanks. Although no FHLBank has ever defaulted on its principal or interest share of an Obligation, there can be no assurance that this will continue to be the case. Financial performance issues could require our FHLB to provide financial assistance to one or more other FHLBanks, for example, by making a payment on an Obligation on behalf of another FHLBank. Such assistance could adversely affect our financial condition, earnings, ability to pay dividends, or ability to redeem or repurchase capital stock.
Exposure to the Office of Finance.
OPERATIONAL RISK
Failures of the Office of Finance could disrupt the ability to conduct and manage our business.
The Office of Finance is a joint office of the FHLBanks established to facilitate the issuance and servicing of Consolidated Obligations, among other things. Pursuant to Finance Agency regulations, the Office of Finance, often in conjunction with the FHLBanks, has adopted policies and procedures for the purposes of facilitating and approving the issuance of Consolidation Obligations. A failure or interruption of the Office of Finance's services as a result of breaches, cyberattacks, or technological risks could disruptnegatively affect the business operations of each FHLBank'sFHLBank, including disruptions to the FHLBanks' access to these funds, which could also harmfunding through the System's debt franchise.sale of Consolidated Obligations. Although the Office of Finance has a business continuity planand security incident response plans in place, our business operations could be constrained, disrupted or otherwise negatively affected if the Office of Finance was not able to perform its functions for a period of time.
Operational and Compliance Risks.
Failures or interruptions in our internal controls, compliance activities, information systems and other technologies, financial and business models, and third-party vendors could harm our financial condition, results of operations, reputation, and relations with members.
Control failures, including failures in our internal controls overAs a financial reporting as well as business interruptions with members and counterparties, could occur from human error, fraud, breakdowns in information and computer systems, errors or misuse of financial and business models and servicesinstitution, we employ (including third-party vendor services), lapses in operating processes, or natural or man-made disasters. If a significant control failure or business interruption were to occur, it could materially damage our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of such failures or interruptions.
We rely heavily on internal and third-party information systems and other technology to manage our business, including the secure processing, storage and transmission of confidential borrower and otherfinancial information in computer systems and networks. For instance, due to our reliance on the book-entry system of the Federal Reserve Banks for debt issuance and servicing operations, we depend on them and their fiscal agent, the Federal Reserve Bank of New York, and one or more settlement agents to issue and make payments of principal and interest on Consolidated Obligations. Failures in information systems and other technologies could occur from human error, fraud, cyberattacks, errors or misuse of models and services we employ, lapses in operating processes, or natural or man-made disasters.
Computer systems, software and networks canmay be increasingly vulnerable to failures and interruptions includingfrom cyberattacks, which may include breaches, unauthorized access, misuse, computer viruses or other malicious or destructive code (such as ransomware) and other events against information owned by our company and customers. These failures and interruptions could jeopardize the confidentiality or integrity of information, or otherwise cause interruptions or malfunctions in operations. Additionally, threats of cyber terrorism, external extremist parties, including state-sponsored actors, result in heightened risk exposure. The techniques used in cyber attacks change frequently and have grown increasingly sophisticated, and these attacks or ensuing security breaches could persist for an extended period of time before being detected. It could take considerable additional time for us to determine the scope, extent, amount, and type of information compromised. We can make no assurance that we will be able to prevent, timely and adequately address, or mitigate failures, interruptions, or cyberattacks in information systems and other technology. If we experience a failure, interruption, or cyberattack in any of these systems, we may be unable to effectively conduct or manage business activities, operating processes, and risk management, which could significantly harm customer relations, our reputation, and operating costs, potentially resulting in material adverse effects on our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of such failures, interruptions, cyberattacks, or cyber terrorism.
Personnel Risk.Our financial condition and results of operations could suffer if we are unable to hire and retain skilled key personnel.
We rely on key personnel for many of our functions and have a relatively small workforce, given the size and complexity of our business. The success of our mission depends, in large part, on the ability to attract and retain key personnel. We must continue to recruit, retain and motivate a qualified and diverse pool of employees, both to maintain our current business, and to execute strategic initiatives. Competition for qualified people or ineffective succession planning could affect the ability to hire or retain effective key personnel, thereby harming our financial condition and results of operations.
Item 1B.Unresolved Staff Comments.
None.
Item 2.Properties.
Our primary offices are located in approximately 79,000 square feet of leased space in downtown Cincinnati, Ohio. We also maintain a leased, fully functioning, back-up facility in suburban Cincinnati. Additionally, we lease a small office in Nashville, Tennessee for the area marketing representative. We believe that our facilities are in good condition, well maintained, and adequate for our current needs.
Item 3.Legal Proceedings.
From time to time, we are subject to various legal proceedings arising in the normal course of business. 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.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
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Item 5. | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. |
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
By law our stock is not publicly traded, and only our members (and former members with a withdrawal notice pending) may own our stock. The par value of our capital stock is $100 per share. As of December 31, 2018,2020, we had 646649 member and former member stockholders and approximately 4327 million shares of capital stock outstanding, all of which were Class B Stock.
We paiddeclared quarterly cash dividends in 20182020 and 20172019 as outlinedshown in the table below.
| | | (Dollars in millions) | (Dollars in millions) | | | | | | | | (Dollars in millions) | | | | | | | |
| | | 2018 | | 2017 | | | 2020 | | | | 2019 | |
| | | | | Annualized | | | | Annualized | | | | Annualized | | | | Annualized | |
| Quarter | | Amount | | Rate | | Form | | Quarter | | Amount | | Rate | | Form | Quarter | | | Rate | | | | Rate | |
| First | | $ | 61 |
| | 5.75 | % | | Cash | | First | | $ | 47 |
| | 4.50 | % | | Cash | First | | | 2.50 | % | | | | 6.00 | % | |
| Second | | 62 |
| | 5.75 |
| | Cash | | Second | | 49 |
| | 4.75 |
| | Cash | Second | | | 2.50 | | | | | 5.50 | | |
| Third | | 68 |
| | 6.00 |
| | Cash | | Third | | 54 |
| | 5.25 |
| | Cash | Third | | | 2.00 | | | | | 4.50 | | |
| Fourth | | 65 |
| | 6.00 |
| | Cash | | Fourth | | 58 |
| | 5.50 |
| | Cash | Fourth | | | 2.00 | | | | | 4.00 | | |
| Total | | $ | 256 |
| | 5.88 |
| | Total | | $ | 208 |
| | 5.00 |
| | Total | | | 2.23 | | | | | 5.05 | | |
Generally, the Board of Directors has discretion to declare or not declare dividends and to determine the rate of any dividend declared. Our policy states that dividends for a quarter are declared and paid from retained earnings after the close of a calendar quarter and are based on average stock balances for the then closed quarter. The Board of Directors' decision to declare dividends is influenced by the financial condition, overall financial performance and retained earnings of the FHLB, and actual and anticipated developments in the overall economic and financial environment including interest rates and the mortgage and credit markets. The dividend rate is generally referenced as a spread to average short-term interest rates experienced during the quarter to help assess a competitive level for our stockholders.
A Finance Agency rule prohibits us from issuing new excess capital stock to members, either by paying stock dividends or otherwise, if before or after the issuance the amount of member excess capital stock exceeds or would exceed one percent of the FHLB's assets. Excess capital stock for this regulatory purpose is calculated as the aggregate of capital stock owned that is in excess of all membership and Mission Asset Activity requirements (as defined in our Capital Plan). At December 31, 2018, we had excess capital stock outstanding totaling more than one percent of total assets.
We may not declare a dividend if, at the time, we are not in compliance with all of our capital requirements. We also may not declare or pay a dividend if, after distributing the dividend, we would fail to meet any of our capital requirements or if we determine that the dividend would create a safety and soundness issue for the FHLB. See Note 1511 of the Notes to the Financial Statements for additional information regarding our capital stock.
RECENT SALES OF UNREGISTERED SECURITIES
From time to time, weWe provide Letters of Credit in the ordinary course of business to support members' obligations issued in support of unaffiliated, third-party offerings of notes, bonds or other securities. We provided $1 million and $3 million of such credit support during 2020 and 2019. We did not provide such credit support during 2018. We provided $12 million and $60 million of such credit support during 2017 and 2016. To the extent that these Letters of Credit are securities for purposes of the Securities Act of 1933, their issuance is exempt from registration pursuant to section 3(a)(2) thereof.
26
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Item 6. | Selected Financial Data. |
Item 6. Selected Financial Data.
The following table presents selected Statement of Condition data, Statement of Income data and financial ratios for the five years ended December 31, 2018.2020.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | 2018 | | 2017 | | 2016 |
| STATEMENT OF CONDITION DATA AT PERIOD END: | | | | | | | | | |
| Total assets | $ | 65,296 | | | $ | 93,492 | | | $ | 99,203 | | | $ | 106,895 | | | $ | 104,635 | |
| Advances | 25,362 | | | 47,370 | | | 54,822 | | | 69,918 | | | 69,882 | |
| Mortgage loans held for portfolio | 9,549 | | | 11,236 | | | 10,502 | | | 9,682 | | | 9,150 | |
Allowance for credit losses on mortgage loans (1) | — | | | 1 | | | 1 | | | 1 | | | 1 | |
Investments (2) | 27,041 | | | 34,389 | | | 33,614 | | | 27,058 | | | 25,334 | |
| Consolidated Obligations, net: | | | | | | | | | |
| Discount Notes | 27,500 | | | 49,084 | | | 46,944 | | | 46,211 | | | 44,690 | |
| Bonds | 31,997 | | | 38,440 | | | 45,659 | | | 54,163 | | | 53,191 | |
| Total Consolidated Obligations, net | 59,497 | | | 87,524 | | | 92,603 | | | 100,374 | | | 97,881 | |
| Mandatorily redeemable capital stock | 19 | | | 22 | | | 23 | | | 30 | | | 35 | |
| Capital: | | | | | | | | | |
| Capital stock - putable | 2,641 | | | 3,367 | | | 4,320 | | | 4,241 | | | 4,157 | |
| Retained earnings | 1,304 | | | 1,094 | | | 1,023 | | | 940 | | | 834 | |
| Accumulated other comprehensive loss | (15) | | | (16) | | | (13) | | | (16) | | | (13) | |
| Total capital | 3,930 | | | 4,445 | | | 5,330 | | | 5,165 | | | 4,978 | |
| STATEMENT OF INCOME DATA: | | | | | | | | | |
| Net interest income | $ | 406 | | | $ | 406 | | | $ | 499 | | | $ | 429 | | | $ | 363 | |
| | | | | | | | | |
| Non-interest income (loss) | (7) | | | (10) | | | (37) | | | (1) | | | 46 | |
| Non-interest expense | 92 | | | 89 | | | 85 | | | 79 | | | 111 | |
| Affordable Housing Program assessments | 31 | | | 31 | | | 38 | | | 35 | | | 30 | |
| Net income | $ | 276 | | | $ | 276 | | | $ | 339 | | | $ | 314 | | | $ | 268 | |
| FINANCIAL RATIOS: | | | | | | | | | |
Dividend payout ratio (3) | 30.3 | % | | 74.1 | % | | 75.6 | % | | 66.3 | % | | 63.9 | % |
Weighted average dividend rate (4) | 2.23 | | | 5.05 | | | 5.88 | | | 5.00 | | | 4.00 | |
| Return on average equity | 5.78 | | | 5.65 | | | 6.29 | | | 6.15 | | | 5.35 | |
| Return on average assets | 0.31 | | | 0.28 | | | 0.32 | | | 0.31 | | | 0.25 | |
Net interest margin (5) | 0.46 | | | 0.42 | | | 0.47 | | | 0.42 | | | 0.35 | |
| Average equity to average assets | 5.39 | | | 5.04 | | | 5.11 | | | 5.00 | | | 4.76 | |
Regulatory capital ratio (6) | 6.07 | | | 4.79 | | | 5.41 | | | 4.88 | | | 4.80 | |
Operating expenses to average assets (7) | 0.080 | | | 0.070 | | | 0.063 | | | 0.060 | | | 0.061 | |
(1)The methodology for determining the allowance for credit losses on mortgage loans changed on January 1, 2020 with the adoption of new accounting guidance on the measurement of credit losses on financial instruments. Consistent with the modified retrospective method of adoption, the prior periods have not been revised to conform to the new basis of accounting.
(2)Investments include interest-bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
(3)Dividend payout ratio is dividends declared in the period as a percentage of net income.
(4)Weighted average dividend rates are dividends paid divided by the average number of shares of capital stock eligible for dividends.
(5)Net interest margin is net interest income as a percentage of average earning assets.
(6)Regulatory capital ratio is period-end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period-end total assets.
(7)Operating expenses comprise compensation and benefits and other operating expenses, which are included in non-interest expense.
|
| | | | | | | | | | | | | | | | | | | |
| | Year Ended December 31, |
| (Dollars in millions) | 2018 | | 2017 | | 2016 | | 2015 | | 2014 |
| STATEMENT OF CONDITION DATA AT PERIOD END: | | | | | | | | | |
| Total assets | $ | 99,203 |
| | $ | 106,895 |
| | $ | 104,635 |
| | $ | 118,756 |
| | $ | 106,607 |
|
| Advances | 54,822 |
| | 69,918 |
| | 69,882 |
| | 73,292 |
| | 70,406 |
|
| Mortgage loans held for portfolio | 10,502 |
| | 9,682 |
| | 9,150 |
| | 7,954 |
| | 6,956 |
|
| Allowance for credit losses on mortgage loans | 1 |
| | 1 |
| | 1 |
| | 2 |
| | 5 |
|
Investments (1) | 33,614 |
| | 27,058 |
| | 25,334 |
| | 37,356 |
| | 26,007 |
|
| Consolidated Obligations, net: | | | | | | | | | |
| Discount Notes | 46,944 |
| | 46,211 |
| | 44,690 |
| | 77,199 |
| | 41,232 |
|
| Bonds | 45,659 |
| | 54,163 |
| | 53,191 |
| | 35,092 |
| | 59,217 |
|
| Total Consolidated Obligations, net | 92,603 |
| | 100,374 |
| | 97,881 |
| | 112,291 |
| | 100,449 |
|
| Mandatorily redeemable capital stock | 23 |
| | 30 |
| | 35 |
| | 38 |
| | 63 |
|
| Capital: | | | | | | | | | |
| Capital stock - putable | 4,320 |
| | 4,241 |
| | 4,157 |
| | 4,429 |
| | 4,267 |
|
| Retained earnings | 1,023 |
| | 940 |
| | 834 |
| | 737 |
| | 656 |
|
| Accumulated other comprehensive loss | (13 | ) | | (16 | ) | | (13 | ) | | (13 | ) | | (17 | ) |
| Total capital | 5,330 |
| | 5,165 |
| | 4,978 |
| | 5,153 |
| | 4,906 |
|
| STATEMENT OF INCOME DATA: | | | | | | | | | |
| Net interest income | $ | 499 |
| | $ | 429 |
| | $ | 363 |
| | $ | 327 |
| | $ | 327 |
|
| Non-interest income (loss) | (37 | ) | | (1 | ) | | 46 |
| | 30 |
| | 23 |
|
| Non-interest expense | 85 |
| | 79 |
| | 111 |
| | 75 |
| | 68 |
|
| Affordable Housing Program assessments | 38 |
| | 35 |
| | 30 |
| | 28 |
| | 28 |
|
| Net income | $ | 339 |
| | $ | 314 |
| | $ | 268 |
| | $ | 254 |
| | $ | 254 |
|
| FINANCIAL RATIOS: | | | | | | | | | |
Dividend payout ratio (2) | 75.6 | % | | 66.3 | % | | 63.9 | % | | 67.7 | % | | 69.5 | % |
Weighted average dividend rate (3) | 5.88 |
| | 5.00 |
| | 4.00 |
| | 4.00 |
| | 4.00 |
|
| Return on average equity | 6.29 |
| | 6.15 |
| | 5.35 |
| | 5.04 |
| | 5.16 |
|
| Return on average assets | 0.32 |
| | 0.31 |
| | 0.25 |
| | 0.24 |
| | 0.25 |
|
Net interest margin (4) | 0.47 |
| | 0.42 |
| | 0.35 |
| | 0.31 |
| | 0.32 |
|
| Average equity to average assets | 5.11 |
| | 5.00 |
| | 4.76 |
| | 4.78 |
| | 4.86 |
|
Regulatory capital ratio (5) | 5.41 |
| | 4.88 |
| | 4.80 |
| | 4.38 |
| | 4.68 |
|
Operating expenses to average assets (6) | 0.063 |
| | 0.060 |
| | 0.061 |
| | 0.054 |
| | 0.050 |
|
| |
(1) | Investments include interest bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities. |
| |
(2) | Dividend payout ratio is dividends declared in the period as a percentage of net income. |
| |
(3) | Weighted average dividend rates are dividends paid divided by the average number of shares of capital stock eligible for dividends. |
| |
(4) | Net interest margin is net interest income before provision/(reversal) for credit losses as a percentage of average earning assets. |
| |
(5) | Regulatory capital ratio is period-end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period-end total assets. |
| |
(6) | Operating expenses comprise compensation and benefits and other operating expenses, which are included in non-interest expense. |
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
| |
Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operations.
|
This discussion and analysis of the FHLB's financial condition and results of operations should be read in conjunction with the Financial Statements and related Notes to Financial Statements contained in this Form 10-K.
EXECUTIVE OVERVIEW
Financial ConditionRecent Developments
Mission Asset ActivityCOVID-19 Pandemic
In 2018,The global outbreak of COVID-19 has impacted communities and businesses worldwide, including those in the FHLB fulfilled itsFifth District. The effects of COVID-19 continue to evolve, and the full impact and duration of the virus are unknown. Despite the uncertainties created by the COVID-19 pandemic, we continued to fulfill our mission byof providing robust access to a key source of readily available and competitively priced wholesale funding to its member financial institutions and supporting itsour commitment to affordable housing and community investment, while maintaining strong capital and paying stockholdersliquidity positions.
We have remained focused on the health and safety of our employees while maintaining full business operations. Employees are working from home with only a competitive dividendlimited number of employees voluntarily working from our downtown Cincinnati location. Although there is no definitive date on when employees will return to the office, we have prepared health and safety policies and procedures to ensure our employees are able to return safely.
At this time, we cannot predict the ultimate impact of COVID-19 on our members, counterparties, vendors, and other third parties we rely upon to conduct our business. However, we continue to monitor the progression of COVID-19 and are committed to assisting members and their capital investment.communities as impacts related to the pandemic continue to unfold.
Financial Condition
Mission Asset Activity
Mission Assets, which we define as Advances, Letters of Credit, and total MPP (including purchase commitments), are the primary means by which we fulfill our mission with direct connections to members. We regularly monitor our balance sheet concentration of Mission Asset Activity. In 2018,One measure we use to assess mission achievement is our Primary Mission Asset ratio, which measures the sum of average Advances and mortgage loans as a percentage of average Consolidated Obligations was 76(adjusted for certain high-quality liquid assets, as permitted by regulation). In 2020, the Primary Mission Asset ratio averaged 75 percent, exceedingwhich exceeded the Federal Housing Finance Agency (Finance Agency)Agency's preferred ratio of 70 percent. In assessing overall mission achievement, we also consider supplemental sources of Mission Asset Activity, the most significant of which is Letters of Credit issued to members.
The following table summarizes our Mission Asset Activity.
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, | | |
| | Ending Balances | | | | Average Balances |
| | | | | | | |
| (In millions) | 2020 | | 2019 | | | | 2020 | | 2019 | | |
| Mission Asset Activity: | | | | | | | | | | | |
| Advances (principal) | $ | 25,007 | | | $ | 47,264 | | | | | $ | 42,917 | | | $ | 47,894 | | | |
| MPP: | | | | | | | | | | | |
| Mortgage loans held for portfolio (principal) | 9,316 | | | 10,981 | | | | | 10,995 | | | 10,499 | | | |
| Mandatory Delivery Contracts (notional) | 137 | | | 936 | | | | | 338 | | | 516 | | | |
| Total MPP | 9,453 | | | 11,917 | | | | | 11,333 | | | 11,015 | | | |
| Letters of Credit (notional) | 28,812 | | | 16,205 | | | | | 20,141 | | | 15,150 | | | |
| Total Mission Asset Activity | $ | 63,272 | | | $ | 75,386 | | | | | $ | 74,391 | | | $ | 74,059 | | | |
|
| | | | | | | | | | | | | | | |
| | Year Ended December 31, |
| | Ending Balances | | Average Balances |
| (In millions) | 2018 | | 2017 | | 2018 | | 2017 |
| Mission Asset Activity: | | | | | | | |
| Advances (principal) | $ | 54,872 |
| | $ | 69,978 |
| | $ | 65,593 |
| | $ | 67,683 |
|
| Mortgage Purchase Program (MPP): | | | | | | | |
| Mortgage loans held for portfolio (principal) | 10,272 |
| | 9,454 |
| | 9,743 |
| | 9,224 |
|
| Mandatory Delivery Contracts (notional) | 146 |
| | 219 |
| | 287 |
| | 293 |
|
| Total MPP | 10,418 |
| | 9,673 |
| | 10,030 |
| | 9,517 |
|
| Letters of Credit (notional) | 14,847 |
| | 14,691 |
| | 14,619 |
| | 16,457 |
|
| Total Mission Asset Activity | $ | 80,137 |
| | $ | 94,342 |
| | $ | 90,242 |
| | $ | 93,657 |
|
At December 31, 2020, 64 percent of members held Mission Asset Activity, which was relatively stable compared to prior periods. The balance of Mission Asset Activity was $80.1$63.3 billion at December 31, 2018,2020, a decrease of $14.2$12.1 billion (15(16 percent) from year-end 2017,2019, which was primarily driven by lower Advance balances. Advance principal balances decreased $15.1 $22.3
billion (22(47 percent) in 2018from year-end 2019 primarily due to a reductionreduced borrowings by large-asset members as these members generally experienced an inflow of deposits on their balance sheets and increased access to other sources of liquidity in borrowingsthe financial markets. The decrease in the balance of Mission Asset Activity was partially offset by an increase of $12.6 billion (78 percent) in Letters of Credit balances from a few large-asset members. However,year-end 2019. The increase in Letters of Credit was due in part to members using Letters of Credit rather than securities to secure increased deposits from states and municipalities during the pandemic. We normally earn fees on Letters of Credit based on the actual average amount of the Letters utilized, which generally is less than the notional amount issued.
Average principal Advance principal balances for 2018 declined2020 decreased only $2.1$5.0 billion (10 percent) compared to 2017.2019 as Advances spiked across our membership at the end of the first quarter as the financial markets reacted to the pandemic. Most of these Advances matured or prepaid by the end of the third quarter of 2020. Advance balances are often volatile due to our members' ability to quickly, normally on the same day, increase or decrease their amount of Advances. We believe providing members flexibility in their funding levels helps support their asset-liability management needs and is a key benefit of membership. At December 31, 2018, 70 percent of members held Mission Asset Activity, which was relatively stable compared to prior periods.
Based on the most-recently available figures, members funded an average of 3.2 percent of their assets with Advances. As in recent years, most members continued to have modestWe believe that reduced demand for Advance borrowings. DemandAdvances from many of our members will, or is likely to, continue in the near future. Our business is designed to support significant changes in asset levels without having to undergo material changes in staffing, operations, risk practices, or general resource needs. A key reason for this scalability is that our Capital Plan provides for additional capital when Advances is affected bygrow and the accessibility and cost of other sources of liquidity and funding, such as deposits, availableopportunity for us to members.retire capital when Advances decline, thereby acting, along with our efficient operating expenses, to preserve competitive profitability.
The MPP principal balance rose $0.8fell $1.7 billion (nine(15 percent) from year-end 2017.2019. During 2018,2020, we purchased $1.9$2.6 billion of mortgage loans, while principal reductions totaled $1.1 billion.of $4.3 billion reflected the significant increase in mortgage loan refinance activity in 2020.
Based on earnings in 2018,2020, we accrued $38$31 million for the Affordable Housing Program (AHP) pool of funds to be available to members in 2019.2021. In addition to the required AHP assessment, we continued ourprovided voluntary sponsorship of twothree other housing
programs which provide resourcesduring 2020. These programs provided funds to pay forcover accessibility rehabilitation and emergency repairs for special needs and elderly homeowners, funds for the replacement or repair of homes damaged or destroyed by natural disasters within the Fifth District, and to help members aid their communities following natural disasters.Advances at zero percent interest for COVID-19 related assistance.
Investments and Other Assets
The balance of investments at December 31, 20182020 was $33.6$27.0 billion, a decrease of $7.3 billion from year-end 2019. At December 31, 2020, investments included $9.7 billion of MBS and $17.3 billion of other investments, which consisted primarily of highly-rated short-term instruments and longer-term U.S. Treasury and GSE obligations held for liquidity. All of our MBS held at December 31, 2020 were issued and guaranteed by Fannie Mae, Freddie Mac or a U.S. agency. The decline in the balance of investments at the end of 2020 was due to decreases in both MBS and liquidity investments. MBS balances declined due to an increase in prepayments of $6.6the underlying mortgages as a result of the low interest rate environment. Due to regulatory limitations regarding the purchase of MBS that reference LIBOR, we have not been able to fully replace the prepaid MBS with suitable alternatives. Liquidity investments decreased as we decided to hold more of our liquidity portfolio as deposits at the Federal Reserve at the end of 2020 in anticipation of volatile market conditions. At December 31, 2020, we held $3.0 billion (24in deposits at the Federal Reserve, which are reflected in cash and due from banks on the Statements of Condition.
Investments averaged $32.9 billion in 2020, a decrease of $4.9 billion (13 percent) from year-end 2017. Investments averaged $29.8 billion2019. The decrease in 2018, an increase of $5.2 billion (21 percent) from the average balance during 2017. The increases in the ending and average balances of investments werewas primarily driven by higher liquiditythe decrease in MBS balances described above. Liquidity investments which can vary significantly on a daily basis during times of volatility in Advance balances. At December 31, 2018, investments included $15.7 billion of mortgage-backed securities (MBS) and $17.9 billion of other investments, which were mostly short-term instruments held for liquidity. All of our MBS held at December 31, 2018 were issued and guaranteed by Fannie Mae, Freddie Mac or a U.S. agency.
We maintained a robust amount of asset liquidity throughout 20182020 across a variety of liquidity measures, as discussed in the "Liquidity Risk" section of "Quantitative and Qualitative Disclosures About Risk Management."
Capital
Capital adequacy remained strong in 2018, surpassingsurpassed all minimum regulatory capital requirements.requirements in 2020. The GAAP capital-to-assets ratio at December 31, 20182020 was 5.376.02 percent, while the regulatory capital-to-assets ratio was 5.416.07 percent. Both ratios exceeded the regulatory required minimum of four percent. Regulatory capital includes mandatorily redeemable capital stock accounted for as a liability under GAAP. The amounts of GAAP and regulatory capital increased $165 millionboth decreased $0.5 billion in 2020, primarily due to the repurchase of $2.3 billion of excess stock and $155 million, respectively,members' redemption of $0.6 billion of stock in 2018, due to2020. The repurchase and redemption of capital stock were partially offset by members' purchases of capital stock associated withto support Advance activity andgrowth at the growth in retained earnings.end of the first quarter. Retained earnings totaled $1.0$1.3 billion at December 31, 2018,2020, an increase of nine percent$0.2 billion (19 percent) from year-end 2017.2019, which is a higher growth rate relative to recent years. The increase in capitalretained earnings was partially offset by a repurchasedue in part to the lower weighted average dividend rate in 2020.
Results of Operations
Overall Results
Our earnings reflect the combination of a stable business model and conservative management of risk. Key factors that can cause significant periodic volatility in our profitability are changes in the level of interest rates, changes in spreads between benchmark interest rates and our short-term funding costs, recognition of net amortization due to accelerated prepayments of mortgage assets, and fair value adjustments related to the use of derivatives and the associated hedged items. The table below summarizes our results of operations.
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | | | 2018 | | |
| Net income | $ | 276 | | | $ | 276 | | | | | $ | 339 | | | |
| Affordable Housing Program assessments | 31 | | | 31 | | | | | 38 | | | |
| Return on average equity (ROE) | 5.78 | % | | 5.65 | % | | | | 6.29 | % | | |
| Return on average assets | 0.31 | | | 0.28 | | | | | 0.32 | | | |
| Weighted average dividend rate | 2.23 | | | 5.05 | | | | | 5.88 | | | |
Average short-term interest rates (1) | 0.51 | | | 2.24 | | | | | 2.07 | | | |
| | | | | | | | | |
| ROE spread to average short-term interest rates | 5.27 | | | 3.41 | | | | | 4.22 | | | |
| Dividend rate spread to average short-term interest rates | 1.72 | | | 2.81 | | | | | 3.81 | | | |
| | | | | | | | | |
| | | | | | | | | |
|
| | | | | | | | | | | |
| | Year Ended December 31, |
| (Dollars in millions) | 2018 | | 2017 | | 2016 |
| Net income | $ | 339 |
| | $ | 314 |
| | $ | 268 |
|
| Affordable Housing Program assessments | 38 |
| | 35 |
| | 30 |
|
| Return on average equity (ROE) | 6.29 | % | | 6.15 | % | | 5.35 | % |
| Return on average assets | 0.32 |
| | 0.31 |
| | 0.25 |
|
| Weighted average dividend rate | 5.88 |
| | 5.00 |
| | 4.00 |
|
| Average 3-month LIBOR | 2.31 |
| | 1.26 |
| | 0.74 |
|
| ROE spread to 3-month LIBOR | 3.98 |
| | 4.89 |
| | 4.61 |
|
| Dividend rate spread to 3-month LIBOR | 3.57 |
| | 3.74 |
| | 3.26 |
|
Net income in 2018 increased $25 million (eight percent) compared to 2017. The increase in net income and ROE was primarily the result of higher net interest income. Net interest income was higher in 2018 compared to 2017 primarily due to the rise in(1) Average short-term interest rates consist of 3-month LIBOR and the Federal funds effective rate.
The historically low interest rate environment in 2020 had a significant impact on earnings. Low long-term interest rates resulted in a higher volume of mortgage refinance activity, which improvedled to elevated levels of mortgage loan repayments and related premium amortization. Additionally, short-term interest rates declined sharply in early 2020 and continued at low levels for the remainder of the year, which lowered the earnings generated from fundinginvesting our capital. Despite these declines, 2020 net income benefited from gains on the sale of interest rate swaptions during the first quarter of 2020 as well as higher prepayment fees on Advances in 2020. We use swaptions to hedge market risk exposure associated with holding fixed-rate mortgage assets with interest-free capital.and may sell swaptions as interest rates change in order to offset actual and anticipated risks.
Earnings levels continued to represent competitive returns on stockholders' capital investment. Our business model is structured to be able to absorb sharp changes in assets because we can execute commensurate changes in liability and capital stock balances. ROE was significantly higher than average short-term rates in the periods presented above, while we maintained risk exposures in line with our appetite for a moderate to low risk profile. The spread between ROE and average short-term rates, such aswhich we compute using 3-month LIBOR and the Federal funds effective rate, is a market benchmark we believe member stockholders actively use to assess the competitiveness of the return on their capital investment.
In December 2018,2020, we paid stockholders a quarterly 6.00dividend at a 2.00 percent annualized dividend rate on their capital investment in our company. The higher dividend rates paid throughout 2018 compared to 2017 was driven in large part by the effects of highercompany, which is 1.84 percentage points above fourth quarter average short-term interest rates. In 2018, we paid anThe lower weighted average dividend rate of 5.88 percent compared to 5.00 percent in 2017.
We believe that our operations and financial condition will continue to generate competitive profitability, reflecting the combination of a stable business model, and a consistent and conservative management of risk. Our business model is
structured to be able to absorb sharp changes in Mission Asset Activity because we can execute commensurate changes in liability balances and capital. Key factors that can cause significant periodic earnings volatility are changes in the level of interest rates, changes in spreads between benchmark interest rates (such as LIBOR) and our short-term funding costs, recognition of net amortization, and fair value adjustments related2020 was due to the useuncertainty surrounding the economic effects from the COVID-19 pandemic and its ultimate impact on our business and profitability, and to grow retained earnings to bolster the capital position going forward.
Effect of Interest Rate Environment
Trends in market interest rates and the resulting shapes of the market yield curves strongly influence the results of operations and profitability because of how they affect members' demand for Mission Asset Activity, spreads on assets, funding costs and decisions in managing the tradeoffs in our market risk/return profile. The following tables presenttable presents key market interest rates (obtained from Bloomberg L.P.).
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Year 2020 | | Year 2019 | | Year 2018 | | | | | | |
| | | | | | | | | |
| | | | | | | | | | | |
| | Ending | | Average | | Ending | | Average | | Ending | | Average | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
| Federal funds effective | 0.09 | % | | 0.37 | % | | 1.55 | % | | 2.16 | % | | 2.40 | % | | 1.83 | % | | | | | | | | |
| Secured Overnight Financing Rate (SOFR) | 0.09 | | | 0.37 | | | 1.55 | | | 2.20 | | | 3.00 | | | 1.85 | | | | | | | | | |
| 3-month LIBOR | 0.24 | | | 0.65 | | | 1.91 | | | 2.33 | | | 2.81 | | | 2.31 | | | | | | | | | |
| 2-year LIBOR | 0.20 | | | 0.49 | | | 1.70 | | | 2.03 | | | 2.66 | | | 2.75 | | | | | | | | | |
| 10-year LIBOR | 0.93 | | | 0.88 | | | 1.90 | | | 2.09 | | | 2.71 | | | 2.95 | | | | | | | | | |
| 2-year U.S. Treasury | 0.12 | | | 0.39 | | | 1.57 | | | 1.97 | | | 2.49 | | | 2.52 | | | | | | | | | |
| 10-year U.S. Treasury | 0.92 | | | 0.89 | | | 1.92 | | | 2.14 | | | 2.69 | | | 2.91 | | | | | | | | | |
15-year mortgage current coupon (1) | 0.65 | | | 1.17 | | | 2.28 | | | 2.52 | | | 3.06 | | | 3.20 | | | | | | | | | |
30-year mortgage current coupon (1) | 1.28 | | | 1.64 | | | 2.71 | | | 2.95 | | | 3.51 | | | 3.65 | | | | | | | | | |
| | | | | | | | | | | | | | | | Year 2020 by Quarter - Average |
| | Year 2018 | | Year 2017 | | Year 2016 | | Quarter 1 | | Quarter 2 | | Quarter 3 | | Quarter 4 |
| | Ending | | Average | | Ending | | Average | | Ending | | Average | |
| Federal funds effective | 2.40 | % | | 1.83 | % | | 1.33 | % | | 1.00 | % | | 0.55 | % | | 0.39 | % | Federal funds effective | 1.25 | % | | 0.06 | % | | 0.09 | % | | 0.09 | % |
| SOFR | | SOFR | 1.25 | | | 0.05 | | | 0.09 | | | 0.09 | |
| 3-month LIBOR | 2.81 |
| | 2.31 |
| | 1.69 |
| | 1.26 |
| | 1.00 |
| | 0.74 |
| 3-month LIBOR | 1.54 | | | 0.61 | | | 0.25 | | | 0.22 | |
| 2-year LIBOR | 2.66 |
| | 2.75 |
| | 2.08 |
| | 1.65 |
| | 1.45 |
| | 1.00 |
| 2-year LIBOR | 1.18 | | | 0.32 | | | 0.22 | | | 0.23 | |
| 10-year LIBOR | 2.71 |
| | 2.95 |
| | 2.40 |
| | 2.29 |
| | 2.34 |
| | 1.70 |
| 10-year LIBOR | 1.34 | | | 0.69 | | | 0.65 | | | 0.87 | |
| 2-year U.S. Treasury | 2.49 |
| | 2.52 |
| | 1.89 |
| | 1.39 |
| | 1.19 |
| | 0.83 |
| 2-year U.S. Treasury | 1.10 | | | 0.19 | | | 0.14 | | | 0.15 | |
| 10-year U.S. Treasury | 2.69 |
| | 2.91 |
| | 2.41 |
| | 2.33 |
| | 2.45 |
| | 1.84 |
| 10-year U.S. Treasury | 1.38 | | | 0.68 | | | 0.65 | | | 0.86 | |
15-year mortgage current coupon (1) | 3.06 |
| | 3.20 |
| | 2.52 |
| | 2.40 |
| | 2.49 |
| | 1.94 |
| 15-year mortgage current coupon (1) | 1.86 | | | 1.09 | | | 0.86 | | | 0.88 | |
30-year mortgage current coupon (1) | 3.51 |
| | 3.65 |
| | 3.00 |
| | 3.03 |
| | 3.14 |
| | 2.63 |
| 30-year mortgage current coupon (1) | 2.31 | | | 1.58 | | | 1.32 | | | 1.37 | |
(1) Simple average of current coupon rates of Fannie Mae and Freddie Mac par MBS indications. |
| | | | | | | | | | | |
| | Year 2018 by Quarter - Average |
| | Quarter 1 | | Quarter 2 | | Quarter 3 | | Quarter 4 |
| Federal funds effective | 1.45 | % | | 1.74 | % | | 1.93 | % | | 2.22 | % |
| 3-month LIBOR | 1.93 |
| | 2.34 |
| | 2.34 |
| | 2.63 |
|
| 2-year LIBOR | 2.40 |
| | 2.74 |
| | 2.86 |
| | 2.98 |
|
| 10-year LIBOR | 2.77 |
| | 2.96 |
| | 2.99 |
| | 3.09 |
|
| 2-year U.S. Treasury | 2.15 |
| | 2.47 |
| | 2.66 |
| | 2.80 |
|
| 10-year U.S. Treasury | 2.76 |
| | 2.92 |
| | 2.92 |
| | 3.04 |
|
15-year mortgage current coupon (1) | 2.93 |
| | 3.20 |
| | 3.24 |
| | 3.42 |
|
30-year mortgage current coupon (1) | 3.40 |
| | 3.64 |
| | 3.67 |
| | 3.89 |
|
| |
(1) | Simple average of current coupon rates of Fannie Mae and Freddie Mac par MBS indications. |
In December 2018, theThe target overnight Federal funds rate increasedwas in the range of zero to 0.25 percent at December 31, 2020, a decrease from a 2.00the range of 1.50 to 2.251.75 percent rangeat December 31, 2019. The low interest rate environment reflects the evolving risks to a 2.25 to 2.50 percent range. economic activity from the COVID-19 pandemic.
Average short-term rates were approximately 0.80170 to 1.10 percentage180 basis points higherlower in 20182020 compared to 2017, while2019 and average long-term rates increaseddecreased by approximately 0.60125 to 0.80 percentage135 basis points during that same period. The gradually risingdecline in interest rate environment continued to benefitrates negatively impacted income during 2018in 2020 primarily because of the lower earnings generated by funding assets with interest-free capital. However, the trends of rising short-term interest rates and flatter market yield curves could lower profitability if they were to continue for a prolonged period or if market yield curves were inverted between certain maturity points. For example, earnings may decrease as a consequence of a flat to inverted yield curve due to narrower spreads between yields earned on new mortgage assetsfrom investing capital and the costsincreased mortgage asset prepayments resulting in higher net amortization of new Consolidated Obligations used to fund them.premiums on those assets.
Business Outlook and Risk Management
This section summarizes the business outlook and what we believe are our current major risk exposures. See Item 1A. Risk Factors for a detailed discussion of certain factors that could affect our corporate objectives, financial condition, and results of operations. "Quantitative and Qualitative Disclosures About Risk Management" provides details on current risk exposures.
Strategic/Business Risk
Advances: Our business is cyclical and Mission Asset Activity normally grows slowly or stabilizesdeclines in periods of moderate macro-economic growth,economic contraction, when financial institutions have ample liquidity, or when there is significant growth in the money supply. Other factors that constrain widespread demand for Advances are the relatively low levels of interest rates and little deviation in Advance rates versus deposit rates,competitiveness of Advances relative to deposits and other competitive sources of wholesale funding.
In the last several years, the percentage of assets that members funded with Advances has shown little variation, in the range of threetwo to four percent. We may see a broad-based increase in Advance demand if one or more of the following occur: aggregate
loan portfolios of our members grow quicker than aggregate deposits, the economy experiences a sustained growth trend, interest rates continuebegin to increase over time, or changes in Federal Reserve policy reduce other sources of liquidity available to members.
MPP: MPP balances are influenced by conditions in the housing and mortgage markets, the competitivenesscompetitiveness of prices we offer to purchase loans as well as program features, and activity from our largest sellers.
Our ongoing strategy for the MPP has two components: 1) increase the number of regular sellers and participants in the program; and 2) increasemanage purchases while maintainingand balances at a prudent level relative to capital and total assets to effectively manage market and credit risks consistent with our risk appetite.
Market Risk
During 2018,2020, as in 2017,2019, the market risk exposure to changing interest rates was moderate overall and well within policy limits. We believe that longer-term profitability would not become uncompetitive unless interest rates were to change quickly and significantly. In the short-term, profitability could become uncompetitive if long-term interest rates decrease in excess of 50 basis points leading to faster prepayments of mortgage assets, which would further accelerate the recognition of purchased premiums.
Capital Adequacy
We believe members place a high value on their capital investment in our company. Capital ratios at December 31, 2018,2020, and all throughout the year, exceeded the regulatory required minimum of four percent. We believe the amount of retained earnings is sufficient to protect against members' impairment risk of their capital stock investment in the FHLB and to provide the opportunity to stabilize or increase future dividends. Our capital policies and Capital Plan also have safeguards to ensure we meet regulatory and prudential capital requirements.
Credit Risk
In 2018,2020, we continued to experiencemaintain a de minimis level of overall residual credit risk exposure from our Credit Services, investments, and derivative transactions. We believe policies and procedures related to credit underwriting, Advance collateral management, and transactions with investment and derivative counterparties continue to fully mitigate these risks. We have never experienced any credit losses, and we continue to have no loan loss reserves or impairment recorded for these instruments. Residual credit risk exposure in the mortgage loan portfolio was minimal. The allowance for credit losses in the MPP was stable during the year and was $1 million at December 31, 2018.
Liquidity Risk
Our liquidity position remained strong during 2018,2020, as did our overall ability to fund operations through the issuance of Consolidated Obligations at acceptable interest costs. Investor demand for FHLBank System debt continued to be robust. There were no substantive stresses on market access or liquidity from external market and political events. Although we can make no assurances, we believe there is only a remote possibility of a liquidity or funding crisis in the System that could impair our ability to participate, on a cost-effective basis, in issuances of new debt, service outstanding debt, maintain adequate capital levels, or pay competitive dividends.
Regulatory and Legislative Risk and Significant Developments
General: The FHLBank System is subject to legislative and regulatory oversight. Legislative and regulatory actions applicable, directly or indirectly, to the FHLBank System in the last decade have increased uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. This is due primarily to the uncertainty around potential future GSE reform, which shows no signs of resolution, and the evolution of mortgage financing moving towards financial institutions currently not eligible for FHLBank membership. See Item 1A. Risk Factors for more discussion. We
cannot predict the ultimate outcome of GSE reform and whether our membership base will be legislatively and regulatorily permitted to evolve in concert with the housing finance market.
Federal Deposit Insurance Corporation (FDIC) Brokered Deposits Restrictions:On January 22, 2021, the FDIC published a final rule, effective April 1, 2021, that amends its brokered deposits regulations that apply to less than well-capitalized insured depository institutions. The FDIC stated that the amendments are intended to modernize and clarify the FDIC’s brokered deposit regulations and they establish a new framework for analyzing the deposit broker definition, which determines whether deposits placed through deposit placement arrangements qualify as brokered deposits. These deposit placement arrangements include those between insured depository institutions and third parties, such as financial technology companies, for a variety of business purposes, including access to deposits. The amendments to the FDIC's brokered deposit regulations, among other things, clarify what it means to be engaged in the business of facilitating the placement of deposits and expand the scope of the primary purpose exception. The rule amendments are expected to have the effect of narrowing the definition of deposit broker and excluding more deposits from treatment as brokered deposits. The amendments also establish an application and reporting
process with respect to the primary purpose exception for businesses that do not meet one of several bright-line tests, and they affirm the FDIC’s position that the brokering of certificates of deposit constitutes deposit brokering.
This rule may have an effect on member demand for certain Advances, but we cannot predict the extent of the impact. We do not expect this rule to materially affect our financial condition or results of operations.
Finance Agency Final Rule on FHLBank Housing Goals Amendments:On June 25, 2020, the Finance Agency published a final rule, effective August 24, 2020, amending the FHLBank housing goals regulation. Enforcement of the final rule will phase in over three years. The final rule eliminated the existing $2.5 billion volume threshold, such that all FHLBanks are subject to a new housing goal, regardless of their mortgage purchase volume. The new housing goal establishes one overall target level requiring 20 percent of an FHLBank's total mortgage purchases to be home-purchase mortgages for low- and very-low income families and low-income areas as well as refinancing mortgages for low-income families. The final rule also establishes a separate small member participation housing goal with a target level of 50 percent. The final rule provides that an FHLBank may request Finance Agency approval of alternative target levels for either or both of the goals. We do not believe these changes will have a material effect on our financial condition or results of operations.
Finance Agency Supervisory Letter - Paycheck Protection Program (PPP) Loans as Collateral for FHLBank Advances:On April 23, 2020, the Finance Agency issued a Supervisory Letter (PPP Supervisory Letter) permitting the FHLBanks to accept PPP loans as collateral for Advances as “Agency Securities,” given the Small Business Administration’s (SBA) 100 percent guarantee of the unpaid principal balance. On April 20, 2020, the SBA's third interim final rule related to PPP loans was published. The rule explicitly waived certain regulatory requirements that must be satisfied before a member could pledge PPP loans to the FHLBanks as collateral. The PPP Supervisory Letter establishes a series of conditions under which the FHLBanks may accept PPP loans as collateral that focus on the financial condition of members, collateral discounts, and pledge dollar limits. On December 27, 2020, the President signed into law an extension of the PPP until March 21, 2021. The April 23, 2020 Supervisory Letter from the Finance Agency allowing us to accept PPP loans as collateral remains in effect.
Coronavirus Aid, Relief, and Economic Security (CARES) Act:The CARES Act was signed into law on March 27, 2020. The $2.2 trillion package was the largest stimulus bill in United States history. The CARES Act is in addition to previous relief legislation passed by Congress in March 2020. The legislation provides the following:
▪Assistance to businesses, states, and municipalities.
▪A loan program for small businesses, non-profits and physician practices that can be forgiven through employee retention incentives.
▪Treasury Secretary authority to make loans or loan guarantees to states, municipalities, and eligible businesses and loosens some regulations imposed through the Dodd-Frank Act.
▪Direct payments to eligible taxpayers and their families.
▪Expanded eligibility for unemployment insurance and payment amounts.
▪Mortgage forbearance provisions and a foreclosure moratorium.
Funding for the PPP, which was created by the CARES Act, was increased with the enactment of subsequent laws, most recently by the Consolidated Appropriations Act, 2021, on December 27, 2020. Additional phases of the CARES Act or other COVID-19 pandemic relief legislation may be enacted by Congress or other actions by the President, state governments, and governmental agencies. In connection with the foreclosure moratorium noted above, we have asked servicers of the mortgage loans we own to temporarily suspend all foreclosure sales and evictions, unless a home is vacant, in order to allow homeowners to stay in their homes during this period. We continue to monitor these actions and guidance as they evolve and to evaluate the potential impact to the U.S. economy; the impacts to mortgages held or serviced by our members that we accept as collateral; the impacts on our MPP portfolio; and the impacts to our overall business.
LIBOR Replacement:Transition:We are planning for the replacement of LIBOR given the announcement that the LIBOR index is expectedFCA will no longer persuade or compel banks to be phased out no later thansubmit rates for the endcalculation of 2021LIBOR and the Federal Reserve Bank of New York's establishment of the Secured Overnight Financing Rate (SOFR)York has established SOFR as its recommended alternative to LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR. In the fourth quarter of 2018, we participatedLIBOR, and immediately after June 30, 2023, in the FHLBank System's first issuancecase of the remaining U.S. dollar LIBOR settings. The market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated BondsObligations and have continued to participate in subsequent issuances. We also began offering SOFR-linked Advances in the fourth quarteron an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk.
As many of our assets and liabilitiesderivatives are still remainindexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management. Part of our LIBOR transition plan includes our previously implemented fallback language for LIBOR-indexed Advances and Consolidated Bonds in new and legacy contracts. As for our investments that are tied to LIBOR, we are monitoring market-wide efforts to enhance fallback language for new activity and develop frameworks to address existing transactions.
On October 23, 2020, the International Swaps and Derivatives Association, Inc. (ISDA), published a Supplement to the 2006 ISDA Definitions (Supplement) and the ISDA 2020 IBOR Fallbacks Protocol (Protocol). Both the Supplement and the Protocol were effective on January 25, 2021. As of that date, all legacy bilateral derivatives transactions subject to Protocol-covered agreements (including ISDA agreements) that incorporate certain covered ISDA definitional booklets and reference a covered Interbank Offered Rate (IBOR), including U.S. dollar LIBOR, were effectively amended to apply the new ISDA-recommended IBOR fallbacks in the event of the relevant IBOR’s cessation. We have adhered to the Protocol and have worked with our counterparties, as necessary, to address over-the-counter derivative agreements referencing U.S. dollar LIBOR as a part of our LIBOR transition efforts.
The Finance Agency has also issued supervisory letters designed to ensure the FHLBanks will be able to identify and prudently manage the risks associated with the termination of LIBOR in a safe and sound manner. As of June 30, 2020, the FHLBanks were required to cease entering into new LIBOR-based financial instruments that mature after December 31, 2021, except for investments and option embedded products. With respect to investments, the Finance Agency required the FHLBanks, by December 31, 2019, to stop purchasing investments that reference LIBOR and mature after December 31, 2021. These phase-out dates did not apply to collateral accepted by the FHLBanks. As directed by the Finance Agency, the FHLBanks began requiring their members to report levels of LIBOR-linked collateral that mature after December 31, 2021. This will assist the FHLBanks in determining the level of member reliance on these assets to support borrowings, make decisions about their future eligibility and the impact of any incremental haircuts and asset value deterioration on borrowing capacity.
We have Advances, investment securities and derivatives with interest rates indexed to LIBOR. Therefore, weEach of these instruments are continuingindexed to plan forLIBOR settings that will no longer be provided after June 30, 2023, as noted above. The following table presents LIBOR-indexed Advances, investment securities and derivatives by contractual maturity at December 31, 2020.
| | | | | | | | | | | |
| (In millions) | Maturing on or before June 30, 2023 | | Maturing after June 30, 2023 |
| LIBOR-Indexed Variable Rate Financial Instruments | | | |
| Advances by redemption term | $ | 2,599 | | | $ | 3,012 | |
MBS by contractual maturity (1) | — | | | 5,929 | |
| | | |
| Total principal amount | $ | 2,599 | | | $ | 8,941 | |
| Derivatives, notional amount by termination date | $ | 9,339 | | | $ | 4,680 | |
(1)MBS are presented by contractual maturity; however, their expected maturities will likely differ from contractual maturities as borrowers may have the eventual replacement of our LIBOR-indexed instruments away from the LIBOR benchmark interest rate. right to call or prepay obligations with or without call or prepayment fees.
The market transition away from LIBOR towards SOFR is expected to be gradual and complicated, including the possible development of term structures and credit adjustments to accommodate differences between LIBOR and SOFR. As such, we are not currently able to predict the ultimate impact of such a transition on our business, financial condition, and results of operations. See Item 1A. Risk Factors for more discussion.
Liquidity Advisory Bulletin:Advisory Bulletin 2018-07 Federal Home Loan Bank Liquidity Guidance (Liquidity AB). In August 2018, the Finance Agency issued a final Advisory Bulletin on expectations with respect to the maintenance
The Liquidity AB will require us to hold an additional amount of liquid assets to meet the new guidance related to the base case liquidity expectations, which may raise our cost of funding. We currently do not believe these changes will have a material effect on our results of operations, but they will make managing liquidity and the balance sheet more operationally challenging. Refer to the "Liquidity Risk" section of "Quantitative and Qualitative Disclosures About Risk Management" for further discussion of the requirements set forth in the Liquidity AB.
Final Rule on FHLBank Capital Requirements: On February 20, 2019, the Finance Agency published a final rule, effective January 1, 2020, pertaining to the capital requirements for the FHLBanks. The final rule revises the credit risk component of the risk-based capital requirement, as well as the limitations on extensions of unsecured credit. The main revisions remove requirements that we calculate credit risk capital charges and unsecured credit limits based on ratings issued by a Nationally Recognized Statistical Rating Organization (NRSRO), and instead require that we establish and use our own internal rating methodology. With respect to derivatives, the rule imposes a new capital charge for cleared derivatives to align with the Dodd-Frank Act’s clearing mandate. The final rule also revises the percentages used to calculate credit risk capital charges for Advances and for non-mortgage assets. We do not expect this rule to materially affect our financial condition or results of operations.
Final Rule Amending AHP Regulations: On November 28, 2018, the Finance Agency published a final rule that amends the operating requirements of the FHLBanks’ AHP. The final rule amendments:
| |
▪ | revise the scoring criteria to create different and new scoring priorities; |
| |
▪ | remove the retention agreement requirement on owner-occupied units using the subsidy solely for rehabilitation; |
| |
▪ | increase the per-household set-aside grant amount to $22,000 with an annual housing price inflation adjustment (up from the current fixed limit of $15,000); |
| |
▪ | clarify the requirements for remediating AHP noncompliance; |
| |
▪ | prohibit our Board of Directors from delegating approval of AHP strategic policy decisions to a committee; and |
| |
▪ | further align AHP monitoring with certain federal government funding programs. |
The majority of the rule’s provisions take effect January 1, 2021, while the owner-occupied retention agreement requirements take effect January 1, 2020. We do not expect this rule to materially affect our financial condition or results of operations.
Proposed Rule on Housing Goals: On November 2, 2018, the Finance Agency published a proposed rule that would amend its existing Federal Home Loan Bank Housing Goals regulation. If adopted as proposed, the proposed amendments would:
| |
▪ | eliminate the $2.5 billion mortgage loan purchase volume threshold that triggers the application of housing goals; |
| |
▪ | establish the target level for the new prospective mortgage loan purchase housing goal at 20 percent of total mortgage loan purchases that are for very low-income families, low-income families, or families in low-income areas, and require that at least 75 percent of all mortgage purchases that count toward the goal be for borrowers with incomes at or below 80 percent of the area median income; |
| |
▪ | establish a goal that 50 percent of mortgage program users meet the definition of “small members” whose assets do not exceed the "community financial institution" asset cap, which is currently set at $1.199 billion; and |
| |
▪ | allow the FHLBanks to request FHFA approval of alternative target percentages for mortgage loan purchase housing goals and small member participation goals. |
We continue to evaluate this proposed rule and its effect on our financial condition and results of operation.
ANALYSIS OF FINANCIAL CONDITION
Credit Services
Credit Activity and Advance Composition
The tablestable below showshows trends in Advance balances by major programs and in the notional amount of Letters of Credit.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| (Dollars in millions) | December 31, 2020 | | December 31, 2019 |
| | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable Rate-Indexed: | | | | | | | |
| LIBOR | $ | 5,611 | | | 22 | % | | $ | 10,430 | | | 22 | % |
| SOFR | 118 | | | 1 | | | 500 | | | 1 | |
| Other | 82 | | | — | | | 221 | | | 1 | |
| Total | 5,811 | | | 23 | | | 11,151 | | | 24 | |
| Fixed-Rate: | | | | | | | |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 19,386 | | | 41 | |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 11,476 | | | 24 | |
Putable (2) | 2,657 | | | 11 | | | 1,444 | | | 3 | |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,358 | | | 5 | |
| Other | 1,151 | | | 5 | | | 1,449 | | | 3 | |
| Total | 19,196 | | | 77 | | | 36,113 | | | 76 | |
| | | | | | | |
| Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 47,264 | | | 100 | % |
| | | | | | | |
| Letters of Credit (notional) | $ | 28,812 | | | | | $ | 16,205 | | | |
| | | (Dollars in millions) | December 31, 2018 | | December 31, 2017 | (Dollars in millions) | December 31, 2020 | | September 30, 2020 | | June 30, 2020 | | March 31, 2020 |
| | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable Rate-Indexed: | | | | | | | | |
| Adjustable/Variable-Rate Indexed: | | Adjustable/Variable-Rate Indexed: | | | | | | | | | | | | | | | |
| LIBOR | $ | 28,740 |
| | 52 | % | | $ | 32,420 |
| | 47 | % | LIBOR | $ | 5,611 | | | 22 | % | | $ | 5,846 | | | 22 | % | | $ | 21,071 | | | 44 | % | | $ | 28,889 | | | 36 | % |
| SOFR | | SOFR | 118 | | | 1 | | | 116 | | | — | | | 116 | | | — | | | 2,000 | | | 3 | |
| Other | 2,144 |
| | 4 |
| | 941 |
| | 1 |
| Other | 82 | | | — | | | 123 | | | 1 | | | 83 | | | — | | | 247 | | | — | |
| Total | 30,884 |
| | 56 |
| | 33,361 |
| | 48 |
| Total | 5,811 | | | 23 | | | 6,085 | | | 23 | | | 21,270 | | | 44 | | | 31,136 | | | 39 | |
| Fixed-Rate: | | | | | | | | Fixed-Rate: | | | | | | | | | | | | | | | |
| Repurchase based (REPO) | 7,003 |
| | 13 |
| | 19,890 |
| | 28 |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 3,896 | | | 15 | | | 8,978 | | | 18 | | | 28,058 | | | 35 | |
| Regular Fixed-Rate | 10,972 |
| | 20 |
| | 11,191 |
| | 16 |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 10,207 | | | 38 | | | 11,445 | | | 24 | | | 14,452 | | | 18 | |
Putable (2) | 460 |
| | 1 |
| | 280 |
| | — |
| Putable (2) | 2,657 | | | 11 | | | 3,107 | | | 12 | | | 3,164 | | | 6 | | | 3,164 | | | 4 | |
| Amortizing/Mortgage Matched | 2,702 |
| | 5 |
| | 2,776 |
| | 4 |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,195 | | | 8 | | | 2,309 | | | 5 | | | 2,439 | | | 3 | |
| Other | 2,851 |
| | 5 |
| | 2,479 |
| | 4 |
| Other | 1,151 | | | 5 | | | 1,158 | | | 4 | | | 1,241 | | | 3 | | | 680 | | | 1 | |
| Total | 23,988 |
| | 44 |
| | 36,616 |
| | 52 |
| Total | 19,196 | | | 77 | | | 20,563 | | | 77 | | | 27,137 | | | 56 | | | 48,793 | | | 61 | |
| Other Advances | — |
| | — |
| | 1 |
| | — |
| |
| | Total Advances Principal | $ | 54,872 |
| | 100 | % | | $ | 69,978 |
| | 100 | % | Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 26,648 | | | 100 | % | | $ | 48,407 | | | 100 | % | | $ | 79,929 | | | 100 | % |
| | | | | | | | | | | | | | | | | | | | | | | | |
| Letters of Credit (notional) | $ | 14,847 |
| | | | $ | 14,691 |
| | | Letters of Credit (notional) | $ | 28,812 | | | $ | 23,011 | | | $ | 22,381 | | | $ | 15,785 | | |
(1)As a percentage of total Advances principal. |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | December 31, 2018 | | September 30, 2018 | | June 30, 2018 | | March 31, 2018 |
| | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable-Rate Indexed: | | | | | | | | | | | | | | | |
| LIBOR | $ | 28,740 |
| | 52 | % | | $ | 20,940 |
| | 36 | % | | $ | 26,659 |
| | 44 | % | | $ | 31,646 |
| | 50 | % |
| Other | 2,144 |
| | 4 |
| | 637 |
| | 1 |
| | 1,130 |
| | 2 |
| | 781 |
| | 1 |
|
| Total | 30,884 |
| | 56 |
| | 21,577 |
| | 37 |
| | 27,789 |
| | 46 |
| | 32,427 |
| | 51 |
|
| Fixed-Rate: | | | | | | | | | | | | | | | |
| REPO | 7,003 |
| | 13 |
| | 18,446 |
| | 32 |
| | 15,355 |
| | 25 |
| | 14,540 |
| | 23 |
|
| Regular Fixed-Rate | 10,972 |
| | 20 |
| | 11,929 |
| | 21 |
| | 12,059 |
| | 20 |
| | 11,677 |
| | 18 |
|
Putable (2) | 460 |
| | 1 |
| | 235 |
| | — |
| | 110 |
| | — |
| | 175 |
| | — |
|
| Amortizing/Mortgage Matched | 2,702 |
| | 5 |
| | 2,800 |
| | 5 |
| | 2,821 |
| | 5 |
| | 2,810 |
| | 4 |
|
| Other | 2,851 |
| | 5 |
| | 2,894 |
| | 5 |
| | 2,532 |
| | 4 |
| | 2,355 |
| | 4 |
|
| Total | 23,988 |
| | 44 |
| | 36,304 |
| | 63 |
| | 32,877 |
| | 54 |
| | 31,557 |
| | 49 |
|
| Other Advances | — |
| | — |
| | 5 |
| | — |
| | — |
| | — |
| | 1 |
| | — |
|
| Total Advances Principal | $ | 54,872 |
| | 100 | % | | $ | 57,886 |
| | 100 | % | | $ | 60,666 |
| | 100 | % | | $ | 63,985 |
| | 100 | % |
| | | | | | | | | | | | | | | | |
| Letters of Credit (notional) | $ | 14,847 |
| | | | $ | 13,952 |
| | | | $ | 14,482 |
| | | | $ | 15,606 |
| | |
| |
(1) | As a percentage of total Advances principal. |
| |
(2) | Excludes Putable Advances where the related put options have expired. These Advances are classified based on their current terms. |
Advance balances at December 31, 20182020 decreased 2247 percent compared to year-end 2017,2019. Advance balances declined in 2020 as large-asset members reduced their borrowings. The reduction in borrowings was primarily driven by these members generally experiencing an inflow of deposits on their balance sheets, while also having access to other liquidity sources as a result of lowercertain government actions related to the pandemic. Despite the overall decline, Advances spiked across our membership at the end of the first quarter of 2020 as the financial markets reacted to the COVID-19 pandemic, and members
turned to us for liquidity, primarily in the form of LIBOR and REPO and variable-rate borrowingsAdvances. Most of these Advances matured or prepaid by a few large-asset members. However, the average Advance principal balanceend of $65.6 billion during 2018 was significantly higher than the ending balance at December 31, 2018. REPOs, which traditionally have the most2020.
volatile balances because a majority of them have overnight maturities, allow our members the most flexibility as their liquidity needs may change daily.
Housing and Community Investment
Our Housing and Community Investment Programs include the Affordable Housing Program and various housing and community economic development-related Advance Usageand grant programs. We fund the Affordable Housing Program with an accrual equal to 10 percent of our previous year's net earnings, mandated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989. See Note 10 of the Notes to Financial Statements for a complete description of the Affordable Housing Program calculation.
The Affordable Housing Program provides funding for the development of affordable housing. The Program consists of a Competitive Program and a homeownership program called Welcome Home, which assists homebuyers with down payments and closing costs. Under the Competitive Program, we currently distribute funds in the form of grants to members that apply and successfully compete in an annual offering. Under Welcome Home, we make funds available beginning in March until they have been fully committed. For both programs, the income of qualifying individuals or households must be 80 percent or less of the area median income. We set aside up to 35 percent of the Affordable Housing Program accrual for Welcome Home and allocate the remainder to the Competitive Program.
Our Board of Directors also may allocate funds to voluntary housing programs. In 2020, the Board re-authorized an additional $2.0 million to the Carol M. Peterson Housing Fund for use during the year. These funds are primarily used as grants to pay for accessibility rehabilitation and emergency repairs for special needs and elderly homeowners. In 2012, the Board of Directors also established the Disaster Reconstruction Program, a voluntary housing program that provides grants for purchase or rehabilitation of a home within the Fifth District for residents that have suffered loss or damage to their primary residence as a result of a state or federally declared disaster. Since the program's inception, we have disbursed over $4.7 million to assist 378 households. Furthermore, in support of our members during the COVID-19 pandemic, we created a new Advance program that offered Advances with terms up to six months at zero percent interest to members between May 1, 2020 and September 30, 2020. These Advances supported COVID-19 related assistance made by all Fifth District members. In 2020, we issued a total of $183 million of these Advances of which $34 million remained outstanding at December 31, 2020.
Two other housing programs that fall outside the auspices of the Affordable Housing Program are the Community Investment Program and the Economic Development Program. Advances under the former program have rates equal to our cost of funds, while Advances under the latter program have rates equal to our cost of funds plus reasonable administrative costs. Members use the Community Investment Program to serve housing needs of low- and moderate-income households and, under certain conditions, community economic development projects. The Economic Development Program is a discounted Advance program used to promote economic development and job creation and retention.
Investments
Types of Investments. A primary reason we hold investments is to carry sufficient asset liquidity. Permissible liquidity investments include Federal funds, certificates of deposit, bank notes, bankers' acceptances, commercial paper, securities purchased under agreements to resell, and debt securities issued by the U.S. government, its agencies, or other GSE's. The first five categories represent unsecured lending to private counterparties. We also may place deposits with the Federal Reserve Bank. We are prohibited by Finance Agency regulations from investing (secured or unsecured) in financial investments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks. Many liquidity investments have short-term maturities.
Subject to regulatory limitations on purchases of new LIBOR-based investments, we are also permitted by regulation to purchase the following other investments, which have longer original maturities than liquidity investments:
▪MBS and collateralized mortgage obligations (together, referred to as MBS) issued by GSEs, other U.S. government agencies or private issuers;
▪asset-backed securities collateralized by manufactured housing loans or home equity loans issued by GSEs or private issuers; and
▪marketable direct obligations of certain government units and agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital.
We have never purchased asset-backed securities and do not own any privately-issued MBS.
Per Finance Agency regulations, the total investment in MBS and asset-backed securities may not exceed 300 percent of previous month-end regulatory capital on the day we purchase the securities. See the “Capital Resources” section below for the definition of regulatory capital.
Purposes of Having Investments. The investments portfolio helps achieve corporate objectives in the following ways:
▪Liquidity management. Liquidity investments support the ability to fund assets on a timely basis, especially Advances, and when it may be more difficult to issue new debt. These investments supply liquidity because we normally fund them with longer-term debt than asset maturities. We also may be able to obtain liquidity by selling certain investments for cash without a significant loss of value.
▪Earnings enhancement. The investments portfolio, especially MBS, assists with earning a competitive return on capital, and increasing funding for Housing and Community Investment programs. In addition, liquidity investments help stabilize earnings because they typically earn a relatively stable spread to the cost of debt issued to fund them.
▪Management of debt issuance. Maintaining a short-term liquidity investment portfolio can help us participate in attractively priced debt issuances, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
▪Support of housing market. Investment in MBS and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
How We Manage Risks of Investments. We strive to ensure our investment holdings have a moderate degree of market risk and limited credit risk, which tends to lower the returns we can expect to earn on these securities. We believe that a philosophy of purchasing investments with a high amount of market or credit risk would be inconsistent with our GSE status and corporate objectives.
Market risk associated with short-term investments tends to be minimal because of their short maturities and because we typically fund them with short-term Consolidated Obligations having similar maturities. We mitigate much of the market risk of MBS, which exists primarily from changes in mortgage prepayment speeds, by limiting their balances to 300 percent of regulatory capital and by funding them with a portfolio of long-term fixed-rate callable and non-callable Obligations. Additionally, we mitigate much of the market risk of longer-term non-MBS securities, and a portion of our MBS, by using interest rate swaps to effectively convert the fixed rate investments to adjustable-rate investments. We also manage the market risk exposure of the entire balance sheet within prudent policy limits.
Finance Agency regulations and internal policies also provide controls on market risk exposure by restricting the types of mortgage loans, MBS and other investments we can hold. These restrictions prohibit, among others, the purchase of interest only or principal only stripped MBS and MBS whose average life varies more than six years under a 300 basis points interest rate shock.
Our internal policies specify guidelines for, and relatively tight constraints on, the types and amounts of short-term investments we are permitted to hold and the maximum amount of credit risk exposure we are permitted to have with eligible counterparties. We are permitted to invest only in the instruments of counterparties with high credit ratings, and because of our conservative
investment policies and practices, we believe all of our investments have high credit quality. We have never had a credit loss or credit-related write down of any investment security.
Deposits
We provide a variety of deposit programs, including demand, overnight, term and Federal funds, which enable depositors to invest funds in short-term liquid assets. We accept deposits from members, other FHLBanks, any institution to which we offer correspondent services, and other government instrumentalities. The rates of interest we pay on deposits are subject to change daily based on comparable money market interest rates. The balances in deposit programs tend to vary positively with the amount of idle funds members have available to invest, as well as the level of short-term interest rates. Deposits have typically represented one to two percent of our funding sources in recent years.
Mortgage Purchase Program (MPP or Mortgage Loans Held for Portfolio)
Description of the MPP
Types of Loans and Benefits. Finance Agency regulations permit FHLBanks to purchase and hold specified whole mortgage loans from their members, which offers members a competitive alternative to the traditional secondary mortgage market and directly supports housing finance. We account for MPP loans as mortgage loans held for portfolio. By selling mortgage loans to us, members can increase their balance sheet liquidity and lower interest rate and mortgage prepayment risks. The MPP particularly enables small- and medium-sized community-based financial institutions to use their existing relationship with us to participate more effectively in the secondary mortgage market.
We purchase two types of mortgage loans: qualifying conforming fixed-rate conventional 1-4 family residential mortgages and residential mortgages fully insured by the Federal Housing Administration (FHA). Members approved to sell us these loans are referred to as Participating Financial Institutions (PFIs).
A “conventional” mortgage refers to a non-government-guaranteed mortgage. A “conforming” mortgage refers to the maximum amount permissible to be lent as a regular prime (i.e., non-jumbo, non-subprime) mortgage. For 2021, the Finance Agency established the conforming limit at $548,250 with loans originated in a limited number of high-cost cities and counties receiving higher conforming limits. We have elected not to purchase mortgages subject to these higher conforming limits.
Loan Purchase Process. A Master Commitment Contract is negotiated with each PFI, in which the PFI agrees to make a best efforts attempt to sell us a specific dollar amount of mortgage loans generally over a period of up to 12 months. We purchase loans pursuant to a Mandatory Delivery Contract, which is a legal commitment we make to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of note rates and prices.
Shortly before delivering the loans that will fill the Mandatory Delivery Contract, the PFI must submit loan level detail including underwriting information. We apply procedures through an automated system designed to screen loans that do not comply with our policies. Our underwriting guidelines generally mirror those of Fannie Mae and Freddie Mac for conforming conventional loans, although our guidelines and pool composition requirements are more conservative in a number of ways in order to further limit credit risk exposure. PFIs are required to make certain representations and warranties against our underwriting guidelines on the loans they sell to us. If a PFI sells us a loan in breach of those representations and warranties, we have the contractual right to require the PFI to repurchase the loan.
How We Manage Risks of the MPP
Market Risk. We mitigate the MPP's market risk similarly to how we mitigate market risk from MBS.
Credit Risk - Conventional Mortgage Loans. A unique feature of the MPP is that it separates the various activities and risks associated with residential mortgage lending for conventional loans and allows these risks and activities to be taken on by different entities. We manage the market risk (including interest rate risk and prepayment risk) and liquidity risk. PFIs manage marketing, originating and, in most cases, servicing the loans. PFIs may either retain servicing or sell it to a qualified and approved third-party servicer (also referred to as a PFI). Because PFIs manage and bear most of the credit risk, they do not pay us a guarantee fee to transfer credit risk.
We manage credit risk exposure for conventional loans primarily through underwriting and pool composition requirements and by applying layered credit enhancements. These enhancements, which apply after a homeowner's equity is exhausted, include available primary mortgage insurance, the Lender Risk Account (discussed below), and Supplemental Mortgage Insurance. Supplemental Mortgage Insurance is applicable to loans acquired before February 2011 and was purchased by the PFI from one
of our approved third-party providers naming us as the beneficiary. These credit enhancements are designed to protect us against credit losses in scenarios of severe downward movements in housing prices and unfavorable changes in other factors that can affect loan delinquencies and defaults.
The Lender Risk Account is a key component of how we manage residual credit risk. It is a holdback of a portion of the initial purchase price. Starting after five years from the loan purchase date, we may return the holdback to PFIs if they manage credit risk to pre-defined acceptable levels of exposure on the loan pools they sell to us. Actual loan losses are deducted from the amount of the purchase-price holdback we return to the PFI. The Lender Risk Account provides PFIs with a strong incentive to sell us high quality performing mortgage loans.
Credit Risk - FHA Mortgage Loans. Because the FHA makes an explicit guarantee on FHA loans, we do not require any credit enhancements on these loans beyond primary mortgage insurance.
"Quantitative and Qualitative Disclosures About Risk Management” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations provides more detail on how we manage market and credit risks for the MPP.
Earnings from the MPP
The MPP enhances long-term profitability on a risk-adjusted basis and augments the return on member stockholders' capital investment. We generate earnings in the MPP from monthly interest payments minus the cost of funding and the cost of hedging the MPP's interest rate risk. Interest income on each loan is computed as the mortgage note rate multiplied by the loan's principal balance:
▪minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans);
▪minus the cost of Supplemental Mortgage Insurance (for applicable loans); and
▪adjusted for the amortization of purchase premiums or the accretion of purchase discounts and for the amortization or accretion of fair value adjustments on loans initially classified as mortgage loan commitments.
For new loan purchases, we consider the cost of the Lender Risk Account when we set conventional loan prices and evaluate the MPP's potential return on investment. The pricing of each structure depends on a number of factors and is specific to the PFI and to the loan pool. We do not receive fees or income for retaining the risk of losses in excess of any credit enhancements.
FUNDING - CONSOLIDATED OBLIGATIONS
Our primary source of funding and hedging market risk exposure is through participation in the sale of Consolidated Obligation debt securities to global investors. Obligations are the joint and several obligations of all the FHLBanks, backed only by the financial resources of these institutions. There are two types of Consolidated Obligations: Consolidated Bonds (Bonds) and Consolidated Discount Notes (Discount Notes).
We participate in the issuance of Bonds for three purposes:
▪to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets;
▪to finance and hedge short-term, adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate funding through the execution of interest rate swaps; and
▪to acquire liquidity investments.
Bonds may have fixed or adjustable rates of interest. Fixed-rate Bonds are either non-callable or callable. A callable Bond is one that we are able to redeem in whole or in part at our discretion on one or more predetermined call dates according to the Bond's offering notice. The maturity of Bonds typically ranges from 1 year to 20 years. Adjustable-rate Bonds use a benchmark market interest rate, typically SOFR, for interest rate resets. We do not participate in the issuance of range Bonds, zero coupon Bonds, or indexed principal redemption Bonds.
We use fixed-rate Bonds to fund longer-term fixed-rate Advances and longer-term fixed-rate mortgage assets, and use adjustable-rate Bonds to fund adjustable-rate Advances and certain longer-term fixed rate investments that have been swapped to an adjustable-rate.
We transact in interest rate swaps to synthetically convert some fixed-rate Bonds to adjustable-rate terms. These are used to hedge adjustable-rate Advances.
We participate in the issuance of Discount Notes to fund short-term Advances, adjustable-rate Advances, putable Advances (which we normally swap to an adjustable-rate), liquidity investments, and a portion of longer-term fixed-rate assets. Discount Notes have maturities from one day to one year, with most of ours normally maturing within three months.
The mix of Obligations fluctuates in response to relative changes in short-term versus long-term assets, relative changes in fixed-rate versus adjustable-rate assets, decisions on market risk management (particularly the amount of funding of longer-term assets with short-term Obligations), and differences in relative costs of various Obligations.
Interest rates on Obligations are affected by a multitude of factors such as: overall economic and credit conditions; credit ratings of the FHLBank System; investor demand and preferences for our debt securities; the level of interest rates and the shape of the U.S. Treasury curve, the SOFR swap curve or LIBOR swap curve; and the supply, volume, timing, and characteristics of debt issuances by the FHLBanks, other GSEs, and other highly rated issuers.
Finance Agency regulations govern the issuance of Obligations. An FHLBank may not issue individual debt securities without Finance Agency approval, and we have never done so. The Office of Finance services Obligations, prepares the FHLBank System's quarterly and annual combined financial statements, and serves as a source of information for the FHLBanks on capital market developments.
We have the primary liability for our portion of Obligations, i.e., those issued on our behalf for which we received the proceeds. However, we also are jointly and severally liable with the other FHLBanks for the payment of principal and interest on all Obligations. If we do not pay the principal or interest in full when due on any Obligation issued on our FHLB's behalf, we are prohibited from paying dividends or redeeming or repurchasing shares of capital stock. If another FHLBank were unable to repay its participation in an Obligation for which it is the primary obligor, the Finance Agency could call on each of the other FHLBanks to repay all or part of the Obligation. The Finance Agency has never invoked this authority.
LIQUIDITY
Our business requires a substantial and continual amount of liquidity to satisfy financial obligations (primarily maturing Consolidated Obligations) in a timely and cost-efficient manner and to provide members access to timely Advance funding and mortgage loan sales in all financial environments. We obtain liquidity by issuing debt, holding short-term assets that mature before their associated funding, and having the ability to sell certain investments without significant accounting or economic consequences. Sources of asset liquidity include cash, maturing Advances, maturing investments, principal paydowns of mortgage assets, the ability to sell certain investments, and interest payments received. Uses of liquidity primarily include repayments of Obligations, issuances of new Advances, purchases of loans under the MPP, purchases of investments, and payments of interest.
Liquidity requirements are significant because Advance balances can be volatile, many have short-term maturities, and we strive to allow members to borrow Advances on the same day they request them. We regularly monitor liquidity risks and the investment and cash resources available to meet liquidity needs, as well as statutory and regulatory liquidity requirements.
Because Obligations have favorable credit ratings and because the FHLBank System is one of the largest sellers of debt in the worldwide capital markets, the System historically has been able to satisfy its liquidity needs through debt issuance across a wide range of structures at relatively favorable spreads to benchmark market interest rates, such as U.S. Treasury securities.
CAPITAL RESOURCES
Capital Requirements
Statutory and Regulatory Requirements
Under Finance Agency regulations, regulatory capital is composed of all capital stock (including stock classified as mandatorily redeemable), retained earnings, general loss allowances, and other amounts from sources the Finance Agency determines are available to absorb losses. Under the Gramm-Leach-Bliley Act of 1999 (GLB Act), permanent capital equals Class B stock plus retained earnings and is available to absorb financial losses.
Finance Agency regulations stipulate that we must comply with three limits on capital leverage and risk-based capital. These ensure a low amount of capital risk while providing for competitive profitability. We have always complied with these regulatory capital requirements.
▪We must maintain at least a four percent minimum regulatory capital-to-assets ratio. This requirement historically has been closest to affecting our operations.
▪We must maintain at least a five percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the four percent unweighted capital requirement.
▪We are subject to a risk-based capital rule in which we must hold an amount of "permanent" capital that exceeds the amount of exposure to market risk, credit risk, and operational risk. How we determine the amount of these risk exposures is stipulated by Finance Agency regulation. Permanent capital includes retained earnings and the regulatory amount of Class B capital stock.
In addition to analyzing Advance balancesthe minimum capital requirements, the GLB Act and our Capital Plan promote the adequacy of our capital to absorb financial losses in three ways. These combine to give member stockholders a clear incentive to require us to minimize our risk profile:
▪the five-year redemption period for Class B stock;
▪the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and
▪the limitations, described below, on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations.
In accordance with the GLB Act, our stock is also putable by dollar trends,members. There are statutory and regulatory restrictions on our obligation or right to redeem or repurchase outstanding stock, including, but not limited to, the following:
▪We may not redeem any capital stock if, following the redemption, we monitorwould fail to satisfy any regulatory capital requirements. By law, we may not redeem any stock if we become undercapitalized.
▪We may not redeem any capital stock without approval of the degreeFinance Agency if either our Board of Directors or the Finance Agency determines that we have incurred or are likely to which members use Advancesincur losses resulting or expected to fundresult in a charge against capital.
If we were to be liquidated, stockholders would be entitled to receive the par value of their balance sheets. The following table showscapital stock after payment in full to our creditors. In addition, each stockholder would be entitled to any retained earnings in an amount proportional to the unweighted, average ratiostockholder's share of the total shares of capital stock. In the event of a merger or consolidation of the FHLB, the Board of Directors would determine the rights and preferences of the FHLB's stockholders, subject to any terms and conditions imposed by the Finance Agency.
Capital Plan
Our Capital Plan ties the amount of each member's required capital stock to the amount of the member's assets and the amount and type of its Mission Asset Activity with us. The Capital Plan has the following basic characteristics:
▪We offer only one class of capital stock, Class B, which is generally redeemable upon a member's five-year advance written notice. We strive to manage capital risks to be able to safely and soundly satisfy redemption requests sooner than five years, although we may elect to wait up to five years (or longer under certain conditions).
▪We issue shares of capital stock as required for an institution to become a member or maintain membership (membership stock), as required for members to capitalize Mission Asset Activity (activity stock), and if we pay dividends in the form of additional shares of stock.
▪We may, subject to the restrictions described above, repurchase certain capital stock (i.e., "excess" capital stock).
We believe the Capital Plan enables us to efficiently increase and decrease capital stock needed to capitalize assets in response to changes in the membership base and demand for Mission Asset Activity. This enables us to maintain a prudent amount of financial leverage and consistently generate a competitive dividend return.
At December 31, 2020, the amount of membership stock required for each member ranged from a minimum of $1,000 to a maximum of $30 million, with the amount within that range determined as a percentage of member assets. Separate from its membership stock, each member is required to purchase and hold activity stock to capitalize its Mission Asset Activity. For purposes of the Capital Plan, Mission Asset Activity includes the principal balance of Advances, guaranteed funds and rate Advance commitments, the principal balance of loans and commitments in the MPP, and beginning January 1, 2021, the notional balance of Letters of Credit.
The FHLB must capitalize its total assets at a rate of at least four percent. The Capital Plan supports the memberships' stock component towards this overall requirement. Each member is required to maintain an amount of activity stock within a range of a minimum and maximum percentage for each type of Mission Asset Activity. The Capital Plan amendment that went into effect on January 1, 2021 changed the activity percentages and set these minimums and maximums to be equal. As a result, the current percentages are as follows:
| | | | | | | | | | | | | | |
| Mission Asset Activity | | Minimum Activity Percentage | | Maximum Activity Percentage |
| Advances | | 4.50% | | 4.50% |
| Advance Commitments | | 4.50 | | 4.50 |
| MPP | | 3.00 | | 3.00 |
| Letters of Credit | | 0.10 | | 0.10 |
If a member owns more stock than is needed to satisfy both its most-recentlymembership stock requirement and the maximum activity stock percentages for its Mission Asset Activity, we designate the remaining stock as the member's excess capital stock. The member may utilize its excess stock to capitalize additional Mission Asset Activity.
Prior to 2021, if an individual member's excess stock reached zero, the Capital Plan had permitted us, with certain limits, to capitalize additional Mission Asset Activity of that member with excess stock owned by other members at the maximum percentage rate. This feature, called “cooperative capital,” enabled us to effectively utilize our excess capital stock holdings. However, with the most recently amended Capital Plan, by setting the minimum and maximum activity requirements to be equal, members are no longer able to utilize this cooperative capital for marginal new business.
Retained Earnings
Purposes and Amount of Retained Earnings
Retained earnings are important to protect members' capital stock investment against the risk of impairment and to enhance our ability to pay stable and competitive dividends when earnings may be volatile. Impairment risk is the risk that members would have to write down the par value of their capital stock investment in our FHLB as a result of their analysis of ultimate recoverability. An extreme situation of earnings instability, in which other-than-temporary losses were experienced and expected for a period of time, could result in members determining that the value of their capital stock investment was impaired.
We have a policy that sets forth a minimum amount of retained earnings we believe is needed to mitigate impairment risk and facilitate dividend stability in light of the risks we face. At December 31, 2020, the minimum retained earnings requirement was approximately $290 million, based on mitigating quantifiable risks under very stressed business and market scenarios to a 99
percent confidence level. At the end of 2020, our retained earnings totaled $1.3 billion. We believe the current amount of retained earnings is fully sufficient to protect our capital stock against impairment risk and to provide for dividend stability.
Joint Capital Agreement to Augment Retained Earnings
The FHLBanks entered into a Joint Capital Enhancement Agreement (the “Capital Agreement”) in February 2011. The Capital Agreement provides that each FHLBank will, on a quarterly basis, allocate at least 20 percent of its net income to a restricted retained earnings account (the “Account”) until the balance of the Account, calculated as of the last day of each calendar quarter, equals at least one percent of that FHLBank's average balance of outstanding Consolidated Obligations for the calendar quarter. The Account is not available figuresto be distributed as dividends except under certain limited circumstances. The Capital Agreement does not limit our ability to use retained earnings held outside of the Account to pay dividends. Although we have always maintained compliance with our capital requirements, we believe the Capital Agreement enhances risk mitigation by building a larger capital buffer over time to absorb unexpected losses, if any, that we may experience.
USE OF DERIVATIVES
Finance Agency regulations and our policies establish guidelines for totalthe execution and use of derivative transactions. We are prohibited from trading in, or the speculative use of, derivatives and have limits on the amount of credit risk to which we may be exposed. Most of our derivatives activity involves interest rate swaps, some of which may include options. We account for all derivatives at fair value.
Similar to our participation in debt issuances, use of derivatives is integral to hedging market risk created by Advances, certain longer-term fixed-rate investments and mortgage assets, including commitments. Derivatives related to Advances most commonly hedge either:
▪below-market rates and/or the market risk exposure on Putable Advances, and certain other Advances, for which members have sold us options embedded within the Advances; or
▪Regular Fixed-Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.
The derivatives we transact related to investments hedge market risk exposure by effectively converting the fixed-rate investment to an adjustable-rate investment. The derivatives we transact related to mortgage assets primarily hedge interest rate risk and prepayment risk. Such derivatives include options on interest rates swaps (swaptions) and sales of to-be-announced MBS for forward settlement.
Derivatives transactions related to Bonds help us intermediate between the preference of capital market investors for intermediate- and long-term fixed-rate debt securities and the preference of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
We may also transact derivatives to reduce the repricing risk of Discount Notes that fund certain overnight and shorter-term assets.
|
| | | | | | | | | | | | | | |
| | December 31, 2018 | | September 30, 2018 | | June 30, 2018 | | March 31, 2018 | | December 31, 2017 |
| Average Advances-to-assets for members | | | | | | | | | |
| Assets less than $1.0 billion (557 members) | 3.05 | % | | 3.16 | % | | 3.18 | % | | 2.86 | % | | 3.04 | % |
| Assets over $1.0 billion (89 members) | 4.26 |
| | 4.61 |
| | 4.85 |
| | 4.10 |
| | 4.95 |
|
| All members | 3.22 |
| | 3.36 |
| | 3.41 |
| | 3.03 |
| | 3.28 |
|
COMPETITION
Advances
Members' demand for our Advances is affected by, among other things, the cost of other sources of funding available, including our members' customer deposits. We compete with other suppliers of wholesale funding, both secured and unsecured, including the federal government, commercial banks, investment banking divisions of commercial banks, brokered deposits and other FHLBanks when our members' affiliated institutions are members of other FHLBanks. In addition, competition is often more significant when originating Advances to larger members, which have greater access to the national and global capital markets.
Our ability to compete successfully with other suppliers of wholesale funding, including other FHLBanks, depends primarily on the total cost of our products to members, which include the rates we charge, earnings and dividend performance, collateral policies, capital stock requirements, product features and members' perceptions of our relative safety and soundness. In addition, our competitive environment continues to be impacted by the Federal Reserve's low interest-rate environment and actions to provide liquidity in the financial markets. See Item 1A. Risk Factors below for further discussion.
Mortgage Purchase Program
The primary competitors for mortgage loans we purchase in the MPP are Fannie Mae and Freddie Mac, government agencies such as the Government National Mortgage Association (Ginnie Mae), and other secondary mortgage market conduits. Fannie Mae and Freddie Mac, in particular, have long-established and efficient programs and are the dominant purchasers of fixed-rate conventional mortgages. In addition, a number of private financial institutions have well-established securitization programs, although they may not currently be as active as they were historically. The MPP also competes with the Federal Reserve to the extent it purchases MBS and affects market prices and the availability of supply.
Debt Issuance
The FHLBank System primarily competes with the U.S. government and other GSEs for funds raised through the issuance of unsecured debt in the national and global debt markets. Increases in the supply of competing debt products may, in the absence of increases in demand, result in higher debt costs.
HUMAN CAPITAL RESOURCES
Our human capital is a significant contributor to the success of our strategic business objectives. As such, we are committed to the health, safety and wellness of our employees. In response to the COVID-19 pandemic, we implemented significant operating environment changes, safety protocols and procedures that we determined were in the best interest of our employees and members, and which comply with government regulations. This includes having nearly all employees work remotely, while implementing additional safety measures for employees continuing any on-site work.
In managing human capital, we focus on our workforce profile and the various programs and philosophies described below.
Workforce Profile
Our workforce is primarily comprised of corporate employees, with one location of principal operations. As of December 31, 2020, we had 241 employees. As of December 31, 2020, approximately 37 percent of our workforce was female, 63 percent male, 85 percent non-minority and 15 percent minority. Our workforce is leanly staffed, and historically has included a number of longer-tenured employees. As of December 31, 2020, the average tenure of our employees was 10 years. We strive to both develop talent from within the organization and supplement with external hires. We believe that developing talent internally results in institutional strength and continuity and promotes loyalty and commitment in our employee base, which furthers our success. However, adding new employees contributes to new ideas, continuous improvement, and our goals of a diverse and inclusive workforce. Our employees are not represented by a collective bargaining unit.
Total Rewards
We seek to attract, develop and retain talented employees to achieve our strategic business initiatives, enhance business performance and provide members with financial services and a competitive return on their capital investment. We strive to
achieve this objective through a combination of development programs, benefits and employee wellness programs, and recognizing and rewarding performance. Specifically, our programs include:
▪Cash compensation – provides competitive salary, transportation and other cash subsidies, and performance based incentives.
▪Benefits – offers health insurance with a health savings account contribution, dental and vision insurance, life and AD&D insurance, supplemental life insurance, long-term disability insurance, employee assistance program, 401(k) retirement savings plan with employer match, and defined benefit pension benefits.
▪Recognition programs – sponsors peer-to-peer recognition program, department recognition program and company-wide recognition.
▪Work / life balance – provides flexible scheduling and time off programs for vacation, illness, personal, holiday, bereavement, jury duty, and paid leave programs for times when caring for a sick family member, bonding with a newborn or recovering from childbirth.
▪Culture – promotes the five core values of dependable, customer focused, inclusive, change oriented and results driven and encourages employee resource groups and other culture and inclusion initiatives.
▪Development programs and training – offers tuition assistance programs, internal educational and development opportunities, and fee reimbursement for external educational and development programs.
▪Management succession planning – assesses talent annually with our leadership and Board of Directors with, at a minimum, a defined plan for positions at Vice President and above.
Diversity and Inclusion Program
Diversity and inclusion is a strategic business priority. Our diversity and inclusion officer reports to the President and Chief Executive Officer, serves as a liaison to the Board of Directors, and is a member of the senior management strategy council. We recognize that diversity increases capacity for innovation and creativity and that inclusion allows us to leverage the unique perspectives of all employees and strengthen retention efforts. We operationalize our commitment through the development and execution of a three-year diversity and inclusion strategic plan that includes quantifiable metrics to measure its success. Our diversity and inclusion officer and team reports regularly on performance against the strategic plan to management and the Board of Directors. We offer a range of opportunities for our employees to connect, and grow personally and professionally through employee resource groups and community outreach. We consider learning an important component of our diversity and inclusion strategic plan and regularly offer educational opportunities to our employees. Employee job descriptions contain inclusive behavior expectations that increase with increasing responsibilities in the organization, and also are included as part of our annual performance management process.
Item 1A.Risk Factors.
The following discussion summarizes risks and uncertainties we currently face. The realization of one or more of the risks could negatively affect our results of operations, financial condition, safety and soundness, and, at the extreme, the viability of our business franchise. The effects could include reductions in Mission Asset Activity, lower earnings and dividends, and, at the extreme, impairment of our capital or an inability to participate in issuances of Consolidated Obligations. The risks identified below are not the only risks we face. Other risks not presently known or which we deem to be currently immaterial may also impact our business. Additionally, the risks identified may adversely affect our business in ways we do not expect or anticipate.
BUSINESS AND REGULATORY RISK
A prolonged economic downturn could further lower Mission Asset Activity and profitability.
Member demand for Mission Asset Activity depends in large part on the general health of the economy and overall business conditions. Numerous external factors can affect our Mission Asset Activity and earnings including:
▪the general state and trends of the economy and financial institutions, especially in the Fifth District;
▪conditions in the financial, credit, mortgage, and housing markets;
▪interest rates;
▪actions of the Federal Reserve to affect liquidity reserves of financial institutions and the money supply;
▪competitive alternatives to our products, such as retail deposits and other sources of wholesale funding;
▪regulations affecting our members' liquidity requirements;
▪the willingness and ability of financial institutions to expand lending; and
▪natural disasters, pandemics or other widespread health emergencies (see the separate Risk Factor on the COVID-19 pandemic), terrorist attacks, civil unrest, or other unanticipated or catastrophic events could create economic and financial disruptions and uncertainties.
These external factors, some of which were experienced in 2020, are likely to have a more severe impact if a prolonged economic downturn is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or actual or potential changes in the legislative and regulatory environment. Any of these factors, or a combination of factors, could adversely affect our business activities and results of operations and may ultimately cause stockholders to request redemption of a portion of their capital or request withdrawal from membership (both referred to in this document as “request withdrawal of capital”).
For example, we believe overall Advance demand has been and continues to be unfavorably affected by the substantial amount of deposit-based liquidity provided to financial institutions through the monetary actions of the Federal Reserve and changes in our members' ability to manage their regulatory liquidity requirements. The Federal Reserve’s policies facilitate liquidity and support stability in the fixed-income markets, which in turn has generally led to substantial deposit growth for our members and decreases in their demand for Advances. See "Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information on recent market activity.
The competitive environment for our products could adversely affect business activities, including decreasing the level and utilization rates of Mission Asset Activity, earnings, and capitalization.
Our primary business is providing liquidity to our members by making Advances to, and purchasing mortgage loans from, our members. Members have access to alternative funding sources, including their customers' deposits and wholesale funding, which may offer more favorable terms than we offer, such as lower rates or more flexible credit or collateral standards. Some of our competitors are not subject to the same body of regulations applicable to us, which enables those competitors to offer products and terms that we are not able to offer. In addition, state and federal regulators’ perception of the stability and reliability of our Advances can also directly impact the amount of Advances used by members.
In connection with purchasing mortgage loans from our members, we face competition in the areas of customer service, purchase prices for the MPP loans and ancillary services such as automated underwriting and loan servicing options. Our primary competitors are Fannie Mae, Freddie Mac, government agencies such as Ginnie Mae, and other secondary mortgage market conduits. In addition, our members continue to face increased competition in mortgage origination from non-bank financial institutions that are not eligible for FHLBank membership, which could reduce the amount of mortgage loans that members can make available to us to purchase.
Increased competition could decrease the amount of Advances and mortgage loans and narrow profitability, both of which could cause stockholders to request withdrawals of capital and ultimately result in a failure to meet our capital adequacy requirements.
In addition, the FHLBank System's offerings of debt compete with the U.S. Treasury, Fannie Mae, Freddie Mac, other GSEs, and corporate, state, and sovereign entities, among others. Increases in the supply and types of competing debt products or other regulatory factors could adversely affect the System's ability to access funding or increase the cost of our debt issuance. Either of these effects could in turn adversely affect our financial condition and results of operations and the value of FHLB membership.
Sharp reductions in Mission Asset Activity resulting from lower usage by large members, consolidation of large members, or continued shift in mortgage lending activities towards entities not eligible for FHLB membership could adversely impact our net income and dividends.
The amount of Mission Asset Activity and capital is concentrated among a small number of our large members. Additionally, the financial industry continues to consolidate and in recent years there has been a systemic trend of financial institutions that are currently ineligible for FHLB membership gaining an increasing market share, especially related to mortgage finance. However, the legislative and regulatory environment faced by the FHLBanks has not changed in response to this trend. Our members could decrease their Mission Asset Activity and the amount of their capital stock as a result of merger and acquisition activity or continued loss of market share to ineligible entities. At December 31, 2020, one member, U.S. Bank, N.A., held over 15 percent of our Advances and one member PFI, Union Savings Bank, accounted for over 30 percent of the outstanding MPP principal balance. Our business model is structured to be able to absorb sharp changes in Mission Asset Activity because we can undertake commensurate reductions in liability balances and capital and because of our relatively modest operating expenses. However, an extremely large and sustained reduction in Mission Asset Activity could affect our profitability and ability to pay competitive dividends, as well as, at the FHLBank System level, raise policy questions about the relevance of the FHLBank System in its traditional mission of supporting housing finance.
Replacement of the LIBOR benchmark interest rate could adversely affect our business, financial condition, and results of operations.
In July 2017, the United Kingdom's Financial Conduct Authority (FCA), which regulates LIBOR, announced that after 2021 it will no longer persuade or compel banks to submit rates for the calculation of LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR, and immediately after June 30, 2023, in the case of the remaining U.S. dollar LIBOR settings. In response, the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to 1) develop a robust alternative to U.S. dollar LIBOR and 2) develop a plan to encourage its use in derivatives and other transactions as appropriate. The ARRC has settled on the establishment of SOFR as its recommended alternative to U.S. dollar LIBOR. SOFR is based on a broad segment of the overnight Treasury repurchase market and is intended to be a measure of the cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR in April 2018 and since then, the market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated Obligations and SOFR-linked Advances on an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk. As many of our assets and derivatives are indexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management.
In September 2019, the Finance Agency issued a supervisory letter providing LIBOR transition guidance. Under the supervisory letter, the FHLBanks were directed, by December 31, 2019, to cease purchasing investments that reference LIBOR and mature after December 31, 2021, and, by March 31, 2020, to no longer enter into any other new LIBOR
referenced financial assets, liabilities and derivatives with maturities beyond December 31, 2021. Except for investments and option embedded products, the ability to enter into new LIBOR referenced transactions was extended to June 30, 2020. As a result of the limitations introduced by the Finance Agency, we may experience less flexibility in our access to funding, higher funding costs, increased basis risk, lower overall demand or increased costs of Advances, and a lack of suitable investment alternatives. Accordingly, the composition of our balance sheet, capital stock level, primary mission assets ratio and net income may be negatively impacted. Additionally, the limitations within the supervisory letter may impact our ability to manage interest-rate risk, which may have a negative effect on our financial condition and results of operations.
During the market transition away from LIBOR, LIBOR may experience increased volatility, and the overnight Treasury repurchase market underlying SOFR may also experience disruptions from time to time, which may result in unexpected fluctuations in SOFR. While market activity in SOFR-linked financial instruments has continued to develop, the progress has been uneven and there can be no guarantee that SOFR will become widely accepted and used across market segments and financial products in a timely manner or that any other alternative reference rate will be developed. Any disruption in the market transition away from LIBOR towards SOFR or another alternate reference rate could result in increased financial, operational, legal, reputational or compliance risks. We are not currently able to predict the ultimate impact the market transition away from LIBOR towards SOFR may have on our business, financial condition, and results of operations. See "Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about the replacement of LIBOR.
The COVID-19 pandemic and related developments have created substantial economic and financial disruptions and uncertainties as well as significant operational changes, which could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
The COVID-19 pandemic, and governmental and public actions taken in response (such as stay-at-home or similar orders, travel restrictions, and business closures), have reduced economic activity and created substantial uncertainty about the future economic environment. There are no comparable recent events that provide guidance as to the long-term effect that the COVID-19 pandemic may have and, as a result, the ultimate impact of the pandemic, including the depth of the economic downturn and the timing and shape of the economic recovery, is highly uncertain. This could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
Prolonged periods of significant economic and financial disruptions and uncertainties resulting from the COVID-19 pandemic, may lead to an increased risk of credit losses, in particular due to decreases in the value of our mortgage loans held for portfolio or collateral securing our Advances or due to member financial difficulties or member failures, and may lead to an increased risk of counterparty defaults. The risk of credit losses may be exacerbated by a prolonged downturn in the residential and commercial real estate markets, including higher mortgage defaults or delinquencies due to rising unemployment and the effect of mortgage forbearance and other relief as well as financial difficulties or failures of mortgage servicers.
Additionally, a prolonged economic downturn resulting from the COVID-19 pandemic may lead to further reduced demand for Advances. Beginning in the second quarter of 2020, demand for Advances decreased significantly as a number of emergency actions taken by the Federal Reserve helped facilitate liquidity and support stability in the fixed-income markets and as members experienced substantial deposit growth. We believe that reduced demand for Advances from many of our members will, or is likely to, continue in the near future.
Overall, the effects of the COVID-19 pandemic have contributed to, and may continue to cause, compression in our net interest income and net interest margin. To the extent interest rates continue to be low, or negative interest rates arise, our business and profitability may be further adversely affected.
Furthermore, stay-at-home or similar orders, travel restrictions, and business shutdowns as a result of the COVID-19 pandemic have led to substantial changes in normal business practices, such as the implementation of widespread work-from-home arrangements for us, as well as many of our members, dealers, investors, and third-party service providers. These changes have increased the risk of operational errors, disruptions and failures, and cybersecurity breaches. It is uncertain when and in what manner normal business operations may return, which could adversely affect our ability to conduct and manage our business.
The extent to which the COVID-19 pandemic may continue to impact our business, financial condition, and results of operations will depend on many factors that remain highly uncertain and difficult to predict, including, but not limited to:
the duration, spread, and severity of the pandemic; additional fiscal stimulus and other measures taken in response to the pandemic; the actions taken to contain the pandemic, including the effectiveness of related vaccines and therapeutics; and how quickly and to what extent normal economic and operating conditions can resume.
Potential GSE reform could unfavorably affect our business model, financial condition, and results of operations.
Due to our GSE status, the ultimate resolution to the conservatorship of Fannie Mae and Freddie Mac could affect the FHLBanks. While there appears to be consensus that a permanent financial and political solution to the current conservatorship status should be implemented, which could include maintaining the current structure, no consensus has evolved to date around any of the various legislative proposals. Some policy proposals directed towards Fannie Mae and Freddie Mac have included provisions applicable to the FHLBank System, such as limitations on Advances and portfolio investments. Other proposals have included broader changes in GSE mortgage finance, such as the FHLBank System being a greater participant in the secondary mortgage market, which could affect the FHLBank System's long-standing business model.
There are significant differences between the FHLBank System and Fannie Mae and Freddie Mac, including the System's focus on lending as opposed to guaranteeing mortgages and its distinctive cooperative business model. GSE legislation could inadequately account for these differences. This could jeopardize the ability of the FHLBank System to continue operating effectively within its current business model, including by adversely changing the perceptions of the capital markets about the risk associated with the debt of housing GSEs. We cannot predict the effects on the System if GSE reform were to be enacted.
Changes in the regulatory and legislative environment could unfavorably affect our business model, financial condition, and results of operations.
In addition to potential GSE reform, the legislative and regulatory environment in which the System operates continues to undergo change. Recently-promulgated and future legislative and regulatory actions could significantly affect our business model, financial condition, or results of operations. Legislative and regulatory actions have also raised our operating costs and imparted added uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. We are unable at this time to predict the ultimate effects the regulatory environment could have on the FHLBank System's business model, our members' view on the value of the FHLBank membership, or on our financial condition and results of operations.
Failure to meet capital adequacy requirements mandated by Finance Agency regulations and supervisory guidance and by our internal policies, or not being able to pay dividends or repurchase or redeem capital stock, may lower demand for Mission Asset Activity, harm results of operations, and lower membership value.
To ensure safe and sound operations, we must hold a minimum amount of capital relative to our asset levels. We must also hold a sufficient amount of retained earnings to help protect members' capital stock investment against impairment risk. If our capital levels fall significantly, we may be unable to pay dividends or redeem and repurchase capital stock in a timely manner (or at all). Such events could adversely affect the value of membership including causing impairment in the value of members' capital investment in our company. Outcomes could be: reduced demand for Mission Asset Activity, decreased profitability, requests from members to redeem a portion of their capital or to withdraw from membership, or increased investors' perception of the riskiness of our FHLB.
MARKET AND LIQUIDITY RISK
Changes in interest rates and mortgage prepayment speeds (together referred to as market risk exposure or interest rate risk exposure) could significantly affect our financial condition and results of operations.
Exposure of earnings to unhedged changes in interest rates and mortgage prepayment speeds is one of our largest ongoing residual risks. We derive most of our income from the interest earned on assets less the interest paid on Consolidated Obligations and deposits used to fund the assets. Spreads on our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model. Market conditions, yield curve shape, competitive forces, and market risk exposure could cause these already narrow asset spreads to decline, which could substantially reduce our
profitability. A key spread relationship is that we tend to utilize Consolidated Discount Notes to fund a significant amount of assets that have adjustable-rates tied to a benchmark interest rate, such as LIBOR or SOFR. Because rates on Discount Notes do not perfectly correlate with other adjustable benchmark interest rates, a narrowing of this spread, for example from investors changing perceptions about the quality of our debt, could lower income and reduce balances of Mission Asset Activity.
We hedge mortgage assets with a combination of Consolidated Obligations and derivatives transactions. Interest rate movements can lower profitability in two primary ways: 1) directly due to their impact on earnings from cash flow mismatches between assets and liabilities; and 2) indirectly via their impact on prepayment speeds on our MBS investments and mortgages purchased under our MPP, which can unfavorably affect the cash flow mismatches. The effects on income can also include acceleration in the amortization of purchased premiums on mortgage assets.
Because it is normally cost-prohibitive to completely mitigate market risk exposure, a residual amount of market risk normally remains after incorporating risk management activities. Sharp increases or decreases in interest rates could adversely affect us and our stockholders by making dividend rates less competitive relative to the returns available to members on alternative investments.
In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders' expectations for an extended period of time and/or market capitalization ratios falling below par which could indicate potential impairment of member stock. In such a situation, members could engage in less Mission Asset Activity and could request a withdrawal of capital. See "Quantitative and Qualitative Disclosures About Risk Management" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about market risk exposure.
Impaired access to the capital markets for debt issuance could decrease the amount of Mission Asset Activity, lower earnings by raising debt costs and, at the extreme, prevent the System from meeting its financial obligations.
Our principal long-term source of funding, liquidity, and market risk management is through access on favorable terms to the capital markets for participation in the issuances of debt securities and execution of derivative transactions at prices and yields that are adequate to support our business model. Our ability to obtain funds through the sale of Consolidated Obligations depends in part on prevailing conditions in the capital markets, particularly the short-term capital markets, because we and the System normally have a large reliance on short-term funding. The System's strong debt ratings, the implicit U.S. government backing of our debt, strong investor demand for FHLBank System debt, and effective funding management are instrumental in ensuring satisfactory access to the capital markets.
We are exposed to liquidity risk if significant disruptions in the capital markets occur. Although the System was able to maintain access to the capital markets for debt issuances on acceptable terms during 2020, there is no assurance this will continue to be the case. Future ability to effectively access the capital markets on acceptable terms could be adversely affected by external events (such as general economic and financial instabilities, political instability, wars, natural disasters, pandemics or other widespread health emergencies, civil unrest or other unanticipated or catastrophic events), deterioration in the perception of financial market participants about the financial strength of Consolidated Obligations, or downgrades to the System's credit ratings. The System could also be affected by the continued changes in the capital markets in response to financial regulations and by the joint and several liability for Consolidated Obligations, which exposes the System as a whole to events at individual FHLBanks. If access to capital markets were to be impaired for an extended period, the effect on our financial condition and results of operations could be material. At the extreme, the System's ability to achieve its mission and satisfy its financial obligations could be threatened.
CREDIT RISK
We are exposed to credit risk that, if realized, could materially affect our financial condition and results of operations.
We believe we have a de minimis overall amount of residual credit risk exposure related to Credit Services, purchases of investments, and transactions in derivatives, and a minimal amount of credit risk exposure related to the MPP. However, we can make no assurances that credit losses could not materially affect our financial condition or results of operations in all scenarios.
The FHLB is an asset-based lender for Advances and Letters of Credit. Advances and Letters of Credit are over-collateralized and we have a perfected first lien position on collateral. However, we do not have full information on the characteristics of, nor do we estimate current market values on, a large portion of collateral. This results in a degree of uncertainty as to the precise amount of over-collateralization.
Our MPP consists of mortgage loans considered to have high credit quality and conservative underwriting and loan characteristics with additional credit enhancements in place designed to protect us against credit losses. The result has been a minimal amount of credit losses historically.
Although Advances and Letters of Credit are over-collateralized and mortgage loans in the MPP are of high credit quality with various credit enhancements, credit risk could increase under a number adverse scenarios, such as damage or destruction of collateral that members pledge to secure Advances or mortgages that we hold in the MPP as a result of natural disasters, which may be caused by the effects of climate change or other catastrophic events. Significant declines in the value of collateral pledged to secure Advances could lead to greater exposure to credit losses in the event of a member default. Additionally, significant and sustained reductions in home prices and sustained elevated levels of unemployment and other factors that influence delinquencies and defaults could increase the risk of credit losses in the MPP.
Some of our liquidity investments are unsecured, as are uncollateralized portions of certain derivatives. We make unsecured liquidity investments in and transact derivatives with highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices. Failure of an investment or derivative counterparty with which we have a large unsecured position could have a material adverse effect on our financial conditions and results of operations. To the extent we engage in derivative transactions required to be cleared under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), we may be exposed to nonperformance from central clearinghouses and Futures Commission Merchants.
Financial institutions are increasingly inter-related as a result of trading, clearing, counterparty, and other relationships. As a result, actual or potential defaults of one or more financial institutions could lead to market-wide disruptions making it difficult for us to find qualified counterparties for transactions.
Financial difficulties at other FHLBanks could require us to provide financial assistance to another FHLBank, which could adversely affect our results of operations or our financial condition.
Each FHLBank has a joint and several liability for principal and interest payments on Consolidated Obligations, which are backed only by the financial resources of the FHLBanks. Although no FHLBank has ever defaulted on its principal or interest share of an Obligation, there can be no assurance that this will continue to be the case. Financial performance issues could require our FHLB to provide financial assistance to one or more other FHLBanks, for example, by making a payment on an Obligation on behalf of another FHLBank. Such assistance could adversely affect our financial condition, earnings, ability to pay dividends, or ability to redeem or repurchase capital stock.
OPERATIONAL RISK
Failures of the Office of Finance could disrupt the ability to conduct and manage our business.
The Office of Finance is a joint office of the FHLBanks established to facilitate the issuance and servicing of Consolidated Obligations, among other things. Pursuant to Finance Agency regulations, the Office of Finance, often in conjunction with the FHLBanks, has adopted policies and procedures for the purposes of facilitating and approving the issuance of Consolidation Obligations. A failure or interruption of the Office of Finance's services as a result of breaches, cyberattacks, or technological risks could negatively affect the business operations of each FHLBank, including disruptions to the FHLBanks' access to funding through the sale of Consolidated Obligations. Although the Office of Finance has business continuity and security incident response plans in place, our business operations could be constrained, disrupted or otherwise negatively affected if the Office of Finance was not able to perform its functions for a period of time.
Failures or interruptions in our information systems and other technologies, financial and business models, and third-party vendors could harm our financial condition, results of operations, reputation, and relations with members.
As a financial institution, we rely heavily on internal and third-party information systems and other technology to manage our business, including the secure processing, storage and transmission of confidential borrower and financial information in computer systems and networks. For instance, due to our reliance on the book-entry system of the Federal Reserve Banks for debt issuance and servicing operations, we depend on them and their fiscal agent, the Federal Reserve Bank of New York, and one or more settlement agents to issue and make payments of principal and interest on Consolidated Obligations. Failures in information systems and other technologies could occur from human error, fraud, cyberattacks, errors or misuse of models and services we employ, lapses in operating processes, or natural or man-made disasters.
Computer systems, software and networks may be increasingly vulnerable to failures and interruptions from cyberattacks, which may include breaches, unauthorized access, misuse, computer viruses or other malicious or destructive code (such as ransomware) and other events against information owned by our company and customers. These failures and interruptions could jeopardize the confidentiality or integrity of information, or otherwise cause interruptions or malfunctions in operations. Additionally, threats of cyber terrorism, external extremist parties, including state-sponsored actors, result in heightened risk exposure. The techniques used in cyber attacks change frequently and have grown increasingly sophisticated, and these attacks or ensuing security breaches could persist for an extended period of time before being detected. It could take considerable additional time for us to determine the scope, extent, amount, and type of information compromised. We can make no assurance that we will be able to prevent, timely and adequately address, or mitigate failures, interruptions, or cyberattacks in information systems and other technology. If we experience a failure, interruption, or cyberattack in any of these systems, we may be unable to effectively conduct or manage business activities, operating processes, and risk management, which could significantly harm customer relations, our reputation, and operating costs, potentially resulting in material adverse effects on our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of such failures, interruptions, cyberattacks, or cyber terrorism.
Our financial condition and results of operations could suffer if we are unable to hire and retain skilled key personnel.
We rely on key personnel for many of our functions and have a relatively small workforce, given the size and complexity of our business. The success of our mission depends, in large part, on the ability to attract and retain key personnel. We must continue to recruit, retain and motivate a qualified and diverse pool of employees, both to maintain our current business, and to execute strategic initiatives. Competition for qualified people or ineffective succession planning could affect the ability to hire or retain effective key personnel, thereby harming our financial condition and results of operations.
Item 1B.Unresolved Staff Comments.
None.
Item 2.Properties.
Our primary offices are located in approximately 79,000 square feet of leased space in downtown Cincinnati, Ohio. We also maintain a leased, fully functioning, back-up facility in suburban Cincinnati. We believe that our facilities are in good condition, well maintained, and adequate for our current needs.
Item 3.Legal Proceedings.
From time to time, we are subject to various legal proceedings arising in the normal course of business. 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.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
By law our stock is not publicly traded, and only our members (and former members with a withdrawal notice pending) may own our stock. The par value of our capital stock is $100 per share. As of December 31, 2020, we had 649 member and former member stockholders and approximately 27 million shares of capital stock outstanding, all of which were Class B Stock.
We declared quarterly cash dividends in 2020 and 2019 as shown in the table below.
| | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | | | | | | | | | | | | |
| | | | 2020 | | | | | | | | 2019 | | |
| | | | Annualized | | | | | | | | Annualized | | |
| Quarter | | | | Rate | | | | | | | | Rate | | |
| First | | | | 2.50 | % | | | | | | | | 6.00 | % | | |
| Second | | | | 2.50 | | | | | | | | | 5.50 | | | |
| Third | | | | 2.00 | | | | | | | | | 4.50 | | | |
| Fourth | | | | 2.00 | | | | | | | | | 4.00 | | | |
| Total | | | | 2.23 | | | | | | | | | 5.05 | | | |
Generally, the Board of Directors has discretion to declare or not declare dividends and to determine the rate of any dividend declared. Our policy states that dividends for a quarter are declared and paid from retained earnings after the close of a calendar quarter and are based on average stock balances for the then closed quarter. The Board of Directors' decision to declare dividends is influenced by the financial condition, overall financial performance and retained earnings of the FHLB, and actual and anticipated developments in the overall economic and financial environment including interest rates and the mortgage and credit markets. The dividend rate is generally referenced as a spread to average short-term interest rates experienced during the quarter to help assess a competitive level for our stockholders.
We may not declare a dividend if, at the time, we are not in compliance with all of our capital requirements. We also may not declare or pay a dividend if, after distributing the dividend, we would fail to meet any of our capital requirements or if we determine that the dividend would create a safety and soundness issue for the FHLB. See Note 11 of the Notes to the Financial Statements for additional information regarding our capital stock.
RECENT SALES OF UNREGISTERED SECURITIES
We provide Letters of Credit in the ordinary course of business to support members' obligations issued in support of unaffiliated, third-party offerings of notes, bonds or other securities. We provided $1 million and $3 million of such credit support during 2020 and 2019. We did not provide such credit support during 2018. To the extent that these Letters of Credit are securities for purposes of the Securities Act of 1933, their issuance is exempt from registration pursuant to section 3(a)(2) thereof.
Item 6. Selected Financial Data.
The following table shows Advance usagepresents selected Statement of members by charter type.
|
| | | | | | | | | | | | | |
| (Dollars in millions) | December 31, 2018 | | December 31, 2017 |
| | Principal Amount of Advances | | Percent of Total Principal Amount of Advances | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances |
| Commercial Banks | $ | 39,195 |
| | 71 | % | | $ | 52,899 |
| | 76 | % |
| Savings Institutions | 5,424 |
| | 10 |
| | 7,369 |
| | 10 |
|
| Credit Unions | 1,564 |
| | 3 |
| | 1,293 |
| | 2 |
|
| Insurance Companies | 8,676 |
| | 16 |
| | 8,357 |
| | 12 |
|
| Community Development Financial Institutions | 1 |
| | — |
| | 1 |
| | — |
|
| Total member Advances | 54,860 |
| | 100 |
| | 69,919 |
| | 100 |
|
| Former member borrowings | 12 |
| | — |
| | 59 |
| | — |
|
| Total principal amount of Advances | $ | 54,872 |
| | 100 | % | | $ | 69,978 |
| | 100 | % |
The following tables present principal balancesCondition data, Statement of Income data and financial ratios for the five membersyears ended December 31, 2020.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | 2018 | | 2017 | | 2016 |
| STATEMENT OF CONDITION DATA AT PERIOD END: | | | | | | | | | |
| Total assets | $ | 65,296 | | | $ | 93,492 | | | $ | 99,203 | | | $ | 106,895 | | | $ | 104,635 | |
| Advances | 25,362 | | | 47,370 | | | 54,822 | | | 69,918 | | | 69,882 | |
| Mortgage loans held for portfolio | 9,549 | | | 11,236 | | | 10,502 | | | 9,682 | | | 9,150 | |
Allowance for credit losses on mortgage loans (1) | — | | | 1 | | | 1 | | | 1 | | | 1 | |
Investments (2) | 27,041 | | | 34,389 | | | 33,614 | | | 27,058 | | | 25,334 | |
| Consolidated Obligations, net: | | | | | | | | | |
| Discount Notes | 27,500 | | | 49,084 | | | 46,944 | | | 46,211 | | | 44,690 | |
| Bonds | 31,997 | | | 38,440 | | | 45,659 | | | 54,163 | | | 53,191 | |
| Total Consolidated Obligations, net | 59,497 | | | 87,524 | | | 92,603 | | | 100,374 | | | 97,881 | |
| Mandatorily redeemable capital stock | 19 | | | 22 | | | 23 | | | 30 | | | 35 | |
| Capital: | | | | | | | | | |
| Capital stock - putable | 2,641 | | | 3,367 | | | 4,320 | | | 4,241 | | | 4,157 | |
| Retained earnings | 1,304 | | | 1,094 | | | 1,023 | | | 940 | | | 834 | |
| Accumulated other comprehensive loss | (15) | | | (16) | | | (13) | | | (16) | | | (13) | |
| Total capital | 3,930 | | | 4,445 | | | 5,330 | | | 5,165 | | | 4,978 | |
| STATEMENT OF INCOME DATA: | | | | | | | | | |
| Net interest income | $ | 406 | | | $ | 406 | | | $ | 499 | | | $ | 429 | | | $ | 363 | |
| | | | | | | | | |
| Non-interest income (loss) | (7) | | | (10) | | | (37) | | | (1) | | | 46 | |
| Non-interest expense | 92 | | | 89 | | | 85 | | | 79 | | | 111 | |
| Affordable Housing Program assessments | 31 | | | 31 | | | 38 | | | 35 | | | 30 | |
| Net income | $ | 276 | | | $ | 276 | | | $ | 339 | | | $ | 314 | | | $ | 268 | |
| FINANCIAL RATIOS: | | | | | | | | | |
Dividend payout ratio (3) | 30.3 | % | | 74.1 | % | | 75.6 | % | | 66.3 | % | | 63.9 | % |
Weighted average dividend rate (4) | 2.23 | | | 5.05 | | | 5.88 | | | 5.00 | | | 4.00 | |
| Return on average equity | 5.78 | | | 5.65 | | | 6.29 | | | 6.15 | | | 5.35 | |
| Return on average assets | 0.31 | | | 0.28 | | | 0.32 | | | 0.31 | | | 0.25 | |
Net interest margin (5) | 0.46 | | | 0.42 | | | 0.47 | | | 0.42 | | | 0.35 | |
| Average equity to average assets | 5.39 | | | 5.04 | | | 5.11 | | | 5.00 | | | 4.76 | |
Regulatory capital ratio (6) | 6.07 | | | 4.79 | | | 5.41 | | | 4.88 | | | 4.80 | |
Operating expenses to average assets (7) | 0.080 | | | 0.070 | | | 0.063 | | | 0.060 | | | 0.061 | |
(1)The methodology for determining the allowance for credit losses on mortgage loans changed on January 1, 2020 with the largest Advance borrowings.adoption of new accounting guidance on the measurement of credit losses on financial instruments. Consistent with the modified retrospective method of adoption, the prior periods have not been revised to conform to the new basis of accounting.
(2)Investments include interest-bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
(3)Dividend payout ratio is dividends declared in the period as a percentage of net income.
(4)Weighted average dividend rates are dividends paid divided by the average number of shares of capital stock eligible for dividends.
(5)Net interest margin is net interest income as a percentage of average earning assets.
(6)Regulatory capital ratio is period-end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period-end total assets.
(7)Operating expenses comprise compensation and benefits and other operating expenses, which are included in non-interest expense.
|
| | | | | | | | | | | | | | | | |
| (Dollars in millions) | | | | | | | | | | |
| December 31, 2018 | | December 31, 2017 |
| Name | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances | | Name | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances |
| JPMorgan Chase Bank, N.A. | | $ | 23,400 |
| | 43 | % | | JPMorgan Chase Bank, N.A. | | $ | 23,950 |
| | 34 | % |
| U.S. Bank, N.A. | | 4,574 |
| | 8 |
| | U.S. Bank, N.A. | | 8,975 |
| | 13 |
|
| Third Federal Savings and Loan Association | | 3,727 |
| | 7 |
| | Third Federal Savings and Loan Association | | 3,756 |
| | 5 |
|
| Nationwide Life Insurance Company | | 2,510 |
| | 5 |
| | The Huntington National Bank | | 3,732 |
| | 5 |
|
| Pinnacle Bank | | 1,444 |
| | 3 |
| | Fifth Third Bank | | 3,140 |
| | 4 |
|
| Total of Top 5 | | $ | 35,655 |
| | 66 | % | | Total of Top 5 | | $ | 43,553 |
| | 61 | % |
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Advance concentration ratios
This discussion and analysis of the FHLB's financial condition and results of operations should be read in conjunction with the Financial Statements and related Notes to Financial Statements contained in this Form 10-K.
EXECUTIVE OVERVIEW
Recent Developments
COVID-19 Pandemic
The global outbreak of COVID-19 has impacted communities and businesses worldwide, including those in the Fifth District. The effects of COVID-19 continue to evolve, and the full impact and duration of the virus are influencedunknown. Despite the uncertainties created by the COVID-19 pandemic, we continued to fulfill our mission of providing robust access to a key source of readily available and generally similarcompetitively priced wholesale funding to concentration ratios of financial activity among our Fifth District financial institutions. We believe that having largemember financial institutions that actively useand supporting our Mission Assets augments the value of membershipcommitment to all members. For example, such activity improves our operating efficiency, increases our earnings and thereby contributions toaffordable housing and community investment, programs. This activity may enablewhile maintaining strong capital and liquidity positions.
We have remained focused on the health and safety of our employees while maintaining full business operations. Employees are working from home with only a limited number of employees voluntarily working from our downtown Cincinnati location. Although there is no definitive date on when employees will return to the office, we have prepared health and safety policies and procedures to ensure our employees are able to return safely.
At this time, we cannot predict the ultimate impact of COVID-19 on our members, counterparties, vendors, and other third parties we rely upon to conduct our business. However, we continue to monitor the progression of COVID-19 and are committed to assisting members and their communities as impacts related to the pandemic continue to unfold.
Financial Condition
Mission Asset Activity
Mission Assets, which we define as Advances, Letters of Credit, and total MPP are the primary means by which we fulfill our mission with direct connections to members. We regularly monitor our balance sheet concentration of Mission Asset Activity. One measure we use to assess mission achievement is our Primary Mission Asset ratio, which measures the sum of average Advances and mortgage loans as a percentage of average Consolidated Obligations (adjusted for certain high-quality liquid assets, as permitted by regulation). In 2020, the Primary Mission Asset ratio averaged 75 percent, which exceeded the Finance Agency's preferred ratio of 70 percent. In assessing overall mission achievement, we also consider supplemental sources of Mission Asset Activity, the most significant of which is Letters of Credit issued to members.
The following table summarizes our Mission Asset Activity.
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, | | |
| | Ending Balances | | | | Average Balances |
| | | | | | | |
| (In millions) | 2020 | | 2019 | | | | 2020 | | 2019 | | |
| Mission Asset Activity: | | | | | | | | | | | |
| Advances (principal) | $ | 25,007 | | | $ | 47,264 | | | | | $ | 42,917 | | | $ | 47,894 | | | |
| MPP: | | | | | | | | | | | |
| Mortgage loans held for portfolio (principal) | 9,316 | | | 10,981 | | | | | 10,995 | | | 10,499 | | | |
| Mandatory Delivery Contracts (notional) | 137 | | | 936 | | | | | 338 | | | 516 | | | |
| Total MPP | 9,453 | | | 11,917 | | | | | 11,333 | | | 11,015 | | | |
| Letters of Credit (notional) | 28,812 | | | 16,205 | | | | | 20,141 | | | 15,150 | | | |
| Total Mission Asset Activity | $ | 63,272 | | | $ | 75,386 | | | | | $ | 74,391 | | | $ | 74,059 | | | |
At December 31, 2020, 64 percent of members held Mission Asset Activity, which was relatively stable compared to prior periods. The balance of Mission Asset Activity was $63.3 billion at December 31, 2020, a decrease of $12.1 billion (16 percent) from year-end 2019, which was primarily driven by lower Advance balances. Advance principal balances decreased $22.3
billion (47 percent) from year-end 2019 primarily due to reduced borrowings by large-asset members as these members generally experienced an inflow of deposits on their balance sheets and increased access to other sources of liquidity in the financial markets. The decrease in the balance of Mission Asset Activity was partially offset by an increase of $12.6 billion (78 percent) in Letters of Credit balances from year-end 2019. The increase in Letters of Credit was due in part to members using Letters of Credit rather than securities to secure increased deposits from states and municipalities during the pandemic. We normally earn fees on Letters of Credit based on the actual average amount of the Letters utilized, which generally is less than the notional amount issued.
Average principal Advance balances for 2020 decreased only $5.0 billion (10 percent) compared to 2019 as Advances spiked across our membership at the end of the first quarter as the financial markets reacted to the pandemic. Most of these Advances matured or prepaid by the end of the third quarter of 2020. Advance balances are often volatile due to members' ability to quickly, normally on the same day, increase or decrease their amount of Advances. We believe providing members flexibility in their funding levels helps support their asset-liability management needs and is a key benefit of membership.
We believe that reduced demand for Advances from many of our members will, or is likely to, continue in the near future. Our business is designed to support significant changes in asset levels without having to undergo material changes in staffing, operations, risk practices, or general resource needs. A key reason for this scalability is that our Capital Plan provides for additional capital when Advances grow and the opportunity for us to obtainretire capital when Advances decline, thereby acting, along with our efficient operating expenses, to preserve competitive profitability.
The MPP principal balance fell $1.7 billion (15 percent) from year-end 2019. During 2020, we purchased $2.6 billion of mortgage loans, while principal reductions of $4.3 billion reflected the significant increase in mortgage loan refinance activity in 2020.
Based on earnings in 2020, we accrued $31 million for the Affordable Housing Program (AHP) pool of funds to be available to members in 2021. In addition to the required AHP assessment, we provided voluntary sponsorship of three other housing programs during 2020. These programs provided funds to cover accessibility and emergency repairs for special needs and elderly homeowners, funds for the replacement or repair of homes damaged or destroyed by natural disasters within the Fifth District, and Advances at zero percent interest for COVID-19 related assistance.
Investments
The balance of investments at December 31, 2020 was $27.0 billion, a decrease of $7.3 billion from year-end 2019. At December 31, 2020, investments included $9.7 billion of MBS and $17.3 billion of other investments, which consisted primarily of highly-rated short-term instruments and longer-term U.S. Treasury and GSE obligations held for liquidity. All of our MBS held at December 31, 2020 were issued and guaranteed by Fannie Mae, Freddie Mac or a U.S. agency. The decline in the balance of investments at the end of 2020 was due to decreases in both MBS and liquidity investments. MBS balances declined due to an increase in prepayments of the underlying mortgages as a result of the low interest rate environment. Due to regulatory limitations regarding the purchase of MBS that reference LIBOR, we have not been able to fully replace the prepaid MBS with suitable alternatives. Liquidity investments decreased as we decided to hold more favorableof our liquidity portfolio as deposits at the Federal Reserve at the end of 2020 in anticipation of volatile market conditions. At December 31, 2020, we held $3.0 billion in deposits at the Federal Reserve, which are reflected in cash and due from banks on the Statements of Condition.
Investments averaged $32.9 billion in 2020, a decrease of $4.9 billion (13 percent) from year-end 2019. The decrease in average investments was primarily driven by the decrease in MBS balances described above. Liquidity investments can vary significantly on a daily basis during times of volatility in Advance balances. We maintained a robust amount of asset liquidity throughout 2020 across a variety of liquidity measures, as discussed in the "Liquidity Risk" section of "Quantitative and Qualitative Disclosures About Risk Management."
Capital
Capital adequacy surpassed all minimum regulatory capital requirements in 2020. The GAAP capital-to-assets ratio at December 31, 2020 was 6.02 percent, while the regulatory capital-to-assets ratio was 6.07 percent. Both ratios exceeded the regulatory required minimum of four percent. Regulatory capital includes mandatorily redeemable capital stock accounted for as a liability under GAAP. GAAP and regulatory capital both decreased $0.5 billion in 2020, primarily due to the repurchase of $2.3 billion of excess stock and members' redemption of $0.6 billion of stock in 2020. The repurchase and redemption of capital stock were partially offset by members' purchases of capital stock to support Advance growth at the end of the first quarter. Retained earnings totaled $1.3 billion at December 31, 2020, an increase of $0.2 billion (19 percent) from year-end 2019, which is a higher growth rate relative to recent years. The increase in retained earnings was due in part to the lower weighted average dividend rate in 2020.
Results of Operations
Overall Results
Our earnings reflect the combination of a stable business model and conservative management of risk. Key factors that can cause significant periodic volatility in our profitability are changes in the level of interest rates, changes in spreads between benchmark interest rates and our short-term funding costs, recognition of net amortization due to accelerated prepayments of mortgage assets, and fair value adjustments related to the use of derivatives and the associated hedged items. The table below summarizes our results of operations.
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | | | 2018 | | |
| Net income | $ | 276 | | | $ | 276 | | | | | $ | 339 | | | |
| Affordable Housing Program assessments | 31 | | | 31 | | | | | 38 | | | |
| Return on average equity (ROE) | 5.78 | % | | 5.65 | % | | | | 6.29 | % | | |
| Return on average assets | 0.31 | | | 0.28 | | | | | 0.32 | | | |
| Weighted average dividend rate | 2.23 | | | 5.05 | | | | | 5.88 | | | |
Average short-term interest rates (1) | 0.51 | | | 2.24 | | | | | 2.07 | | | |
| | | | | | | | | |
| ROE spread to average short-term interest rates | 5.27 | | | 3.41 | | | | | 4.22 | | | |
| Dividend rate spread to average short-term interest rates | 1.72 | | | 2.81 | | | | | 3.81 | | | |
| | | | | | | | | |
| | | | | | | | | |
(1) Average short-term interest rates consist of 3-month LIBOR and the Federal funds effective rate.
The historically low interest rate environment in 2020 had a significant impact on earnings. Low long-term interest rates resulted in a higher volume of mortgage refinance activity, which led to elevated levels of mortgage loan repayments and related premium amortization. Additionally, short-term interest rates declined sharply in early 2020 and continued at low levels for the remainder of the year, which lowered the earnings generated from investing our capital. Despite these declines, 2020 net income benefited from gains on the sale of interest rate swaptions during the first quarter of 2020 as well as higher prepayment fees on Advances in 2020. We use swaptions to hedge market risk exposure associated with holding fixed-rate mortgage assets and may sell swaptions as interest rates change in order to offset actual and anticipated risks.
Earnings levels continued to represent competitive returns on stockholders' capital investment. Our business model is structured to be able to absorb sharp changes in assets because we can execute commensurate changes in liability and capital stock balances. ROE was higher than average short-term rates in the periods presented above, while we maintained risk exposures in line with our appetite for a moderate risk profile. The spread between ROE and average short-term rates, which we compute using 3-month LIBOR and the Federal funds effective rate, is a market benchmark we believe member stockholders actively use to assess the competitiveness of the return on their capital investment.
In December 2020, we paid stockholders a quarterly dividend at a 2.00 percent annualized rate on their capital investment in our company, which is 1.84 percentage points above fourth quarter average short-term interest rates. The lower weighted average dividend rate in 2020 was due to the uncertainty surrounding the economic effects from the COVID-19 pandemic and its ultimate impact on our business and profitability, and to grow retained earnings to bolster the capital position going forward.
Effect of Interest Rate Environment
Trends in market interest rates and the resulting shapes of the market yield curves strongly influence the results of operations and profitability because of how they affect members' demand for Mission Asset Activity, spreads on assets, funding costs and helpsdecisions in managing the tradeoffs in our market risk/return profile. The following table presents key market interest rates (obtained from Bloomberg L.P.).
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Year 2020 | | Year 2019 | | Year 2018 | | | | | | |
| | | | | | | | | |
| | | | | | | | | | | |
| | Ending | | Average | | Ending | | Average | | Ending | | Average | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
| Federal funds effective | 0.09 | % | | 0.37 | % | | 1.55 | % | | 2.16 | % | | 2.40 | % | | 1.83 | % | | | | | | | | |
| Secured Overnight Financing Rate (SOFR) | 0.09 | | | 0.37 | | | 1.55 | | | 2.20 | | | 3.00 | | | 1.85 | | | | | | | | | |
| 3-month LIBOR | 0.24 | | | 0.65 | | | 1.91 | | | 2.33 | | | 2.81 | | | 2.31 | | | | | | | | | |
| 2-year LIBOR | 0.20 | | | 0.49 | | | 1.70 | | | 2.03 | | | 2.66 | | | 2.75 | | | | | | | | | |
| 10-year LIBOR | 0.93 | | | 0.88 | | | 1.90 | | | 2.09 | | | 2.71 | | | 2.95 | | | | | | | | | |
| 2-year U.S. Treasury | 0.12 | | | 0.39 | | | 1.57 | | | 1.97 | | | 2.49 | | | 2.52 | | | | | | | | | |
| 10-year U.S. Treasury | 0.92 | | | 0.89 | | | 1.92 | | | 2.14 | | | 2.69 | | | 2.91 | | | | | | | | | |
15-year mortgage current coupon (1) | 0.65 | | | 1.17 | | | 2.28 | | | 2.52 | | | 3.06 | | | 3.20 | | | | | | | | | |
30-year mortgage current coupon (1) | 1.28 | | | 1.64 | | | 2.71 | | | 2.95 | | | 3.51 | | | 3.65 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| | Year 2020 by Quarter - Average |
| | Quarter 1 | | Quarter 2 | | Quarter 3 | | Quarter 4 |
| | | | | | | |
| Federal funds effective | 1.25 | % | | 0.06 | % | | 0.09 | % | | 0.09 | % |
| SOFR | 1.25 | | | 0.05 | | | 0.09 | | | 0.09 | |
| 3-month LIBOR | 1.54 | | | 0.61 | | | 0.25 | | | 0.22 | |
| 2-year LIBOR | 1.18 | | | 0.32 | | | 0.22 | | | 0.23 | |
| 10-year LIBOR | 1.34 | | | 0.69 | | | 0.65 | | | 0.87 | |
| 2-year U.S. Treasury | 1.10 | | | 0.19 | | | 0.14 | | | 0.15 | |
| 10-year U.S. Treasury | 1.38 | | | 0.68 | | | 0.65 | | | 0.86 | |
15-year mortgage current coupon (1) | 1.86 | | | 1.09 | | | 0.86 | | | 0.88 | |
30-year mortgage current coupon (1) | 2.31 | | | 1.58 | | | 1.32 | | | 1.37 | |
(1) Simple average of current coupon rates of Fannie Mae and Freddie Mac par MBS indications.
The target overnight Federal funds rate was in the range of zero to 0.25 percent at December 31, 2020, a decrease from the range of 1.50 to 1.75 percent at December 31, 2019. The low interest rate environment reflects the evolving risks to economic activity from the COVID-19 pandemic.
Average short-term rates were approximately 170 to 180 basis points lower in 2020 compared to 2019 and average long-term rates decreased by approximately 125 to 135 basis points during that same period. The decline in interest rates negatively impacted income in 2020 primarily because of the lower earnings generated from investing capital and the increased mortgage asset prepayments resulting in higher net amortization of premiums on those assets.
Business Outlook and Risk Management
This section summarizes the business outlook and what we believe are our current major risk exposures. See Item 1A. Risk Factors for a detailed discussion of certain factors that could affect our corporate objectives, financial condition, and results of operations. "Quantitative and Qualitative Disclosures About Risk Management" provides details on current risk exposures.
Strategic/Business Risk
Advances: Our business is cyclical and Mission Asset Activity normally declines in periods of economic contraction, when financial institutions have ample liquidity, or when there is significant growth in the money supply. Other factors that constrain widespread demand for Advances are the low levels of interest rates and competitiveness of Advances relative to deposits and other sources of wholesale funding.
In the last several years, the percentage of assets that members funded with Advances has shown little variation, in the range of two to four percent. We may see a broad-based increase in Advance demand if one or more of the following occur: aggregate
loan portfolios of our members grow quicker than aggregate deposits, interest rates begin to increase over time, or changes in Federal Reserve policy reduce other sources of liquidity available to members.
MPP: MPP balances are influenced by conditions in the housing and mortgage markets, the competitiveness of prices we offer to purchase loans as well as program features, and activity from our largest sellers.
Our ongoing strategy for the MPP has two components: 1) increase the number of regular sellers and participants in the program; and 2) manage purchases and balances at a prudent level relative to capital and total assets to effectively manage market and credit risks consistent with our risk appetite.
Market Risk
During 2020, as in 2019, the market risk exposure to changing interest rates was moderate overall and well within policy limits. We believe that longer-term profitability would not become uncompetitive unless interest rates were to change quickly and significantly. In the short-term, profitability could become uncompetitive if long-term interest rates decrease in excess of 50 basis points leading to faster prepayments of mortgage assets, which would further accelerate the recognition of purchased premiums.
Capital Adequacy
We believe members place a high value on their capital investment in our company. Capital ratios at December 31, 2020, and all throughout the year, exceeded the regulatory required minimum of four percent. We believe the amount of retained earnings is sufficient to protect against members' impairment risk of their capital stock investment in the FHLB and to provide the opportunity to stabilize or increase future dividends. Our capital policies and Capital Plan also have safeguards to ensure we meet regulatory and prudential capital requirements.
Credit Risk
In 2020, we continued to maintain a de minimis level of overall residual credit risk exposure from our Credit Services, investments, and derivative transactions. We believe policies and procedures related to credit underwriting, Advance collateral management, and transactions with investment and derivative counterparties continue to mitigate these risks. We have never experienced any credit losses, and we continue to have no loan loss reserves or impairment recorded for these instruments. Residual credit risk exposure in the mortgage loan portfolio was minimal.
Liquidity Risk
Our liquidity position remained strong during 2020, as did our overall ability to fund operations through the issuance of Consolidated Obligations at acceptable interest costs. Investor demand for FHLBank System debt continued to be robust. There were no substantive stresses on market access or liquidity from external market and political events. Although we can make no assurances, we believe there is only a remote possibility of a liquidity or funding crisis in the System that could impair our ability to participate, on a cost-effective basis, in issuances of new debt, service outstanding debt, maintain adequate capital levels, or pay competitive dividends.
Regulatory and Legislative Risk and Significant Developments
General: The FHLBank System is subject to legislative and regulatory oversight. Legislative and regulatory actions applicable, directly or indirectly, to the FHLBank System in the last decade have increased uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. This is due primarily to the uncertainty around potential future GSE reform, and the evolution of mortgage financing moving towards financial institutions currently not eligible for FHLBank membership. See Item 1A. Risk Factors for more discussion. We cannot predict the ultimate outcome of GSE reform and whether our membership base will be legislatively and regulatorily permitted to evolve in concert with the housing finance market.
Federal Deposit Insurance Corporation (FDIC) Brokered Deposits Restrictions:On January 22, 2021, the FDIC published a final rule, effective April 1, 2021, that amends its brokered deposits regulations that apply to less than well-capitalized insured depository institutions. The FDIC stated that the amendments are intended to modernize and clarify the FDIC’s brokered deposit regulations and they establish a new framework for analyzing the deposit broker definition, which determines whether deposits placed through deposit placement arrangements qualify as brokered deposits. These deposit placement arrangements include those between insured depository institutions and third parties, such as financial technology companies, for a variety of business purposes, including access to deposits. The amendments to the FDIC's brokered deposit regulations, among other things, clarify what it means to be engaged in the business of facilitating the placement of deposits and expand the scope of the primary purpose exception. The rule amendments are expected to have the effect of narrowing the definition of deposit broker and excluding more deposits from treatment as brokered deposits. The amendments also establish an application and reporting
process with respect to the primary purpose exception for businesses that do not meet one of several bright-line tests, and they affirm the FDIC’s position that the brokering of certificates of deposit constitutes deposit brokering.
This rule may have an effect on member demand for certain Advances, but we cannot predict the extent of the impact. We do not expect this rule to materially affect our financial condition or results of operations.
Finance Agency Final Rule on FHLBank Housing Goals Amendments:On June 25, 2020, the Finance Agency published a final rule, effective August 24, 2020, amending the FHLBank housing goals regulation. Enforcement of the final rule will phase in over three years. The final rule eliminated the existing $2.5 billion volume threshold, such that all FHLBanks are subject to a new housing goal, regardless of their mortgage purchase volume. The new housing goal establishes one overall target level requiring 20 percent of an FHLBank's total mortgage purchases to be home-purchase mortgages for low- and very-low income families and low-income areas as well as refinancing mortgages for low-income families. The final rule also establishes a separate small member participation housing goal with a target level of 50 percent. The final rule provides that an FHLBank may request Finance Agency approval of alternative target levels for either or both of the goals. We do not believe these changes will have a material effect on our financial condition or results of operations.
Finance Agency Supervisory Letter - Paycheck Protection Program (PPP) Loans as Collateral for FHLBank Advances:On April 23, 2020, the Finance Agency issued a Supervisory Letter (PPP Supervisory Letter) permitting the FHLBanks to accept PPP loans as collateral for Advances as “Agency Securities,” given the Small Business Administration’s (SBA) 100 percent guarantee of the unpaid principal balance. On April 20, 2020, the SBA's third interim final rule related to PPP loans was published. The rule explicitly waived certain regulatory requirements that must be satisfied before a member could pledge PPP loans to the FHLBanks as collateral. The PPP Supervisory Letter establishes a series of conditions under which the FHLBanks may accept PPP loans as collateral that focus on the financial condition of members, collateral discounts, and pledge dollar limits. On December 27, 2020, the President signed into law an extension of the PPP until March 21, 2021. The April 23, 2020 Supervisory Letter from the Finance Agency allowing us maintain competitively priced Mission Assets.to accept PPP loans as collateral remains in effect.
Coronavirus Aid, Relief, and Economic Security (CARES) Act:The CARES Act was signed into law on March 27, 2020. The $2.2 trillion package was the largest stimulus bill in United States history. The CARES Act is in addition to previous relief legislation passed by Congress in March 2020. The legislation provides the following:
▪Assistance to businesses, states, and municipalities.
▪A loan program for small businesses, non-profits and physician practices that can be forgiven through employee retention incentives.
▪Treasury Secretary authority to make loans or loan guarantees to states, municipalities, and eligible businesses and loosens some regulations imposed through the Dodd-Frank Act.
▪Direct payments to eligible taxpayers and their families.
▪Expanded eligibility for unemployment insurance and payment amounts.
▪Mortgage Loans Heldforbearance provisions and a foreclosure moratorium.
Funding for Portfolio (Mortgage Purchase Program,the PPP, which was created by the CARES Act, was increased with the enactment of subsequent laws, most recently by the Consolidated Appropriations Act, 2021, on December 27, 2020. Additional phases of the CARES Act or MPP)other COVID-19 pandemic relief legislation may be enacted by Congress or other actions by the President, state governments, and governmental agencies. In connection with the foreclosure moratorium noted above, we have asked servicers of the mortgage loans we own to temporarily suspend all foreclosure sales and evictions, unless a home is vacant, in order to allow homeowners to stay in their homes during this period. We continue to monitor these actions and guidance as they evolve and to evaluate the potential impact to the U.S. economy; the impacts to mortgages held or serviced by our members that we accept as collateral; the impacts on our MPP portfolio; and the impacts to our overall business.
LIBOR Transition:We are planning for the replacement of LIBOR given that the FCA will no longer persuade or compel banks to submit rates for the calculation of LIBOR and the Federal Reserve Bank of New York has established SOFR as its recommended alternative to LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR, and immediately after June 30, 2023, in the case of the remaining U.S. dollar LIBOR settings. The market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated Obligations and SOFR-linked Advances on an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk.
As many of our assets and derivatives are still indexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management. Part of our LIBOR transition plan includes our previously implemented fallback language for LIBOR-indexed Advances and Consolidated Bonds in new and legacy contracts. As for our investments that are tied to LIBOR, we are monitoring market-wide efforts to enhance fallback language for new activity and develop frameworks to address existing transactions.
On October 23, 2020, the International Swaps and Derivatives Association, Inc. (ISDA), published a Supplement to the 2006 ISDA Definitions (Supplement) and the ISDA 2020 IBOR Fallbacks Protocol (Protocol). Both the Supplement and the Protocol were effective on January 25, 2021. As of that date, all legacy bilateral derivatives transactions subject to Protocol-covered agreements (including ISDA agreements) that incorporate certain covered ISDA definitional booklets and reference a covered Interbank Offered Rate (IBOR), including U.S. dollar LIBOR, were effectively amended to apply the new ISDA-recommended IBOR fallbacks in the event of the relevant IBOR’s cessation. We have adhered to the Protocol and have worked with our counterparties, as necessary, to address over-the-counter derivative agreements referencing U.S. dollar LIBOR as a part of our LIBOR transition efforts.
The Finance Agency has also issued supervisory letters designed to ensure the FHLBanks will be able to identify and prudently manage the risks associated with the termination of LIBOR in a safe and sound manner. As of June 30, 2020, the FHLBanks were required to cease entering into new LIBOR-based financial instruments that mature after December 31, 2021, except for investments and option embedded products. With respect to investments, the Finance Agency required the FHLBanks, by December 31, 2019, to stop purchasing investments that reference LIBOR and mature after December 31, 2021. These phase-out dates did not apply to collateral accepted by the FHLBanks. As directed by the Finance Agency, the FHLBanks began requiring their members to report levels of LIBOR-linked collateral that mature after December 31, 2021. This will assist the FHLBanks in determining the level of member reliance on these assets to support borrowings, make decisions about their future eligibility and the impact of any incremental haircuts and asset value deterioration on borrowing capacity.
We have Advances, investment securities and derivatives with interest rates indexed to LIBOR. Each of these instruments are indexed to LIBOR settings that will no longer be provided after June 30, 2023, as noted above. The following table presents LIBOR-indexed Advances, investment securities and derivatives by contractual maturity at December 31, 2020.
| | | | | | | | | | | |
| (In millions) | Maturing on or before June 30, 2023 | | Maturing after June 30, 2023 |
| LIBOR-Indexed Variable Rate Financial Instruments | | | |
| Advances by redemption term | $ | 2,599 | | | $ | 3,012 | |
MBS by contractual maturity (1) | — | | | 5,929 | |
| | | |
| Total principal amount | $ | 2,599 | | | $ | 8,941 | |
| Derivatives, notional amount by termination date | $ | 9,339 | | | $ | 4,680 | |
(1)MBS are presented by contractual maturity; however, their expected maturities will likely differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
The market transition away from LIBOR towards SOFR is gradual and complicated, including the possible development of term structures and credit adjustments to accommodate differences between LIBOR and SOFR. As such, we are not currently able to predict the ultimate impact of such a transition on our business, financial condition, and results of operations.
ANALYSIS OF FINANCIAL CONDITION
Credit Services
Credit Activity and Advance Composition
The table below shows principal purchasestrends in Advance balances by major programs and reductions of loans in the MPP for eachnotional amount of Letters of Credit.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| (Dollars in millions) | December 31, 2020 | | December 31, 2019 |
| | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable Rate-Indexed: | | | | | | | |
| LIBOR | $ | 5,611 | | | 22 | % | | $ | 10,430 | | | 22 | % |
| SOFR | 118 | | | 1 | | | 500 | | | 1 | |
| Other | 82 | | | — | | | 221 | | | 1 | |
| Total | 5,811 | | | 23 | | | 11,151 | | | 24 | |
| Fixed-Rate: | | | | | | | |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 19,386 | | | 41 | |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 11,476 | | | 24 | |
Putable (2) | 2,657 | | | 11 | | | 1,444 | | | 3 | |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,358 | | | 5 | |
| Other | 1,151 | | | 5 | | | 1,449 | | | 3 | |
| Total | 19,196 | | | 77 | | | 36,113 | | | 76 | |
| | | | | | | |
| Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 47,264 | | | 100 | % |
| | | | | | | |
| Letters of Credit (notional) | $ | 28,812 | | | | | $ | 16,205 | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | December 31, 2020 | | September 30, 2020 | | June 30, 2020 | | March 31, 2020 |
| | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable-Rate Indexed: | | | | | | | | | | | | | | | |
| LIBOR | $ | 5,611 | | | 22 | % | | $ | 5,846 | | | 22 | % | | $ | 21,071 | | | 44 | % | | $ | 28,889 | | | 36 | % |
| SOFR | 118 | | | 1 | | | 116 | | | — | | | 116 | | | — | | | 2,000 | | | 3 | |
| Other | 82 | | | — | | | 123 | | | 1 | | | 83 | | | — | | | 247 | | | — | |
| Total | 5,811 | | | 23 | | | 6,085 | | | 23 | | | 21,270 | | | 44 | | | 31,136 | | | 39 | |
| Fixed-Rate: | | | | | | | | | | | | | | | |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 3,896 | | | 15 | | | 8,978 | | | 18 | | | 28,058 | | | 35 | |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 10,207 | | | 38 | | | 11,445 | | | 24 | | | 14,452 | | | 18 | |
Putable (2) | 2,657 | | | 11 | | | 3,107 | | | 12 | | | 3,164 | | | 6 | | | 3,164 | | | 4 | |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,195 | | | 8 | | | 2,309 | | | 5 | | | 2,439 | | | 3 | |
| Other | 1,151 | | | 5 | | | 1,158 | | | 4 | | | 1,241 | | | 3 | | | 680 | | | 1 | |
| Total | 19,196 | | | 77 | | | 20,563 | | | 77 | | | 27,137 | | | 56 | | | 48,793 | | | 61 | |
| | | | | | | | | | | | | | | |
| Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 26,648 | | | 100 | % | | $ | 48,407 | | | 100 | % | | $ | 79,929 | | | 100 | % |
| | | | | | | | | | | | | | | |
| Letters of Credit (notional) | $ | 28,812 | | | | | $ | 23,011 | | | | | $ | 22,381 | | | | | $ | 15,785 | | | |
(1)As a percentage of total Advances principal.
(2)Excludes Putable Advances where the last two years.related put options have expired or where the Advance is indexed to a variable-rate. These Advances are classified based on their current terms.
|
| | | | | | | |
| (In millions) | 2018 | | 2017 |
| Balance, beginning of year | $ | 9,454 |
| | $ | 8,926 |
|
| Principal purchases | 1,936 |
| | 1,747 |
|
| Principal reductions | (1,118 | ) | | (1,219 | ) |
| Balance, end of year | $ | 10,272 |
| | $ | 9,454 |
|
Although there were 102 active members participating in the MPPAdvance balances at December 31, 2018, over 502020 decreased 47 percent compared to year-end 2019. Advance balances declined in 2020 as large-asset members reduced their borrowings. The reduction in borrowings was primarily driven by these members generally experiencing an inflow of deposits on their balance sheets, while also having access to other liquidity sources as a result of certain government actions related to the pandemic. Despite the overall decline, Advances spiked across our membership at the end of the principal purchases in 2018 resulted from activityfirst quarter of our three largest sellers. All loans acquired in 2018 were conventional loans.2020 as the financial markets reacted to the COVID-19 pandemic, and members
The following tables show the percentage of principal balances from Participating Financial Institutions (PFIs) supplying five percent or more of total principal and the percentage of principal balances from all other PFIs. As shownturned to us for liquidity, primarily in the table below, MPP activity is concentrated amongst a few members.form of LIBOR and REPO Advances. Most of these Advances matured or prepaid by the end of 2020.
|
| | | | | | | | | | | | | | |
| (Dollars in millions) | December 31, 2018 | | | December 31, 2017 |
| | Principal | | % of Total | | | Principal | | % of Total |
| Union Savings Bank | $ | 3,449 |
| | 34 | % | | Union Savings Bank | $ | 3,247 |
| | 34 | % |
| Guardian Savings Bank FSB | 987 |
| | 10 |
| | Guardian Savings Bank FSB | 933 |
| | 10 |
|
| All others | 5,836 |
| | 56 |
| | PNC Bank, N.A. (1) | 516 |
| | 5 |
|
| Total | $ | 10,272 |
| | 100 | % | | All others | 4,758 |
| | 51 |
|
| | | | | | Total | $ | 9,454 |
| | 100 | % |
(1)Former member.
We closely track the refinancing incentives of our mortgage assets (including loans in the MPP and MBS) because the option for homeowners to change their principal payments normally represents the largest portion of our market risk exposure and can affect MPP balances. MPP principal paydowns in 2018 and 2017 were low, equating to eight and nine percent annual constant prepayment rates, respectively, due to a sustained increase in mortgage rates.
The MPP's composition of balances by loan type, original final maturity, and weighted-average mortgage note rate did not change materially in 2018. The weighted average note rate increased by 0.09 percentage points in 2018 to end the year at 4.00 percent. MPP yields earned in 2018, after consideration of funding and hedging costs, continued to offer favorable returns relative to their market and credit risk exposure.
Housing and Community Investment
Our Housing and Community Investment Programs include the Affordable Housing Program and various housing and community economic development-related Advance and grant programs. We fund the Affordable Housing Program with an accrual equal to 10 percent of our previous year's net earnings, mandated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989. See Note 10 of the Notes to Financial Statements for a complete description of the Affordable Housing Program calculation.
The Affordable Housing Program provides funding for the development of affordable housing. The Program consists of a Competitive Program and a homeownership program called Welcome Home, which assists homebuyers with down payments and closing costs. Under the Competitive Program, we currently distribute funds in the form of grants to members that apply and successfully compete in an annual offering. Under Welcome Home, we make funds available beginning in March until they have been fully committed. For both programs, the income of qualifying individuals or households must be 80 percent or less of the area median income. We set aside up to 35 percent of the Affordable Housing Program accrual for Welcome Home and allocate the remainder to the Competitive Program.
Our Board of Directors also may allocate funds to voluntary housing programs. In 2020, the Board re-authorized an additional $2.0 million to the Carol M. Peterson Housing Fund for use during the year. These funds are primarily used as grants to pay for accessibility rehabilitation and emergency repairs for special needs and elderly homeowners. In 2012, the Board of Directors also established the Disaster Reconstruction Program, a voluntary housing program that provides grants for purchase or rehabilitation of a home within the Fifth District for residents that have suffered loss or damage to their primary residence as a result of a state or federally declared disaster. Since the program's inception, we have disbursed over $4.7 million to assist 378 households. Furthermore, in support of our members during the COVID-19 pandemic, we created a new Advance program that offered Advances with terms up to six months at zero percent interest to members between May 1, 2020 and September 30, 2020. These Advances supported COVID-19 related assistance made by all Fifth District members. In 2020, we issued a total of $183 million of these Advances of which $34 million remained outstanding at December 31, 2020.
Two other housing programs that fall outside the auspices of the Affordable Housing Program are the Community Investment Program and the Economic Development Program. Advances under the former program have rates equal to our cost of funds, while Advances under the latter program have rates equal to our cost of funds plus reasonable administrative costs. Members use the Community Investment Program to serve housing needs of low- and moderate-income households and, under certain conditions, community economic development projects. The Economic Development Program is a discounted Advance program used to promote economic development and job creation and retention.
Investments
Types of Investments. A primary reason we hold investments is to carry sufficient asset liquidity. Permissible liquidity investments include Federal funds, certificates of deposit, bank notes, bankers' acceptances, commercial paper, securities purchased under agreements to resell, and debt securities issued by the U.S. government, its agencies, or other GSE's. The first five categories represent unsecured lending to private counterparties. We also may place deposits with the Federal Reserve Bank. We are prohibited by Finance Agency regulations from investing (secured or unsecured) in financial investments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks. Many liquidity investments have short-term maturities.
Subject to regulatory limitations on purchases of new LIBOR-based investments, we are also permitted by regulation to purchase the following other investments, which have longer original maturities than liquidity investments:
▪MBS and collateralized mortgage obligations (together, referred to as MBS) issued by GSEs, other U.S. government agencies or private issuers;
▪asset-backed securities collateralized by manufactured housing loans or home equity loans issued by GSEs or private issuers; and
▪marketable direct obligations of certain government units and agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital.
We have never purchased asset-backed securities and do not own any privately-issued MBS.
Per Finance Agency regulations, the total investment in MBS and asset-backed securities may not exceed 300 percent of previous month-end regulatory capital on the day we purchase the securities. See the “Capital Resources” section below for the definition of regulatory capital.
Purposes of Having Investments. The investments portfolio helps achieve corporate objectives in the following ways:
▪Liquidity management. Liquidity investments support the ability to fund assets on a timely basis, especially Advances, and when it may be more difficult to issue new debt. These investments supply liquidity because we normally fund them with longer-term debt than asset maturities. We also may be able to obtain liquidity by selling certain investments for cash without a significant loss of value.
▪Earnings enhancement. The investments portfolio, especially MBS, assists with earning a competitive return on capital, and increasing funding for Housing and Community Investment programs. In addition, liquidity investments help stabilize earnings because they typically earn a relatively stable spread to the cost of debt issued to fund them.
▪Management of debt issuance. Maintaining a short-term liquidity investment portfolio can help us participate in attractively priced debt issuances, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
▪Support of housing market. Investment in MBS and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
How We Manage Risks of Investments. We strive to ensure our investment holdings have a moderate degree of market risk and limited credit risk, which tends to lower the returns we can expect to earn on these securities. We believe that a philosophy of purchasing investments with a high amount of market or credit risk would be inconsistent with our GSE status and corporate objectives.
Market risk associated with short-term investments tends to be minimal because of their short maturities and because we typically fund them with short-term Consolidated Obligations having similar maturities. We mitigate much of the market risk of MBS, which exists primarily from changes in mortgage prepayment speeds, by limiting their balances to 300 percent of regulatory capital and by funding them with a portfolio of long-term fixed-rate callable and non-callable Obligations. Additionally, we mitigate much of the market risk of longer-term non-MBS securities, and a portion of our MBS, by using interest rate swaps to effectively convert the fixed rate investments to adjustable-rate investments. We also manage the market risk exposure of the entire balance sheet within prudent policy limits.
Finance Agency regulations and internal policies also provide controls on market risk exposure by restricting the types of mortgage loans, MBS and other investments we can hold. These restrictions prohibit, among others, the purchase of interest only or principal only stripped MBS and MBS whose average life varies more than six years under a 300 basis points interest rate shock.
Our internal policies specify guidelines for, and relatively tight constraints on, the types and amounts of short-term investments we are permitted to hold and the maximum amount of credit risk exposure we are permitted to have with eligible counterparties. We are permitted to invest only in the instruments of counterparties with high credit ratings, and because of our conservative
investment policies and practices, we believe all of our investments have high credit quality. We have never had a credit loss or credit-related write down of any investment security.
Deposits
We provide a variety of deposit programs, including demand, overnight, term and Federal funds, which enable depositors to invest funds in short-term liquid assets. We accept deposits from members, other FHLBanks, any institution to which we offer correspondent services, and other government instrumentalities. The rates of interest we pay on deposits are subject to change daily based on comparable money market interest rates. The balances in deposit programs tend to vary positively with the amount of idle funds members have available to invest, as well as the level of short-term interest rates. Deposits have typically represented one to two percent of our funding sources in recent years.
Mortgage Purchase Program (MPP or Mortgage Loans Held for Portfolio)
Description of the MPP
Types of Loans and Benefits. Finance Agency regulations permit FHLBanks to purchase and hold specified whole mortgage loans from their members, which offers members a competitive alternative to the traditional secondary mortgage market and directly supports housing finance. We account for MPP loans as mortgage loans held for portfolio. By selling mortgage loans to us, members can increase their balance sheet liquidity and lower interest rate and mortgage prepayment risks. The MPP particularly enables small- and medium-sized community-based financial institutions to use their existing relationship with us to participate more effectively in the secondary mortgage market.
We purchase two types of mortgage loans: qualifying conforming fixed-rate conventional 1-4 family residential mortgages and residential mortgages fully insured by the Federal Housing Administration (FHA). Members approved to sell us these loans are referred to as Participating Financial Institutions (PFIs).
A “conventional” mortgage refers to a non-government-guaranteed mortgage. A “conforming” mortgage refers to the maximum amount permissible to be lent as a regular prime (i.e., non-jumbo, non-subprime) mortgage. For 2021, the Finance Agency established the conforming limit at $548,250 with loans originated in a limited number of high-cost cities and counties receiving higher conforming limits. We have elected not to purchase mortgages subject to these higher conforming limits.
Loan Purchase Process. A Master Commitment Contract is negotiated with each PFI, in which the PFI agrees to make a best efforts attempt to sell us a specific dollar amount of mortgage loans generally over a period of up to 12 months. We purchase loans pursuant to a Mandatory Delivery Contract, which is a legal commitment we make to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of note rates and prices.
Shortly before delivering the loans that will fill the Mandatory Delivery Contract, the PFI must submit loan level detail including underwriting information. We apply procedures through an automated system designed to screen loans that do not comply with our policies. Our underwriting guidelines generally mirror those of Fannie Mae and Freddie Mac for conforming conventional loans, although our guidelines and pool composition requirements are more conservative in a number of ways in order to further limit credit risk exposure. PFIs are required to make certain representations and warranties against our underwriting guidelines on the loans they sell to us. If a PFI sells us a loan in breach of those representations and warranties, we have the contractual right to require the PFI to repurchase the loan.
How We Manage Risks of the MPP
Market Risk. We mitigate the MPP's market risk similarly to how we mitigate market risk from MBS.
Credit Risk - Conventional Mortgage Loans. A unique feature of the MPP is that it separates the various activities and risks associated with residential mortgage lending for conventional loans and allows these risks and activities to be taken on by different entities. We manage the market risk (including interest rate risk and prepayment risk) and liquidity risk. PFIs manage marketing, originating and, in most cases, servicing the loans. PFIs may either retain servicing or sell it to a qualified and approved third-party servicer (also referred to as a PFI). Because PFIs manage and bear most of the credit risk, they do not pay us a guarantee fee to transfer credit risk.
We manage credit risk exposure for conventional loans primarily through underwriting and pool composition requirements and by applying layered credit enhancements. These enhancements, which apply after a homeowner's equity is exhausted, include available primary mortgage insurance, the Lender Risk Account (discussed below), and Supplemental Mortgage Insurance. Supplemental Mortgage Insurance is applicable to loans acquired before February 2011 and was purchased by the PFI from one
of our approved third-party providers naming us as the beneficiary. These credit enhancements are designed to protect us against credit losses in scenarios of severe downward movements in housing prices and unfavorable changes in other factors that can affect loan delinquencies and defaults.
The Lender Risk Account is a key component of how we manage residual credit risk. It is a holdback of a portion of the initial purchase price. Starting after five years from the loan purchase date, we may return the holdback to PFIs if they manage credit risk to pre-defined acceptable levels of exposure on the loan pools they sell to us. Actual loan losses are deducted from the amount of the purchase-price holdback we return to the PFI. The Lender Risk Account provides PFIs with a strong incentive to sell us high quality performing mortgage loans.
Credit Risk - FHA Mortgage Loans. Because the FHA makes an explicit guarantee on FHA loans, we do not require any credit enhancements on these loans beyond primary mortgage insurance.
"Quantitative and Qualitative Disclosures About Risk Management” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations provides more detail on how we manage market and credit risks for the MPP.
Earnings from the MPP
The MPP enhances long-term profitability on a risk-adjusted basis and augments the return on member stockholders' capital investment. We generate earnings in the MPP from monthly interest payments minus the cost of funding and the cost of hedging the MPP's interest rate risk. Interest income on each loan is computed as the mortgage note rate multiplied by the loan's principal balance:
▪minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans);
▪minus the cost of Supplemental Mortgage Insurance (for applicable loans); and
▪adjusted for the amortization of purchase premiums or the accretion of purchase discounts and for the amortization or accretion of fair value adjustments on loans initially classified as mortgage loan commitments.
For new loan purchases, we consider the cost of the Lender Risk Account when we set conventional loan prices and evaluate the MPP's potential return on investment. The pricing of each structure depends on a number of factors and is specific to the PFI and to the loan pool. We do not receive fees or income for retaining the risk of losses in excess of any credit enhancements.
FUNDING - CONSOLIDATED OBLIGATIONS
Our primary source of funding and hedging market risk exposure is through participation in the sale of Consolidated Obligation debt securities to global investors. Obligations are the joint and several obligations of all the FHLBanks, backed only by the financial resources of these institutions. There are two types of Consolidated Obligations: Consolidated Bonds (Bonds) and Consolidated Discount Notes (Discount Notes).
We participate in the issuance of Bonds for three purposes:
▪to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets;
▪to finance and hedge short-term, adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate funding through the execution of interest rate swaps; and
▪to acquire liquidity investments.
Bonds may have fixed or adjustable rates of interest. Fixed-rate Bonds are either non-callable or callable. A callable Bond is one that we are able to redeem in whole or in part at our discretion on one or more predetermined call dates according to the Bond's offering notice. The maturity of Bonds typically ranges from 1 year to 20 years. Adjustable-rate Bonds use a benchmark market interest rate, typically SOFR, for interest rate resets. We do not participate in the issuance of range Bonds, zero coupon Bonds, or indexed principal redemption Bonds.
We use fixed-rate Bonds to fund longer-term fixed-rate Advances and longer-term fixed-rate mortgage assets, and use adjustable-rate Bonds to fund adjustable-rate Advances and certain longer-term fixed rate investments that have been swapped to an adjustable-rate.
We transact in interest rate swaps to synthetically convert some fixed-rate Bonds to adjustable-rate terms. These are used to hedge adjustable-rate Advances.
We participate in the issuance of Discount Notes to fund short-term Advances, adjustable-rate Advances, putable Advances (which we normally swap to an adjustable-rate), liquidity investments, and a portion of longer-term fixed-rate assets. Discount Notes have maturities from one day to one year, with most of ours normally maturing within three months.
The mix of Obligations fluctuates in response to relative changes in short-term versus long-term assets, relative changes in fixed-rate versus adjustable-rate assets, decisions on market risk management (particularly the amount of funding of longer-term assets with short-term Obligations), and differences in relative costs of various Obligations.
Interest rates on Obligations are affected by a multitude of factors such as: overall economic and credit conditions; credit ratings of the FHLBank System; investor demand and preferences for our debt securities; the level of interest rates and the shape of the U.S. Treasury curve, the SOFR swap curve or LIBOR swap curve; and the supply, volume, timing, and characteristics of debt issuances by the FHLBanks, other GSEs, and other highly rated issuers.
Finance Agency regulations govern the issuance of Obligations. An FHLBank may not issue individual debt securities without Finance Agency approval, and we have never done so. The Office of Finance services Obligations, prepares the FHLBank System's quarterly and annual combined financial statements, and serves as a source of information for the FHLBanks on capital market developments.
We have the primary liability for our portion of Obligations, i.e., those issued on our behalf for which we received the proceeds. However, we also are jointly and severally liable with the other FHLBanks for the payment of principal and interest on all Obligations. If we do not pay the principal or interest in full when due on any Obligation issued on our FHLB's behalf, we are prohibited from paying dividends or redeeming or repurchasing shares of capital stock. If another FHLBank were unable to repay its participation in an Obligation for which it is the primary obligor, the Finance Agency could call on each of the other FHLBanks to repay all or part of the Obligation. The Finance Agency has never invoked this authority.
LIQUIDITY
Our business requires a substantial and continual amount of liquidity to satisfy financial obligations (primarily maturing Consolidated Obligations) in a timely and cost-efficient manner and to provide members access to timely Advance funding and mortgage loan sales in all financial environments. We obtain liquidity by issuing debt, holding short-term assets that mature before their associated funding, and having the ability to sell certain investments without significant accounting or economic consequences. Sources of asset liquidity include cash, maturing Advances, maturing investments, principal paydowns of mortgage assets, the ability to sell certain investments, and interest payments received. Uses of liquidity primarily include repayments of Obligations, issuances of new Advances, purchases of loans under the MPP, purchases of investments, and payments of interest.
Liquidity requirements are significant because Advance balances can be volatile, many have short-term maturities, and we strive to allow members to borrow Advances on the same day they request them. We regularly monitor liquidity risks and the investment and cash resources available to meet liquidity needs, as well as statutory and regulatory liquidity requirements.
Because Obligations have favorable credit ratings and because the FHLBank System is one of the largest sellers of debt in the worldwide capital markets, the System historically has been able to satisfy its liquidity needs through debt issuance across a wide range of structures at relatively favorable spreads to benchmark market interest rates, such as U.S. Treasury securities.
CAPITAL RESOURCES
Capital Requirements
Statutory and Regulatory Requirements
Under Finance Agency regulations, regulatory capital is composed of all capital stock (including stock classified as mandatorily redeemable), retained earnings, general loss allowances, and other amounts from sources the Finance Agency determines are available to absorb losses. Under the Gramm-Leach-Bliley Act of 1999 (GLB Act), permanent capital equals Class B stock plus retained earnings and is available to absorb financial losses.
Finance Agency regulations stipulate that we must comply with three limits on capital leverage and risk-based capital. These ensure a low amount of capital risk while providing for competitive profitability. We have always complied with these regulatory capital requirements.
▪We must maintain at least a four percent minimum regulatory capital-to-assets ratio. This requirement historically has been closest to affecting our operations.
▪We must maintain at least a five percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the four percent unweighted capital requirement.
▪We are subject to a risk-based capital rule in which we must hold an amount of "permanent" capital that exceeds the amount of exposure to market risk, credit risk, and operational risk. How we determine the amount of these risk exposures is stipulated by Finance Agency regulation. Permanent capital includes retained earnings and the regulatory amount of Class B capital stock.
In addition to the minimum capital requirements, the GLB Act and our Capital Plan promote the adequacy of our capital to absorb financial losses in three ways. These combine to give member stockholders a clear incentive to require us to minimize our risk profile:
▪the five-year redemption period for Class B stock;
▪the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and
▪the limitations, described below, on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations.
In accordance with the GLB Act, our stock is also putable by members. There are statutory and regulatory restrictions on our obligation or right to redeem or repurchase outstanding stock, including, but not limited to, the following:
▪We may not redeem any capital stock if, following the redemption, we would fail to satisfy any regulatory capital requirements. By law, we may not redeem any stock if we become undercapitalized.
▪We may not redeem any capital stock without approval of the Finance Agency if either our Board of Directors or the Finance Agency determines that we have incurred or are likely to incur losses resulting or expected to result in a charge against capital.
If we were to be liquidated, stockholders would be entitled to receive the par value of their capital stock after payment in full to our creditors. In addition, each stockholder would be entitled to any retained earnings in an amount proportional to the stockholder's share of the total shares of capital stock. In the event of a merger or consolidation of the FHLB, the Board of Directors would determine the rights and preferences of the FHLB's stockholders, subject to any terms and conditions imposed by the Finance Agency.
Capital Plan
Our Capital Plan ties the amount of each member's required capital stock to the amount of the member's assets and the amount and type of its Mission Asset Activity with us. The Capital Plan has the following basic characteristics:
▪We offer only one class of capital stock, Class B, which is generally redeemable upon a member's five-year advance written notice. We strive to manage capital risks to be able to safely and soundly satisfy redemption requests sooner than five years, although we may elect to wait up to five years (or longer under certain conditions).
▪We issue shares of capital stock as required for an institution to become a member or maintain membership (membership stock), as required for members to capitalize Mission Asset Activity (activity stock), and if we pay dividends in the form of additional shares of stock.
▪We may, subject to the restrictions described above, repurchase certain capital stock (i.e., "excess" capital stock).
We believe the Capital Plan enables us to efficiently increase and decrease capital stock needed to capitalize assets in response to changes in the membership base and demand for Mission Asset Activity. This enables us to maintain a prudent amount of financial leverage and consistently generate a competitive dividend return.
At December 31, 2020, the amount of membership stock required for each member ranged from a minimum of $1,000 to a maximum of $30 million, with the amount within that range determined as a percentage of member assets. Separate from its membership stock, each member is required to purchase and hold activity stock to capitalize its Mission Asset Activity. For purposes of the Capital Plan, Mission Asset Activity includes the principal balance of Advances, guaranteed funds and rate Advance commitments, the principal balance of loans and commitments in the MPP, and beginning January 1, 2021, the notional balance of Letters of Credit.
The FHLB must capitalize its total assets at a rate of at least four percent. The Capital Plan supports the memberships' stock component towards this overall requirement. Each member is required to maintain an amount of activity stock within a range of a minimum and maximum percentage for each type of Mission Asset Activity. The Capital Plan amendment that went into effect on January 1, 2021 changed the activity percentages and set these minimums and maximums to be equal. As a result, the current percentages are as follows:
| | | | | | | | | | | | | | |
| Mission Asset Activity | | Minimum Activity Percentage | | Maximum Activity Percentage |
| Advances | | 4.50% | | 4.50% |
| Advance Commitments | | 4.50 | | 4.50 |
| MPP | | 3.00 | | 3.00 |
| Letters of Credit | | 0.10 | | 0.10 |
If a member owns more stock than is needed to satisfy both its membership stock requirement and the maximum activity stock percentages for its Mission Asset Activity, we designate the remaining stock as the member's excess capital stock. The member may utilize its excess stock to capitalize additional Mission Asset Activity.
Prior to 2021, if an individual member's excess stock reached zero, the Capital Plan had permitted us, with certain limits, to capitalize additional Mission Asset Activity of that member with excess stock owned by other members at the maximum percentage rate. This feature, called “cooperative capital,” enabled us to effectively utilize our excess capital stock holdings. However, with the most recently amended Capital Plan, by setting the minimum and maximum activity requirements to be equal, members are no longer able to utilize this cooperative capital for marginal new business.
Retained Earnings
Purposes and Amount of Retained Earnings
Retained earnings are important to protect members' capital stock investment against the risk of impairment and to enhance our ability to pay stable and competitive dividends when earnings may be volatile. Impairment risk is the risk that members would have to write down the par value of their capital stock investment in our FHLB as a result of their analysis of ultimate recoverability. An extreme situation of earnings instability, in which other-than-temporary losses were experienced and expected for a period of time, could result in members determining that the value of their capital stock investment was impaired.
We have a policy that sets forth a minimum amount of retained earnings we believe is needed to mitigate impairment risk and facilitate dividend stability in light of the risks we face. At December 31, 2020, the minimum retained earnings requirement was approximately $290 million, based on mitigating quantifiable risks under very stressed business and market scenarios to a 99
percent confidence level. At the end of 2020, our retained earnings totaled $1.3 billion. We believe the current amount of retained earnings is fully sufficient to protect our capital stock against impairment risk and to provide for dividend stability.
Joint Capital Agreement to Augment Retained Earnings
The FHLBanks entered into a Joint Capital Enhancement Agreement (the “Capital Agreement”) in February 2011. The Capital Agreement provides that each FHLBank will, on a quarterly basis, allocate at least 20 percent of its net income to a restricted retained earnings account (the “Account”) until the balance of the Account, calculated as of the last day of each calendar quarter, equals at least one percent of that FHLBank's average balance of outstanding Consolidated Obligations for the calendar quarter. The Account is not available to be distributed as dividends except under certain limited circumstances. The Capital Agreement does not limit our ability to use retained earnings held outside of the Account to pay dividends. Although we have always maintained compliance with our capital requirements, we believe the Capital Agreement enhances risk mitigation by building a larger capital buffer over time to absorb unexpected losses, if any, that we may experience.
USE OF DERIVATIVES
Finance Agency regulations and our policies establish guidelines for the execution and use of derivative transactions. We are prohibited from trading in, or the speculative use of, derivatives and have limits on the amount of credit risk to which we may be exposed. Most of our derivatives activity involves interest rate swaps, some of which may include options. We account for all derivatives at fair value.
Similar to our participation in debt issuances, use of derivatives is integral to hedging market risk created by Advances, certain longer-term fixed-rate investments and mortgage assets, including commitments. Derivatives related to Advances most commonly hedge either:
▪below-market rates and/or the market risk exposure on Putable Advances, and certain other Advances, for which members have sold us options embedded within the Advances; or
▪Regular Fixed-Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.
The derivatives we transact related to investments hedge market risk exposure by effectively converting the fixed-rate investment to an adjustable-rate investment. The derivatives we transact related to mortgage assets primarily hedge interest rate risk and prepayment risk. Such derivatives include options on interest rates swaps (swaptions) and sales of to-be-announced MBS for forward settlement.
Derivatives transactions related to Bonds help us intermediate between the preference of capital market investors for intermediate- and long-term fixed-rate debt securities and the preference of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
We may also transact derivatives to reduce the repricing risk of Discount Notes that fund certain overnight and shorter-term assets.
Use of derivatives can result in a substantial amount of volatility of accounting and economic earnings. We strive to maintain a low amount of earnings volatility from realized gains and losses on derivatives. We accept a higher amount of earnings volatility from unrealized gains and losses on recording derivatives at fair values, to the extent our use of derivatives effectively hedge market risk exposure.
COMPETITION
Advances
Members' demand for our Advances is affected by, among other things, the cost of other sources of funding available, including our members' customer deposits. We compete with other suppliers of wholesale funding, both secured and unsecured, including the federal government, commercial banks, investment banking divisions of commercial banks, brokered deposits and other FHLBanks when our members' affiliated institutions are members of other FHLBanks. In addition, competition is often more significant when originating Advances to larger members, which have greater access to the national and global capital markets.
Our ability to compete successfully with other suppliers of wholesale funding, including other FHLBanks, depends primarily on the total cost of our products to members, which include the rates we charge, earnings and dividend performance, collateral policies, capital stock requirements, product features and members' perceptions of our relative safety and soundness. In addition, our competitive environment continues to be impacted by the Federal Reserve's low interest-rate environment and actions to provide liquidity in the financial markets. See Item 1A. Risk Factors below for further discussion.
Mortgage Purchase Program
The primary competitors for mortgage loans we purchase in the MPP are Fannie Mae and Freddie Mac, government agencies such as the Government National Mortgage Association (Ginnie Mae), and other secondary mortgage market conduits. Fannie Mae and Freddie Mac, in particular, have long-established and efficient programs and are the dominant purchasers of fixed-rate conventional mortgages. In addition, a number of private financial institutions have well-established securitization programs, although they may not currently be as active as they were historically. The MPP also competes with the Federal Reserve to the extent it purchases MBS and affects market prices and the availability of supply.
Debt Issuance
The FHLBank System primarily competes with the U.S. government and other GSEs for funds raised through the issuance of unsecured debt in the national and global debt markets. Increases in the supply of competing debt products may, in the absence of increases in demand, result in higher debt costs.
HUMAN CAPITAL RESOURCES
Our human capital is a significant contributor to the success of our strategic business objectives. As such, we are committed to the health, safety and wellness of our employees. In response to the COVID-19 pandemic, we implemented significant operating environment changes, safety protocols and procedures that we determined were in the best interest of our employees and members, and which comply with government regulations. This includes having nearly all employees work remotely, while implementing additional safety measures for employees continuing any on-site work.
In managing human capital, we focus on our workforce profile and the various programs and philosophies described below.
Workforce Profile
Our workforce is primarily comprised of corporate employees, with one location of principal operations. As of December 31, 2020, we had 241 employees. As of December 31, 2020, approximately 37 percent of our workforce was female, 63 percent male, 85 percent non-minority and 15 percent minority. Our workforce is leanly staffed, and historically has included a number of longer-tenured employees. As of December 31, 2020, the average tenure of our employees was 10 years. We strive to both develop talent from within the organization and supplement with external hires. We believe that developing talent internally results in institutional strength and continuity and promotes loyalty and commitment in our employee base, which furthers our success. However, adding new employees contributes to new ideas, continuous improvement, and our goals of a diverse and inclusive workforce. Our employees are not represented by a collective bargaining unit.
Total Rewards
We seek to attract, develop and retain talented employees to achieve our strategic business initiatives, enhance business performance and provide members with financial services and a competitive return on their capital investment. We strive to
achieve this objective through a combination of development programs, benefits and employee wellness programs, and recognizing and rewarding performance. Specifically, our programs include:
▪Cash compensation – provides competitive salary, transportation and other cash subsidies, and performance based incentives.
▪Benefits – offers health insurance with a health savings account contribution, dental and vision insurance, life and AD&D insurance, supplemental life insurance, long-term disability insurance, employee assistance program, 401(k) retirement savings plan with employer match, and defined benefit pension benefits.
▪Recognition programs – sponsors peer-to-peer recognition program, department recognition program and company-wide recognition.
▪Work / life balance – provides flexible scheduling and time off programs for vacation, illness, personal, holiday, bereavement, jury duty, and paid leave programs for times when caring for a sick family member, bonding with a newborn or recovering from childbirth.
▪Culture – promotes the five core values of dependable, customer focused, inclusive, change oriented and results driven and encourages employee resource groups and other culture and inclusion initiatives.
▪Development programs and training – offers tuition assistance programs, internal educational and development opportunities, and fee reimbursement for external educational and development programs.
▪Management succession planning – assesses talent annually with our leadership and Board of Directors with, at a minimum, a defined plan for positions at Vice President and above.
Diversity and Inclusion Program
Diversity and inclusion is a strategic business priority. Our diversity and inclusion officer reports to the President and Chief Executive Officer, serves as a liaison to the Board of Directors, and is a member of the senior management strategy council. We recognize that diversity increases capacity for innovation and creativity and that inclusion allows us to leverage the unique perspectives of all employees and strengthen retention efforts. We operationalize our commitment through the development and execution of a three-year diversity and inclusion strategic plan that includes quantifiable metrics to measure its success. Our diversity and inclusion officer and team reports regularly on performance against the strategic plan to management and the Board of Directors. We offer a range of opportunities for our employees to connect, and grow personally and professionally through employee resource groups and community outreach. We consider learning an important component of our diversity and inclusion strategic plan and regularly offer educational opportunities to our employees. Employee job descriptions contain inclusive behavior expectations that increase with increasing responsibilities in the organization, and also are included as part of our annual performance management process.
Item 1A.Risk Factors.
The following discussion summarizes risks and uncertainties we currently face. The realization of one or more of the risks could negatively affect our results of operations, financial condition, safety and soundness, and, at the extreme, the viability of our business franchise. The effects could include reductions in Mission Asset Activity, lower earnings and dividends, and, at the extreme, impairment of our capital or an inability to participate in issuances of Consolidated Obligations. The risks identified below are not the only risks we face. Other risks not presently known or which we deem to be currently immaterial may also impact our business. Additionally, the risks identified may adversely affect our business in ways we do not expect or anticipate.
BUSINESS AND REGULATORY RISK
A prolonged economic downturn could further lower Mission Asset Activity and profitability.
Member demand for Mission Asset Activity depends in large part on the general health of the economy and overall business conditions. Numerous external factors can affect our Mission Asset Activity and earnings including:
▪the general state and trends of the economy and financial institutions, especially in the Fifth District;
▪conditions in the financial, credit, mortgage, and housing markets;
▪interest rates;
▪actions of the Federal Reserve to affect liquidity reserves of financial institutions and the money supply;
▪competitive alternatives to our products, such as retail deposits and other sources of wholesale funding;
▪regulations affecting our members' liquidity requirements;
▪the willingness and ability of financial institutions to expand lending; and
▪natural disasters, pandemics or other widespread health emergencies (see the separate Risk Factor on the COVID-19 pandemic), terrorist attacks, civil unrest, or other unanticipated or catastrophic events could create economic and financial disruptions and uncertainties.
These external factors, some of which were experienced in 2020, are likely to have a more severe impact if a prolonged economic downturn is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or actual or potential changes in the legislative and regulatory environment. Any of these factors, or a combination of factors, could adversely affect our business activities and results of operations and may ultimately cause stockholders to request redemption of a portion of their capital or request withdrawal from membership (both referred to in this document as “request withdrawal of capital”).
For example, we believe overall Advance demand has been and continues to be unfavorably affected by the substantial amount of deposit-based liquidity provided to financial institutions through the monetary actions of the Federal Reserve and changes in our members' ability to manage their regulatory liquidity requirements. The Federal Reserve’s policies facilitate liquidity and support stability in the fixed-income markets, which in turn has generally led to substantial deposit growth for our members and decreases in their demand for Advances. See "Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information on recent market activity.
The competitive environment for our products could adversely affect business activities, including decreasing the level and utilization rates of Mission Asset Activity, earnings, and capitalization.
Our primary business is providing liquidity to our members by making Advances to, and purchasing mortgage loans from, our members. Members have access to alternative funding sources, including their customers' deposits and wholesale funding, which may offer more favorable terms than we offer, such as lower rates or more flexible credit or collateral standards. Some of our competitors are not subject to the same body of regulations applicable to us, which enables those competitors to offer products and terms that we are not able to offer. In addition, state and federal regulators’ perception of the stability and reliability of our Advances can also directly impact the amount of Advances used by members.
In connection with purchasing mortgage loans from our members, we face competition in the areas of customer service, purchase prices for the MPP loans and ancillary services such as automated underwriting and loan servicing options. Our primary competitors are Fannie Mae, Freddie Mac, government agencies such as Ginnie Mae, and other secondary mortgage market conduits. In addition, our members continue to face increased competition in mortgage origination from non-bank financial institutions that are not eligible for FHLBank membership, which could reduce the amount of mortgage loans that members can make available to us to purchase.
Increased competition could decrease the amount of Advances and mortgage loans and narrow profitability, both of which could cause stockholders to request withdrawals of capital and ultimately result in a failure to meet our capital adequacy requirements.
In addition, the FHLBank System's offerings of debt compete with the U.S. Treasury, Fannie Mae, Freddie Mac, other GSEs, and corporate, state, and sovereign entities, among others. Increases in the supply and types of competing debt products or other regulatory factors could adversely affect the System's ability to access funding or increase the cost of our debt issuance. Either of these effects could in turn adversely affect our financial condition and results of operations and the value of FHLB membership.
Sharp reductions in Mission Asset Activity resulting from lower usage by large members, consolidation of large members, or continued shift in mortgage lending activities towards entities not eligible for FHLB membership could adversely impact our net income and dividends.
The amount of Mission Asset Activity and capital is concentrated among a small number of our large members. Additionally, the financial industry continues to consolidate and in recent years there has been a systemic trend of financial institutions that are currently ineligible for FHLB membership gaining an increasing market share, especially related to mortgage finance. However, the legislative and regulatory environment faced by the FHLBanks has not changed in response to this trend. Our members could decrease their Mission Asset Activity and the amount of their capital stock as a result of merger and acquisition activity or continued loss of market share to ineligible entities. At December 31, 2020, one member, U.S. Bank, N.A., held over 15 percent of our Advances and one member PFI, Union Savings Bank, accounted for over 30 percent of the outstanding MPP principal balance. Our business model is structured to be able to absorb sharp changes in Mission Asset Activity because we can undertake commensurate reductions in liability balances and capital and because of our relatively modest operating expenses. However, an extremely large and sustained reduction in Mission Asset Activity could affect our profitability and ability to pay competitive dividends, as well as, at the FHLBank System level, raise policy questions about the relevance of the FHLBank System in its traditional mission of supporting housing finance.
Replacement of the LIBOR benchmark interest rate could adversely affect our business, financial condition, and results of operations.
In July 2017, the United Kingdom's Financial Conduct Authority (FCA), which regulates LIBOR, announced that after 2021 it will no longer persuade or compel banks to submit rates for the calculation of LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR, and immediately after June 30, 2023, in the case of the remaining U.S. dollar LIBOR settings. In response, the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to 1) develop a robust alternative to U.S. dollar LIBOR and 2) develop a plan to encourage its use in derivatives and other transactions as appropriate. The ARRC has settled on the establishment of SOFR as its recommended alternative to U.S. dollar LIBOR. SOFR is based on a broad segment of the overnight Treasury repurchase market and is intended to be a measure of the cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR in April 2018 and since then, the market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated Obligations and SOFR-linked Advances on an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk. As many of our assets and derivatives are indexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management.
In September 2019, the Finance Agency issued a supervisory letter providing LIBOR transition guidance. Under the supervisory letter, the FHLBanks were directed, by December 31, 2019, to cease purchasing investments that reference LIBOR and mature after December 31, 2021, and, by March 31, 2020, to no longer enter into any other new LIBOR
referenced financial assets, liabilities and derivatives with maturities beyond December 31, 2021. Except for investments and option embedded products, the ability to enter into new LIBOR referenced transactions was extended to June 30, 2020. As a result of the limitations introduced by the Finance Agency, we may experience less flexibility in our access to funding, higher funding costs, increased basis risk, lower overall demand or increased costs of Advances, and a lack of suitable investment alternatives. Accordingly, the composition of our balance sheet, capital stock level, primary mission assets ratio and net income may be negatively impacted. Additionally, the limitations within the supervisory letter may impact our ability to manage interest-rate risk, which may have a negative effect on our financial condition and results of operations.
During the market transition away from LIBOR, LIBOR may experience increased volatility, and the overnight Treasury repurchase market underlying SOFR may also experience disruptions from time to time, which may result in unexpected fluctuations in SOFR. While market activity in SOFR-linked financial instruments has continued to develop, the progress has been uneven and there can be no guarantee that SOFR will become widely accepted and used across market segments and financial products in a timely manner or that any other alternative reference rate will be developed. Any disruption in the market transition away from LIBOR towards SOFR or another alternate reference rate could result in increased financial, operational, legal, reputational or compliance risks. We are not currently able to predict the ultimate impact the market transition away from LIBOR towards SOFR may have on our business, financial condition, and results of operations. See "Executive Overview" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about the replacement of LIBOR.
The COVID-19 pandemic and related developments have created substantial economic and financial disruptions and uncertainties as well as significant operational changes, which could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
The COVID-19 pandemic, and governmental and public actions taken in response (such as stay-at-home or similar orders, travel restrictions, and business closures), have reduced economic activity and created substantial uncertainty about the future economic environment. There are no comparable recent events that provide guidance as to the long-term effect that the COVID-19 pandemic may have and, as a result, the ultimate impact of the pandemic, including the depth of the economic downturn and the timing and shape of the economic recovery, is highly uncertain. This could increase many of the risks we face and adversely affect our business, financial condition, and results of operations.
Prolonged periods of significant economic and financial disruptions and uncertainties resulting from the COVID-19 pandemic, may lead to an increased risk of credit losses, in particular due to decreases in the value of our mortgage loans held for portfolio or collateral securing our Advances or due to member financial difficulties or member failures, and may lead to an increased risk of counterparty defaults. The risk of credit losses may be exacerbated by a prolonged downturn in the residential and commercial real estate markets, including higher mortgage defaults or delinquencies due to rising unemployment and the effect of mortgage forbearance and other relief as well as financial difficulties or failures of mortgage servicers.
Additionally, a prolonged economic downturn resulting from the COVID-19 pandemic may lead to further reduced demand for Advances. Beginning in the second quarter of 2020, demand for Advances decreased significantly as a number of emergency actions taken by the Federal Reserve helped facilitate liquidity and support stability in the fixed-income markets and as members experienced substantial deposit growth. We believe that reduced demand for Advances from many of our members will, or is likely to, continue in the near future.
Overall, the effects of the COVID-19 pandemic have contributed to, and may continue to cause, compression in our net interest income and net interest margin. To the extent interest rates continue to be low, or negative interest rates arise, our business and profitability may be further adversely affected.
Furthermore, stay-at-home or similar orders, travel restrictions, and business shutdowns as a result of the COVID-19 pandemic have led to substantial changes in normal business practices, such as the implementation of widespread work-from-home arrangements for us, as well as many of our members, dealers, investors, and third-party service providers. These changes have increased the risk of operational errors, disruptions and failures, and cybersecurity breaches. It is uncertain when and in what manner normal business operations may return, which could adversely affect our ability to conduct and manage our business.
The extent to which the COVID-19 pandemic may continue to impact our business, financial condition, and results of operations will depend on many factors that remain highly uncertain and difficult to predict, including, but not limited to:
the duration, spread, and severity of the pandemic; additional fiscal stimulus and other measures taken in response to the pandemic; the actions taken to contain the pandemic, including the effectiveness of related vaccines and therapeutics; and how quickly and to what extent normal economic and operating conditions can resume.
Potential GSE reform could unfavorably affect our business model, financial condition, and results of operations.
Due to our GSE status, the ultimate resolution to the conservatorship of Fannie Mae and Freddie Mac could affect the FHLBanks. While there appears to be consensus that a permanent financial and political solution to the current conservatorship status should be implemented, which could include maintaining the current structure, no consensus has evolved to date around any of the various legislative proposals. Some policy proposals directed towards Fannie Mae and Freddie Mac have included provisions applicable to the FHLBank System, such as limitations on Advances and portfolio investments. Other proposals have included broader changes in GSE mortgage finance, such as the FHLBank System being a greater participant in the secondary mortgage market, which could affect the FHLBank System's long-standing business model.
There are significant differences between the FHLBank System and Fannie Mae and Freddie Mac, including the System's focus on lending as opposed to guaranteeing mortgages and its distinctive cooperative business model. GSE legislation could inadequately account for these differences. This could jeopardize the ability of the FHLBank System to continue operating effectively within its current business model, including by adversely changing the perceptions of the capital markets about the risk associated with the debt of housing GSEs. We cannot predict the effects on the System if GSE reform were to be enacted.
Changes in the regulatory and legislative environment could unfavorably affect our business model, financial condition, and results of operations.
In addition to potential GSE reform, the legislative and regulatory environment in which the System operates continues to undergo change. Recently-promulgated and future legislative and regulatory actions could significantly affect our business model, financial condition, or results of operations. Legislative and regulatory actions have also raised our operating costs and imparted added uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. We are unable at this time to predict the ultimate effects the regulatory environment could have on the FHLBank System's business model, our members' view on the value of the FHLBank membership, or on our financial condition and results of operations.
Failure to meet capital adequacy requirements mandated by Finance Agency regulations and supervisory guidance and by our internal policies, or not being able to pay dividends or repurchase or redeem capital stock, may lower demand for Mission Asset Activity, harm results of operations, and lower membership value.
To ensure safe and sound operations, we must hold a minimum amount of capital relative to our asset levels. We must also hold a sufficient amount of retained earnings to help protect members' capital stock investment against impairment risk. If our capital levels fall significantly, we may be unable to pay dividends or redeem and repurchase capital stock in a timely manner (or at all). Such events could adversely affect the value of membership including causing impairment in the value of members' capital investment in our company. Outcomes could be: reduced demand for Mission Asset Activity, decreased profitability, requests from members to redeem a portion of their capital or to withdraw from membership, or increased investors' perception of the riskiness of our FHLB.
MARKET AND LIQUIDITY RISK
Changes in interest rates and mortgage prepayment speeds (together referred to as market risk exposure or interest rate risk exposure) could significantly affect our financial condition and results of operations.
Exposure of earnings to unhedged changes in interest rates and mortgage prepayment speeds is one of our largest ongoing residual risks. We derive most of our income from the interest earned on assets less the interest paid on Consolidated Obligations and deposits used to fund the assets. Spreads on our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model. Market conditions, yield curve shape, competitive forces, and market risk exposure could cause these already narrow asset spreads to decline, which could substantially reduce our
profitability. A key spread relationship is that we tend to utilize Consolidated Discount Notes to fund a significant amount of assets that have adjustable-rates tied to a benchmark interest rate, such as LIBOR or SOFR. Because rates on Discount Notes do not perfectly correlate with other adjustable benchmark interest rates, a narrowing of this spread, for example from investors changing perceptions about the quality of our debt, could lower income and reduce balances of Mission Asset Activity.
We hedge mortgage assets with a combination of Consolidated Obligations and derivatives transactions. Interest rate movements can lower profitability in two primary ways: 1) directly due to their impact on earnings from cash flow mismatches between assets and liabilities; and 2) indirectly via their impact on prepayment speeds on our MBS investments and mortgages purchased under our MPP, which can unfavorably affect the cash flow mismatches. The effects on income can also include acceleration in the amortization of purchased premiums on mortgage assets.
Because it is normally cost-prohibitive to completely mitigate market risk exposure, a residual amount of market risk normally remains after incorporating risk management activities. Sharp increases or decreases in interest rates could adversely affect us and our stockholders by making dividend rates less competitive relative to the returns available to members on alternative investments.
In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders' expectations for an extended period of time and/or market capitalization ratios falling below par which could indicate potential impairment of member stock. In such a situation, members could engage in less Mission Asset Activity and could request a withdrawal of capital. See "Quantitative and Qualitative Disclosures About Risk Management" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information about market risk exposure.
Impaired access to the capital markets for debt issuance could decrease the amount of Mission Asset Activity, lower earnings by raising debt costs and, at the extreme, prevent the System from meeting its financial obligations.
Our principal long-term source of funding, liquidity, and market risk management is through access on favorable terms to the capital markets for participation in the issuances of debt securities and execution of derivative transactions at prices and yields that are adequate to support our business model. Our ability to obtain funds through the sale of Consolidated Obligations depends in part on prevailing conditions in the capital markets, particularly the short-term capital markets, because we and the System normally have a large reliance on short-term funding. The System's strong debt ratings, the implicit U.S. government backing of our debt, strong investor demand for FHLBank System debt, and effective funding management are instrumental in ensuring satisfactory access to the capital markets.
We are exposed to liquidity risk if significant disruptions in the capital markets occur. Although the System was able to maintain access to the capital markets for debt issuances on acceptable terms during 2020, there is no assurance this will continue to be the case. Future ability to effectively access the capital markets on acceptable terms could be adversely affected by external events (such as general economic and financial instabilities, political instability, wars, natural disasters, pandemics or other widespread health emergencies, civil unrest or other unanticipated or catastrophic events), deterioration in the perception of financial market participants about the financial strength of Consolidated Obligations, or downgrades to the System's credit ratings. The System could also be affected by the continued changes in the capital markets in response to financial regulations and by the joint and several liability for Consolidated Obligations, which exposes the System as a whole to events at individual FHLBanks. If access to capital markets were to be impaired for an extended period, the effect on our financial condition and results of operations could be material. At the extreme, the System's ability to achieve its mission and satisfy its financial obligations could be threatened.
CREDIT RISK
We are exposed to credit risk that, if realized, could materially affect our financial condition and results of operations.
We believe we have a de minimis overall amount of residual credit risk exposure related to Credit Services, purchases of investments, and transactions in derivatives, and a minimal amount of credit risk exposure related to the MPP. However, we can make no assurances that credit losses could not materially affect our financial condition or results of operations in all scenarios.
The FHLB is an asset-based lender for Advances and Letters of Credit. Advances and Letters of Credit are over-collateralized and we have a perfected first lien position on collateral. However, we do not have full information on the characteristics of, nor do we estimate current market values on, a large portion of collateral. This results in a degree of uncertainty as to the precise amount of over-collateralization.
Our MPP consists of mortgage loans considered to have high credit quality and conservative underwriting and loan characteristics with additional credit enhancements in place designed to protect us against credit losses. The result has been a minimal amount of credit losses historically.
Although Advances and Letters of Credit are over-collateralized and mortgage loans in the MPP are of high credit quality with various credit enhancements, credit risk could increase under a number adverse scenarios, such as damage or destruction of collateral that members pledge to secure Advances or mortgages that we hold in the MPP as a result of natural disasters, which may be caused by the effects of climate change or other catastrophic events. Significant declines in the value of collateral pledged to secure Advances could lead to greater exposure to credit losses in the event of a member default. Additionally, significant and sustained reductions in home prices and sustained elevated levels of unemployment and other factors that influence delinquencies and defaults could increase the risk of credit losses in the MPP.
Some of our liquidity investments are unsecured, as are uncollateralized portions of certain derivatives. We make unsecured liquidity investments in and transact derivatives with highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices. Failure of an investment or derivative counterparty with which we have a large unsecured position could have a material adverse effect on our financial conditions and results of operations. To the extent we engage in derivative transactions required to be cleared under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), we may be exposed to nonperformance from central clearinghouses and Futures Commission Merchants.
Financial institutions are increasingly inter-related as a result of trading, clearing, counterparty, and other relationships. As a result, actual or potential defaults of one or more financial institutions could lead to market-wide disruptions making it difficult for us to find qualified counterparties for transactions.
Financial difficulties at other FHLBanks could require us to provide financial assistance to another FHLBank, which could adversely affect our results of operations or our financial condition.
Each FHLBank has a joint and several liability for principal and interest payments on Consolidated Obligations, which are backed only by the financial resources of the FHLBanks. Although no FHLBank has ever defaulted on its principal or interest share of an Obligation, there can be no assurance that this will continue to be the case. Financial performance issues could require our FHLB to provide financial assistance to one or more other FHLBanks, for example, by making a payment on an Obligation on behalf of another FHLBank. Such assistance could adversely affect our financial condition, earnings, ability to pay dividends, or ability to redeem or repurchase capital stock.
OPERATIONAL RISK
Failures of the Office of Finance could disrupt the ability to conduct and manage our business.
The Office of Finance is a joint office of the FHLBanks established to facilitate the issuance and servicing of Consolidated Obligations, among other things. Pursuant to Finance Agency regulations, the Office of Finance, often in conjunction with the FHLBanks, has adopted policies and procedures for the purposes of facilitating and approving the issuance of Consolidation Obligations. A failure or interruption of the Office of Finance's services as a result of breaches, cyberattacks, or technological risks could negatively affect the business operations of each FHLBank, including disruptions to the FHLBanks' access to funding through the sale of Consolidated Obligations. Although the Office of Finance has business continuity and security incident response plans in place, our business operations could be constrained, disrupted or otherwise negatively affected if the Office of Finance was not able to perform its functions for a period of time.
Failures or interruptions in our information systems and other technologies, financial and business models, and third-party vendors could harm our financial condition, results of operations, reputation, and relations with members.
As a financial institution, we rely heavily on internal and third-party information systems and other technology to manage our business, including the secure processing, storage and transmission of confidential borrower and financial information in computer systems and networks. For instance, due to our reliance on the book-entry system of the Federal Reserve Banks for debt issuance and servicing operations, we depend on them and their fiscal agent, the Federal Reserve Bank of New York, and one or more settlement agents to issue and make payments of principal and interest on Consolidated Obligations. Failures in information systems and other technologies could occur from human error, fraud, cyberattacks, errors or misuse of models and services we employ, lapses in operating processes, or natural or man-made disasters.
Computer systems, software and networks may be increasingly vulnerable to failures and interruptions from cyberattacks, which may include breaches, unauthorized access, misuse, computer viruses or other malicious or destructive code (such as ransomware) and other events against information owned by our company and customers. These failures and interruptions could jeopardize the confidentiality or integrity of information, or otherwise cause interruptions or malfunctions in operations. Additionally, threats of cyber terrorism, external extremist parties, including state-sponsored actors, result in heightened risk exposure. The techniques used in cyber attacks change frequently and have grown increasingly sophisticated, and these attacks or ensuing security breaches could persist for an extended period of time before being detected. It could take considerable additional time for us to determine the scope, extent, amount, and type of information compromised. We can make no assurance that we will be able to prevent, timely and adequately address, or mitigate failures, interruptions, or cyberattacks in information systems and other technology. If we experience a failure, interruption, or cyberattack in any of these systems, we may be unable to effectively conduct or manage business activities, operating processes, and risk management, which could significantly harm customer relations, our reputation, and operating costs, potentially resulting in material adverse effects on our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of such failures, interruptions, cyberattacks, or cyber terrorism.
Our financial condition and results of operations could suffer if we are unable to hire and retain skilled key personnel.
We rely on key personnel for many of our functions and have a relatively small workforce, given the size and complexity of our business. The success of our mission depends, in large part, on the ability to attract and retain key personnel. We must continue to recruit, retain and motivate a qualified and diverse pool of employees, both to maintain our current business, and to execute strategic initiatives. Competition for qualified people or ineffective succession planning could affect the ability to hire or retain effective key personnel, thereby harming our financial condition and results of operations.
Item 1B.Unresolved Staff Comments.
None.
Item 2.Properties.
Our primary offices are located in approximately 79,000 square feet of leased space in downtown Cincinnati, Ohio. We also maintain a leased, fully functioning, back-up facility in suburban Cincinnati. We believe that our facilities are in good condition, well maintained, and adequate for our current needs.
Item 3.Legal Proceedings.
From time to time, we are subject to various legal proceedings arising in the normal course of business. 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.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
By law our stock is not publicly traded, and only our members (and former members with a withdrawal notice pending) may own our stock. The par value of our capital stock is $100 per share. As of December 31, 2020, we had 649 member and former member stockholders and approximately 27 million shares of capital stock outstanding, all of which were Class B Stock.
We declared quarterly cash dividends in 2020 and 2019 as shown in the table below.
| | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | | | | | | | | | | | | |
| | | | 2020 | | | | | | | | 2019 | | |
| | | | Annualized | | | | | | | | Annualized | | |
| Quarter | | | | Rate | | | | | | | | Rate | | |
| First | | | | 2.50 | % | | | | | | | | 6.00 | % | | |
| Second | | | | 2.50 | | | | | | | | | 5.50 | | | |
| Third | | | | 2.00 | | | | | | | | | 4.50 | | | |
| Fourth | | | | 2.00 | | | | | | | | | 4.00 | | | |
| Total | | | | 2.23 | | | | | | | | | 5.05 | | | |
Generally, the Board of Directors has discretion to declare or not declare dividends and to determine the rate of any dividend declared. Our policy states that dividends for a quarter are declared and paid from retained earnings after the close of a calendar quarter and are based on average stock balances for the then closed quarter. The Board of Directors' decision to declare dividends is influenced by the financial condition, overall financial performance and retained earnings of the FHLB, and actual and anticipated developments in the overall economic and financial environment including interest rates and the mortgage and credit markets. The dividend rate is generally referenced as a spread to average short-term interest rates experienced during the quarter to help assess a competitive level for our stockholders.
We may not declare a dividend if, at the time, we are not in compliance with all of our capital requirements. We also may not declare or pay a dividend if, after distributing the dividend, we would fail to meet any of our capital requirements or if we determine that the dividend would create a safety and soundness issue for the FHLB. See Note 11 of the Notes to the Financial Statements for additional information regarding our capital stock.
RECENT SALES OF UNREGISTERED SECURITIES
We provide Letters of Credit in the ordinary course of business to support members' obligations issued in support of unaffiliated, third-party offerings of notes, bonds or other securities. We provided $1 million and $3 million of such credit support during 2020 and 2019. We did not provide such credit support during 2018. To the extent that these Letters of Credit are securities for purposes of the Securities Act of 1933, their issuance is exempt from registration pursuant to section 3(a)(2) thereof.
Item 6. Selected Financial Data.
The following table presents selected Statement of Condition data, Statement of Income data and financial ratios for the five years ended December 31, 2020.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | 2018 | | 2017 | | 2016 |
| STATEMENT OF CONDITION DATA AT PERIOD END: | | | | | | | | | |
| Total assets | $ | 65,296 | | | $ | 93,492 | | | $ | 99,203 | | | $ | 106,895 | | | $ | 104,635 | |
| Advances | 25,362 | | | 47,370 | | | 54,822 | | | 69,918 | | | 69,882 | |
| Mortgage loans held for portfolio | 9,549 | | | 11,236 | | | 10,502 | | | 9,682 | | | 9,150 | |
Allowance for credit losses on mortgage loans (1) | — | | | 1 | | | 1 | | | 1 | | | 1 | |
Investments (2) | 27,041 | | | 34,389 | | | 33,614 | | | 27,058 | | | 25,334 | |
| Consolidated Obligations, net: | | | | | | | | | |
| Discount Notes | 27,500 | | | 49,084 | | | 46,944 | | | 46,211 | | | 44,690 | |
| Bonds | 31,997 | | | 38,440 | | | 45,659 | | | 54,163 | | | 53,191 | |
| Total Consolidated Obligations, net | 59,497 | | | 87,524 | | | 92,603 | | | 100,374 | | | 97,881 | |
| Mandatorily redeemable capital stock | 19 | | | 22 | | | 23 | | | 30 | | | 35 | |
| Capital: | | | | | | | | | |
| Capital stock - putable | 2,641 | | | 3,367 | | | 4,320 | | | 4,241 | | | 4,157 | |
| Retained earnings | 1,304 | | | 1,094 | | | 1,023 | | | 940 | | | 834 | |
| Accumulated other comprehensive loss | (15) | | | (16) | | | (13) | | | (16) | | | (13) | |
| Total capital | 3,930 | | | 4,445 | | | 5,330 | | | 5,165 | | | 4,978 | |
| STATEMENT OF INCOME DATA: | | | | | | | | | |
| Net interest income | $ | 406 | | | $ | 406 | | | $ | 499 | | | $ | 429 | | | $ | 363 | |
| | | | | | | | | |
| Non-interest income (loss) | (7) | | | (10) | | | (37) | | | (1) | | | 46 | |
| Non-interest expense | 92 | | | 89 | | | 85 | | | 79 | | | 111 | |
| Affordable Housing Program assessments | 31 | | | 31 | | | 38 | | | 35 | | | 30 | |
| Net income | $ | 276 | | | $ | 276 | | | $ | 339 | | | $ | 314 | | | $ | 268 | |
| FINANCIAL RATIOS: | | | | | | | | | |
Dividend payout ratio (3) | 30.3 | % | | 74.1 | % | | 75.6 | % | | 66.3 | % | | 63.9 | % |
Weighted average dividend rate (4) | 2.23 | | | 5.05 | | | 5.88 | | | 5.00 | | | 4.00 | |
| Return on average equity | 5.78 | | | 5.65 | | | 6.29 | | | 6.15 | | | 5.35 | |
| Return on average assets | 0.31 | | | 0.28 | | | 0.32 | | | 0.31 | | | 0.25 | |
Net interest margin (5) | 0.46 | | | 0.42 | | | 0.47 | | | 0.42 | | | 0.35 | |
| Average equity to average assets | 5.39 | | | 5.04 | | | 5.11 | | | 5.00 | | | 4.76 | |
Regulatory capital ratio (6) | 6.07 | | | 4.79 | | | 5.41 | | | 4.88 | | | 4.80 | |
Operating expenses to average assets (7) | 0.080 | | | 0.070 | | | 0.063 | | | 0.060 | | | 0.061 | |
(1)The methodology for determining the allowance for credit losses on mortgage loans changed on January 1, 2020 with the adoption of new accounting guidance on the measurement of credit losses on financial instruments. Consistent with the modified retrospective method of adoption, the prior periods have not been revised to conform to the new basis of accounting.
(2)Investments include interest-bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
(3)Dividend payout ratio is dividends declared in the period as a percentage of net income.
(4)Weighted average dividend rates are dividends paid divided by the average number of shares of capital stock eligible for dividends.
(5)Net interest margin is net interest income as a percentage of average earning assets.
(6)Regulatory capital ratio is period-end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period-end total assets.
(7)Operating expenses comprise compensation and benefits and other operating expenses, which are included in non-interest expense.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
This discussion and analysis of the FHLB's financial condition and results of operations should be read in conjunction with the Financial Statements and related Notes to Financial Statements contained in this Form 10-K.
EXECUTIVE OVERVIEW
Recent Developments
COVID-19 Pandemic
The global outbreak of COVID-19 has impacted communities and businesses worldwide, including those in the Fifth District. The effects of COVID-19 continue to evolve, and the full impact and duration of the virus are unknown. Despite the uncertainties created by the COVID-19 pandemic, we continued to fulfill our mission of providing robust access to a key source of readily available and competitively priced wholesale funding to member financial institutions and supporting our commitment to affordable housing and community investment, while maintaining strong capital and liquidity positions.
We have remained focused on the health and safety of our employees while maintaining full business operations. Employees are working from home with only a limited number of employees voluntarily working from our downtown Cincinnati location. Although there is no definitive date on when employees will return to the office, we have prepared health and safety policies and procedures to ensure our employees are able to return safely.
At this time, we cannot predict the ultimate impact of COVID-19 on our members, counterparties, vendors, and other third parties we rely upon to conduct our business. However, we continue to monitor the progression of COVID-19 and are committed to assisting members and their communities as impacts related to the pandemic continue to unfold.
Financial Condition
Mission Asset Activity
Mission Assets, which we define as Advances, Letters of Credit, and total MPP are the primary means by which we fulfill our mission with direct connections to members. We regularly monitor our balance sheet concentration of Mission Asset Activity. One measure we use to assess mission achievement is our Primary Mission Asset ratio, which measures the sum of average Advances and mortgage loans as a percentage of average Consolidated Obligations (adjusted for certain high-quality liquid assets, as permitted by regulation). In 2020, the Primary Mission Asset ratio averaged 75 percent, which exceeded the Finance Agency's preferred ratio of 70 percent. In assessing overall mission achievement, we also consider supplemental sources of Mission Asset Activity, the most significant of which is Letters of Credit issued to members.
The following table summarizes our Mission Asset Activity.
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| Year Ended December 31, | | |
| | Ending Balances | | | | Average Balances |
| | | | | | | |
| (In millions) | 2020 | | 2019 | | | | 2020 | | 2019 | | |
| Mission Asset Activity: | | | | | | | | | | | |
| Advances (principal) | $ | 25,007 | | | $ | 47,264 | | | | | $ | 42,917 | | | $ | 47,894 | | | |
| MPP: | | | | | | | | | | | |
| Mortgage loans held for portfolio (principal) | 9,316 | | | 10,981 | | | | | 10,995 | | | 10,499 | | | |
| Mandatory Delivery Contracts (notional) | 137 | | | 936 | | | | | 338 | | | 516 | | | |
| Total MPP | 9,453 | | | 11,917 | | | | | 11,333 | | | 11,015 | | | |
| Letters of Credit (notional) | 28,812 | | | 16,205 | | | | | 20,141 | | | 15,150 | | | |
| Total Mission Asset Activity | $ | 63,272 | | | $ | 75,386 | | | | | $ | 74,391 | | | $ | 74,059 | | | |
At December 31, 2020, 64 percent of members held Mission Asset Activity, which was relatively stable compared to prior periods. The balance of Mission Asset Activity was $63.3 billion at December 31, 2020, a decrease of $12.1 billion (16 percent) from year-end 2019, which was primarily driven by lower Advance balances. Advance principal balances decreased $22.3
billion (47 percent) from year-end 2019 primarily due to reduced borrowings by large-asset members as these members generally experienced an inflow of deposits on their balance sheets and increased access to other sources of liquidity in the financial markets. The decrease in the balance of Mission Asset Activity was partially offset by an increase of $12.6 billion (78 percent) in Letters of Credit balances from year-end 2019. The increase in Letters of Credit was due in part to members using Letters of Credit rather than securities to secure increased deposits from states and municipalities during the pandemic. We normally earn fees on Letters of Credit based on the actual average amount of the Letters utilized, which generally is less than the notional amount issued.
Average principal Advance balances for 2020 decreased only $5.0 billion (10 percent) compared to 2019 as Advances spiked across our membership at the end of the first quarter as the financial markets reacted to the pandemic. Most of these Advances matured or prepaid by the end of the third quarter of 2020. Advance balances are often volatile due to members' ability to quickly, normally on the same day, increase or decrease their amount of Advances. We believe providing members flexibility in their funding levels helps support their asset-liability management needs and is a key benefit of membership.
We believe that reduced demand for Advances from many of our members will, or is likely to, continue in the near future. Our business is designed to support significant changes in asset levels without having to undergo material changes in staffing, operations, risk practices, or general resource needs. A key reason for this scalability is that our Capital Plan provides for additional capital when Advances grow and the opportunity for us to retire capital when Advances decline, thereby acting, along with our efficient operating expenses, to preserve competitive profitability.
The MPP principal balance fell $1.7 billion (15 percent) from year-end 2019. During 2020, we purchased $2.6 billion of mortgage loans, while principal reductions of $4.3 billion reflected the significant increase in mortgage loan refinance activity in 2020.
Based on earnings in 2020, we accrued $38$31 million for the Affordable Housing Program (AHP) pool of funds to be available to members in 2021. In addition to the required AHP assessment, we provided voluntary sponsorship of three other housing programs during 2020. These programs provided funds to cover accessibility and emergency repairs for special needs and elderly homeowners, funds for the replacement or repair of homes damaged or destroyed by natural disasters within the Fifth District, and Advances at zero percent interest for COVID-19 related assistance.
Investments
The balance of investments at December 31, 2020 was $27.0 billion, a decrease of $7.3 billion from year-end 2019. At December 31, 2020, investments included $9.7 billion of MBS and $17.3 billion of other investments, which consisted primarily of highly-rated short-term instruments and longer-term U.S. Treasury and GSE obligations held for liquidity. All of our MBS held at December 31, 2020 were issued and guaranteed by Fannie Mae, Freddie Mac or a U.S. agency. The decline in the balance of investments at the end of 2020 was due to decreases in both MBS and liquidity investments. MBS balances declined due to an increase in prepayments of the underlying mortgages as a result of the low interest rate environment. Due to regulatory limitations regarding the purchase of MBS that reference LIBOR, we have not been able to fully replace the prepaid MBS with suitable alternatives. Liquidity investments decreased as we decided to hold more of our liquidity portfolio as deposits at the Federal Reserve at the end of 2020 in anticipation of volatile market conditions. At December 31, 2020, we held $3.0 billion in deposits at the Federal Reserve, which are reflected in cash and due from banks on the Statements of Condition.
Investments averaged $32.9 billion in 2020, a decrease of $4.9 billion (13 percent) from year-end 2019. The decrease in average investments was primarily driven by the decrease in MBS balances described above. Liquidity investments can vary significantly on a daily basis during times of volatility in Advance balances. We maintained a robust amount of asset liquidity throughout 2020 across a variety of liquidity measures, as discussed in the "Liquidity Risk" section of "Quantitative and Qualitative Disclosures About Risk Management."
Capital
Capital adequacy surpassed all minimum regulatory capital requirements in 2020. The GAAP capital-to-assets ratio at December 31, 2020 was 6.02 percent, while the regulatory capital-to-assets ratio was 6.07 percent. Both ratios exceeded the regulatory required minimum of four percent. Regulatory capital includes mandatorily redeemable capital stock accounted for as a liability under GAAP. GAAP and regulatory capital both decreased $0.5 billion in 2020, primarily due to the repurchase of $2.3 billion of excess stock and members' redemption of $0.6 billion of stock in 2020. The repurchase and redemption of capital stock were partially offset by members' purchases of capital stock to support Advance growth at the end of the first quarter. Retained earnings totaled $1.3 billion at December 31, 2020, an increase of $0.2 billion (19 percent) from year-end 2019, which is a higher growth rate relative to recent years. The increase in retained earnings was due in part to the lower weighted average dividend rate in 2020.
Results of Operations
Overall Results
Our earnings reflect the combination of a stable business model and conservative management of risk. Key factors that can cause significant periodic volatility in our profitability are changes in the level of interest rates, changes in spreads between benchmark interest rates and our short-term funding costs, recognition of net amortization due to accelerated prepayments of mortgage assets, and fair value adjustments related to the use of derivatives and the associated hedged items. The table below summarizes our results of operations.
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| | | | | | |
| Year Ended December 31, |
| (Dollars in millions) | 2020 | | 2019 | | | | 2018 | | |
| Net income | $ | 276 | | | $ | 276 | | | | | $ | 339 | | | |
| Affordable Housing Program assessments | 31 | | | 31 | | | | | 38 | | | |
| Return on average equity (ROE) | 5.78 | % | | 5.65 | % | | | | 6.29 | % | | |
| Return on average assets | 0.31 | | | 0.28 | | | | | 0.32 | | | |
| Weighted average dividend rate | 2.23 | | | 5.05 | | | | | 5.88 | | | |
Average short-term interest rates (1) | 0.51 | | | 2.24 | | | | | 2.07 | | | |
| | | | | | | | | |
| ROE spread to average short-term interest rates | 5.27 | | | 3.41 | | | | | 4.22 | | | |
| Dividend rate spread to average short-term interest rates | 1.72 | | | 2.81 | | | | | 3.81 | | | |
| | | | | | | | | |
| | | | | | | | | |
(1) Average short-term interest rates consist of 3-month LIBOR and the Federal funds effective rate.
The historically low interest rate environment in 2020 had a significant impact on earnings. Low long-term interest rates resulted in a higher volume of mortgage refinance activity, which led to elevated levels of mortgage loan repayments and related premium amortization. Additionally, short-term interest rates declined sharply in early 2020 and continued at low levels for the remainder of the year, which lowered the earnings generated from investing our capital. Despite these declines, 2020 net income benefited from gains on the sale of interest rate swaptions during the first quarter of 2020 as well as higher prepayment fees on Advances in 2020. We use swaptions to hedge market risk exposure associated with holding fixed-rate mortgage assets and may sell swaptions as interest rates change in order to offset actual and anticipated risks.
Earnings levels continued to represent competitive returns on stockholders' capital investment. Our business model is structured to be able to absorb sharp changes in assets because we can execute commensurate changes in liability and capital stock balances. ROE was higher than average short-term rates in the periods presented above, while we maintained risk exposures in line with our appetite for a moderate risk profile. The spread between ROE and average short-term rates, which we compute using 3-month LIBOR and the Federal funds effective rate, is a market benchmark we believe member stockholders actively use to assess the competitiveness of the return on their capital investment.
In December 2020, we paid stockholders a quarterly dividend at a 2.00 percent annualized rate on their capital investment in our company, which is 1.84 percentage points above fourth quarter average short-term interest rates. The lower weighted average dividend rate in 2020 was due to the uncertainty surrounding the economic effects from the COVID-19 pandemic and its ultimate impact on our business and profitability, and to grow retained earnings to bolster the capital position going forward.
Effect of Interest Rate Environment
Trends in market interest rates and the resulting shapes of the market yield curves strongly influence the results of operations and profitability because of how they affect members' demand for Mission Asset Activity, spreads on assets, funding costs and decisions in managing the tradeoffs in our market risk/return profile. The following table presents key market interest rates (obtained from Bloomberg L.P.).
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| | Year 2020 | | Year 2019 | | Year 2018 | | | | | | |
| | | | | | | | | |
| | | | | | | | | | | |
| | Ending | | Average | | Ending | | Average | | Ending | | Average | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
| Federal funds effective | 0.09 | % | | 0.37 | % | | 1.55 | % | | 2.16 | % | | 2.40 | % | | 1.83 | % | | | | | | | | |
| Secured Overnight Financing Rate (SOFR) | 0.09 | | | 0.37 | | | 1.55 | | | 2.20 | | | 3.00 | | | 1.85 | | | | | | | | | |
| 3-month LIBOR | 0.24 | | | 0.65 | | | 1.91 | | | 2.33 | | | 2.81 | | | 2.31 | | | | | | | | | |
| 2-year LIBOR | 0.20 | | | 0.49 | | | 1.70 | | | 2.03 | | | 2.66 | | | 2.75 | | | | | | | | | |
| 10-year LIBOR | 0.93 | | | 0.88 | | | 1.90 | | | 2.09 | | | 2.71 | | | 2.95 | | | | | | | | | |
| 2-year U.S. Treasury | 0.12 | | | 0.39 | | | 1.57 | | | 1.97 | | | 2.49 | | | 2.52 | | | | | | | | | |
| 10-year U.S. Treasury | 0.92 | | | 0.89 | | | 1.92 | | | 2.14 | | | 2.69 | | | 2.91 | | | | | | | | | |
15-year mortgage current coupon (1) | 0.65 | | | 1.17 | | | 2.28 | | | 2.52 | | | 3.06 | | | 3.20 | | | | | | | | | |
30-year mortgage current coupon (1) | 1.28 | | | 1.64 | | | 2.71 | | | 2.95 | | | 3.51 | | | 3.65 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| | Year 2020 by Quarter - Average |
| | Quarter 1 | | Quarter 2 | | Quarter 3 | | Quarter 4 |
| | | | | | | |
| Federal funds effective | 1.25 | % | | 0.06 | % | | 0.09 | % | | 0.09 | % |
| SOFR | 1.25 | | | 0.05 | | | 0.09 | | | 0.09 | |
| 3-month LIBOR | 1.54 | | | 0.61 | | | 0.25 | | | 0.22 | |
| 2-year LIBOR | 1.18 | | | 0.32 | | | 0.22 | | | 0.23 | |
| 10-year LIBOR | 1.34 | | | 0.69 | | | 0.65 | | | 0.87 | |
| 2-year U.S. Treasury | 1.10 | | | 0.19 | | | 0.14 | | | 0.15 | |
| 10-year U.S. Treasury | 1.38 | | | 0.68 | | | 0.65 | | | 0.86 | |
15-year mortgage current coupon (1) | 1.86 | | | 1.09 | | | 0.86 | | | 0.88 | |
30-year mortgage current coupon (1) | 2.31 | | | 1.58 | | | 1.32 | | | 1.37 | |
(1) Simple average of current coupon rates of Fannie Mae and Freddie Mac par MBS indications.
The target overnight Federal funds rate was in the range of zero to 0.25 percent at December 31, 2020, a decrease from the range of 1.50 to 1.75 percent at December 31, 2019. The low interest rate environment reflects the evolving risks to economic activity from the COVID-19 pandemic.
Average short-term rates were approximately 170 to 180 basis points lower in 2020 compared to 2019 and average long-term rates decreased by approximately 125 to 135 basis points during that same period. The decline in interest rates negatively impacted income in 2020 primarily because of the lower earnings generated from investing capital and the increased mortgage asset prepayments resulting in higher net amortization of premiums on those assets.
Business Outlook and Risk Management
This section summarizes the business outlook and what we believe are our current major risk exposures. See Item 1A. Risk Factors for a detailed discussion of certain factors that could affect our corporate objectives, financial condition, and results of operations. "Quantitative and Qualitative Disclosures About Risk Management" provides details on current risk exposures.
Strategic/Business Risk
Advances: Our business is cyclical and Mission Asset Activity normally declines in periods of economic contraction, when financial institutions have ample liquidity, or when there is significant growth in the money supply. Other factors that constrain widespread demand for Advances are the low levels of interest rates and competitiveness of Advances relative to deposits and other sources of wholesale funding.
In the last several years, the percentage of assets that members funded with Advances has shown little variation, in the range of two to four percent. We may see a broad-based increase in Advance demand if one or more of the following occur: aggregate
loan portfolios of our members grow quicker than aggregate deposits, interest rates begin to increase over time, or changes in Federal Reserve policy reduce other sources of liquidity available to members.
MPP: MPP balances are influenced by conditions in the housing and mortgage markets, the competitiveness of prices we offer to purchase loans as well as program features, and activity from our largest sellers.
Our ongoing strategy for the MPP has two components: 1) increase the number of regular sellers and participants in the program; and 2) manage purchases and balances at a prudent level relative to capital and total assets to effectively manage market and credit risks consistent with our risk appetite.
Market Risk
During 2020, as in 2019, the market risk exposure to changing interest rates was moderate overall and well within policy limits. We believe that longer-term profitability would not become uncompetitive unless interest rates were to change quickly and significantly. In the short-term, profitability could become uncompetitive if long-term interest rates decrease in excess of 50 basis points leading to faster prepayments of mortgage assets, which would further accelerate the recognition of purchased premiums.
Capital Adequacy
We believe members place a high value on their capital investment in our company. Capital ratios at December 31, 2020, and all throughout the year, exceeded the regulatory required minimum of four percent. We believe the amount of retained earnings is sufficient to protect against members' impairment risk of their capital stock investment in the FHLB and to provide the opportunity to stabilize or increase future dividends. Our capital policies and Capital Plan also have safeguards to ensure we meet regulatory and prudential capital requirements.
Credit Risk
In 2020, we continued to maintain a de minimis level of overall residual credit risk exposure from our Credit Services, investments, and derivative transactions. We believe policies and procedures related to credit underwriting, Advance collateral management, and transactions with investment and derivative counterparties continue to mitigate these risks. We have never experienced any credit losses, and we continue to have no loan loss reserves or impairment recorded for these instruments. Residual credit risk exposure in the mortgage loan portfolio was minimal.
Liquidity Risk
Our liquidity position remained strong during 2020, as did our overall ability to fund operations through the issuance of Consolidated Obligations at acceptable interest costs. Investor demand for FHLBank System debt continued to be robust. There were no substantive stresses on market access or liquidity from external market and political events. Although we can make no assurances, we believe there is only a remote possibility of a liquidity or funding crisis in the System that could impair our ability to participate, on a cost-effective basis, in issuances of new debt, service outstanding debt, maintain adequate capital levels, or pay competitive dividends.
Regulatory and Legislative Risk and Significant Developments
General: The FHLBank System is subject to legislative and regulatory oversight. Legislative and regulatory actions applicable, directly or indirectly, to the FHLBank System in the last decade have increased uncertainty regarding the business model and membership base under which the FHLBanks may operate in the future. This is due primarily to the uncertainty around potential future GSE reform, and the evolution of mortgage financing moving towards financial institutions currently not eligible for FHLBank membership. See Item 1A. Risk Factors for more discussion. We cannot predict the ultimate outcome of GSE reform and whether our membership base will be legislatively and regulatorily permitted to evolve in concert with the housing finance market.
Federal Deposit Insurance Corporation (FDIC) Brokered Deposits Restrictions:On January 22, 2021, the FDIC published a final rule, effective April 1, 2021, that amends its brokered deposits regulations that apply to less than well-capitalized insured depository institutions. The FDIC stated that the amendments are intended to modernize and clarify the FDIC’s brokered deposit regulations and they establish a new framework for analyzing the deposit broker definition, which determines whether deposits placed through deposit placement arrangements qualify as brokered deposits. These deposit placement arrangements include those between insured depository institutions and third parties, such as financial technology companies, for a variety of business purposes, including access to deposits. The amendments to the FDIC's brokered deposit regulations, among other things, clarify what it means to be engaged in the business of facilitating the placement of deposits and expand the scope of the primary purpose exception. The rule amendments are expected to have the effect of narrowing the definition of deposit broker and excluding more deposits from treatment as brokered deposits. The amendments also establish an application and reporting
process with respect to the primary purpose exception for businesses that do not meet one of several bright-line tests, and they affirm the FDIC’s position that the brokering of certificates of deposit constitutes deposit brokering.
This rule may have an effect on member demand for certain Advances, but we cannot predict the extent of the impact. We do not expect this rule to materially affect our financial condition or results of operations.
Finance Agency Final Rule on FHLBank Housing Goals Amendments:On June 25, 2020, the Finance Agency published a final rule, effective August 24, 2020, amending the FHLBank housing goals regulation. Enforcement of the final rule will phase in over three years. The final rule eliminated the existing $2.5 billion volume threshold, such that all FHLBanks are subject to a new housing goal, regardless of their mortgage purchase volume. The new housing goal establishes one overall target level requiring 20 percent of an FHLBank's total mortgage purchases to be home-purchase mortgages for low- and very-low income families and low-income areas as well as refinancing mortgages for low-income families. The final rule also establishes a separate small member participation housing goal with a target level of 50 percent. The final rule provides that an FHLBank may request Finance Agency approval of alternative target levels for either or both of the goals. We do not believe these changes will have a material effect on our financial condition or results of operations.
Finance Agency Supervisory Letter - Paycheck Protection Program (PPP) Loans as Collateral for FHLBank Advances:On April 23, 2020, the Finance Agency issued a Supervisory Letter (PPP Supervisory Letter) permitting the FHLBanks to accept PPP loans as collateral for Advances as “Agency Securities,” given the Small Business Administration’s (SBA) 100 percent guarantee of the unpaid principal balance. On April 20, 2020, the SBA's third interim final rule related to PPP loans was published. The rule explicitly waived certain regulatory requirements that must be satisfied before a member could pledge PPP loans to the FHLBanks as collateral. The PPP Supervisory Letter establishes a series of conditions under which the FHLBanks may accept PPP loans as collateral that focus on the financial condition of members, collateral discounts, and pledge dollar limits. On December 27, 2020, the President signed into law an extension of the PPP until March 21, 2021. The April 23, 2020 Supervisory Letter from the Finance Agency allowing us to accept PPP loans as collateral remains in effect.
Coronavirus Aid, Relief, and Economic Security (CARES) Act:The CARES Act was signed into law on March 27, 2020. The $2.2 trillion package was the largest stimulus bill in United States history. The CARES Act is in addition to previous relief legislation passed by Congress in March 2020. The legislation provides the following:
▪Assistance to businesses, states, and municipalities.
▪A loan program for small businesses, non-profits and physician practices that can be forgiven through employee retention incentives.
▪Treasury Secretary authority to make loans or loan guarantees to states, municipalities, and eligible businesses and loosens some regulations imposed through the Dodd-Frank Act.
▪Direct payments to eligible taxpayers and their families.
▪Expanded eligibility for unemployment insurance and payment amounts.
▪Mortgage forbearance provisions and a foreclosure moratorium.
Funding for the PPP, which was created by the CARES Act, was increased with the enactment of subsequent laws, most recently by the Consolidated Appropriations Act, 2021, on December 27, 2020. Additional phases of the CARES Act or other COVID-19 pandemic relief legislation may be enacted by Congress or other actions by the President, state governments, and governmental agencies. In connection with the foreclosure moratorium noted above, we have asked servicers of the mortgage loans we own to temporarily suspend all foreclosure sales and evictions, unless a home is vacant, in order to allow homeowners to stay in their homes during this period. We continue to monitor these actions and guidance as they evolve and to evaluate the potential impact to the U.S. economy; the impacts to mortgages held or serviced by our members that we accept as collateral; the impacts on our MPP portfolio; and the impacts to our overall business.
LIBOR Transition:We are planning for the replacement of LIBOR given that the FCA will no longer persuade or compel banks to submit rates for the calculation of LIBOR and the Federal Reserve Bank of New York has established SOFR as its recommended alternative to LIBOR. On March 5, 2021, the FCA announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative immediately after December 31, 2021, in the case of 1-week and 2-month U.S. dollar LIBOR, and immediately after June 30, 2023, in the case of the remaining U.S. dollar LIBOR settings. The market activity in SOFR-linked financial instruments has continued to develop and we have offered SOFR-linked Consolidated Obligations and SOFR-linked Advances on an ongoing basis. In addition, a SOFR-based derivatives market has begun to emerge and we have begun to use SOFR-based derivatives to manage interest-rate risk.
As many of our assets and derivatives are still indexed to LIBOR, we have developed and implemented a LIBOR transition plan, which addresses considerations such as LIBOR exposure, fallback language, operational preparedness, and balance sheet management. Part of our LIBOR transition plan includes our previously implemented fallback language for LIBOR-indexed Advances and Consolidated Bonds in new and legacy contracts. As for our investments that are tied to LIBOR, we are monitoring market-wide efforts to enhance fallback language for new activity and develop frameworks to address existing transactions.
On October 23, 2020, the International Swaps and Derivatives Association, Inc. (ISDA), published a Supplement to the 2006 ISDA Definitions (Supplement) and the ISDA 2020 IBOR Fallbacks Protocol (Protocol). Both the Supplement and the Protocol were effective on January 25, 2021. As of that date, all legacy bilateral derivatives transactions subject to Protocol-covered agreements (including ISDA agreements) that incorporate certain covered ISDA definitional booklets and reference a covered Interbank Offered Rate (IBOR), including U.S. dollar LIBOR, were effectively amended to apply the new ISDA-recommended IBOR fallbacks in the event of the relevant IBOR’s cessation. We have adhered to the Protocol and have worked with our counterparties, as necessary, to address over-the-counter derivative agreements referencing U.S. dollar LIBOR as a part of our LIBOR transition efforts.
The Finance Agency has also issued supervisory letters designed to ensure the FHLBanks will be able to identify and prudently manage the risks associated with the termination of LIBOR in a safe and sound manner. As of June 30, 2020, the FHLBanks were required to cease entering into new LIBOR-based financial instruments that mature after December 31, 2021, except for investments and option embedded products. With respect to investments, the Finance Agency required the FHLBanks, by December 31, 2019, to stop purchasing investments that reference LIBOR and mature after December 31, 2021. These phase-out dates did not apply to collateral accepted by the FHLBanks. As directed by the Finance Agency, the FHLBanks began requiring their members to report levels of LIBOR-linked collateral that mature after December 31, 2021. This will assist the FHLBanks in determining the level of member reliance on these assets to support borrowings, make decisions about their future eligibility and the impact of any incremental haircuts and asset value deterioration on borrowing capacity.
We have Advances, investment securities and derivatives with interest rates indexed to LIBOR. Each of these instruments are indexed to LIBOR settings that will no longer be provided after June 30, 2023, as noted above. The following table presents LIBOR-indexed Advances, investment securities and derivatives by contractual maturity at December 31, 2020.
| | | | | | | | | | | |
| (In millions) | Maturing on or before June 30, 2023 | | Maturing after June 30, 2023 |
| LIBOR-Indexed Variable Rate Financial Instruments | | | |
| Advances by redemption term | $ | 2,599 | | | $ | 3,012 | |
MBS by contractual maturity (1) | — | | | 5,929 | |
| | | |
| Total principal amount | $ | 2,599 | | | $ | 8,941 | |
| Derivatives, notional amount by termination date | $ | 9,339 | | | $ | 4,680 | |
(1)MBS are presented by contractual maturity; however, their expected maturities will likely differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
The market transition away from LIBOR towards SOFR is gradual and complicated, including the possible development of term structures and credit adjustments to accommodate differences between LIBOR and SOFR. As such, we are not currently able to predict the ultimate impact of such a transition on our business, financial condition, and results of operations.
ANALYSIS OF FINANCIAL CONDITION
Credit Services
Credit Activity and Advance Composition
The table below shows trends in Advance balances by major programs and in the notional amount of Letters of Credit.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| (Dollars in millions) | December 31, 2020 | | December 31, 2019 |
| | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable Rate-Indexed: | | | | | | | |
| LIBOR | $ | 5,611 | | | 22 | % | | $ | 10,430 | | | 22 | % |
| SOFR | 118 | | | 1 | | | 500 | | | 1 | |
| Other | 82 | | | — | | | 221 | | | 1 | |
| Total | 5,811 | | | 23 | | | 11,151 | | | 24 | |
| Fixed-Rate: | | | | | | | |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 19,386 | | | 41 | |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 11,476 | | | 24 | |
Putable (2) | 2,657 | | | 11 | | | 1,444 | | | 3 | |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,358 | | | 5 | |
| Other | 1,151 | | | 5 | | | 1,449 | | | 3 | |
| Total | 19,196 | | | 77 | | | 36,113 | | | 76 | |
| | | | | | | |
| Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 47,264 | | | 100 | % |
| | | | | | | |
| Letters of Credit (notional) | $ | 28,812 | | | | | $ | 16,205 | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | December 31, 2020 | | September 30, 2020 | | June 30, 2020 | | March 31, 2020 |
| | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) | | Balance | | Percent(1) |
| Adjustable/Variable-Rate Indexed: | | | | | | | | | | | | | | | |
| LIBOR | $ | 5,611 | | | 22 | % | | $ | 5,846 | | | 22 | % | | $ | 21,071 | | | 44 | % | | $ | 28,889 | | | 36 | % |
| SOFR | 118 | | | 1 | | | 116 | | | — | | | 116 | | | — | | | 2,000 | | | 3 | |
| Other | 82 | | | — | | | 123 | | | 1 | | | 83 | | | — | | | 247 | | | — | |
| Total | 5,811 | | | 23 | | | 6,085 | | | 23 | | | 21,270 | | | 44 | | | 31,136 | | | 39 | |
| Fixed-Rate: | | | | | | | | | | | | | | | |
| Repurchase based (REPO) | 3,780 | | | 15 | | | 3,896 | | | 15 | | | 8,978 | | | 18 | | | 28,058 | | | 35 | |
| Regular Fixed-Rate | 9,587 | | | 38 | | | 10,207 | | | 38 | | | 11,445 | | | 24 | | | 14,452 | | | 18 | |
Putable (2) | 2,657 | | | 11 | | | 3,107 | | | 12 | | | 3,164 | | | 6 | | | 3,164 | | | 4 | |
| Amortizing/Mortgage Matched | 2,021 | | | 8 | | | 2,195 | | | 8 | | | 2,309 | | | 5 | | | 2,439 | | | 3 | |
| Other | 1,151 | | | 5 | | | 1,158 | | | 4 | | | 1,241 | | | 3 | | | 680 | | | 1 | |
| Total | 19,196 | | | 77 | | | 20,563 | | | 77 | | | 27,137 | | | 56 | | | 48,793 | | | 61 | |
| | | | | | | | | | | | | | | |
| Total Advances Principal | $ | 25,007 | | | 100 | % | | $ | 26,648 | | | 100 | % | | $ | 48,407 | | | 100 | % | | $ | 79,929 | | | 100 | % |
| | | | | | | | | | | | | | | |
| Letters of Credit (notional) | $ | 28,812 | | | | | $ | 23,011 | | | | | $ | 22,381 | | | | | $ | 15,785 | | | |
(1)As a percentage of total Advances principal.
(2)Excludes Putable Advances where the related put options have expired or where the Advance is indexed to a variable-rate. These Advances are classified based on their current terms.
Advance balances at December 31, 2020 decreased 47 percent compared to year-end 2019. Advance balances declined in 2020 as large-asset members reduced their borrowings. The reduction in borrowings was primarily driven by these members generally experiencing an inflow of deposits on their balance sheets, while also having access to other liquidity sources as a result of certain government actions related to the pandemic. Despite the overall decline, Advances spiked across our membership at the end of the first quarter of 2020 as the financial markets reacted to the COVID-19 pandemic, and members
turned to us for liquidity, primarily in the form of LIBOR and REPO Advances. Most of these Advances matured or prepaid by the end of 2020.
Advance Usage
In addition to analyzing Advance balances by dollar trends, we monitor the degree to which members use Advances to fund their balance sheets. The following table shows the unweighted, average ratio of each member's Advance balance to its most-recently available figures for total assets.
| | | | | | | | | | | | | | | | | | |
| | December 31, 2020 | | | | | | | | | December 31, 2019 |
| Average Advances-to-assets for members | | | | | | | | | | |
| Assets less than $1.0 billion (514 members) | 1.99 | % | | | | | | | | | 2.55 | % |
| Assets over $1.0 billion (114 members) | 2.11 | | | | | | | | | | 3.31 | |
| All members | 2.01 | | | | | | | | | | 2.67 | |
The following table shows Advance usage of members by charter type.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | |
| (Dollars in millions) | December 31, 2020 | | December 31, 2019 |
| Principal Amount of Advances | | Percent of Total Principal Amount of Advances | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances |
| Commercial Banks | $ | 9,530 | | | 38 | % | | $ | 31,590 | | | 67 | % |
| Savings Institutions | 4,922 | | | 20 | | | 5,689 | | | 12 | |
| Credit Unions | 1,344 | | | 5 | | | 1,307 | | | 3 | |
| Insurance Companies | 9,201 | | | 37 | | | 8,629 | | | 18 | |
| Community Development Financial Institutions | — | | | — | | | 1 | | | — | |
| Total member Advances | 24,997 | | | 100 | | | 47,216 | | | 100 | |
| Former member borrowings | 10 | | | — | | | 48 | | | — | |
| Total principal amount of Advances | $ | 25,007 | | | 100 | % | | $ | 47,264 | | | 100 | % |
The following tables present principal balances for the five members with the largest Advance borrowings.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (Dollars in millions) | | | | | | | | | | |
| December 31, 2020 | | December 31, 2019 |
| Name | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances | | Name | | Principal Amount of Advances | | Percent of Total Principal Amount of Advances |
| U.S. Bank, N.A. | | $ | 4,273 | | | 17 | % | | U.S. Bank, N.A. | | $ | 13,874 | | | 29 | % |
| Third Federal Savings and Loan Association | | 3,443 | | | 14 | | | JPMorgan Chase Bank, N.A. | | 4,500 | | | 10 | |
| Nationwide Life Insurance Company | | 2,062 | | | 8 | | | Third Federal Savings and Loan Association | | 3,883 | | | 8 | |
| Protective Life Insurance Company | | 1,955 | | | 8 | | | First Horizon Bank | | 2,200 | | | 5 | |
| Western-Southern Life Assurance Co. | | 1,344 | | | 5 | | | Pinnacle Bank | | 2,063 | | | 4 | |
| Total of Top 5 | | $ | 13,077 | | | 52 | % | | Total of Top 5 | | $ | 26,520 | | | 56 | % |
Advance concentration ratios are influenced by, and generally similar to, concentration ratios of financial activity among our Fifth District financial institutions. We believe that having large financial institutions that actively use our Mission Assets augments the value of membership to all members. For example, such activity improves our operating efficiency, increases our earnings and thereby contributions to housing and community investment programs. This activity may enable us to obtain more favorable funding costs, and helps us maintain competitively priced Mission Assets.
Mortgage Loans Held for Portfolio (Mortgage Purchase Program, or MPP)
The table below shows principal purchases and reductions of loans in the MPP for each of the last two years.
| | | | | | | | | | | | | |
| | | | | |
| (In millions) | 2020 | | | 2019 | |
| Balance, beginning of year | $ | 10,981 | | | | $ | 10,272 | | |
| Principal purchases | 2,626 | | | | 2,631 | | |
| Principal reductions | (4,291) | | | | (1,922) | | |
| Balance, end of year | $ | 9,316 | | | | $ | 10,981 | | |
Although there were 82 active members participating in the MPP during 2020, approximately 50 percent of the principal purchases in 2020 resulted from activity of our seven largest sellers. All loans acquired in 2020 were conventional loans.
The following tables show the percentage of principal balances from Participating Financial Institutions (PFIs) supplying five percent or more of total principal and the percentage of principal balances from all other PFIs. As shown below, MPP activity is concentrated amongst a few members.
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | |
| (Dollars in millions) | December 31, 2020 | | | December 31, 2019 |
| | Principal | | % of Total | | | Principal | | % of Total |
| Union Savings Bank | $ | 2,826 | | | 30 | % | | Union Savings Bank | $ | 3,574 | | | 33 | % |
| Guardian Savings Bank FSB | 796 | | | 9 | | | Guardian Savings Bank FSB | 1,004 | | | 9 | |
| All others | 5,694 | | | 61 | | | FirstBank | 714 | | | 7 | |
| Total | $ | 9,316 | | | 100 | % | | All others | 5,689 | | | 51 | |
| | | | | Total | $ | 10,981 | | | 100 | % |
We closely track the refinancing incentives of our mortgage assets (including loans in the MPP and MBS) because the option for homeowners to change their principal payments normally represents the largest portion of our market risk exposure and can affect MPP balances. MPP principal paydowns increased in 2020 to a 30 percent annual constant prepayment rate, compared to the 14 percent rate for all of 2019, driven by reductions in mortgage rates. MPP yields on purchases in 2020, after consideration of funding and hedging costs, continued to offer favorable returns. However, MPP yields on existing portfolio balances, net of funding and hedging costs, have declined and are expected to remain at lower levels in the short-term due to the increased prepayment speeds noted above. Despite the lower yields on existing MPP balances, the metrics of portfolio return relative to their market and credit risks continue to indicate that the MPP has generated, and can be expected to continue to generate, a profitable long-term, risk-adjusted return.
Housing and Community Investment
In 2020, we accrued $31 million of earnings for the Affordable Housing Program, which will be awarded to members in 2019. This amount represents an increase of $3 million from 2017 due to the higher earnings in 2018.2021 through either our competitive or Welcome Home programs.
Including funds available in 20182020 from previous years, we had $29$28 million available for the competitive Affordable Housing Program in 2018,2020, which we awarded to 6749 projects through a single competitive offering. In addition, we disbursed $13over $11 million to 188178 members on behalf of 2,5532,206 homebuyers through the Welcome Home Program, which assists homebuyers with down payments and closing costs. In total, more than one-thirdapproximately 40 percent of members applied for funding under the two Affordable Housing Programs.
Additionally, in 2018,2020, our Board committed $1.5$2.0 million to the Carol M. Peterson Housing Fund, which helped 262332 homeowners, and replenishedcontinued its commitment to the Disaster Reconstruction Program. Furthermore, in support of our members during the COVID-19 pandemic, we created a new Advance program that offered Advances with terms up to six months at zero percent interest to members between May 1, 2020 and September 30, 2020. These Advances supported COVID-19 related assistance made by all Fifth District members. In 2020, we issued a total of $183 million of these Advances of which $34 million remained outstanding at December 31, 2020. The Carol M. Peterson Housing Fund, Disaster Reconstruction Program (DRP) with an added $3.6 million, bringing the DRP fund to $5 million. Bothand COVID-19 related Advances are all voluntary programs beyond the 10 percent of earnings that we are required by law to set aside for the Affordable Housing Program.
Our activities to support affordable housing and economic development also include offering Advances through the Affordable Housing Program, Community Investment Program and Economic Development Program with below-market interest rates at or near funding costs. At the end of 2018,2020, Advance balances under these programs totaled $444$302 million.
Investments
The table below presents the ending and average balances of theour investment portfolio.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | |
| (In millions) | 2020 | | 2019 |
| | Ending Balance | | Average Balance | | Ending Balance | | Average Balance |
| Liquidity investments | $ | 17,285 | | | $ | 20,548 | | | $ | 20,924 | | | $ | 22,525 | |
| MBS | 9,756 | | | 11,864 | | | 13,465 | | | 15,029 | |
Other investments (1) | — | | | 459 | | | — | | 232 | |
| Total investments | $ | 27,041 | | | $ | 32,871 | | | $ | 34,389 | | | $ | 37,786 | |
|
| | | | | | | | | | | | | | | |
| (In millions) | 2018 | | 2017 |
| | Ending Balance | | Average Balance | | Ending Balance | | Average Balance |
| Liquidity investments | $ | 17,858 |
| | $ | 13,989 |
| | $ | 12,286 |
| | $ | 9,757 |
|
| MBS | 15,756 |
| | 15,741 |
| | 14,772 |
| | 14,710 |
|
Other investments (1) | — |
| | 64 |
| | — |
| | 84 |
|
| Total investments | $ | 33,614 |
| | $ | 29,794 |
| | $ | 27,058 |
| | $ | 24,551 |
|
| |
(1) | The average balance includes the rights or obligations to cash collateral, which are included in the fair value of derivative assets or derivative liabilities on the Statements of Condition at period end. |
(1)The average balance includes the rights or obligations to cash collateral, which are included in the fair value of derivative assets or derivative liabilities on the Statements of Condition at period end.
We continued
Liquidity investments are either short-term (primarily overnight), or longer-term, but can be easily sold and converted to maintaincash. It is normal for liquidity investments to vary by up to several billion dollars on a robust amount of asset liquidity.daily basis. Liquidity investment levels can vary significantly based on changes in the amount of actual Advances, anticipated demand for Advances, liquidity needs, the availability of acceptable net spreads, and the number of eligible counterparties that meet our unsecured credit risk criteria. It is normal for liquidity investments to vary by up to several billion dollars on a daily basis.
The higher amountbalance of liquidity investments was lower at December 31, 2018 was primarily2020 compared to year-end 2019 as we decided to hold more of our liquidity portfolio as deposits at the Federal Reserve in anticipation of volatile market conditions. At December 31, 2020, we held $3.0 billion in deposits at the Federal Reserve, which are reflected in cash and due from banks on the Statements of Condition. The average balance of liquidity investments in 2020 and 2019 were ample and relatively stable as we continued to volatility in Advance activity, especially short-term and variable-rate Advance borrowings.hold U.S. Treasury obligations to help meet regulatory liquidity requirements. Under the regulatory requirements, liquidity includes certain high-quality liquid assets, which are defined as U.S. Treasury obligations with remaining maturities of 10 years or less held as trading securities or available-for-sale securities.
Our overarching strategy for balances of MBS is to keep holdings as close as possible to the regulatory maximum ofmaximum. Finance Agency regulations prohibit us from purchasing MBS if our investment in these securities exceeds three times regulatory capital subjecton the day we intend to purchase the availability of securities that we believe provide acceptable risk/return tradeoffs.securities. The ratio of MBS to regulatory capital was 2.942.46 at December 31, 2018. 2020. The MBS ratio was lower than normal primarily due to the decline in MBS balances given paydowns in the low interest rate environment and the regulatory limitations regarding the purchase of investments that reference LIBOR. Given these limitations, we have not been able to fully replace the prepaid MBS with suitable alternatives that we believe provide an acceptable risk/return tradeoff.
The balance of MBS at December 31, 20182020 consisted of $13.7$8.7 billion of securities issued by Fannie Mae or Freddie Mac (of which $8.7$5.9 billion were floating-rate securities), $0.3 billion of floating-rate securities issued by the National Credit Union Administration (NCUA), and $1.7$1.0 billion of securities issued by Ginnie Mae (which are primarily fixed rate). We held no private-label MBS.
The table below shows principal purchases and paydowns of our MBS for each of the last two years.
| | | | | | | | | | | |
| (In millions) | MBS Principal |
| 2020 | | 2019 |
| Balance, beginning of year | $ | 13,447 | | | $ | 15,734 | |
| Principal purchases | 149 | | | 1,205 | |
| Principal paydowns | (3,851) | | | (3,492) | |
| | | |
| Balance, end of year | $ | 9,745 | | | $ | 13,447 | |
|
| | | | | | | |
| (In millions) | MBS Principal |
| | 2018 | | 2017 |
| Balance, beginning of year | $ | 14,746 |
| | $ | 14,487 |
|
| Principal purchases | 3,839 |
| | 2,679 |
|
| Principal paydowns | (2,851 | ) | | (2,420 | ) |
| Balance, end of year | $ | 15,734 |
| | $ | 14,746 |
|
PrincipalMBS principal paydowns in 20182020 equated to a 1627 percent annual constant prepayment rate, compared to a 15up from the 20 percent rate experienced in 2017.2019. The higher prepayment rate experienced in 2020 is a result of the historically low mortgage rate environment.
Consolidated Obligations
The table below presents the ending and average balances of our participations in Consolidated Obligations.
|
| | | | | | | | | | | | | | | |
| (In millions) | 2018 | | 2017 |
| | Ending Balance | | Average Balance | | Ending Balance | | Average Balance |
| Discount Notes: | | | | | | | |
| Par | $ | 47,071 |
| | $ | 49,273 |
| | $ | 46,259 |
| | $ | 43,166 |
|
| Discount | (127 | ) | | (88 | ) | | (48 | ) | | (42 | ) |
| Total Discount Notes | 46,944 |
| | 49,185 |
| | 46,211 |
| | 43,124 |
|
| Bonds: | | | | | | | |
| Unswapped fixed-rate | 25,982 |
| | 26,566 |
| | 26,710 |
| | 26,707 |
|
| Unswapped adjustable-rate | 15,470 |
| | 16,967 |
| | 20,895 |
| | 18,500 |
|
| Swapped fixed-rate | 4,195 |
| | 5,982 |
| | 6,552 |
| | 7,131 |
|
| Total par Bonds | 45,647 |
| | 49,515 |
| | 54,157 |
| | 52,338 |
|
Other items (1) | 12 |
| | (13 | ) | | 6 |
| | 29 |
|
| Total Bonds | 45,659 |
| | 49,502 |
| | 54,163 |
| | 52,367 |
|
Total Consolidated Obligations (2) | $ | 92,603 |
| | $ | 98,687 |
| | $ | 100,374 |
| | $ | 95,491 |
|
| |
(1) | Includes unamortized premiums/discounts, fair value option valuation adjustments, hedging and other basis adjustments. |
| |
(2) | The 11 FHLBanks have joint and several liability for the par amount of all of the Consolidated Obligations issued on their behalves. The par amount of the outstanding Consolidated Obligations for all of the FHLBanks was (in millions) $1,031,617 and $1,034,260 at December 31, 2018 and 2017, respectively.
|
The balances of Consolidated Obligations fluctuate with changes in the balances of our assets. For example, the volatility in certain Advances and liquidity investments contributed to the higher average balance of Discount Notes in 2018. Additionally, the decline in unswapped adjustable-rate Bonds at December 31, 2018 was primarily due to lower variable-rate Advance balances. We fund variable-rate assets with Discount Notes (a portion of which may be swapped), adjustable-rate Bonds, and swapped fixed-rate Bonds because they give us the ability to effectively match the underlying rate reset periods embedded in these assets. The balances and composition of our Consolidated Obligations tend to fluctuate with changes in the balances and composition of our assets. In addition, changes in the amount and composition of our funding may be necessary from time to time to meet the days positive liquidity and asset/liability maturity funding gap requirements discussed in the "Liquidity Risk" section of "Quantitative and Qualitative Disclosures About Risk Management."
The compositiontable below presents the ending and average balances of our participations in Consolidated Obligations.
| | | | | | | | | | | | | | | | | | | | | | | |
| | | |
| (In millions) | 2020 | | 2019 |
| | Ending Balance | | Average Balance | | Ending Balance | | Average Balance |
| Discount Notes: | | | | | | | |
| Unswapped | $ | 27,503 | | | $ | 39,478 | | | $ | 36,776 | | | $ | 39,286 | |
| Swapped | — | | | 3,843 | | | 12,401 | | | 5,291 | |
| Total par Discount Notes | 27,503 | | | 43,321 | | | 49,177 | | | 44,577 | |
Other items (1) | (3) | | | (37) | | | (93) | | | (95) | |
| Total Discount Notes | 27,500 | | | 43,284 | | | 49,084 | | | 44,482 | |
| Bonds: | | | | | | | |
| Unswapped fixed-rate | 18,940 | | | 21,288 | | | 22,420 | | | 24,423 | |
Unswapped adjustable-rate (2) | 10,639 | | | 13,394 | | | 11,012 | | | 16,132 | |
| Swapped fixed-rate | 2,372 | | | 3,547 | | | 4,949 | | | 5,310 | |
| Total par Bonds | 31,951 | | | 38,229 | | | 38,381 | | | 45,865 | |
Other items (1) | 46 | | | 68 | | | 59 | | | 44 | |
| Total Bonds | 31,997 | | | 38,297 | | | 38,440 | | | 45,909 | |
Total Consolidated Obligations (3) | $ | 59,497 | | | $ | 81,581 | | | $ | 87,524 | | | $ | 90,391 | |
(1)Includes unamortized premiums/discounts, fair value option valuation adjustments, hedging and other basis adjustments.
(2)Unswapped adjustable-rate Bonds are indexed to either LIBOR or SOFR. At December 31, 2020, 100 percent were indexed to SOFR. At December 31, 2019, 1 percent were indexed to LIBOR and 99 percent were indexed to SOFR.
(3)The 11 FHLBanks have joint and several liability for the par amount of all of the Consolidated Obligations issued on their behalves. The par amount of the outstanding Consolidated Obligations for all of the FHLBanks was (in millions) $746,772 and $1,025,895 at December 31, 2020 and 2019, respectively.
The ending balance of Discount Notes was lower at December 31, 2020 compared to year-end 2019 due to the reduction in short-term and variable-rate Advances in the last three quarters of 2020. Additionally, given our preference to use unswapped Discount Notes and unswapped adjustable-rate Bonds in the current market environment, we had no swapped Discount Notes outstanding at December 31, 2020. The average balance of Discount Notes in 2020 was significantly higher compared to the balance at the end of 2020 due to the growth in short-term and variable-rate Advances across our membership at the end of the first quarter of 2020 as the financial markets reacted to the COVID-19 pandemic.
The average balance of unswapped fixed-rate Bonds, which typically have initial maturities greater than one year, was relatively stabledeclined in 20182020 compared to 2017. the average balance in 2019 due to terminating higher coupon fixed-rate Bonds with embedded options as interest rates fell.
The following table shows the allocation on December 31, 20182020 of unswapped fixed-rate Bonds according to their final remaining maturity and next call date (for callable Bonds). We believe that the allocations of Bonds among these classifications provide effective mitigation of market risk exposure to both higher and lower interest rates.
| | | | | | | | | | | | | | | | | | |
| | | | | | |
| (In millions) | Year of Maturity | | Year of Next Call |
| | Callable | Noncallable | | Total | | Callable |
| Due in 1 year or less | $ | — | | $ | 5,797 | | | $ | 5,797 | | | $ | 4,292 | |
| Due after 1 year through 2 years | 25 | | 2,662 | | | 2,687 | | | 120 | |
| Due after 2 years through 3 years | 936 | | 2,363 | | | 3,299 | | | — | |
| Due after 3 years through 4 years | 540 | | 1,253 | | | 1,793 | | | — | |
| Due after 4 years through 5 years | 1,182 | | 728 | | | 1,910 | | | — | |
| Thereafter | 1,729 | | 1,725 | | | 3,454 | | | — | |
| Total | $ | 4,412 | | $ | 14,528 | | | $ | 18,940 | | | $ | 4,412 | |
|
| | | | | | | | | | | | | |
| (In millions) | Year of Maturity | | Year of Next Call |
| | Callable | Non-callable | Total | | Callable |
| Due in 1 year or less | $ | 704 |
| $ | 4,738 |
| $ | 5,442 |
| | $ | 6,268 |
|
| Due after 1 year through 2 years | 1,036 |
| 4,179 |
| 5,215 |
| | 36 |
|
| Due after 2 years through 3 years | 1,629 |
| 3,121 |
| 4,750 |
| | — |
|
| Due after 3 years through 4 years | 394 |
| 2,471 |
| 2,865 |
| | — |
|
| Due after 4 years through 5 years | 952 |
| 2,232 |
| 3,184 |
| | — |
|
| Thereafter | 1,589 |
| 2,937 |
| 4,526 |
| | — |
|
| Total | $ | 6,304 |
| $ | 19,678 |
| $ | 25,982 |
| | $ | 6,304 |
|
Deposits
Total deposits with us are normally a relatively minor source of low-cost funding. Total interest bearinginterest-bearing deposits at December 31, 20182020 were $0.7$1.3 billion, an increase of two percent$0.4 billion from year-end 2017. The average balance of total interest bearing deposits in 2018 was $0.8 billion, an 18 percent increase from the average balance during 2017.2019.
Derivatives Hedging Activity and Liquidity
Our use of derivatives is discussed in the "Effect of the Use of Derivatives on Net Interest Income" sectionand "Non-Interest Income (Loss)" sections in "Results of Operations." Liquidity is discussed in the "Liquidity Risk" section in “Quantitative and Qualitative Disclosures About Risk Management.”
Capital Resources
The following tables present capital amounts and capital-to-assets ratios, on both a GAAP and regulatory basis. We consider the regulatory ratio to be a better representation of financial leverage than the GAAP ratio because, although the GAAP ratio treats mandatorily redeemable capital stock as a liability, it protects investors in our debt in the same manner as GAAP capital stock and retained earnings.
| | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| | | |
| (In millions) | 2020 | | 2019 |
| Period End | | Average | | Period End | | Average |
| GAAP and Regulatory Capital | | | | | | | |
| GAAP Capital Stock | $ | 2,641 | | | $ | 3,567 | | | $ | 3,367 | | | $ | 3,827 | |
| Mandatorily Redeemable Capital Stock | 19 | | | 55 | | | 22 | | | 25 | |
| Regulatory Capital Stock | 2,660 | | | 3,622 | | | 3,389 | | | 3,852 | |
| Retained Earnings | 1,304 | | | 1,228 | | | 1,094 | | | 1,069 | |
| Regulatory Capital | $ | 3,964 | | | $ | 4,850 | | | $ | 4,483 | | | $ | 4,921 | |
|
| | | | | | | | | | | | | | | |
| | Year Ended December 31, |
| (In millions) | 2018 | | 2017 |
| | Period End | | Average | | Period End | | Average |
| GAAP and Regulatory Capital | | | | | | | |
| GAAP Capital Stock | $ | 4,320 |
| | $ | 4,387 |
| | $ | 4,241 |
| | $ | 4,183 |
|
| Mandatorily Redeemable Capital Stock | 23 |
| | 30 |
| | 30 |
| | 46 |
|
| Regulatory Capital Stock | 4,343 |
| | 4,417 |
| | 4,271 |
| | 4,229 |
|
| Retained Earnings | 1,023 |
| | 1,025 |
| | 940 |
| | 928 |
|
| Regulatory Capital | $ | 5,366 |
| | $ | 5,442 |
| | $ | 5,211 |
| | $ | 5,157 |
|
| | | | | | | | | | | | | | | | | | | | | | | |
| | | |
| 2020 | | 2019 |
| | Period End | | Average | | Period End | | Average |
| GAAP and Regulatory Capital-to-Assets Ratio | | | | | | | |
| GAAP | 6.02 | % | | 5.39 | % | | 4.75 | % | | 5.04 | % |
Regulatory (1) | 6.07 | | | 5.47 | | | 4.79 | | | 5.08 | |
(1) At all times, the FHLBanks must maintain at least a four percent minimum regulatory capital-to-assets ratio.
|
| | | | | | | | | | | |
| | 2018 | | 2017 |
| | Period End | | Average | | Period End | | Average |
| GAAP and Regulatory Capital-to-Assets Ratio | | | | | | | |
| GAAP | 5.37 | % | | 5.11 | % | | 4.83 | % | | 5.00 | % |
Regulatory (1) | 5.41 |
| | 5.16 |
| | 4.88 |
| | 5.06 |
|
| |
(1) | At all times, the FHLBanks must maintain at least a four percent minimum regulatory capital-to-assets ratio. |
The following table presents the sources of change in regulatory capital stock balances in 20182020 and 2017.2019.
| | | (In millions) | 2018 | | 2017 | (In millions) | 2020 | | 2019 |
| Regulatory stock balance at beginning of year | $ | 4,271 |
| | $ | 4,192 |
| Regulatory stock balance at beginning of year | $ | 3,389 | | | $ | 4,343 | |
| Stock purchases: | | | | Stock purchases: | |
| Membership stock | 25 |
| | 13 |
| Membership stock | 25 | | | 157 | |
| Activity stock | 413 |
| | 341 |
| Activity stock | 2,110 | | | 435 | |
| Stock repurchases/redemptions: | | | | Stock repurchases/redemptions: | |
| Redemption of member excess | (40 | ) | | (259 | ) | Redemption of member excess | (558) | | | — | |
| Repurchase of member excess | (297 | ) | | — |
| Repurchase of member excess | (2,300) | | | (1,538) | |
| Withdrawals | (29 | ) | | (16 | ) | Withdrawals | (6) | | | (8) | |
| Regulatory stock balance at the end of the year | $ | 4,343 |
| | $ | 4,271 |
| Regulatory stock balance at the end of the year | $ | 2,660 | | | $ | 3,389 | |
Members' purchases of capital stock in 2020 were primarily to support Advance growth at the end of the first quarter. However, the decrease in GAAP and regulatory capital balances was primarily due to our repurchase of excess capital stock as Advance balances subsequently declined.
The table below shows the amount of excess capital stock.
| | | (In millions) | December 31, 2018 | | December 31, 2017 | (In millions) | December 31, 2020 | | December 31, 2019 |
| Excess capital stock (Capital Plan definition) | $ | 1,015 |
| | $ | 391 |
| Excess capital stock (Capital Plan definition) | $ | 228 | | | $ | 37 | |
| Cooperative utilization of capital stock | $ | 558 |
| | $ | 585 |
| Cooperative utilization of capital stock | $ | 380 | | | $ | 781 | |
| Mission Asset Activity capitalized with cooperative capital stock | $ | 13,950 |
| | $ | 14,620 |
| Mission Asset Activity capitalized with cooperative capital stock | $ | 9,499 | | | $ | 19,536 | |
A portion of our capital stock is excess, meaning it is not required as a condition to being a member and is not currently capitalizing Mission Asset Activity. Excess capital stock provides a base of capital to manage financial leverage at prudent levels, augments loss protections for bondholders, and capitalizesmay be used to capitalize a portion of growth in Mission Assets. TheAt December 31, 2020, the amount of excess
See the "Capital Adequacy" section in “Quantitative and Qualitative Disclosures About Risk Management” for discussion of our retained earnings.
The following table provides the number of member stockholders by charter type.
