FEDERAL HOME LOAN BANK OF CHICAGO - Annual Report (10-K) Item 1. Business.

PART I

Item 1.

Business.

Where to Find More Information

The Federal Home Loan Bank of Chicago ¹ maintains a website located at www.fhlbc.com where we make available our financial statements and other information regarding the Bank free of charge. We are required to file with the Securities and Exchange Commission (“SEC”) an annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. The SEC maintains a website that contains these reports and other information regarding our electronic filings located at www.sec.gov. These reports may also be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Further information about the operation of the Public Reference Room may be obtained by calling 1-800-SEC-0330. Information on these websites, or that can be accessed through these websites, does not constitute a part of this annual report.

A glossary of key terms can be found on page 96 of this annual report on Form 10-K.

Introduction

The Bank is a federally chartered corporation and one of 12 Federal Home Loan Banks (the “FHLBs”) that with the Federal Housing Finance Board (the “Finance Board”) and the Office of Finance, comprise the Federal Home Loan Bank System (the “System”). The FHLBs are government-sponsored enterprises (“GSE”) of the United States of America and were organized under the Federal Home Loan Bank Act of 1932, as amended (“FHLB Act”), in order to improve the availability of funds to support home ownership. Each FHLB operates as a separate entity with its own management, employees and board of directors.

Each FHLB is a member-owned cooperative with members from a specifically defined geographic district. Our defined geographic district consists of the states of Illinois and Wisconsin. We are supervised and regulated by the Finance Board, which is an independent federal agency in the executive branch of the United States government. At the request of the Finance Board, on October 10, 2007, we entered into a consensual cease and desist order (“C&D Order”) with the Finance Board. See Regulatory Developments on page 15.

Unless otherwise specified, references to “we,” “us,” “our” and “the Bank” are to the Federal Home Loan Bank of Chicago.

As a cooperative, only members and former members (under limited circumstances) may own our capital stock and receive dividends on their investments in our capital stock. All federally-insured depository institutions, insurance companies engaged in residential housing finance, and credit unions located in Illinois and Wisconsin are eligible to apply for membership. All members are required to purchase our capital stock as a condition of membership, and our capital stock is not publicly traded.

As of December 31, 2007, we had 337 full time and 6 part time employees.

Mission Statement

Our mission is to deliver value to our members, and promote and support their growth and success, by providing:

highly reliable liquidity;

secured advances, wholesale mortgage financing, and other products and services designed to meet members’ needs; and

direct financial support for members’ affordable housing and community investment programs.

Business Overview

We provide credit to members principally in the form of secured loans, called “advances.” We also provide funding for home mortgage loans to members approved as Participating Financial Institutions (“PFIs”) through the Mortgage Partnership Finance ^® (“MPF”) Program ² .

Our primary funding source is proceeds from the sale to the public of FHLB debt instruments (“consolidated obligations”) which are, under the FHLB Act, the joint and several obligations of all the FHLBs. Consolidated obligations are not obligations of the United States government, and the United States government does not guarantee them. Additional funds are provided by deposits, other borrowings, and the issuance of capital stock. We also provide members and non-members with correspondent services such as safekeeping, wire transfers, and cash management.

“Mortgage Partnership Finance,” “MPF,” “MPF Shared Funding,” “eMPF,” and “Downpayment Plus” are registered trademarks of the Federal Home Loan Bank of Chicago.

Membership Trends

The following tables show the outstanding advances, capital stock holdings, and the geographic locations of our members by type of institution and includes 12 members as of December 31, 2007 that have indicated their intention to withdraw from membership pending a six month notice period or merge with out-of-district institutions with capital stock redemption subject to approval by the Finance Board:


December 31, 2007	Number of Institutions			Percent of Total
December 31, 2007	Illinois	Wisconsin	Total	Percent of Total
Commercial banks	440	224	664	79%
Thrifts	91	35	126	15%
Credit unions	17	22	39	5%
Insurance companies	9	3	12	1%

Total	557	284	841	100%


December 31, 2006
Commercial banks	450	228	678	79%
Thrifts	93	36	129	15%
Credit unions	16	21	37	4%
Insurance companies	10	4	14	2%

Total	569	289	858	100%


December 31, 2007		Advances			Capital Stock
Commercial banks	$	20,325		$	1,687
Thrifts		7,406			695
Credit unions		633			119
Insurance companies		1,681			182

Total at par	$	30,045		$	2,683
Adjustments		176	¹	$	(22	) ²

Balance on the statement of condition	$	30,221		$	2,661


December 31, 2006
Commercial banks	$	16,638		$	1,620
Thrifts		7,648			681
Credit unions		332			118
Insurance companies		1,623			182

Total at par	$	26,241		$	2,601
Adjustments		(62	) ¹		(14	) ²

Balance on the statement of condition	$	26,179		$	2,587

SFAS 133 hedging adjustments.

SFAS 150 adjustment for mandatorily redeemable capital stock reclassified as a liability on the statements of condition.

The following table shows the concentration of our members by asset size:


December 31,	2007	2006
Member Asset Size:
Less than $100 million	37%	39%
$100 million to $1 billion	57%	55%
Excess of $1 billion	6%	6%

Total	100%	100%

On a net basis, our membership declined by 17 financial institutions during 2007. We lost 25 members due to mergers, of which 17 members merged with other financial institutions located within our membership district of Illinois and Wisconsin and 8 members were acquired by institutions located outside of our district. In addition, three members withdrew from membership in 2007 while we accepted 11 new members. From January 1, 2008 through February 29, 2008, we received notice of four out-of-district mergers, including MidAmerica Bank, FSB, and one withdrawal of membership whereby we reclassified $157 million of capital stock to mandatorily redeemable capital stock during this time period.

On October 1, 2007, Bank of America completed its purchase of LaSalle Bank Corporation, parent of our member LaSalle Bank N.A. Bank of America, which is headquartered outside of our district in Charlotte, North Carolina, or its subsidiaries maintain memberships with the FHLBs of Atlanta, Boston, Indianapolis, New York, San Francisco, and Seattle. Since the acquisition, LaSalle has maintained an active relationship with us. However, we cannot predict if Bank of America will maintain LaSalle’s business, charter or membership with us.

MidAmerica Bank FSB became ineligible for membership with us due to an out-of-district merger with National City Bank, effective February 9, 2008. As a result, we reclassified $146 million of capital stock to mandatorily redeemable capital stock. Prior to redeeming its capital stock, Mid America will need to satisfy all of its outstanding obligations to us, including payment of its outstanding $2.4 billion of advances that mature in various terms ranging from 1 week to 3.4 years.

For discussion of how recent regulatory actions affect redemption of our capital stock and may impact future membership trends, see Consent Cease and Desist Order on page 15 and Risk Factors on page 16.

For 2007 and 2006, we had 722 and 735 members which have used advances, the MPF Program, or other credit products at any point during the year, representing 86% of our total membership for both periods.

Business Segments

We manage our operations by grouping products and services within two operating segments. The measure of profit or loss and total assets for each segment is contained in Operating Segment Results on page 40. These operating segments are:

The Traditional Member Finance segment which includes traditional funding, liquidity, advances to members, derivative activities with members, standby letters of credit, investments, and deposit products.

The MPF segment which includes primarily MPF Loans and MPF Shared Funding ^® investment securities.

Traditional Member Finance Segment

Advances

Our advances to members:

support residential mortgages held in member portfolios;

serve as a funding source;

provide members with asset-liability management capabilities;

provide interim funding for those members that choose to sell or securitize their mortgages;

support important housing markets, including those focused on very low-, low-, and moderate-income households; and

provide funds to member community financial institutions (“CFI”) for secured loans to small businesses, small farms, and small agri-businesses.

We are permitted to make advances to non-member eligible housing associates pursuant to the FHLB Act, if they are mortgagees approved under Title II of the National Housing Act who meet certain other requirements. At December 31, 2007 and 2006, we did not have any advances outstanding to non-member housing associates.

We make secured, fixed- or floating-rate advances to our members. Advances are secured by mortgages and other collateral that our members pledge. We determine the maximum amount and term of advances we will lend to a member as follows:

we assess the member’s creditworthiness and financial condition;

we value the collateral pledged to us; and

we conduct periodic collateral reviews to establish the amount we will lend against each collateral type.

We are required to obtain and maintain a security interest in eligible collateral at the time we originate or renew an advance. For further detail on our underwriting and collateral guidelines, see Credit Risk – Advances on page 60.

We offer a variety of fixed - and adjustable-rate advances, with maturities ranging from one day to 30 years. Examples of standard advance structures include the following:

Fixed-Rate Advances: Fixed-rate advances have maturities from one day to 30 years.

Variable-Rate Advances: Variable-rate advances include advances which have interest rates that reset periodically at a fixed spread to LIBOR, Federal Funds or some other index. Depending upon the type of advance selected, the member may have an interest-rate cap on the advance, which may limit the rate of interest the member would have to pay.

Putable Advances: We issue putable, fixed-rate advances in which we have the right to exercise a put option, in whole or in part, after a predefined lockout date, at par, upon five business days notice. In the event that we exercise the put option, the related advance is extinguished through one of the following options: (1) repayment by the member, (2) replacement with our funding, offered to the member subject to compliance by the member with our credit policy (and at the then-prevailing market rate of interest), (3) in the absence of any action by the member, replacement by an open-line advance, subject to compliance by the member with our credit policy (and at the then-prevailing market rate of interest), or (4) other settlement if replacement funding is not available pursuant to the terms of our credit policy.

Other Advances: (1) Open-line advances are designed to provide flexible funding to meet our members’ daily liquidity needs and may be drawn for one day. These advances are automatically renewed. Rates are set daily after the close of business. (2) Fixed amortizing advances have maturities that range from one year to 15 years, with the principal repaid over the term of the advances monthly, quarterly or semi-annually.

Investments

We maintain a portfolio of investments, for liquidity purposes, to manage capital stock redemptions, and to provide additional earnings. To ensure the availability of funds to meet

member credit needs, we maintain a portfolio of short-term liquid assets, principally Federal Funds sold and commercial paper entered into with highly rated institutions. Our longer-term investment securities portfolio includes securities issued by the United States government, United States government agencies, GSEs, and mortgage-backed securities (“MBS”) that are issued by GSEs or that carry the highest ratings from Moody’s Investors Service (“Moody’s”), Standard and Poor’s Rating Service (“S&P”), or Fitch Ratings, Inc. (“Fitch”) at the time of purchase. Securities issued by GSEs are not guaranteed by the United States government.

The long-term investment securities portfolio provides us with higher returns than those available from shorter term investments. It is not our practice to purchase investment securities issued directly by members or their affiliates. However, we may purchase investment securities issued by affiliates of members in the secondary market through a third party at arm’s length.

Under Finance Board regulations, we are prohibited from trading securities for speculative purposes or engaging in market-making activities. Additionally, we are prohibited from investing in certain types of securities or loans, including:

instruments, such as common stock, that represent an ownership in an entity, other than common stock in small business investment companies, or certain investments targeted to low-income persons or communities;

instruments issued by non-United States entities, other than those issued by United States branches and agency offices of foreign commercial banks;

non-investment grade debt instruments, other than certain investments targeted to low-income persons or communities, or instruments that were downgraded after purchase;

whole mortgages or other whole loans, other than, (1) those acquired under our MPF Program, (2) certain investments targeted to low-income persons or communities, (3) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from a Nationally Recognized Statistical Rating Organization (“NRSRO”), (4) MBS or asset-backed securities backed by manufactured housing loans or home equity loans; and, (5) certain foreign housing loans authorized under the FHLB Act; and

non-United States dollar-denominated securities.

The Finance Board’s Financial Management Policy also prohibits us from purchasing:

interest-only or principal-only stripped MBS;

residual-interest or interest-accrual classes of collateralized mortgage obligations and Real Estate Mortgage Investment Conduits; and

fixed-rate MBS or floating-rate MBS that on the trade date are at rates equal to their contractual cap and that have average lives that vary by more than six years under an assumed instantaneous interest rate change of 300 basis points.

The Finance Board’s Financial Management Policy further limits our investment in MBS and related investments by requiring that the total carrying value of our MBS and related investments not exceed 300% of our previous month-end “regulatory capital” on the day we purchase the securities and we may not exceed our holdings of such securities in any one calendar quarter by more than 50% of our total regulatory capital at the beginning of that quarter. Regulatory capital consists of our total capital stock (including the mandatorily redeemable capital stock) plus our retained earnings. We are permitted to include a Designated Amount of the outstanding principal balance of our subordinated notes in the calculation of our MBS and investments’ limitation as more fully described in Note 18 – Capital Stock and Mandatorily Redeemable Capital Stock. However, we are subject to an overall cap on MBS and related investments so that such investments may not exceed $13.563 billion. At December 31, 2007, those investments, excluding MPF Shared Funding ^® securities, were $9.7 billion or 224% of regulatory capital and Designated Amount of subordinated notes.

Other Mission-Related Community Investment Cash Advance Programs

We assist members in meeting their Community Reinvestment Act responsibilities through a variety of specialized programs. These programs:

provide direct and indirect support for housing and community economic development lending programs;

are designed to ensure that communities throughout our district are safe and desirable places to work and live; and

provide members access to grants and reduced interest rate advances to help them provide funds for affordable rental and owner-occupied housing, small business, and other economic development projects that benefit very low, low, and moderate income individuals, households, and neighborhoods.

Outlined below is a more detailed description of our mission-related programs that we administer and fund:

Affordable Housing Program (“AHP”) – We offer AHP subsidies in the form of direct grants to members in partnership with community sponsors to stimulate affordable rental and homeownership opportunities for households with incomes at or below 80% of the area’s median income, adjusted for family size. AHP subsidies can be used to fund housing acquisition, rehabilitation, and new construction or to cover down payment and closing costs. This program is funded each year with approximately 10% of our income before assessments.

We awarded AHP competitive subsidies totaling $20 million and $26 million for the years ended December 31, 2007 and 2006, for projects designed to provide housing to 4,498 and 5,426 households. In 2007, these subsidies were awarded semi-annually in the second and fourth quarters. In 2008, these subsidies will be awarded in the third quarter. Amounts accrued, but not awarded, are recorded as a liability on our statements of condition.

The Downpayment Plus ^® Program (part of the AHP), in partnership with our members, assists primarily first-time home buyers with down payment and closing cost requirements. During the years ended December 31, 2007 and 2006, in addition to the AHP competitive subsidies, $7 million and $11 million were awarded to Downpayment Plus to assist 1,471 and 2,240 very low-, low-, and moderate-income homebuyers.

Community Investment Program (“CIP”)/Community Economic Development Advance (“CEDA”) Program – We offer two programs where members may apply for advances to support affordable housing development or community economic development lending. These programs provide advance funding at interest rates below regular advance rates for terms typically up to 10 years. Our CIP and CEDA programs may be used to finance affordable home ownership housing, multi-family rental projects, new roads and bridges, agriculture and farm activities, public facilities and infrastructure, and small businesses. For the years ended December 31, 2007 and 2006, we had $1.7 billion and $2.0 billion, respectively, in advances outstanding under the CIP and CEDA programs.

Derivative Activities with Members

We provide smaller members access to the derivatives market by entering into interest rate derivatives directly with them. We enter into offsetting interest rate derivatives with non-member counterparties in cases where we are not

using the interest rate derivatives for our own hedging purposes. See Note 22 – Derivatives and Hedging Activities for a discussion of our use of interest rate derivatives as part of our interest rate risk management and hedging strategies.

Deposits

We accept deposits from our members, institutions eligible to become members, any institution for which we are providing correspondent services, other FHLBs, or other government instrumentalities. We offer several types of deposits to our deposit customers including demand, overnight, and term deposits. For a description of our liquidity requirements with respect to member deposits see Liquidity on page 44.

Standby Letters of Credit

We provide members with standby letters of credit to support their obligations to third parties. Members may use standby letters of credit to facilitate residential housing finance and community lending or for liquidity and asset-liability management purposes. Our underwriting and collateral requirements for standby letters of credit are the same as the underwriting and collateral requirements for advances. For a description of our standby letters of credit see Off-Balance Sheet Arrangements on page 53.

Competition

We compete with other suppliers of both secured and unsecured wholesale funding. Demand for our advances is primarily affected by the cost of other available sources of liquidity for our members, including our members’ customer deposits. Other suppliers of wholesale funding include investment banks, commercial banks, and other FHLBs when our members’ affiliated institutions are members of other FHLBs. Under the FHLB Act and Finance Board regulations, affiliated institutions in different FHLB districts may be members of different FHLBs.

Some members may have limited access to alternative funding sources while other members may have access to a wider range of funding sources, such as repurchase agreements, brokered deposits, commercial paper, covered bonds collateralized with residential mortgage loans, and other funding sources. Some members, particularly larger members, may have independent access to the national and global financial markets.

The availability of alternative funding sources influences the demand for our advances and can vary as a result of a number of factors, such as market conditions, products, members’ creditworthiness, and availability of collateral. We

compete for advances on the basis of the total cost of our products to our members (which includes the rates we charge as well as any dividends we pay), credit and collateral terms, prepayment terms, product features such as embedded options, and the ability to meet members’ specific requests on a timely basis.

Mortgage Partnership Finance ^® Segment

Introduction

We developed the MPF ^® Program to allow us to invest in mortgages, which helps fulfill our housing mission, diversifies our assets beyond our Traditional Member Finance segment, and provides an additional source of liquidity to our members. The MPF Program is a secondary mortgage market structure under which we purchase and fund eligible mortgage loans from or through PFIs, and in some cases, we have purchased participations in pools of eligible mortgage loans from other FHLBs (collectively, “MPF Loans”). MPF Loans are conforming conventional and Government fixed-rate mortgage loans secured by one-to-four family residential properties with maturities ranging from 5 years to 30 years or participations in such mortgage loans.

MPF Program Design

We have entered into agreements with other participating FHLBs under which we and they (“MPF Banks”) acquire MPF Loans from their member PFIs and we provide programmatic and operational support in our role as “MPF Provider.” The MPF Program is designed to allocate the risks of MPF Loans among the MPF Banks and PFIs and to take advantage of their respective strengths in managing these risks. PFIs have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing PFIs to originate MPF Loans, whether through retail or wholesale operations, and to retain or acquire servicing of MPF Loans, the MPF Program gives control of those functions that most impact credit quality to PFIs. The MPF Banks are responsible for managing the interest rate risk, prepayment risk, and liquidity risk associated with owning MPF Loans.

Finance Board regulations define the acquisition of Acquired Member Assets (“AMA”) as a core mission activity of the FHLBs. In order for conventional MPF Loans to meet the AMA requirements, we developed different MPF Loan products for sharing the credit risk associated with MPF Loans with PFIs. MPF Government Loans also qualify as AMA and are insured or guaranteed by one of the following government agencies: the Federal Housing Administration (“FHA”); the Department of Veterans Affairs (“VA”); the Rural Housing Service of the Department of Agriculture (“RHS”); or Department of Housing and Urban Development (“ HUD”).

PFIs may currently choose from five MPF Loan products. Four of these products (Original MPF, MPF 125, MPF Plus, and MPF Government) are closed loan products in which we purchase loans that have been acquired or have already been closed by the PFI with its own funds. However, under the MPF 100 product, we “table fund” MPF Loans; that is, we provide the funds for the PFI as our agent to make the MPF Loan to the borrower. The PFI performs all the traditional retail loan origination functions under this and all other MPF products. With respect to the MPF 100 product, we are considered the originator of the MPF Loan for accounting purposes since the PFI is acting as our agent when originating the MPF Loan.

Participation of other FHLBs

The current MPF Banks are the FHLBs of: Atlanta, Boston, Chicago, Dallas, Des Moines, New York, Pittsburgh, San Francisco, and Topeka. The FHLB of San Francisco ceased offering new master commitments to its PFIs in October 2006 and its agreement with us was terminated effective January 4, 2008, although the agreement continues to apply to its existing portfolio of MPF Loans. Our agreement with the FHLB of Atlanta was terminated effective February 4, 2008, although the agreement continues to apply to its MPF Loans acquired under master commitments executed prior to February 4, 2008. Because our revenues from MPF transaction processing services paid by the FHLB of Atlanta will take several years to materially decrease and those paid by the FHLB of San Francisco are not significant, these terminations will not have a material effect on our MPF business or operations.

MPF Banks generally acquire whole loans from their respective PFIs but may also acquire them from a member PFI of another MPF Bank with permission of the PFI’s respective MPF Bank. Alternatively, MPF Banks may acquire participations from another MPF Bank.

In connection with our business strategy to reduce our on-balance sheet MPF Loan portfolio, we no longer enter into agreements to purchase participation interests in new master commitments from other FHLBs, and in 2007 we completed our obligations to purchase participation interests under existing agreements. We continue to purchase MPF Loans directly from PFIs of the FHLB of Dallas and pay the FHLB of Dallas a fee for acting as our marketing agent. We capitalize this fee as part of the acquisition cost of the MPF Loans and amortize it over the contractual life.

MPF Provider

In our role as MPF Provider, we establish the eligibility standards under which an MPF Bank member may become a PFI, the structure of MPF Loan products and the eligibility

rules for MPF Loans. In addition, we manage the pricing and delivery mechanism for MPF Loans and the back-office processing of MPF Loans in our role as master servicer and master custodian. We have engaged Wells Fargo Bank N.A. as our vendor for master servicing and as the primary custodian for the MPF Program. We have also contracted with other custodians meeting MPF Program eligibility standards at the request of certain PFIs. These other custodians are typically affiliates of PFIs and in some cases a PFI acts as self-custodian.

We publish and maintain the MPF Origination Guide and MPF Servicing Guide (together, “MPF Guides”), which detail the requirements PFIs must follow in originating or selling and servicing MPF Loans. We maintain the infrastructure through which MPF Banks may fund or purchase MPF Loans through their PFIs. This infrastructure includes both a telephonic delivery system and a web-based delivery system accessed through the eMPF ^® website. In exchange for providing these services, we receive a fee from the other MPF Banks.

PFI Eligibility

Members and eligible housing associates may apply to become a PFI of their respective MPF Bank. If a member is an affiliate of a holding company, which has another affiliate that is an active PFI, the member is only eligible to become a PFI if it is a member of the same MPF Bank as the existing PFI. The MPF Bank reviews the general eligibility of the member, its servicing qualifications and ability to supply documents, data, and reports required to be delivered by PFIs under the MPF Program. The member and its MPF Bank sign an MPF Program Participating Financial Institution Agreement (“PFI Agreement”) that provides the terms and conditions for the sale or funding of MPF Loans, including required credit enhancement, and it establishes the terms and conditions for servicing MPF Loans. All of the PFI’s obligations under the PFI Agreement are secured in the same manner as the other obligations of the PFI under its regular advances agreement with the MPF Bank. The MPF Bank has the right under the PFI Agreement to request additional collateral to secure the PFI’s obligations.

PFI Responsibilities

For conventional MPF Loan products, PFIs assume or retain a portion of the credit risk on the MPF Loans we fund or purchase by providing credit enhancement (“CE Amount”) either through a direct liability to pay credit losses up to a specified amount or through a contractual obligation to provide supplemental mortgage guaranty insurance (“SMI”). The PFI’s CE Amount covers losses for MPF Loans under a master commitment in excess of the MPF Bank’s first loss account (“FLA”). The FLA is a memo account used

to track the MPF Bank’s exposure to losses until the CE Amount is available to cover losses. PFIs are paid a credit enhancement fee (“CE Fee”) for managing credit risk and in some instances, all or a portion of the CE Fee may be performance based. See MPF Loans Credit Enhancement Structure for a detailed discussion of the credit enhancement and risk sharing arrangements for the MPF Program on page 62.

PFIs are required to comply with the MPF Program policies contained in the MPF Guides which include eligibility requirements for PFIs; anti-predatory lending policies; loan eligibility and underwriting requirements; loan documentation; and custodian requirements. The MPF Guides also detail the PFI’s servicing duties and responsibilities for reporting, remittances, default management, and disposition of properties acquired by foreclosure or deed in lieu of foreclosure.

In connection with each sale to, or funding by, an MPF Bank, the PFI makes customary representations and warranties in the PFI Agreement and under the MPF Guides. These representations and warranties include eligibility and conformance of the MPF Loans with the requirements in the MPF Guides, compliance with predatory lending laws, and the integrity of the data transmitted to the MPF Provider.

In addition, the MPF Guides require each PFI to maintain errors and omissions insurance and a fidelity bond and to provide an annual certification with respect to its insurance and its compliance with the MPF Program requirements.

Mortgage Standards

PFIs are required to deliver mortgage loans that meet the underwriting and eligibility requirements in the MPF Guides, which may be amended for individual PFIs by waivers that exempt a PFI from complying with specified provisions of the MPF Guides. PFIs may utilize an approved automated underwriting system or underwrite MPF Loans manually. The current underwriting and eligibility guidelines in the MPF Guides with respect to MPF Loans are broadly summarized as follows:

Mortgage characteristics. MPF Loans must be qualifying 5-year to 30-year conforming conventional or Government fixed-rate, fully amortizing mortgage loans, secured by first liens on owner-occupied one-to-four unit single-family residential properties and single unit second homes. Conforming loan size, which is established annually, as required by Finance Board regulations, may not exceed the loan limits permitted to be set by the Office of Federal Housing Enterprise Oversight (“OFHEO”) each year. Condominium,

planned unit development, and manufactured homes are acceptable property types as are mortgages on leasehold estates (though manufactured homes must be on land owned in fee simple by the borrower).

Loan-to-Value Ratio and Primary Mortgage Insurance . The maximum loan-to-value ratio (“LTV”) for conventional MPF Loans must not exceed 95%, though an MPF Bank’s AHP mortgage loans may have LTVs up to 100% (but may not exceed 105% total LTV, which compares the property value to the total amount of all mortgage loans outstanding against a property). Government MPF Loans may not exceed the LTV limits set by the applicable government agency. Conventional MPF Loans with LTVs greater than 80% require certain amounts of primary mortgage insurance (“PMI”) from a mortgage guaranty insurance (“MI”) company rated at least “AA” or “Aa” and acceptable for use in S&P’s LEVELS ^® modeling software, which calculates the PFI’s required CE Amount for MPF Loans.

Documentation and Compliance with Applicable Law. The mortgage documents and mortgage transaction must comply with all applicable laws, and mortgage loans must be documented using standard Fannie Mae/Freddie Mac Uniform Instruments.

Ineligible Mortgage Loans. The following types of mortgage loans are not eligible for delivery under the MPF Program: (1) mortgage loans which must be excluded from securities rated by S&P (2) mortgage loans not meeting the MPF Program eligibility requirements as set forth in the MPF Guides and agreements; (3) mortgage loans that are classified as high cost, high rate, high risk, or Home Ownership and Equity Protection Act loans, or loans in similar categories defined under predatory lending or abusive lending laws; and (4) subprime or non-traditional mortgage loans.

MPF Loan Delivery Process

Outlined below is the MPF Loan delivery process:

The PFI enters into a best efforts master commitment with its MPF Bank in order to deliver mortgage loans under the MPF Program. The master commitment provides the general terms under which the PFI will deliver mortgage loans to an MPF Bank, including a maximum loan delivery amount, maximum credit enhancement obligation and expiration date.

PFIs may then request one or more mandatory funding or purchase delivery commitments to sell or originate eligible mortgage loans.

Each MPF Loan delivered must conform to specified ranges of interest rates, maturity terms, and business days for delivery (which may be extended for a fee) detailed in the delivery commitment or it will be rejected by us as MPF Provider.

Each MPF Loan under a delivery commitment is linked to a master commitment so that the cumulative CE Amount can be determined for each master commitment.

The sum of MPF Loans delivered by the PFI under a specific delivery commitment cannot exceed the amount specified in the delivery commitment without the assessment of a price adjustment fee.

Delivery commitments that are not fully funded by their expiration dates are subject to pair-off or extension fees. Pair-off fees are charged to a PFI for failing to deliver the amount of loans specified in a delivery commitment, and extension fees are charged to a PFI for extending the time deadline to deliver loans on a delivery commitment. Such fees are designed to protect the MPF Bank against changes in market prices.

Once an MPF Loan is funded or purchased, the PFI must deliver a qualifying promissory note and certain other required documents to the designated custodian. The designated custodian reports to the MPF Provider whether the documentation package matches the funding information transmitted to the MPF Provider and otherwise meets MPF Program requirements.

Quality Assurance Process

In our role as MPF Provider, we conduct an initial quality assurance review of a selected sample of conventional MPF Loans from each PFI’s initial MPF Loan delivery. We do not currently conduct quality assurance reviews of MPF Government Loans. Subsequently, we perform periodic reviews of a sample of conventional MPF Loans to determine whether the reviewed MPF Loans complied with the MPF Program requirements at the time of acquisition.

Any exception that indicates a negative trend in compliance is discussed with the PFI and can result in the suspension or termination of a PFI’s ability to deliver new MPF Loans if the concern is not adequately addressed.

When a PFI fails to comply with the requirements of the PFI Agreement, MPF Guides, including servicing breaches, applicable law, or terms of mortgage documents, the PFI may be required to provide an indemnification covering related losses or to

See MPF Loans Credit Enhancement Structure on page 62 for a detailed discussion of the credit enhancement and risk sharing arrangements of the various MPF products.

MPF Loan Participations

During the fourth quarter of 2007, we completed the purchase of participations from other FHLBs and are no longer purchasing participation interests. At December 31, 2007, 55.4% of the total par value of MPF Loans we own represents participations acquired from other MPF Banks. Participation percentages for MPF Loans may range from 1% to 100% and the participation percentages in MPF Loans may vary by each master commitment, by agreement of the MPF Bank selling the participation interests (the “Owner Bank”), us, in our role as MPF Provider, and other MPF Banks purchasing a participation interest.

The Owner Bank is responsible for the following:

evaluating and monitoring the creditworthiness of each PFI;

reporting to any participant MPF Bank initially, and at least annually thereafter on the creditworthiness of the PFI;

ensuring that adequate collateral is available from each of its PFIs to secure any direct obligation portion of the PFI’s CE Amount; and

enforcing the PFI’s obligations under its PFI Agreement.

The risk sharing and rights of the Owner Bank and participating MPF Bank(s) are as follows:

each pays its respective pro rata share of each MPF Loan acquired under a delivery commitment and related master commitment based upon a specified participation percentage;

each receives its respective pro rata share of principal and interest payments and is responsible for CE Fees based upon its participation percentage for each MPF Loan under the related delivery commitment, and for the Original MPF product, each is responsible for monthly allocations to the FLA based upon the unpaid principal balance of, and its participation percentage for each MPF Loan;

each is responsible for its respective pro rata share of FLA exposure and losses incurred with respect to the master commitment based upon the overall risk sharing percentage for the master commitment, except that for the Original MPF product, each shares in exposure to loss based on its respective percentage of the FLA at the time the loss is allocated; and

each may economically hedge its share of delivery commitments as they are issued under a master commitment.

The FLA and CE Amount apply to all the MPF Loans in a master commitment regardless of participation arrangements, so an MPF Bank’s share of credit losses is based on its respective participation interest in the entire master commitment. For example, assume an MPF Bank’s specified participation percentage was 25% under a $100 million master commitment and that no changes were made to the master commitment. The MPF Bank’s risk sharing percentage of credit losses would be 25%.

In the case where an MPF Bank changes its initial percentage in the master commitment, the risk sharing percentage will also change. For example, if an MPF Bank were to acquire 25% of the first $50 million and 50% of the second $50 million of MPF Loans delivered under a master commitment, the MPF Bank would share in 37.5% of the credit losses in that $100 million master commitment, while it would receive principal and interest payments on the individual MPF Loans that remain outstanding in a given month, some in which it may own a 25% interest and the others in which it may own a 50% interest.

The arrangement is slightly different for the Original MPF product because each MPF Bank’s participation percentage in the FLA is based upon its share of each MPF Loan as the FLA increases over time. If the participation percentage never changes over the life of a master commitment, then the risk of loss is based on the MPF Bank’s respective investment percentage in the master commitment. If the percentage participations differ for various MPF Loans, each MPF Bank’s percentage of the FLA will be impacted by those differences because MPF Loans are acquired and repaid at different times. For example, if a master commitment had a total FLA of $100,000 (as of the date of the loss), and one participant MPF Bank’s FLA is $25,000 and the other MPF Bank’s FLA is $75,000, then the first MPF Bank would incur 25% of the loss incurred at such time and the other MPF Bank would incur 75%.

MPF Servicing

The PFI or its servicing affiliate generally retains the right and responsibility for servicing MPF Loans it delivers. The PFI is responsible for collecting the borrower’s monthly payments and otherwise dealing with the borrower with respect to the MPF Loan and the mortgaged property. Based on monthly reports the PFI is required to provide the master servicer, appropriate withdrawals are made from the PFI’s deposit account with the applicable MPF Bank. In some cases, the PFI has agreed to advance principal and interest payments on the scheduled remittance date when the borrower has failed to pay provided the collateral securing the MPF Loan is sufficient to reimburse the PFI for advanced amounts. The PFI recovers the advanced

amounts either from future collections or upon the liquidation of the collateral securing the MPF Loan.

If an MPF Loan becomes delinquent, the PFI is required to contact the borrower to determine the cause of the delinquency and whether the borrower will be able to cure the default. The MPF Guides permit certain types of forbearance plans. Upon any MPF Loan becoming 90 days or more delinquent, the master servicer monitors and reviews the PFI’s default management activities for that MPF Loan, including timeliness of notices to the mortgagor, forbearance proposals, property protection activities, and foreclosure referrals, all in accordance with the MPF Guides.

Upon liquidation of any MPF Loan and submission of each realized loss calculation from the PFI, the master servicer reviews the realized loss calculation for conformity with the primary MI requirements, if applicable, and conformity to the cost and timeliness standards of the MPF Guides. The master servicer disallows the reimbursement to the PFI of any servicing advances related to the PFI’s failure to perform in accordance with the MPF Guides.

If there is a loss on a conventional MPF Loan, the loss is allocated to the master commitment and shared in accordance with the risk sharing structure for that particular master commitment. The servicer pays any gain on sale of real-estate owned property to the MPF Bank, or in the case of a participation, the gain is paid to the MPF Banks based upon their respective interest in the MPF Loan. However, the amount of the gain is available to reduce subsequent losses incurred under the master commitment before such losses are allocated between the MPF Bank and the PFI.

The MPF Provider monitors the PFI’s compliance with MPF Program requirements throughout the servicing process, and brings any material concerns to the attention of the MPF Bank. Minor lapses in servicing are charged to the PFI. Major lapses in servicing could result in a PFI’s servicing rights being terminated for cause and the servicing of the particular MPF Loans being transferred to a new, qualified servicing PFI.

Although PFIs or their servicing affiliates generally service the MPF Loans delivered by the PFI, certain PFIs choose to sell the servicing rights on a concurrent basis (servicing released) or in a bulk transfer to another PFI, which is permitted with the consent of the MPF Bank(s) involved. One PFI has been designated to acquire servicing under the MPF Program’s concurrent sale of servicing option. In addition, several PFIs have acquired servicing rights on a concurrent servicing released basis or bulk transfer basis without the direct support from the MPF Program.

MPF Shared Funding ^® Program

In 2003, we invested in AMA eligible securities through the MPF Shared Funding program. The MPF Shared Funding program provided a platform to allow mortgage loans to be sold through the MPF Program system to a third party-sponsored trust and “pooled” into securities. Similar to our MPF Provider role, we serve as master servicer and master custodian for the benefit of the holders of the securities. Under the program, we purchased the AMA eligible securities, which are rated at least “AA”, and retained some of the securities and sold some to other FHLBs. No residual interest is created or retained on our balance sheet.

Aside from potential liquidity benefits on future transactions, there is not a material difference in our risk profile or earnings between holding MPF Shared Funding securities and holding the mortgage loans backing the securities. We have not completed any MPF Shared Funding transactions since June, 2003.

Competition

We compete for the purchase of mortgage loans from members with other secondary market participants, such as Fannie Mae, Freddie Mac, large mortgage aggregators and private investors. Some of these competitors have greater resources, larger volumes of business, and longer operating histories. In addition, we compete with other FHLBs that offer other mortgage purchase programs, to the extent that our members have affiliates that are members of these other FHLBs. We primarily compete on the basis of transaction structure, price, products, and services offered.

The participation of FHLBs in other mortgage purchase programs may have implications on the MPF Program. Specifically, the competition for mortgage loans between these programs may impact the amount of mortgage loans acquired and the purchase price for such loans. In this regard, we face risk that the pool of eligible mortgage loans available for purchase will be reduced, as well as profit margin risk. Because of the somewhat extensive infrastructure and processes required by our members to participate in the MPF Program, the application approval process can be relatively long. For example, we require an applicant to demonstrate the ability and the staff to originate and service mortgage loans to industry accepted standards. These infrastructure and process requirements can be disincentives to prospective participating members, as many of our smaller members lack the resources to participate in more than one program.

Multi-district memberships are not currently permitted in the System, so we generally do not compete for mortgage loans from members of other MPF Banks. Affiliated entities under

a parent holding company are only permitted to access the MPF Program through one MPF Bank, so it is possible that a PFI with an affiliate in another MPF Bank district could choose to terminate its PFI status with us and then access the MPF Program through its affiliate. Other than to determine PFI eligibility, we do not require members to report information concerning affiliates that may be members of other FHLBs. The eligibility requirements for holding company affiliates do not apply to the Mortgage Purchase Program but pertain solely to participation in the MPF Program. We do not participate in the Mortgage Purchase Program, which may include member participants that are affiliates of PFIs participating in the MPF Program.

Funding Services

Consolidated Obligations

Our primary source of funds is the sale to the public of FHLB debt instruments, called consolidated obligations in the capital markets. Additional funds are provided by deposits, other borrowings, subordinated debt and the issuance of capital stock. Consolidated obligations, which consist of bonds and discount notes, are the joint and several obligations of the FHLBs, although the primary obligation is with the individual FHLB that receives the proceeds from sale. Consolidated obligations are sold to the public through the Office of Finance using authorized securities dealers. Consolidated obligations are backed only by the financial resources of the FHLBs and are not guaranteed by the United States government. See Funding on page 45 for further discussion.

Subordinated Debt

No FHLB is permitted to issue individual debt unless it has received approval from the Finance Board. As approved by the Finance Board, we issued $1 billion of 10-year subordinated notes in 2006. The subordinated notes are not obligations of, and are not guaranteed by, the United States government or any of the FHLBs other than the Bank. For further discussion of our subordinated notes, see Note 15 – Subordinated Notes.

Competition

We compete with the United States government, Fannie Mae, Freddie Mac, and other GSEs, as well as corporate, sovereign, and supranational entities, including the World Bank, 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 or lower amounts of debt issued at the same cost than otherwise would be the case. In addition, the availability and cost of

funds raised through issuance of certain types of unsecured debt may be adversely affected by regulatory initiatives. Although the available supply of funds from the FHLBs’ debt issuances has kept pace with the funding requirements of our members, there can be no assurance that this will continue to be the case.

The sale of callable debt and the execution of callable interest-rate swaps that mirror the debt has been an important source of competitive funding for us. We also rely heavily on the callable debt markets to reduce the interest rate exposure inherent in our mortgage-based assets, including MBS and MPF Loans. Consequently, the availability of markets for callable debt and interest-rate derivatives may be an important determinant of our relative cost of funds and ability to manage interest rate risk. Due to the higher relative risk of callable debt, there is a limited investor market relative to the supply generated from the FHLBs and other GSEs, including Fannie Mae or Freddie Mac. There is no assurance that the current breadth and depth of these markets will be sustained.

Oversight, Audits, and Related Actions

Regulatory Oversight

Under the FHLB Act, the Finance Board regulates and supervises us to ensure that we carry out our housing finance mission, remain adequately capitalized, are able to raise funds in the capital markets, and operate in a safe and sound manner. The Finance Board also establishes policies and regulations covering our operations. The Finance Board is governed by a five-member board; four board members are appointed by the President of the United States, with the advice and consent of the Senate, to serve seven-year terms. The fifth member of the board is the Secretary of HUD or the Secretary’s designee.

The Finance Board’s operating and capital expenditures are funded by assessments on the FHLBs; no tax dollars or other appropriations support the operations of the Finance Board. To assess our safety and soundness, the Finance Board conducts annual, on-site examinations as well as periodic on-site reviews. Additionally, we are required to submit monthly financial information on our condition and results of operations to the Finance Board.

The Government Corporations Control Act, to which we are subject, provides that before a government corporation issues and offers obligations to the public, the Secretary of the Treasury shall prescribe the form, denomination, maturity, interest rate, and conditions of the obligations, the way and time issued, and the selling price. The FHLB Act also authorizes the Secretary of the Treasury discretion to purchase consolidated obligations up to an aggregate

principal amount of $4.0 billion. No borrowings under this authority have been outstanding since 1977. We must submit annual management reports to Congress, the President, the Office of Management and Budget, and the Comptroller General. These reports include a statement of financial condition, a statement of operations, a statement of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent public accounting firm on our financial statements.

Regulatory Developments

Written Agreement

On June 30, 2004, we entered into a Written Agreement with the Finance Board to address issues identified in their 2004 examination of the Bank. The Written Agreement was subsequently amended three times in order to adjust the Bank’s minimum regulatory capital requirements. We operated under the Written Agreement until the Finance Board terminated the agreement on October 10, 2007 as part of a consensual cease and desist order with the Bank, the terms of which are discussed below.

Under the Written Agreement we agreed to implement changes to enhance our risk management, capital management, governance, and internal control practices, and to submit a business and capital management plan to the Finance Board. In addition, the Written Agreement, as amended, required us to:

limit increases in the aggregate net book value of our AMA (i.e. MPF assets) under the MPF Program to no greater than 10% per annum;

maintain a ratio of regulatory capital stock, plus retained earnings, plus a Designated Amount of our subordinated notes to total assets of at least 4.5%; and

maintain an aggregate amount of outstanding regulatory capital stock plus a Designated Amount of our subordinated notes of at least $3.500 billion.

While under the Written Agreement, we worked with the Finance Board to develop strategic and operational alternatives to strengthen our capital base and transition to a more traditional Federal Home Loan Bank structure, including the following:

adopting a new Retained Earnings and Dividends Policy in April 2006;

changing the structure of our balance sheet by not replacing most of our MPF Program assets as they paid down while continuing to serve our members with this product;

exploring alternative methods of capitalizing and funding AMA under the MPF Program;

reducing outstanding voluntary capital stock;

implementing expense reduction initiatives, including a reduction-in-force on May 1, 2007;

reviewing our expense structure throughout the Bank and focusing on ways to enhance efficiency;

refocusing on our core advances business; and

exploring other methods to increase our net income, including balance sheet restructuring alternatives.

Consent Cease and Desist Order

At the request of the Finance Board, on October 10, 2007, we entered into a Consent Cease and Desist Order (“C&D Order”) with the Finance Board. The C&D Order states that the Finance Board has determined that requiring us to take the actions specified in the C&D Order will “improve the condition and practices at the Bank, stabilize its capital, and provide the Bank an opportunity to address the principal supervisory concerns identified by the Finance Board.” The C&D Order places several requirements on us, including the following:

We must maintain a ratio of regulatory capital stock, plus retained earnings, plus a Designated Amount of subordinated notes to total assets of at least 4.5%, and a minimum total amount of the sum of regulatory capital stock plus a Designated Amount of subordinated notes of $3.600 billion;

Capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other membership termination, require prior approval of the Director of the Office of Supervision of the Finance Board (“OS Director”). The C&D Order provides that the OS Director may approve a written request by us for proposed redemptions or repurchases if the OS Director determines that allowing the redemption or repurchase would be consistent with maintaining the capital adequacy of the Bank and its continued safe and sound operations;

Dividend declarations are subject to the prior written approval of the OS Director;

Within 120 days of the effective date of the C&D Order, we were required to submit a capital plan to the Finance Board consistent with the requirements of the Gramm-Leach-Bliley Act (“GLB Act”) and Finance Board regulations, along with strategies for implementing the plan; and

We were required to review and revise our market risk management and hedging policies, procedures and practices to address issues identified in the Finance Board’s 2007 examination of the Bank, and within 90 days of the effective date of the C&D Order submit revised policies and procedures to the OS Director for non-objection prior to implementation.

Our Written Agreement with the Finance Board was terminated under the terms of the C&D Order and the minimum capital and leverage requirements for the Bank, previously included in the Written Agreement, are now in the C&D Order modified as described above.

We intend to fully comply with the C&D Order, and have already taken actions to meet many of the requirements, including:

We have reviewed our market risk hedging policies, procedures and practices, and submitted revised policies and procedures to the OS Director on January 7, 2008; and

On February 6, 2008 we submitted a capital plan and implementation strategies to the Finance Board for its approval to provide for the conversion of our capital stock under the GLB Act; and

We remain in compliance with the minimum capital and leverage requirements under the C&D Order.

Regulatory Audits

The Comptroller General has authority under the FHLB Act to audit or examine the Bank and the Finance Board and to decide the extent to which we fairly and effectively fulfill the purposes of the FHLB Act. Furthermore, the Government Corporations Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent registered public accounting firm. If the Comptroller General conducts such a review, then the results and any recommendations must be reported to the Congress, the Office of Management and Budget, and the FHLB in question. The Comptroller General may also conduct a separate audit of any of our financial statements.

Taxation

We are exempt from all federal, state, and local taxation except for real estate property taxes, which are a component of our lease payments for office space or on real estate we own as a result of foreclosure on MPF Loans.

REFCORP & AHP Assessments

In lieu of taxes, we set aside funds at a 10% rate on our income for the AHP and pay a 20% assessment for the Resolution Funding Corporation (“REFCORP”). Since each is net of the other, the overall effective rate is approximately 26.5%. For details on our assessments for the three years ended December 31, 2007, see Note 16 – Assessments.

Item 1A.

Risk Factors.

The Board of Directors’ recent decisions not to pay dividends and our anticipated inability to pay dividends for some period may decrease member demand for advances and increase membership withdrawals.

As discussed in Retained Earnings and Dividends on page 51, our Board of Directors decided to retain the full amount of third and fourth quarter 2007 net income rather than declaring dividends on the results for those quarters. While any future dividend determination by our Board of Directors will depend principally on future operating results, the C&D Order provides that our dividend declarations are subject to the prior written approval of the OS Director. There can be no assurance that the OS Director would approve such recommendations if made. We believe that our projected financial performance and the impact of the C&D Order will continue to negatively impact our ability to pay future dividends. If we continue not to pay dividends or resume paying lower dividends, we may experience decreased member demand for advances requiring capital stock purchases and increased membership requests for withdrawals that may adversely affect our results of operations and financial condition.

The amount of net interest income that we earn may be adversely affected by changes in interest rates.

Market risk is the potential for loss due to market value changes in financial instruments we hold. Interest rate risk is a critical component of market risk. We are exposed to interest rate risk primarily from the effects of changes in interest rates on our interest earning assets and our funding sources which finance these assets. Mortgage-related assets are the predominant sources of interest rate risk in our market risk profile. Changes in interest rates affect both the value of our mortgage-related assets and prepayment rates on those assets. These assets include MPF Loans and MBS.

Our overall objective in managing interest rate risk is to maintain a neutral duration of equity position and also remain within our management advisory and regulatory limits. Given recent market volatility and the complexity of our balance sheet, managing to these limits can be expensive and difficult to achieve. We manage our interest