Derivatives and Hedging Activities

Nature of Business Activity. The Bank is exposed to interest rate risk primarily from the effect of interest rate changes on its interest-earning assets and funding sources that finance these assets. The goal of the Bank’s interest rate risk management strategy is not to eliminate interest rate risk, but to manage it within appropriate limits. To mitigate the risk of loss, the Bank has established policies and procedures which include guidelines on the amount of exposure to interest rate changes it is willing to accept.

Consistent with Finance Agency requirements, the Bank enters into derivatives to manage the interest rate risk exposures inherent in otherwise unhedged assets and funding positions and to achieve the Bank’s risk management objectives. Finance Agency regulation and the Bank’s Risk Governance Policy prohibit trading in or the speculative use of derivative instruments and limit credit risk arising from these instruments. The Bank may use derivatives to reduce funding costs for consolidated obligations and to manage interest rate risk and mortgage prepayment risk positions. Interest rate swaps (also referred to as derivatives) are an integral part of the Bank’s financial management strategy.

The Bank may use derivatives to:


•	reduce interest rate sensitivity and repricing gaps of assets, liabilities and interest rate exchange agreements;


•	reduce funding costs by combining a derivative with a consolidated obligation as the cost of a combined funding structure can be lower than the cost of a comparable consolidated obligation bond;


•	preserve a favorable interest rate spread between the yield of an asset (e.g., an advance) and the cost of the related liability (e.g., the consolidated obligation bond used to fund the advance). Without the use of derivatives, this interest rate spread could be reduced or eliminated when a change in the interest rate on the advance does not match a change in the interest rate on the bond;


•	mitigate the adverse earnings effects of the shortening or extension of certain assets (e.g., advances or mortgage assets) and liabilities;


•	protect the value of existing asset or liability positions or of anticipated transactions;


•	manage embedded options in assets and liabilities; and


•	manage its overall asset/liability portfolio.

Types of Interest Rate Exchange Agreements. The Bank’s Risk Governance Policy establishes guidelines for its use of interest rate exchange agreements. The Bank can use instruments such as the following to reduce funding costs and to manage exposure to interest rate risks inherent in the normal course of business:


•	interest rate swaps;


•	interest rate swaptions; and


•	interest rate caps or floors.

A strategy the Bank may use to manage interest rate risk is to acquire and maintain a portfolio of assets and liabilities which, together with associated interest rate derivatives, limits the Bank’s risk exposure. The Bank may use interest rate derivatives to adjust the effective maturity, repricing frequency, or option characteristics of financial instruments (such as advances, MPF loans, MBS, and consolidated obligations) to achieve risk management objectives.

Interest Rate Swaps. An interest rate swap is an agreement between two entities to exchange cash flows in the future. The agreement sets the dates on which the cash flows will be paid and the manner in which the cash flows will be calculated. One of the simplest forms of an interest rate swap involves the promise by one party to pay cash flows equivalent to the interest on a notional amount at a predetermined fixed rate for a given period of time. In return for this promise, this party receives cash flows equivalent to the interest on the same notional amount at a variable-rate index for the same period of time. The variable rate received by the Bank in most interest rate exchange agreements is LIBOR.

Swaptions. A swaption is an option on a swap that gives the buyer the right to enter into a specified interest rate swap at a certain time in the future. When used as a hedge, a swaption can protect the Bank when it is planning to lend or borrow funds in the future against future interest rate changes. The Bank may purchase both payer swaptions and receiver swaptions. A payer swaption is the option to make fixed interest payments at a later date and a receiver swaption is the option to receive fixed interest payments at a later date.

Interest Rate Cap and Floor Agreements. In an interest rate cap agreement, a cash flow is generated if the price or rate of an underlying variable rises above a certain threshold (or cap) price. In an interest rate floor agreement, a cash flow is generated if the price or rate of an underlying variable falls below a certain threshold (or floor) price. Caps and floors are designed as protection against the interest rate on a variable-rate asset or liability falling below or rising above a certain level.

Application of Interest Rate Exchange Agreements. Derivative financial instruments are used by the Bank in three ways:


•	by designating them as a fair value or cash flow hedge of an associated financial instrument, a firm commitment or an anticipated transaction; or


•	in asset/liability management (i.e.,“economic” hedges that do not qualify for hedge accounting).

The Bank reevaluates its hedging strategies from time to time and may change the hedging techniques it uses or adopt new strategies.

Management uses derivatives when they are considered to be a cost-effective alternative to achieve the Bank’s financial and risk management objectives. Accordingly, the Bank may enter into derivatives that do not qualify for hedge accounting (economic hedges).

Types of Hedged Items. The Bank documents at inception all relationships between derivatives designated as hedging instruments and hedged items, its risk management objectives and strategies for undertaking various hedge transactions, and its method of assessing effectiveness. This process includes linking all derivatives that are designated as fair value or cash flow hedges to (1) assets and liabilities on the Statement of Condition, (2) firm commitments, or (3) forecasted transactions. The Bank also formally assesses (both at the hedge’s inception and on a monthly basis) whether the derivatives that it uses in hedging transactions have been effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain effective in future periods. The Bank uses regression analyses to assess the effectiveness of its hedges.

Consolidated Obligations. While consolidated obligations are the joint and several obligations of the FHLBanks, each FHLBank has consolidated obligations for which it is the primary obligor. To date, no FHLBank has ever had to assume or pay the consolidated obligations of another FHLBank. The Bank enters into derivatives to hedge the interest rate risk associated with its specific debt issuances. The Bank manages the risk arising from changing market prices and volatility of a consolidated obligation by matching the cash inflow on the interest rate exchange agreement with the cash outflow on the consolidated obligation.

For instance, in a typical transaction, fixed-rate consolidated obligations are issued by the Bank, and the Bank simultaneously enters into a matching derivative in which the counterparty pays fixed cash flows designed to mirror, in timing and amount, the cash outflows the Bank pays on the consolidated obligation. The Bank pays a variable cash flow that closely matches the interest payments it receives on short-term or variable-rate advances (typically one- or three-month LIBOR). The fixed-rate obligation and matching derivative are treated as fair value hedge relationships. The Bank may issue variable-rate consolidated bonds indexed to LIBOR, the U.S. Prime rate, or Federal funds rate and simultaneously execute interest rate swaps to hedge the basis risk of the variable-rate debt. Basis risk represents the risk that changes to one interest rate index will not perfectly offset changes to another interest rate index.

This strategy of issuing bonds while simultaneously entering into derivatives enables the Bank to offer a wider range of attractively priced advances to its members and may allow the Bank to reduce its funding costs. The continued attractiveness of such debt depends on yield relationships between the bond and interest rate exchange markets. If conditions in these markets change, the Bank may alter the types or terms of the bonds that it issues. By acting in both the capital and the swap markets, the Bank can generally raise funds at lower costs than through the issuance of simple fixed- or variable-rate consolidated obligations in the capital markets alone.

Advances. The Bank offers a wide array of advance structures to meet members’ funding needs. These advances may have maturities up to 30 years with variable or fixed rates and may include early termination features or options. The Bank may use derivatives to adjust the repricing and/or options characteristics of advances in order to match more closely the characteristics of the funding liabilities. In general, whenever a member executes a fixed-rate advance or a variable-rate advance with embedded options, the Bank will simultaneously execute a derivative that offsets the terms and embedded options, if any, in the advance. For example, the Bank may hedge a fixed-rate advance with an interest rate swap where the Bank pays a fixed-rate coupon and receives a variable-rate coupon, effectively converting the fixed-rate advance to a variable-rate advance. This type of hedge is typically treated as a fair value hedge.

When issuing convertible advances, the Bank may purchase put options from a member that allow the Bank to convert the advance from a fixed rate to a variable rate if interest rates increase/decrease. A convertible advance carries an interest rate lower than a comparable-maturity fixed-rate advance that does not have the conversion feature. With a putable advance, the Bank effectively purchases a put option from the member that allows the Bank to put or extinguish the fixed-rate advance, which the Bank normally would exercise when interest rates increase. The Bank may hedge these advances by entering into a cancelable interest rate exchange agreement.

Mortgage Loans. The Bank invests in fixed-rate mortgage loans. The prepayment options embedded in these mortgage loans can result in extensions or contractions in the expected repayment of these investments, depending on changes in estimated prepayment speeds. The Bank manages the interest rate and prepayment risks associated with mortgages through a combination of debt issuance and, at times, derivatives, such as interest rate caps and floors, swaptions and callable swaps.

Although these derivatives are valid economic hedges against the prepayment risk of the loans, they are not specifically linked to individual loans and, therefore, do not receive either fair value or cash flow hedge accounting. These derivatives are marked-to-market through earnings.

Anticipated Streams of Future Cash Flows. The Bank may enter into an option to hedge a specified future variable cash flow stream as a result of rolling over short-term, fixed-rate financial instruments such as LIBOR advances and consolidated discount notes. The option will effectively cap the variable cash stream at a predetermined target rate.

Firm Commitments. Certain mortgage purchase commitments are considered derivatives. When the mortgage purchase commitment derivative settles, the current market value of the commitment is included with the basis of the mortgage loan and amortized accordingly.

The Bank may also hedge a firm commitment for a forward starting advance through the use of an interest rate swap. In this case, the swap will function as the hedging instrument for both the firm commitment and the subsequent advance. Because the firm commitment ends at the same exact time that the advance is settled, the fair value change associated with the firm commitment is effectively rolled into the basis of the advance.

Investments. The Bank primarily invests in certificates of deposit, U.S. Treasuries, U.S. agency obligations, MBS, and the taxable portion of state or local housing finance agency obligations, which may be classified as HTM, AFS or trading securities. The interest rate and prepayment risks associated with these investment securities are managed through a combination of debt issuance and from time to time, derivatives. The Bank may manage the prepayment and interest rate risks by funding investment securities with consolidated obligations that have call features or by hedging the prepayment risk with caps or floors, callable swaps or swaptions. The Bank may manage duration risk by funding investment securities with consolidated obligations that contain call features. The Bank may also manage the risk arising from changing market prices and volatility of investment securities by matching the cash outflow on the derivatives with the cash inflow on the investment securities. If the Bank held derivatives associated with trading securities, carried at fair value, or HTM securities, carried at amortized cost, they would be designated as economic hedges. If the Bank held AFS securities that have been hedged, those securities may qualify as either a fair value hedge or a cash flow hedge.

Anticipated Debt Issuance. The Bank may enter into interest rate swaps for the anticipated issuance of fixed-rate consolidated obligations (bonds) to lock in the cost of funding. The interest rate swap is terminated upon issuance of the fixed-rate consolidated obligations (bond) with the realized gain or loss on the interest rate swap recorded in other comprehensive income (loss). Realized gains and losses reported in AOCI are recognized as earnings in the periods in which earnings are affected by the cash flows of the fixed-rate consolidated obligations (bonds). This type of hedge is typically treated as a cash flow hedge.

Financial Statement Effect and Additional Financial Information. Derivative Notional Amounts. The notional amount of derivatives serves as a factor in determining periodic interest payments or cash flows received and paid. However, the notional amount of derivatives represents neither the actual amounts exchanged nor the overall exposure of the Bank to credit and market risk. Additionally, notional values are not meaningful measures of the risks associated with derivatives.

The following tables summarize the notional and fair value of derivative instruments as of December 31, 2012 and 2011.



	December 31, 2012
(in thousands)	Notional Amount of Derivatives		Derivative Assets			Derivative Liabilities
Derivatives in hedge accounting relationships:
Interest rate swaps	$	25,661,620	$	273,265		$	878,667
Derivatives not in hedge accounting relationships:
Interest rate swaps	$	4,318,343	$	37,767		$	6,036
Interest rate caps	1,199,750		1,968			—
Mortgage delivery commitments	34,332		622			—
Total derivatives not in hedge accounting relationships	$	5,552,425	$	40,357		$	6,036
Total derivatives before netting and collateral adjustments	$	31,214,045	$	313,622		$	884,703
Netting adjustments			(253,923		)	(253,923		)
Cash collateral and related accrued interest			(31,896		)	(320,355		)
Total collateral and netting adjustments⁽¹⁾			(285,819		)	(574,278		)
Derivative assets and derivative liabilities as reported on the Statement of Condition			$	27,803		$	310,425



	December 31, 2011
(in thousands)	Notional Amount of Derivatives		Derivative Assets			Derivative Liabilities
Derivatives in hedge accounting relationships:
Interest rate swaps	$	27,389,135	$	368,159		$	1,306,235
Derivatives not in hedge accounting relationships:
Interest rate swaps	$	2,241,681	$	1,378		$	7,029
Interest rate caps	1,466,750		4,146			15
Mortgage delivery commitments	13,984		158			8
Total derivatives not in hedge accounting relationships	$	3,722,415	$	5,682		$	7,052
Total derivatives before netting and collateral adjustments	$	31,111,550	$	373,841		$	1,313,287
Netting adjustments			(329,297		)	(329,297		)
Cash collateral and related accrued interest			(8,288		)	(542,015		)
Total collateral and netting adjustments⁽¹⁾			(337,585		)	(871,312		)
Derivative assets and derivative liabilities as reported on the Statement of Condition			$	36,256		$	441,975

Note:

⁽¹⁾Amounts represent the effect of legally enforceable master netting agreements that allow the Bank to settle positive and negative positions and also cash collateral held or placed with the same counterparties.

The following table presents the components of net gains (losses) on derivatives and hedging activities as presented in the Statement of Income.



	Year ended December 31,
(in thousands)	2012			2011			2010
Derivatives and hedged items in fair value hedging relationships:
Interest rate swaps - fair value hedge ineffectiveness	$	5,752		$	(3,043	)	$	(335	)
Derivatives not designated as hedging instruments:
Economic hedges:
Interest rate swaps	$	(2,655	)	$	550		$	(1,961	)
Interest rate caps or floors	(2,162		)	(5,392		)	(4,960		)
Net interest settlements	2,311			(835		)	(1,364		)
Mortgage delivery commitments	7,525			2,765			3,000
Other	14			233			894
Total net gains (losses) related to derivatives not designated as hedging instruments	$	5,033		$	(2,679	)	$	(4,391	)
Net gains (losses) on derivatives and hedging activities	$	10,785		$	(5,722	)	$	(4,726	)

The following tables present, by type of hedged item, the gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the Bank’s net interest income for 2012, 2011 and 2010.



(in thousands)	Gains/(Losses) on Derivative			Gains/(Losses) on Hedged Item			Net Fair Value Hedge Ineffectiveness		Effect of Derivatives on Net Interest Income⁽¹⁾
2012
Hedged item type:
Advances	$	416,309		$	(415,139	)	$	1,170	$	(371,423	)
Consolidated obligations – bonds	(75,235		)	79,817			4,582		180,474
Total	$	341,074		$	(335,322	)	$	5,752	$	(190,949	)



(in thousands)	Gains/(Losses) on Derivative			Gains/(Losses) on Hedged Item			Net Fair Value Hedge Ineffectiveness			Effect of Derivatives on Net Interest Income⁽¹⁾
2011
Hedged item type:
Advances	$	(44,474	)	$	41,958		$	(2,516	)	$	(486,288	)
Consolidated obligations – bonds	67,775			(68,302		)	(527		)	213,037
Total	$	23,301		$	(26,344	)	$	(3,043	)	$	(273,251	)



(in thousands)	Gains/(Losses) on Derivative		Gains/(Losses) on Hedged Item			Net Fair Value Hedge Ineffectiveness			Effect of Derivatives on Net Interest Income⁽¹⁾
2010
Hedged item type:
Advances	$	15,959	$	(16,676	)	$	(717	)	$	(770,733	)
Consolidated obligations – bonds	84,498		(84,116		)	382			368,876
Total	$	100,457	$	(100,792	)	$	(335	)	$	(401,857	)

Note:

⁽¹⁾Represents the net interest settlements on derivatives in fair value hedge relationships presented in the interest income/expense line item of the respective hedged item.

The Bank had no active cash flow hedging relationships during 2012 or 2011. As of December 31, 2012, the deferred net gains (losses) on derivative instruments in AOCI expected to be reclassified to earnings during the next 12 months, as well as the losses reclassified from AOCI into income, were not material.

Managing Credit Risk on Derivatives. The Bank is subject to credit risk due to nonperformance by counterparties to the derivative agreements. The Bank manages counterparty credit risk through credit analysis, reliance on netting provisions in its ISDA)agreements, collateral requirements and adherence to the requirements set forth in its ISDA agreements, policies and regulations. The Bank’s ISDA Master Agreements have typically required segregation of the Bank’s collateral posted with the counterparty and typically do not permit rehypothecation. In view of recent and expected continuing developments in the derivatives market, including OTC derivatives, the Bank anticipates managing this risk differently in the future including considering permitting re-hypothecation or not requiring collateral segregation.

The contractual or notional amount of derivatives reflects the involvement of the Bank in the various classes of financial instruments. The notional amount of derivatives does not measure the credit risk exposure of the Bank, and the maximum credit exposure of the Bank is substantially less than the notional amount. The Bank requires collateral agreements that establish collateral delivery thresholds by counterparty. The maximum credit risk is defined as the estimated cost of replacing interest rate swaps, mandatory delivery contracts for mortgage loans, and purchased caps and floors that have a net positive market value, assuming the counterparty defaults and the related collateral, if any, is of no value to the Bank.

The following table presents credit risk exposure on derivative instruments, excluding circumstances where a counterparty’s pledged collateral to the Bank exceeds the Bank’s net position.



	December 31,
(in thousands)	2012		2011
Credit risk exposure⁽¹⁾	$	59,699	$	44,544
Cash collateral held	31,896		8,288
Net exposure after cash collateral	27,803		36,256
Non-cash collateral held⁽²⁾	1,343		—
Net exposure after collateral	$	26,460	$	36,256

Note:

⁽¹⁾ Includes net accrued interest receivable of $6.6 million and $3.1 million at December 31, 2012 and 2011, respectively.

⁽²⁾ Typically consists of U.S. Treasury securities.

Generally, the Bank’s ISDA agreements contain provisions that require the Bank to post additional collateral with its counterparties if there is deterioration in its credit rating and the net liability position exceeds the relevant threshold. If the Bank’s credit rating is lowered by a major credit rating agency, the Bank would be required to deliver additional collateral on derivative instruments in net liability positions. The aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position (before cash collateral and related accrued interest) at December 31, 2012 was $630.8 million for which the Bank has posted cash and securities collateral with a fair value of approximately $577.9 million in the normal course of business. If the Bank’s credit rating had been lowered one notch (i.e., from its current rating to the next lower rating), the Bank would have been required to deliver up to an additional $37.2 million of collateral to its derivative counterparties at December 31, 2012.

The Bank transacts most of its derivatives with large banks and major broker-dealers. Some of these banks and broker-dealers or their affiliates buy, sell, and distribute consolidated obligations. Note 21 discusses assets pledged by the Bank to these counterparties. The Bank is not a derivatives dealer and does not trade derivatives for speculative purposes.