FEDERAL HOME LOAN BANK OF ATLANTA - 10-Q - 20071108 - MANAGEMENT_ANALYSIS
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Information
Some of the statements made in this quarterly report on Form 10-Q may be “forward-looking statements,” which include statements with respect to the plans, objectives, expectations, estimates and future
performance of the Bank and involve known and unknown risks, uncertainties, and other factors, many of which may be beyond the Bank’s control and which may cause the Bank’s actual results, performance, or achievements to be materially
different from future results, performance, or achievements expressed or implied by the forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. The reader can
identify these forward-looking statements through the Bank’s use of words such as “may,” “will,” “anticipate,” “hope,” “project,” “assume,” “should,” “indicate,”
“would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “could,” “intend,” “seek,” “target,” and
other similar words and expressions of the future. Such forward-looking statements include statements regarding any one or more of the following topics:
•
The Bank’s business strategy and changes in operations, including, without limitation, product growth and change in product mix
•
Future performance, including profitability, developments, or market forecasts
•
Forward-looking accounting and financial statement effects.
The forward-looking statements may not be realized due to a variety of factors, including, without limitation, those risk factors provided under Item 1A of the Bank’s Form 10-K and those risk factors presented under Item 1A
in Part II of this quarterly report on Form 10-Q.
All written or oral statements that are made by or are attributable to the Bank are expressly qualified
in their entirety by this cautionary notice. The reader should not place undue reliance on forward-looking statements, since the statements speak only as of the date that they are made. The Bank has no obligation and does not undertake publicly to
update, revise, or correct any of the forward-looking statements after the date of this quarterly report, or after the respective dates on which these statements otherwise are made, whether as a result of new information, future events, or
otherwise.
The discussion presented below provides an analysis of the Bank’s results of operations and financial condition for the three- and
nine-months ended September 30, 2007 and 2006. Management’s discussion and analysis should be read in conjunction with the financial statements and accompanying notes presented elsewhere in the report, as well as the Bank’s audited
financial statements for the year ended December 31, 2006.
The Bank is a cooperative whose primary business activity is providing loans, which the Bank refers to as
“advances,” to its members and eligible housing associates. The Bank also purchases single-family mortgage loans from members, makes grants and subsidized advances under its Affordable Housing Program (“AHP”), and provides
correspondent banking services to members and eligible nonmembers. The consolidated obligations issued by the Office of Finance on behalf of the Federal Home Loan Banks are the principal funding source for Bank assets. The Bank is primarily liable
for repayment of consolidated obligations issued on its behalf and is jointly and severally liable for the consolidated obligations issued on behalf of the other FHLBanks. Deposits, other borrowings, and the issuance of capital stock provide
additional funding to the Bank.
Financial Condition
As of September 30, 2007, total assets were $190.7 billion, an increase of $50.0 billion, or 35.5 percent, from December 31, 2006, primarily as a result of an increase in federal funds sold and advances. Advances, the largest
asset on the Bank’s balance sheet, increased by $37.8 billion, or 37.3 percent, during this same period. The significant increase in advances during this period, substantially all of which increase occurred during the third quarter, primarily
resulted from increased liquidity needs of the Bank’s members during the third quarter in light of unanticipated disruptions in the credit markets during that time. The Bank experienced demand from a variety of its member institutions, from
credit unions to commercial lenders, and that activity was spread throughout the Bank’s district. Most of these new advances have a contractual maturity of four years or less.
As of September 30, 2007, total liabilities were $182.9 billion, an increase of $48.3 billion, or 35.9 percent, from December 31, 2006, primarily as a result of an increase in consolidated obligations.
Consolidated obligations, the largest liability on the Bank’s balance sheet, increased by $47.1 billion, or 37.1 percent, during this same period. The significant increase in consolidated obligations during this period, substantially all of
which increase occurred during the third quarter, corresponds to the Bank’s need to increase liquidity to fund the increased demand for advances by the Bank’s members during the period. Of the increase in consolidated obligations during
the period, $25.7 billion, or 54.6 percent, occurred in discount notes.
As of September 30, 2007, total capital was $7.9 billion, an increase of $1.7
billion, or 27.5 percent, from December 31, 2006, primarily as a result of an increase in the Bank’s activity-based stock. The Bank increased its retained earnings during the third quarter of 2007 by $34.1 million. The Bank’s retained
earnings balance was $460.0 million as of September 30, 2007. The Bank continues to meet capital-to-assets regulatory ratios and liquidity requirements at levels well above regulatory minimums.
Results of Operations
The Bank views return on equity
(“ROE”) as the most important measure of profitability with net income as a second priority. ROE is a measure of a shareholder’s return on its investment in the Bank. While under the Bank’s current business model, net income
fluctuates with interest rates, maintaining a minimum amount of net income is important to meet higher operating costs and to ensure that volatility associated with derivative accounting under GAAP can be absorbed with current income. In addition,
AHP and Resolution Funding Corporation (“REFCORP”) assessments are tied directly to income. The Bank attempts to provide a return on this
investment, which, when combined with providing members with access to low-cost funding, will be competitive with comparable investments.
The Bank’s
annualized ROE was 7.52 percent for the three months ended September 30, 2007, compared to 6.83 percent for the three months ended September 30, 2006, and its annualized return on average assets was 0.31 percent for the three months ended
September 30, 2007, compared to 0.30 percent for the three months ended September 30, 2006. This increase in ROE was a result of the increase in net income, discussed below, partially offset by the increase in the Bank’s average
capital during the period.
The Bank’s annualized ROE was 6.65 percent for the nine months ended September 30, 2007 as compared to 6.81 percent
for the nine months ended September 30, 2006, and its annualized return on average assets was 0.28 percent and 0.30 percent for the nine-month periods ended September 30, 2007 and 2006, respectively. Although there was a slight increase in
net income (0.75 percent) for the nine months ended September 30, 2007 as compared to the nine months ended September 30, 2006, ROE decreased during the period due to the 3.20 percent increase in the Bank’s average capital.
The Bank’s net income for the three months ended September 30, 2007 totaled $133.1 million, an increase of 20.0 percent from $111.0 million for
the three months ended September 30, 2006. The significant increase in net income for the three months ended September 30, 2007 compared to the same period ended September 30, 2006 was due in part to an increase in net interest income
resulting from the increase in advance demand. The increase, however, was offset partially by the two basis point decrease in interest rate spread. A substantial portion of the remaining increase in net income for the three-month period was due to
the increase in other income, which resulted from the effect of the interaction of interest rates on the Bank’s trading securities and derivative and hedging activities.
For the nine months ended September 30, 2007, net income totaled $322.2 million, an increase of 0.75 percent from $319.8 million for the nine months ended September 30, 2006. Net interest income increased
slightly for the period, but the five basis point decline in interest rate spread during the period counteracted most of the gains resulting from the increased advance balance for the period.
The Bank’s interest rate spread decreased by two and five basis points for the three- and nine- month periods ended September 30, 2007, respectively, as
compared to the corresponding periods ended September 30, 2006. The decreases in interest rate spread during the periods was primarily due to the increased volume of lower spread advances, and lower average investments in MBS due to the
tightened MBS market. One basis point of the decrease was due to a reduction in the amount of interest expense moved to other income on SFAS 133 non-qualifying hedges when comparing the nine months ended September 30, 2007 and 2006.
Business Outlook
Although the Bank experienced a significant
increase in demand for advances during the third quarter of 2007, if credit market disruptions continue to settle, the Bank does not expect that new advance activity will continue to increase at the same rate. In the current credit market, the Bank
does not expect significant prepayments of advances and therefore anticipates a substantial increase in total assets at December 31, 2007, as compared to December 31, 2006. As these advances mature, members may or may not renew them
depending on their needs at that time. Management expects that the increased asset levels will continue to have a positive effect on net income and ROE for 2007 and 2008, although management
anticipates that this effect will be muted to an extent due to compressed interest rate spreads. In light of the fact that most of the new advances mature in
four years or less, this positive net income effect may continue for some time, but will lessen as advances mature and are repaid. If disruptions in the credit market return, management expects that the Bank will serve once again as a source of
liquidity to its members, which would result in increased advances.
The relationship between short- and long-term interest rates affects the Bank’s
profitability. The two most unfavorable interest-rate scenarios are (1) a dramatic rise in short-term rates coupled with a modest or no increase in long-term rates and (2) a dramatic decrease in long-term rates coupled with little change
in short-term rates. Under the first scenario the ability to generate additional returns by managing the interest-rate risk associated with retaining longer term assets and funding with shorter liabilities is limited. This environment, if sustained
for a long period of time, could reduce the Bank’s ability to generate competitive returns. The second scenario would be expected to result in significant mortgage prepayments, which would result in lower investment yields.
Management expects to continue to use interest-rate derivatives to hedge the Bank’s MBS and mortgage portfolios. These derivatives assist in mitigating
interest-rate and prepayment risk. However, to the extent that they do not qualify for hedge accounting treatment under GAAP, their use could result in earnings volatility. Management also uses derivative instruments to hedge other macro-level risks
that do not qualify for hedge accounting treatment under GAAP. However, management seeks to contain the magnitude of mark-to-market adjustments by limiting the use of derivative instruments to hedge macro-level risks. Alternatively, management uses
cash market liabilities that are not subject to mark-to-market requirements.
Management strives to maintain relatively low operating expenses, consistent
with a wholesale banking structure, without sacrificing adequate systems and staffing. Management expects that operating expenses as a percent of assets generally should remain stable over the next few years, and that operating expenses on an
absolute basis should increase moderately due to increased staffing and system expenses. These increases should not have a material adverse effect on the Bank’s financial performance.
Financial Condition
The Bank’s principal assets consist of
advances, short- and long-term investments, and mortgage loans held for portfolio. The Bank obtains funding to support its business primarily through the issuance by the Office of Finance on the Bank’s behalf of debt securities in the form of
consolidated obligations.
The following table presents the distribution of the Bank’s total assets, liabilities, and capital by major class as of the
dates indicated (dollar amounts in thousands). These items are discussed in more detail below:
Advances were $139.3 billion at September 30, 2007, an increase of $37.8 billion, or 37.3 percent, from December 31, 2006. The increase in advances was due primarily to increased liquidity needs of the Bank’s members during
disruptions in the credit markets during the third quarter. At September 30, 2007, 59.6 percent of the Bank’s advances were variable-rate, the majority of which were indexed primarily to the London Interbank Offered Rate
(“LIBOR”). The Bank also offers variable-rate advances tied to the federal funds rate, prime rate and CMS (constant maturity swap) rates.
The
concentration of the Bank’s advances to its 10 largest borrowing member institutions was as follows:
Advances to 10 largest
borrowing member
institutions
Percent of total advances
outstanding
September 30, 2007
$96.8 billion
69.9%
December 31, 2006
$64.7 billion
63.5%
Advances to Countrywide Bank, FSB, the Bank’s largest borrower, were $51.1 billion at
September 30, 2007, representing 36.8 percent of the Bank’s total outstanding advances as of September 30, 2007. Management believes that the Bank holds sufficient collateral, on a member-specific basis, to secure the advances to
these 10 institutions, and the Bank does not expect to incur any credit losses on these advances.
Investments
The Bank maintains a portfolio of investments for liquidity purposes, to provide for the availability of funds to meet member credit needs and to provide additional
earnings. Investment income also enhances
the Bank’s capacity to meet its commitment to affordable housing and community investment, to cover operating expenses, and to satisfy the Bank’s
annual REFCORP and AHP assessments.
The Bank’s short-term investments consist of overnight and term federal funds, and interest-bearing deposits. The
Bank’s long-term investments consist of MBS issued by government-sponsored mortgage agencies or that carry the highest rating from Moody’s or S&P, securities issued by the U.S. government or U.S. government agencies, and consolidated
obligations issued by other FHLBanks. The long-term investment portfolio generally provides the Bank with higher returns than those available in the short-term money markets. The following table sets forth more detailed information regarding short-
and long-term investments held by the Bank (dollar amounts in thousands):
Increase/ (Decrease)
As of September 30, 2007
As of December 31, 2006
Amount
Percent
Short-term investments:
Interest-bearing deposits
$
828,402
$
800,982
$
27,420
3.42
Federal funds sold
21,052,036
10,532,000
10,520,036
99.89
Total short-term investments
$
21,880,438
$
11,332,982
$
10,547,456
93.07
Long-term investments:
Trading securities:
Government-sponsored enterprises debt obligations
$
4,201,848
$
4,175,011
$
26,837
0.64
Other FHLBanks’ bonds
277,851
280,488
(2,637)
(0.94)
State or local housing agency obligations
59,441
59,810
(369)
(0.62)
Held-to-maturity securities:
State or local housing agency obligations
124,968
107,180
17,788
16.60
Mortgage-backed securities:
U.S. agency obligations-guaranteed
50,638
65,882
(15,244)
(23.14)
Government-sponsored enterprises
2,078,061
2,160,861
(82,800)
(3.83)
Other
18,175,900
16,995,788
1,180,112
6.94
Total long-term investments
$
24,968,707
$
23,845,020
$
1,123,687
4.71
As of September 30, 2007, total short-term investments were $21.9 billion, an increase of $10.5 billion from
December 31, 2006. This increase was due primarily to an increase in federal funds sold due to higher amounts of liquidity at quarter-end resulting from increased consolidated obligation discount note issuance and the tightening of the MBS
market during the third quarter.
As of September 30, 2007, total long-term investments were $25.0 billion, an increase of $1.1 billion from
December 31, 2006. This increase was due primarily to a $1.1 billion, or 5.63 percent, increase in the Bank’s MBS portfolio.
The Finance Board
limits an FHLBank’s investment in MBS and asset-backed securities by requiring that the total book value of MBS owned by the FHLBank may not exceed 300 percent of the FHLBank’s previous month-end regulatory capital on the day it purchases
the securities. On September 30, 2007, these investments amounted to 252.6 percent of the Bank’s total regulatory capital.
Held-to-maturity
securities are evaluated for impairment on a quarterly basis, or more frequently if events or changes in circumstances indicate that these investments are impaired. The Bank would record an impairment charge when a held-to-maturity security has
experienced an other-than-temporary decline in fair value, or its cost may not be recoverable. The Bank reviewed its held-to-maturity securities as of September 30, 2007 and has determined that all unrealized losses were temporary and related
to increases in interest rates. Additionally, the Bank has the ability and the intent to hold such investments to maturity, at which time the unrealized losses will be recovered
.
Mortgage loans purchased from participating financial institutions under the MPP and MPF Program and loan participations purchased under the Affordable Multifamily Participation Program (“AMPP”) comprised
1.84 percent of the Bank’s total assets as of September 30, 2007, compared to 2.13 percent as of December 31, 2006. Although mortgage loans held for portfolio as a percentage of total assets decreased during this period because of the
increase in total assets, the mortgage loan balance at September 30, 2007 increased by $502.5 million, or 16.7 percent, from the 2006 year-end balance. This is consistent with the Bank’s current plans for slow, modest growth in its
mortgage loan portfolio with a strategic emphasis on MPP over the MPF Program. The Bank believes it will be able to fund this planned growth through the issuance of bullet and callable consolidated obligations. In 2006, the Bank ceased purchasing
assets under AMPP but retains its existing portfolio, which eventually will be reduced to zero in accordance with the ordinary course of the maturities of the assets.
As of September 30, 2007 and December 31, 2006, the Bank’s mortgage loan portfolio was concentrated in the Southeast because those members selling loans to the Bank were located primarily in the
Southeast.
Consolidated Obligations
The Bank funds
its assets primarily through the issuance of consolidated obligation bonds and, to a lesser extent, consolidated obligation discount notes. Consolidated obligation issuances financed 91.3 percent of the $190.7 billion in total assets at
September 30, 2007, a slight increase from the financing ratio of 90.2 percent as of December 31, 2006.
As of September 30, 2007, the Bank
had outstanding consolidated bonds totaling $143.5 billion, compared to $122.1 billion as of December 31, 2006. Consolidated obligation bonds outstanding at September 30, 2007 and December 31, 2006 were primarily fixed-rate debt.
However, the Bank often enters into derivatives simultaneously with the issuance of consolidated obligation bonds to convert, in effect, the investor-defined terms of these debt instruments into terms more consistent with management’s funding
strategies. Of the par value of $143.9 billion of consolidated obligation bonds outstanding as of September 30, 2007, $115.1 billion, or 80.0 percent, had their terms reconfigured through the use of interest rate exchange agreements. The
comparable notional amount of such outstanding derivatives at December 31, 2006 was $99.2 billion, or 80.6 percent, of the total par value of consolidated obligation bonds.
As of September 30, 2007, the Bank had outstanding consolidated discount notes totaling $30.7 billion, compared to $4.9 billion as of December 31, 2006. The increase in consolidated obligation bonds and
discount notes from December 31, 2006 to September 30, 2007 occurred primarily in the third quarter and was due to the Bank’s need to increase liquidity to fund the increased demand for advances by the Bank’s members during the
period.
Deposits
The Bank offers demand and
overnight deposits and a short-term deposit program to members primarily as a liquidity management service. In addition, a member that services mortgage loans may deposit in the Bank funds collected in connection with the mortgage loans, pending
disbursement of those funds to the
owners of the mortgage loan. For demand deposits, the Bank pays interest at the overnight rate. The interest-rate paid on term deposits is dependent upon the
term of the deposit.
Most of these deposits represent member liquidity investments, which members may withdraw on demand. Therefore, the total account
balance of the Bank’s deposits may be quite volatile. As a matter of prudence, the Bank typically invests deposit funds in liquid short-term assets. Member loan demand, deposit flows, and liquidity management strategies influence the amount and
volatility of deposit balances carried with the Bank. Deposits totaled $5.7 billion as of September 30, 2007, compared to $4.6 billion as of December 31, 2006. Demand deposits comprised the largest percentage of deposits, representing 99.1
percent of total deposits as of September 30, 2007 compared to 96.2 percent as of December 31, 2006.
To support its member deposits, the FHLBank
Act requires the Bank to have as a reserve an amount equal to or greater than the current deposits received from its members. These reserves are required to be invested in obligations of the United States, deposits in eligible banks or trust
companies, or advances with maturities not exceeding five years. The Bank was in compliance with this depository liquidity requirement as of September 30, 2007.
Other Liabilities
The $60.1 million, or 2.03 percent, increase in other liabilities to $3.0 billion at
September 30, 2007 from the 2006 year-end balance was due primarily to:
•
a $256.4 million increase in accrued interest payable as a result of the increase in consolidated obligations,
•
a $144.7 million increase in derivative liabilities due to the interaction of interest rates on associated derivatives,
•
a $150.0 million increase in payables related to securities purchased but not yet delivered, and
•
a $500.0 million decrease in securities sold under agreement to repurchase due to the maturity of such securities during the third quarter of 2007.
Capital
As of September 30,
2007, the Bank had total capital of $7.9 billion, an increase of $1.7 billion, or 27.5 percent, from the 2006 year-end balance. An increase in advance balances that resulted in an increase in the Bank’s activity-based stock was the primary
factor causing the increase in the Bank’s total capital.
The FHLBank Act and Finance Board regulations specify that each FHLBank must meet certain
minimum regulatory capital standards. Finance Board staff has indicated that mandatorily redeemable capital stock is considered capital for regulatory purposes, and the Bank’s $170.6 million and $215.7 million in mandatorily redeemable capital
stock at September 30, 2007 and December 31, 2006, respectively, is included in the line item “Total regulatory capital” in the table below.
The Bank was in compliance with the Finance Board’s regulatory capital rules and requirements as shown in the following table (dollar amounts in thousands):
As of September 30, 2007, the Bank had capital stock subject to mandatory redemption from 22 members and
former members, consisting of B1 membership stock and B2 activity-based stock. The Bank is not required to redeem or repurchase such stock until the expiration of the five-year redemption period or, with respect to activity-based stock, until the
later of the expiration of the five-year redemption period or the activity no longer remains outstanding. In accordance with the Bank’s current practice, if activity-based stock becomes excess stock as a result of an activity no longer
remaining outstanding, the Bank will repurchase the excess activity-based stock if the dollar amount of excess stock exceeds the threshold specified by the Bank, which is currently $100 thousand. As of September 30, 2007 and December 31,
2006, the Bank’s activity-based stock included $41.7 million and $52.6 million, respectively, of excess shares subject to repurchase by the Bank at its discretion. The Bank’s excess stock threshold and standard repurchase practice may be
changed at the Bank’s discretion with proper notice to members.
Results of Operations
Net Income
The following table sets forth the Bank’s
significant income components for the three- and nine-month periods ended September 30, 2007 and 2006 and provides information regarding the changes during the periods (dollar amounts in thousands):
Components of Net Income
Three Months Ended September 30,
Increase/
(Decrease)
Increase/
(Decrease) %
Nine Months Ended September 30,
Increase/
(Decrease)
Increase/
(Decrease) %
2007
2006
2007
2006
Net interest income
$
187,245
$
170,387
$
16,858
9.89
$
504,079
$
498,695
$
5,384
1.08
Other income
20,276
6,714
13,562
202.00
12,288
11,841
447
3.78
Other expense
25,756
25,656
100
0.39
76,638
74,536
2,102
2.82
Total assessments
48,462
40,284
8,178
20.30
117,476
116,111
1,365
1.18
Net income
133,142
110,983
22,159
19.97
322,181
319,774
2,407
0.75
Net income increased during the three months ended September 30, 2007 compared to the same period ended
September 30, 2006, as a result of an increase in both net interest income and other income. Net income was relatively flat for the nine months ended September 30, 2007 when compared to the same period ended September 30, 2006.
The primary source of the Bank’s earnings is net interest income. Net interest income equals interest earned on assets (including member advances, mortgage loans, MBS held in portfolio, and other investments), less the interest expense
incurred on consolidated obligations, deposits, and other borrowings. Also included in net interest income are miscellaneous related items such as prepayment fees earned and the amortization of debt issuance discounts, concession fees and SFAS
133-related adjustments.
The following tables present spreads between the average yield on total interest-earning assets and the average cost of
interest-bearing liabilities during the three- and nine-month periods ended September 30, 2007, compared to the same periods ended September 30, 2006 (dollar amounts in thousands). As noted in the tables below, during the three- and
nine-month periods ended September 30, 2007 compared to the same periods ended September 30, 2006, interest rate spread decreased by two basis points and five basis points, respectively. The decreases in interest rate spread during the
periods was primarily due to the increased volume of lower spread advances, and lower average investments in MBS due to the tightened MBS market. One basis point of the decrease was due to a reduction in the amount of interest expense moved to other
income on SFAS 133 non-qualifying hedges when comparing the nine months ended September 30, 2007 and 2006.
Net interest income for the periods presented was affected by changes in average balances (volume change) and changes in
average rates (rate change) of interest-earnings assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing
liabilities affected the Bank’s interest income and interest expense (in thousands). As noted in the tables, changes in net interest income for the three months ended September 30, 2007, compared to the same period ended September 30,
2006, were primarily volume related. Changes in net interest income for the nine months ended September 30, 2007, compared to the same period ended September 30, 2006, were both rate and volume related.
Volume and Rate Table *
Three Months Ended September 30,
Nine Months Ended September 30,
2007 vs. 2006
2007 vs. 2006
Volume
Rate
Increase
(Decrease)
Volume
Rate
Increase
(Decrease)
Increase (decrease) in interest income
:
Federal funds sold
$
71,847
$
(2,120)
$
69,727
$
129,265
$
25,926
$
155,191
Interest-bearing deposits
3,300
94
3,394
10,536
1,787
12,323
Long-term investments
(7,104)
5,482
(1,622)
(32,935)
18,143
(14,792)
Advances
237,938
10,004
247,942
276,783
318,516
595,299
Mortgage loans held for portfolio
4,851
1,370
6,221
11,346
3,931
15,277
Loans to other FHLBanks
(23)
(1)
(24)
(54)
3
(51)
Total
310,809
14,829
325,638
394,941
368,306
763,247
Increase (decrease) in interest expense:
Demand and overnight deposits
24,990
(719)
24,271
38,669
12,672
51,341
Term deposits
(275)
15
(260)
(816)
96
(720)
Other interest-bearing deposits
(1,649)
(17)
(1,666)
(2,443)
432
(2,011)
Short-term borrowings
115,060
(2,396)
112,664
72,467
16,102
88,569
Long-term debt
145,002
31,273
176,275
240,255
378,581
618,836
Other borrowings
(3,089)
585
(2,504)
(666)
2,514
1,848
Total
280,039
28,741
308,780
347,466
410,397
757,863
Increase (decrease) in net interest income
$
30,770
$
(13,912)
$
16,858
$
47,475
$
(42,091)
$
5,384
*
Volume change is calculated as the change in volume multiplied by the previous rate, while rate change is the change in rate multiplied by the previous volume. The rate/volume
change, change in rate multiplied by change in volume, is allocated between volume change and rate change at the ratio each component bears to the absolute value of its total.
Other Income
The following table presents the components of other
income (in thousands):
Three Months Ended September 30,
Nine Months Ended September 30,
2007
2006
Increase/
(Decrease)
2007
2006
Increase/
(Decrease)
Other income:
Service fees
$
562
$
565
$
(3)
$
1,892
$
1,741
$
151
Net gains (losses) on trading securities
92,538
98,661
(6,123)
19,723
(81,251)
100,974
Net (losses) gains on derivatives and hedging activities
(72,816)
(92,542)
19,726
(9,898)
90,879
(100,777)
Other
(8)
30
(38)
571
472
99
Total other income
$
20,276
$
6,714
$
13,562
$
12,288
$
11,841
$
447
The Bank’s net gains (losses) on trading securities and net (losses) gains on derivatives and hedging
activities comprise the majority of other income. The Bank hedges trading securities with derivative transactions, and the income effect of the market-value change for these securities under SFAS No.115,
Accounting for Certain Investments in Debt
and Equity Securities
, during the three- and nine-month periods ended September 30, 2007 and 2006 was offset by market-value changes in the related derivatives. The overall changes in other income during the periods were caused primarily by
the adjustments required to report trading securities at fair value, as required by GAAP, and hedging-related adjustments, which are reported
in the overall hedging activities (including those related to trading securities). The net gains (losses) on trading securities for the three- and nine-month
periods ended September 30, 2007 were due to falling interest rates in the portions of the yield curve pertaining to the maturities of these securities.
The following table details each of the components of net (losses) gains on derivatives and hedging activities, for the three- and nine-month periods ended September 30, 2007 and 2006 (in thousands). When hedging, both the derivative
instrument and the related asset or liability are marked-to-market and net (losses) gains on derivatives and hedging activities reflects the degree of ineffectiveness in the hedging activity, which can be favorable or unfavorable to net income at
any particular point. Net (losses) gains on derivatives and hedging activities also includes the interest component for hedging activity not qualifying for hedge accounting treatment under GAAP.
Net (Losses) Gains on Derivatives and Hedging Activities
Management generally uses derivative instruments to hedge net interest income, with a primary goal of stabilizing
the interest-rate spread over time and mitigating interest-rate risk and cash-flow variability.
The table below outlines the overall effect of hedging
activities on net interest income and other income related results (in thousands). For a description regarding the individual interest components discussed below, see the Bank’s Form 10-K.
Three Months Ended September 30,
Nine Months Ended September 30,
2007
2006
2007
2006
Net interest income
$
187,245
$
170,387
$
504,079
$
498,695
Interest components of hedging activities included in net interest income:
Hedging advances
$
176,930
$
172,045
$
491,647
$
388,387
Hedging consolidated obligations
(106,076)
(235,415)
(324,401)
(580,497)
Hedging related amortization
(320)
(8,526)
(15,093)
(37,892)
Net increase (decrease) in net interest income
$
70,534
$
(71,896)
$
152,153
$
(230,002)
Interest components of derivative activity included in other income:
Non-interest expense during the three- and nine-month periods ended September 30, 2007 increased 12.6 percent and 1.82 percent, respectively, compared to the same periods ended September 30, 2006. The increase during the three
months ended September 30, 2007 was due primarily to increased AHP and REFCORP assessments. The REFCORP assessment is established as a fixed percent of GAAP net income, and AHP assessment is established as a fixed percent of regulatory net
income (which is the Bank’s net income before interest expense related to mandatorily redeemable capital stock under SFAS No. 150,
Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
).
The increase during the nine months ended September 30, 2007 was due primarily to an increase in AHP and REFCORP assessments and an increase in operating expenses caused by an increase in salary and benefits expense.
Liquidity and Capital Resources
Liquidity is necessary to satisfy
members’ borrowing needs on a timely basis, repay maturing and called consolidated obligations, and meet other obligations and operating requirements. Many members rely on the Bank as a source of standby liquidity, and the Bank attempts to be
in a position to meet member funding needs on a timely basis.
The Bank attempts to maintain sufficient liquidity to service debt obligations for at least
90 days, assuming restricted debt market access. In addition, Finance Board regulations and Bank policy require the Bank to maintain contingent liquidity in an amount sufficient to meet its liquidity needs for five business days if it is unable to
access the capital markets. The Bank was in compliance with these requirements at September 30, 2007.
The Bank’s principal source of liquidity
is consolidated obligation debt instruments, which enjoy government-sponsored enterprise status and are rated Aaa/P-1 by Moody’s and AAA/A-1+ by S&P. To provide liquidity, the Bank also may use other short-term borrowings, such as federal
funds purchased, securities sold under agreements to repurchase, and loans from other FHLBanks. These funding sources depend on the Bank’s ability to access the capital markets at competitive market rates. Although the Bank maintains secured
and unsecured lines of credit with money market counterparties, the Bank’s income and liquidity would be affected adversely if it were not able to access the capital markets at competitive rates for a long period. Historically, the FHLBanks
have had excellent capital market access.
During the credit market disruption that occurred during the third quarter of 2007, the Bank increased its
liquidity through the capital markets to meet member advance demand. If credit market disruptions continue to settle, the Bank does not anticipate its liquidity needs will increase at that same rate. If disruptions in the credit market return,
management expects that the Bank once again will serve as a source of liquidity to is members and that it will meet this increased liquidity demand through increased consolidation obligation issuance. In addition, at September 30, 2007, the
Bank held an increased amount of federal funds sold, a source of liquidity for the Bank. A number of factors could influence whether the Bank’s federal funds sold balance will continue in that amount, such as member advance demand and the
availability and quality of the MBS market.
Contingency plans are in place that prioritize the allocation of liquidity resources in the event of
operational disruptions at the Bank or the Office of Finance, as well as systemic Federal Reserve wire transfer system disruptions. Additionally, the FHLBank Act authorizes the Secretary of Treasury, at his or
her discretion, to purchase consolidated obligations up to an aggregate principal amount of $4 billion. No borrowings under this authority have been
outstanding since 1977.
The Bank is jointly and severally liable with each and all of the other FHLBanks for the payment of principal and interest on
consolidated obligation of all the FHLBanks. On October 10, 2007, FHLBank Chicago disclosed that it had entered into a consensual cease and desist order with the Finance Board, which concurrently terminated its prior written agreement with the
Finance Board. Pursuant to FHLBank Chicago’s disclosure, the order states that the Finance Board has determined that requiring FHLBank Chicago to take the actions specified in the order will “improve the condition and practices of FHLBank
Chicago, stabilize its capital, and provide FHLBank Chicago an opportunity to address the principal supervisory concerns identified by the Finance Board.”
FHLBank Chicago also disclosed that the order places several requirements on it:
•
FHLBank Chicago must maintain a ratio of regulatory capital (including subordinated debt) to total assets of at least 4.5 percent, and a minimum total level of the
sum of capital stock plus subordinated debt of $3.6 billion.
•
FHLBank Chicago may not redeem or repurchase any capital stock from members without prior approval from the Finance Board; the Finance Board can approve redemptions
or repurchases if they determine that such actions would be consistent with maintaining the capital adequacy of the Bank.
•
Dividend declarations are subject to the prior written approval of the Finance Board.
•
FHLBank Chicago will review and revise its market risk management policies, and commission periodic independent reviews of the effectiveness of its market risk
management.
•
FHLBank Chicago will submit a Capital Structure Plan to the Finance Board outlining a conversion under the GLB Act, along with strategies for implementing the Plan.
Based on its knowledge, management of the Bank does not believe that these developments should affect the Bank’s individual
liability on the FHLBanks’ outstanding consolidated obligations.
Off-balance Sheet Commitments
The Bank’s primary off-balance sheet commitments are as follows:
•
The Bank has joint and several liability for all of the consolidated obligations issued by the Office of Finance on behalf of the FHLBanks
•
The Bank has outstanding commitments arising from standby letters of credit.
Should an FHLBank be unable to satisfy its payment obligation under a consolidated obligation for which it is the primary obligor, any of the other FHLBanks, including the Bank, could be called upon to repay all or
any part of such payment obligation, as determined or approved by the Finance Board. The Bank considers the joint and several liability as a related party guarantee. These related party guarantees meet the scope exceptions in Financial
Interpretation Number 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others
. Accordingly, the Bank has not recognized a liability for its joint and several obligations
related to other FHLBanks’ consolidated obligations at
September 30, 2007 or December 31, 2006. As of September 30, 2007, the FHLBanks had $1.1 trillion in aggregate par value of consolidated
obligations issued and outstanding, $174.8 billion of which was attributable to the Bank.
As of September 30, 2007, the Bank had outstanding standby
letters of credit of approximately $4.7 billion with original terms of less than three months to 15 years, with the longest final expiration in 2018
.
Commitments to extend credit, including standby letters of credit, are agreements to lend.
The Bank issues a standby letter of credit on behalf of a member in exchange for a fee. A member may use these standby letters of credit to facilitate a financing arrangement. If the Bank is required to make payment for a beneficiary’s draw,
the Bank converts such paid amount to a collateralized advance to the member. The Bank requires its borrowers to collateralize fully the face amount of any letter of credit issued by the Bank, as if such face amount were an advance to the borrower.
Based on management’s credit analyses and collateral requirements, the Bank presently does not deem it necessary to have an allowance for these unfunded letters of credit.
Contractual Obligations
Consolidated obligation bonds increased by $21.4 billion, or 17.5 percent, from
December 31, 2006 to September 30, 2007. Additional information on the Bank’s consolidated obligation bonds is included in Note 6 to the interim financial statements included in this Form 10-Q.
Risk Management
A discussion of the Bank’s risk management is
described in detail in the Bank’s Form 10-K. Management does not expect that the problems in the residential loan market involving subprime loans will affect the Bank’s financial condition or results of operation. The Bank believes that it
has minimal exposure to subprime loans due to its business model and its credit risk policies pertaining to advances, investments, and mortgage loan programs.
Critical Accounting Policies and Estimates
The Bank’s critical accounting policies and estimates are described in detail in the
Bank’s Form 10-K. There have been no material changes to these policies and estimates during the period reported.
Recent Accounting Guidance
SFAS No. 157, Fair Value Measurements
(“SFAS 157”), was issued in September 2006. In defining fair value, SFAS 157 retains the
exchange price notion in earlier definitions of fair value. However, the definition of fair value under SFAS 157 focuses on the price that would be received to sell an asset or paid to transfer a liability (an exit price), not the price that would
be paid to acquire the asset or received to assume the liability (an entry price). SFAS 157 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, SFAS 157 does not expand
the use of fair value in any new circumstances. SFAS 157 also establishes a fair value hierarchy that prioritizes the information used to develop assumptions used to determine the exit price. Under this standard, fair value measurements would be
disclosed separately by level within the fair value hierarchy. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods
within those fiscal years, with early adoption permitted. The Bank does not expect the adoption of SFAS 157 to have a material effect on its financial
condition or results of operations.
SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of
FASB Statement No. 115
(“SFAS 159”), issued in February 2007, creates a fair value option allowing an entity irrevocably to elect fair value as the initial and subsequent measurement attribute for certain financial assets and
financial liabilities, with changes in fair value recognized in earnings as they occur. SFAS 159 requires an entity to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair
values from the carrying amounts of assets and liabilities measured using another measurement attribute on the face of the statement of financial position. SFAS 159 also requires an entity to provide information that would allow users to understand
the effect on earnings of changes in the fair value on those instruments selected for the fair value election. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. The Bank does not expect the
adoption of SFAS 159 to have a material effect on its financial condition or results of operations.
FASB Staff Position No. FIN 39-1, Amendment of FASB
Interpretation No. 39
(“FSP FIN 39-1”), issued in April 2007, permits an entity to offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral (a
receivable) or the obligation to return cash collateral (a payable) arising from derivative instruments recognized at fair value executed with the same counterparty under a master netting arrangement. Under FSP FIN 39-1, the receivable or payable
related to cash collateral may not be offset if the amount recognized does not represent or approximate fair value or arises from instruments in a master netting arrangement that are not eligible to be offset. The decision whether to offset such
fair value amounts represents an elective accounting policy decision that, once elected, must be applied consistently. An entity should recognize the effects of applying FSP FIN 39-1 as a change in accounting principle through retrospective
application for all financial statements presented unless it is impracticable to do so. Upon adoption of FSP FIN 39-1, an entity is permitted to change its accounting policy to offset or not offset fair value amounts recognized for derivative
instruments under master netting arrangements. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with earlier application permitted. The Bank does not expect the adoption of FSP FIN 39-1 to have a material effect on
its financial condition or results of operations.
Next Section
Previous Section