The following Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our interim financial statements and related notes presented under Part I Item 1 of this quarterly report on Form 10-Q and the annual report on Form 10-K for the year ended
December 31, 2013, which includes audited financial statements and related notes for the year ended December 31, 2013. Our MD&A includes the following sections:
§ Executive Level Overview - a general description of our business and financial
§ Financial Market Trends - a discussion of current trends in the financial
markets and overall economic environment, including the related impact on our
§ Critical Accounting Policies and Estimates - a discussion of accounting
policies that require critical estimates and assumptions;
§ Results of Operations - an analysis of our operating results, including
disclosures about the sustainability of our earnings;
§ Financial Condition - an analysis of our financial position;
§ Liquidity and Capital Resources - an analysis of our cash flows and capital
§ Risk Management - a discussion of our risk management strategies;
§ Recently Issued Accounting Standards; and
§ Recent Regulatory and Legislative Developments.
Executive Level Overview We are a regional wholesale bank that makes advances (loans) to, purchases mortgages from, and provides limited other financial services to our member institutions. We are one of 12 district FHLBanks which, together with the
Office of Finance, a joint office of the FHLBanks, make up the FHLBank System. As independent, member-owned cooperatives, the FHLBanks seek to maintain a balance between their public purpose and their ability to provide adequate returns on the capital supplied by their members. The FHLBanks are supervised and regulated by the Finance Agency, an independent agency in the executive branch of the U.S. government. The Finance Agency'smission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment. Our primary funding source is consolidated obligations issued through the FHLBanks' Office of Finance. The Office of Financeis a joint office of the FHLBanks that facilitates the issuance and servicing of the consolidated obligations. The Finance Agencyand the U.S. Secretary of the Treasury oversee the issuance of FHLBank debt through the Office of Finance. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally considered the FHLBanks' consolidated obligations as "Federal agency" debt. As a result, the FHLBanks have traditionally had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings, and the issuance of capital stock. We serve eligible financial institutions in Colorado, Kansas, Nebraska, and Oklahoma(collectively, the Tenth Districtof the FHLBank System). Initially, members are required to purchase shares of Class A Common Stock based on the member's total assets. Each member may be required to purchase activity-based capital stock (Class B Common Stock) as it engages in certain business activities with the FHLBank, including advances and Acquired Member Assets (AMA), at levels determined by management with the Board of Director'sapproval and within the ranges stipulated in the Capital Stock Plan. Currently, our capital increases when members are required to purchase additional capital stock in the form of Class B Common Stock to support an increase in advance borrowings. In the past, capital stock also increased when members sold additional mortgage loans to us; however, members are no longer required to purchase capital stock for AMA activity (former members previously required to purchase AMA activity-based stock are subject to the prior requirement as long as there are unpaid principal balances outstanding). At our discretion, we may repurchase excess Class B Common Stock if there is a decline in a member's advances. We believe it is important to manage our business and the associated risks so that we can always strive to meet the following objectives: (1) achieve our liquidity, housing finance and community development missions by meeting member credit needs by offering advances, supporting residential mortgage lending through the MPF Program and through other products; (2) repurchase excess capital stock in order to appropriately manage the size of our balance sheet; and (3) pay appropriate dividends. 44
Table of Contents
Table 1 presents Selected Financial Data for the periods indicated (dollar amounts in thousands):
Table 1 03/31/2014 12/31/2013 09/30/2013 06/30/2013 03/31/2013 Statement of Condition (as of period end): Total assets
$ 32,099,092 $ 33,950,304 $ 36,144,769 $ 35,708,766 $ 33,958,134Investments1 9,524,184 8,704,552 10,328,938 10,720,934 10,225,440 Advances 16,112,925 17,425,487 18,805,283 18,817,468 17,581,906 Mortgage loans, net2 5,984,655 5,949,480 5,912,377 5,958,984 5,923,911 Total liabilities 30,369,008 32,149,084 34,331,505 33,808,148 32,139,181 Deposits 1,020,230 961,888 757,216 918,360 1,346,535 Consolidated obligation bonds, net3 19,765,733 20,056,964 21,055,434 20,866,135 21,319,639 Consolidated obligation discount notes, net3 9,356,707 10,889,565 12,185,294 11,621,564 9,204,351 Total consolidated obligations, net3 29,122,440 30,946,529 33,240,728 32,487,699 30,523,990 Mandatorily redeemable capital stock 4,641 4,764 5,184 5,410 4,979 Total capital 1,730,084 1,801,220 1,813,264 1,900,618 1,818,953 Capital stock 1,165,809 1,252,249 1,295,669 1,404,501 1,344,456 Total retained earnings 581,425 567,332 538,650 518,306 498,172 Accumulated other comprehensive income (loss) (AOCI) (17,150) (18,361) (21,055) (22,189) (23,675) Statement of Income (for the quarterly period ended): Net interest income 54,494 59,125 54,546
52,018 52,084 Provision (reversal) for credit losses on mortgage loans 295 (135) 530 (416) 1,947 Other income (loss) (16,673) (3,239) (9,831) (7,274) (10,474) Other expenses 12,784 14,934 12,430 13,123 12,275 Income before assessments 24,742 41,087 31,755 32,037 27,388 Affordable Housing Program (AHP) assessments 2,475 4,109 3,176 3,204 2,740 Net income 22,267 36,978 28,579 28,833 24,648 Selected Financial Ratios and Other Financial Data (for the quarterly period ended): Dividends paid in cash4 79 77 73 73 68 Dividends paid in stock4 8,095 8,219 8,162 8,626 7,690
dividend rate5 2.60 % 2.51 % 2.31 % 2.48 % 2.39 % Dividend payout ratio6 36.71 % 22.43 % 28.81 % 30.17 % 31.48 % Return on average equity 4.91 % 7.94 % 5.87 % 6.10 % 5.57 % Return on average assets 0.27 % 0.40 % 0.31 % 0.32 % 0.29 % Average equity to average assets 5.57 % 5.09 % 5.37 % 5.31 % 5.21 % Net interest margin7 0.67 % 0.65 % 0.60 % 0.59 % 0.62 % Total capital ratio8 5.39 % 5.31 % 5.02 % 5.32 % 5.36 % Regulatory capital ratio9 5.46 % 5.37 % 5.09 % 5.40 % 5.44 % Ratio of earnings to fixed charges10 1.48 1.80 1.58 1.55 1.45
1 Includes trading securities, held-to-maturity securities, interest-bearing
deposits, securities purchased under agreements to resell and Federal funds
2 The allowance for credit losses on mortgage loans was
6,891,000, 6,590,000 and 7,086,000 as of
liable to repay. See Note 9 to the financial statements for a description of
the total consolidated obligations of all 12 FHLBanks for which we are jointly
and severally liable under the requirements of the
governs the issuance of debt for the 12 FHLBanks. 4 Dividends reclassified as interest expense on mandatorily redeemable capital
stock and not included as dividends recorded in accordance with accounting
principles generally accepted in
5 Dividends paid in cash and stock on both classes of stock as a percentage of
average capital stock eligible for dividends. 6 Ratio disclosed represents dividends declared and paid during the year as a
percentage of net income for the period presented, although the
regulation requires dividends be paid out of known income prior to declaration
7 Net interest income as a percentage of average earning assets. 8 GAAP capital stock, which excludes mandatorily redeemable capital stock, plus
retained earnings and AOCI as a percentage of total assets. 9 Regulatory capital (i.e., permanent capital and Class A capital stock) as a
percentage of total assets. 10 Total earnings divided by fixed charges (interest expense including
amortization/accretion of premiums, discounts and capitalized expenses related
to indebtedness). 45
Table of Contents Net income for the quarter ended
March 31, 2014was $22.3 millioncompared to $24.6 millionfor the quarter ended March 31, 2013. The $2.3 milliondecrease was due to a $10.9 millionincrease in net losses from derivative and hedging activities, partially offset by a $4.4 milliondecrease in net losses on trading securities, a $2.4 millionincrease in net interest income and an $1.7 milliondecrease in the provision for loan losses. The increase in net losses from derivative and hedging activities for the quarter ended March 31, 2014was primarily a result of a sizable decline in the fair value of interest rate caps due to interest rate fluctuations, compared to a slight gain in the fair value of the caps reported for the quarter ended March 31, 2013. The decrease in net loss on trading securities during the current quarter compared to the prior year quarter was due primarily to fair value fluctuations caused by the interplay between interest rates and the remaining term of these securities. The increase in net interest income is the result of: (1) a decrease in the overall cost of borrowing compared to the prior year as some relatively high-rate debt matured or was called in late 2013; and (2) a 16 basis point increase in the average yield on mortgage loans. These factors resulted in an increase in the net interest margin for the first quarter of 2014 to 0.67 percent, compared to 0.62 percent for the same period in 2013. Detailed discussion relating to the fluctuations in net interest income, net gain (loss) on derivatives and hedging activities and net gain (loss) on trading securities can be found under this Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." Total assets decreased $1.9 billion, or 5.5 percent, from December 31, 2013to March 31, 2014. This decrease was due to a $1.3 billion, or 7.5 percent, decrease in advances and a $0.8 billion, or 10.1 percent, decrease in investment securities, partially offset by a net $0.3 billionincrease in cash and investments with overnight maturities. The majority of the decrease in advances was in our line of credit portfolio, and was generally due to members continuing to maintain higher levels of balance sheet liquidity, which decreases the need for advances. The decrease in investment securities is due to paydowns and maturities that were not reinvested, as part of the balance sheet initiative described in greater detail below. Total liabilities decreased $1.8 billion, or 5.5 percent, from December 31, 2013to March 31, 2014. This decrease was primarily due to a $1.5 billiondecrease in consolidated obligation discount notes. The decrease in discount notes from December 31, 2013to March 31, 2014was primarily a result of a decrease in short-term advances, which are generally funded by discount notes. For additional information, see Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition." The Class B dividend rate increased to 4.0 percent in the first quarter of 2014, while the Class A dividend rate remained unchanged. Changes in the weighted average dividend rates over the periods ended March 31, 2014(2.60 percent) and 2013 (2.39 percent) occurred primarily due to the Class B dividend rate increase, which was partially offset by changes in the mix of Class A and Class B stock. Factors impacting the stock class mix and average dividend rates include: (1) a reduction in our activity stock (Class B) requirement for AMA in the third quarter of 2013; (2) weekly exchanges of excess Class B stock to Class A; and (3) periodic repurchases of excess Class A stock. Our balance sheet management strategies for the period of 2014-2016 will focus on improving our core mission asset ratios and include the establishment of benchmark ratios of: (1) advances to consolidated obligations (Tier 1 ratio); and (2) advances plus AMA to consolidated obligations (Tier 2 ratio) (see further discussion of these benchmark ratios under Item 1A - Risk Factors" in our annual report on Form 10-K, incorporated by reference herein). Benchmarks established for 2014 will likely entail a reduced allocation to MBS, money market and other investments over time through paydowns and maturities, but without the sale of any assets. We are also changing our management of capital levels, including a reduction in our activity-based stock purchase requirement (see "Financial Condition - Capital" under this Item 2), establishing periodic repurchases of excess stock and increasing our dividend payout ratio among other practices, while maintaining sufficient levels of liquidity to fulfill our mission. 46
Table of Contents Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy.
General discussion of the level of market interest rates:
Table 2 presents selected market interest rates as of the dates or for the periods shown.
Table 2 03/31/2014 03/31/2013 Market Three-month Three-month 03/31/2014 12/31/2013 03/31/2013
Instrument Average Average Ending Rate Ending Rate Ending Rate Overnight
0.07 % 0.0 to 0.25 Federal funds effective/target rate1 0.14 % 0.0 to 0.25 % 0.0 to 0.25 % % Federal Open Market Committee (FOMC) target rate for overnight Federal funds1 0.0 to 0.25 0.0 to 0.25 0.0 to 0.25 0.0 to 0.25 0.0 to 0.25 3-month U.S. 0.04 0.07 Treasury bill1 0.08 0.03 0.07 3-month LIBOR1 0.24 0.29 0.23 0.25 0.28 2-year U.S. 0.36 0.24 Treasury note1 0.25 0.43 0.38 5-year U.S. 1.59 0.77 Treasury note1 0.81 1.74 1.73 10-year U.S. 2.76 1.85 Treasury note1 1.93 2.73 3.00 30-year 4.54 3.76 residential mortgage note rate2 3.72 4.56 4.72
1 Source is
the averages and the target rate for the ending rates). 2
Bloomberg. In March 2014, the Federal Open Market Committee (FOMC) reduced asset purchases by $10 billiona month and reiterated that other policy tools would be employed as appropriate, until the outlook for the labor market had improved substantially in a context of price stability. However, the FOMC acknowledged that other economic conditions besides unemployment and inflation may warrant continued accommodative monetary policy, which means a continued low target for the Federal funds rate. The FOMC has stated and reiterated that there is no set schedule, and that speed and timing of asset purchase reductions would be data dependent, but market participants generally expect asset repurchases to end in the second half of 2014 and an increase in the Federal funds rate as early as 2015. The 5- and 10-year Treasury rates rose upon the release of this information. We issue debt at a spread above U.S. Treasury securities, so higher interest rates increase the cost of issuing FHLBank consolidated obligations and increase the cost of advances to our members and housing associates. The market volatility that started in the last half of 2013 began to subside in late 2013 and early 2014, which has positively impacted demand for our longer-term debt, despite investors still being somewhat cautious about bond purchases, due to the possibility of continued increases in market rates. Dealers also remain reluctant to hold significant inventories of new longer-term bullet and callable Agency debt as a result of losses incurred on debt inventories in 2013, but they continue to facilitate debt placement. The spread over U.S. Treasuries at which we can issue longer-term bullet and callable bonds has narrowed from what we experienced in 2013 due to the aforementioned market correction. We fund a large portion of our fixed rate mortgage assets and some fixed rate advances with callable bonds. For further discussion see this Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Consolidated Obligations."
Other factors impacting FHLBank consolidated obligations:
Investors continue to view FHLBank consolidated obligations as carrying a relatively strong credit profile. Historically our strong credit profile has resulted in steady investor demand for FHLBank discount notes and short-term bonds, which allowed the overall cost to issue short-term consolidated obligations to remain relatively low throughout the first quarter of 2014. The U.S. government reached an agreement to suspend the nation's borrowing limit through
March 15, 2015; therefore, concerns over the federal debt ceiling limit, which could result in increased liquidity concerns for market participants and a move back into cash or other short-term investments, have been temporarily delayed. 47
Table of Contents
Critical Accounting Policies and Estimates
The preparation of our financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect our reported results and disclosures. Several of our accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to results. These assumptions and assessments include the following: § Accounting related to derivatives; § Fair value determinations; § Accounting for OTTI of investments; § Accounting for deferred premium/discount associated with MBS; and § Determining the adequacy of the allowance for credit losses.
Changes in any of the estimates and assumptions underlying critical accounting policies could have a material effect on our financial statements.
The accounting policies that management believes are the most critical to an understanding of our financial results and condition and require complex management judgment are described under Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in the annual report on Form 10-K, incorporated by reference herein. There were no material changes to our critical accounting policies and estimates during the quarter ended
March 31, 2014.
Results of Operations
Earnings Analysis: Table 3 presents changes in the major components of our earnings (dollar amounts in thousands):
Table 3 Increase (Decrease) in Earnings Components Three-month Periods Ended 03/31/2014 vs. 03/31/2013 Percentage Dollar Change Change Total interest income
$ (6,913)(6.1) % Total interest expense (9,323) (15.4) Net interest income 2,410 4.6 Provision for credit losses on mortgage loans (1,652)
Net interest income after mortgage loan loss provision 4,062
Net gain (loss) on trading securities 4,362
Net gain (loss) on derivatives and hedging activities (10,921)
(357.1) Other non-interest income 360 15.8 Total other income (loss) (6,199) (59.2) Operating expenses 709 7.2 Other non-interest expenses (200) (8.5) Total other expenses 509 4.1 AHP assessments (265) (9.7) NET INCOME
$ (2,381)(9.7) % Net income for the quarter ended March 31, 2014was $22.3 millioncompared to $24.6 millionfor the quarter ended March 31, 2013. The $2.3 milliondecrease was due to a $10.9 millionincrease in net losses from derivative and hedging activities, partially offset by a $4.4 milliondecrease in net losses on trading securities, a $2.4 millionincrease in net interest income and a $1.7 milliondecrease in the provision for loan losses. Return on equity (ROE) was 4.91 percent and 5.57 percent for the quarters ended March 31, 2014and 2013, respectively. Dividends paid to members totaled $8.2 millionfor the quarter ended March 31, 2014compared to $7.8 millionfor the prior year quarter. 48
Table of Contents Net Interest Income: Net interest income, which includes interest earned on advances, mortgage loans and investments less interest paid on consolidated obligations, deposits, and other borrowings is the primary source of our earnings. The increase in net interest income for the quarter ended
March 31, 2014compared to the quarter ended March 31, 2013was due primarily to an increase in our net interest spread and margin despite a decrease in average interest-earning assets (see Table 4). The increases in net interest spread and margin were driven primarily by an overall decrease in the cost of borrowing and also by an increase in the average yield on mortgage loans, which is discussed in greater detail below. The average yield on investments, which consists of interest-bearing deposits, Federal funds sold, reverse repurchase agreements and investment securities, remained at 1.09 percent for the quarters ended March 31, 2013and 2014, despite a decrease in the average balance. While individual yields have declined between periods, the proportion of average low yield, short-term investments has declined considerably, which led to the overall unchanged average yield on investments. Prepayments of higher rate MBS/CMOs slowed between periods, which also helped maintain the steady yield on investments. The average yield on advances decreased 12 bps, from 0.80 percent for the quarter ended March 31, 2013to 0.68 percent for the current quarter. The decrease in the average yield on advances was due to growth in our lowest yielding advance product and a decrease in prepayment fees between quarters. Further, a significant portion of our advances are swapped to LIBORso the decrease in the average one- and three-month LIBORrates during the first quarter of 2014 compared to the first quarter of 2013 also contributed to the decline in advance yields. The average yield on mortgage loans increased 16 bps, from 3.29 percent for the quarter ended March 31, 2013to 3.45 percent for the quarter ended March 31, 2014. The increase in yield is due to a decline in premium amortization as mortgage rates have increased and prepayments have decreased (yields on interest earning assets decline as premiums are amortized; amortization accelerates as prepayments increase). We expect this yield to remain relatively steady for the next several quarters, as mortgage interest rates are not anticipated to fluctuate significantly from current levels. The average cost of consolidated obligation bonds decreased 9 bps, from 1.08 percent for the quarter ended March 31, 2013to 0.99 percent for the current quarter. This decrease was largely a result of: (1) replacing some called and matured higher-cost consolidated obligation bonds with debt at a much lower cost in late 2013; and (2) the decrease in the average one- and three-month LIBORrates during the first quarter of 2014 compared to the first quarter of 2013 (a significant portion of our consolidated obligation bonds are swapped to LIBOR). Because we expect short-term interest rates to remain low for an extended period of time, we expect our total interest bearing liability cost to remain relatively stable over the next few quarters. When we call and replace callable debt, it generally increases interest costs in the short term due to the acceleration of the unamortized concessions on the debt when it is called because concession costs are amortized to contractual maturity. However, this increase is offset by the lower rate on the new debt and the funding benefit due to the timing differences between the date the debt is called and the forward settlement date of the new debt (conventionally not exceeding 30 days). For further discussion of how we use callable bonds, see Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Consolidated Obligations." Our net interest spread is impacted by derivative and hedging activities, as the assets and liabilities hedged with derivative instruments designated under fair value hedging relationships are adjusted for changes in fair values, while other assets and liabilities are carried at historical cost. Further, net interest payments or receipts on interest rate swaps designated as fair value hedges and the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the hedged asset or liability. However, net interest payments or receipts on derivatives that do not qualify for hedge accounting (economic hedges) flow through net gain (loss) on derivatives and hedging activities instead of net interest income (net interest received/paid on economic derivatives is identified in Tables 6 and 7 under this Item 2), which distorts yields, especially for trading investments that are swapped to a variable rate. 49
Table of Contents Table 4 presents average balances and annualized yields of major earning asset categories and the sources funding those earning assets (dollar amounts in thousands): Table 4 Three-month Periods Ended 03/31/2014 03/31/2013 Interest Interest Average Balance Income/ Expense Yield Average Balance Income/ Expense Yield Interest-earning assets: Interest-bearing deposits
$ 210,800$ 37 0.07 % $ 310,655$ 113 0.15 % Securities purchased under agreements to resell 86,111 14 0.06 1,457,381 527 0.15 Federal funds sold 1,472,222 249 0.07 1,102,511 421 0.15 Investment securities1 7,814,066 25,347 1.32 8,625,394 29,773 1.40 Advances2,3 17,348,274 29,063 0.68 16,845,815 33,412 0.80 Mortgage loans2,4,5 5,963,407 50,761 3.45 5,936,696 48,102 3.29 Other interest-earning assets 23,753 390 6.69 25,121 426 6.87 Total earning assets 32,918,633 105,861 1.30 34,303,573 112,774 1.33 Other non-interest-earning assets 109,332 147,286 Total assets $ 33,027,965 $ 34,450,859Interest-bearing liabilities: Deposits $ 1,072,934$ 238 0.09 % $ 1,347,856$ 313 0.09 % Consolidated obligations2: Discount Notes 9,433,498 1,844 0.08 8,944,444 2,437 0.11 Bonds 20,262,917 49,240 0.99 21,665,227 57,898 1.08 Other borrowings 7,280 45 2.45 11,349 42 1.50 Total interest-bearing liabilities 30,776,629 51,367 0.68 31,968,876 60,690 0.77 Capital and other non-interest-bearing funds 2,251,336 2,481,983 Total funding $ 33,027,965
Net interest income and net interest spread6
$ 54,4940.62 % $ 52,0840.56 % Net interest margin7 0.67 % 0.62 %
1 The non-credit portion of the OTTI discount on held-to-maturity securities is
excluded from the average balance for calculations of yield since the change
runs through equity.
Interest income/expense and average rates include the effect of associated 2 derivatives. 3 Advance income includes prepayment fees on terminated advances. 4 CE fee payments are netted against interest earnings on the mortgage loans.
The expense related to CE fee payments to PFIs was
three-month periods ended
Mortgage loans average balance includes outstanding principal for
non-performing conventional loans. However, these loans no longer accrue 5 interest.
Net interest spread is the difference between the yield on interest-earning 6 assets and the cost of interest-bearing liabilities.
Net interest margin is net interest income as a percentage of average 7 interest-earning assets.
Table of Contents Changes in the volume of interest-earning assets and the level of interest rates influence changes in net interest income, net interest spread and net interest margin. Table 5 summarizes changes in interest income and interest expense (in thousands): Table 5 Three-month Periods Ended 03/31/2014 vs. 03/31/2013 Increase (Decrease) Due to Volume1,2 Rate1,2 Total Interest Income: Interest-bearing deposits
$ (29) $ (47) $ (76)Securities purchased under agreements to resell (320) (193) (513) Federal funds sold 112 (284) (172) Investment securities (2,698) (1,728) (4,426) Advances 972 (5,321) (4,349) Mortgage loans 217 2,442 2,659 Other assets (24) (12) (36) Total earning assets (1,770) (5,143) (6,913) Interest Expense: Deposits (62) (13) (75) Consolidated obligations: Discount notes 127 (720) (593) Bonds (3,606) (5,052) (8,658) Other borrowings (18) 21 3 Total interest-bearing liabilities (3,559) (5,764) (9,323) Change in net interest income $ 1,789 $ 621 $ 2,410
1 Changes in interest income and interest expense not identifiable as either
volume-related or rate-related have been allocated to volume and rate based
upon the proportion of the absolute value of the volume and rate changes. 2 Amounts used to calculate volume and rate changes are based on numbers in
dollars. Accordingly, recalculations using the amounts in thousands as
disclosed in this report may not produce the same results.
Net Gain (Loss) on Derivatives and Hedging Activities: The volatility in other income (loss) is predominately driven by fair value fluctuations on derivative and hedging transactions, which include interest rate swaps, caps and floors. Net gain (loss) from derivatives and hedging activities is sensitive to several factors, including: (1) the general level of interest rates; (2) the shape of the term structure of interest rates; and (3) implied volatilities of interest rates. The fair value of options, particularly interest rate caps and floors, are also impacted by the time value decay that occurs as the options approach maturity, but this factor represents the normal amortization of the cost of these options and flows through income irrespective of any changes in the other factors impacting the fair value of the options (level of rates, shape of curve and implied volatility). As demonstrated in Tables 6 and 7, the majority of the derivative gains and losses are related to economic hedges, such as interest rate swaps matched to GSE debentures classified as trading securities and interest rate caps and floors, which do not qualify for hedge accounting treatment under GAAP. Net interest payments or receipts on these economic hedges flow through net gain (loss) on derivatives and hedging activities instead of net interest income, which distorts yields, especially for trading investments that are swapped to variable rates. Net interest received/paid on economic hedges is identified in Tables 6 and 7. Ineffectiveness on fair value hedges contributes to gains and losses on derivatives, but to a much lesser degree. We generally record gains on derivatives when the overall level of interest rates rises over the period and record losses when the overall level of interest rates falls over the period, due to the mix of the economic hedges. During the first quarter of 2013, the general level of the interest rate swap curve increased and steepened. This rise in interest rates and the steepening of the curve resulted in recognition of gains in our interest rate swaps matched to GSE debentures and our interest rate cap portfolio. However, the gain in our cap portfolio due to the rise in interest rates and steepening of the curve was partially offset by a decline in cap volatility as well as the time value decay of the options resulting in minor gains during the quarter. The largest portion of the gain in the economic hedges for the first quarter of 2013 related to investments was attributable to our interest rate swaps matched to GSE debentures. These GSE debentures were swapped to
LIBORat acquisition and carry fixed rates which are high relative to LIBORresulting in net interest paid on the interest rate swaps. 51
Table of Contents The economic losses in the first quarter of 2014 were primarily a result of losses on our interest rate cap portfolio. A decline in long term interest rates in the first quarter of 2014 coupled with time decay resulted in a decline in the fair values of our caps. These losses related to investments were partially offset by gains on our interest rate swaps matched to GSE debentures. These GSE debentures were swapped to
LIBORat acquisition and carry fixed rates, which are currently higher relative to LIBOR, resulting in net interest paid on the interest rate swaps. While the net interest received (paid) on the associated interest rate swap is recorded in net gain (loss) on derivatives and hedging activities, the interest on the underlying hedged items, the investment securities, is recorded in interest income, with any changes in fair value recognized in net gain (loss) on trading securities. These swaps require us to pay a rate substantially higher than LIBOR, so their fair values are negative (i.e., we owe the swap counterparties). As these swaps approach maturity, their current negative fair values will converge to zero, resulting in an effective amortization in their negative fair values (i.e., time decay). The first quarter 2014 gains on these swaps were primarily attributable to a slight increase in intermediate interest rates (e.g., two-year to four-year rates) and time decay (effective amortization of the negative fair values as the interest rate swaps approach maturity). The remaining driver for the fluctuation in the net gain (loss) on derivatives and hedging activities in the first quarter of 2014 was related to economic hedges matched to consolidated obligation bonds. We receive a fixed rate higher than LIBORon these swaps, so the decrease and flattening of the interest rate swap curve resulted in slight gains on the economic interest rate swaps matched to consolidated obligation bonds (e.g., gains resulting from receiving an above market rate as interest rates decrease).
Tables 6 and 7 categorize the earnings impact by product for hedging activities (in thousands):