asymmetry of accounting rules that require the marking to market of the derivative, but not the held-to-maturity assets being hedged. In the case of "securities held at fair value," changes in their market value appear on the income statement as an "unrecognized gain or loss on securities held at fair value." To the extent derivatives are used to hedge against changes in the market value of securities held at fair value, the income-statement categories “unrealized gain or loss on securities held at fair value" and realized or unrealized "gains or losses on derivatives and hedging activities" tend to move in opposite directions. Consequently, a given change in interest rates will tend to generate gains on one set of instrument and losses on the other. To gauge the overall effect, one must consider the net effect of the change in value of the derivatives and of the securities held at fair value. The following table provides that information for the FHLBanks during the second quarter and the first half of 2003. For the second quarter of 2003, the combined effect of gains/ losses on derivatives and the unrealized gain/loss on securities held at fair value was to contribute $16 million to income before REFCORP and AHP assessments of $613 million. For the first half of 2003, the combined effect of gains/losses on derivatives and the unrealized gain/loss on securities held at fair value was to decrease income before REFCORP and AHP assessments by $31 million resulting in a total of $1.2 billion. In each case, the net effect was less than 3 percent of income before assessments for REFCORP and AHP. Thus, in isolation, the gain or loss on derivatives and hedging activities offer an incomplete picture of the effectiveness of an institution's hedging strategies. As bank supervisors, we are principally concerned with whether an FHLBank has a well conceived, properly documented, and prudently implemented hedging program that is designed to limit or reduce risk and that is subject to rigorous internal controls and oversight. Q.3.b. How can we be sure that the Home Loan Banks are using derivatives to hedge risk instead of to speculate? A.3.b. At June 30, 2003, the FHLBanks had notional derivatives of $693.8 billion. The total net exposure at fair value was $2.2 billion. A focus of our supervisory policy, on-site examinations, and offsite monitoring is to review FHLBank derivatives activities for compliance with our rule prohibiting their use for speculative purposes. The following factors mitigate against the speculative use of derivatives by the FHLBanks. rd rules specifically require that all derivative transeither qualify as hedging instruments pursuant to cepted accounting principles in the United States he FHLBank must demonstrate the nonspeculative CFR § 956.6). e contracts with a single counterparty must be govsingle master agreement to facilitate the netting of such as International Swaps and Derivatives AssoA) agreements. ard rules require that all derivative contracts be market and subsequent collateral adjustments occur ently than monthly. e Board receives information on the derivatives of the through monthly and quarterly sections of the call re ement of the on-site examination of each FHLBank of the policies and procedures dealing with derivaIl as a review of the internal controls, documentation, board of director oversight, and segregation of duties à derivatives transactions. as part of its annual audit, each FHLBank undergoes the accounting for its derivative instruments by the independent external auditor. è risk limits at the individual FHLBanks are a critical rolling the use of derivatives for speculative purposes. limits are regulatory, for example, limits on duration cained in the Finance Board's Financial Management limits are properly adopted and monitored by the elf, subject to asset-liability committee and board of oval. Duration of equity and value at risk, as well as res, such as market-value sensitivity to a variety of 5, are effective ways to assess the extent to which dege risk exposure. The Finance Board regularly reviews ith both regulatory and internal risk limits as part of te examinations. nce Board examiners also assess whether the ave appropriate policies, procedures, and controls in ing their use of derivatives at the instrument level. s of such policies, procedures, and controls include a eveloping and approving hedging strategies and conplementation of those strategies. We expect those conde risk limits, identification of individuals within the pproved to conduct a trade, requirements for docuge transactions, including risk analytics showing the exposure(s) reduced by the trade, and procedures to be ver risk limits are violated. mentioned steps limit the likelihood of unauthorized tives by any FHLBank. Nevertheless, a number of Fiinitiatives should provide additional transparency and rsight of FHLBank derivative activity. For example, Board has requested proposals for purposes of acquirprise Risk Management system to enhance further our of the FHLBanks. This sophisticated computerized y management software should enable the Finance Board to generate a "second opinion" of risk exposure calculations generated by the FHLBanks, to compare risk exposures of the FHLBanks using a common set of methodologies and assumptions, and to measure additional risk exposures as the need arises. In the coming months, the Finance Board also expects to issue further guidance regarding market-risk management information that will be reported to the Finance Board for supervisory and monitoring purposes, providing additional information on the risk implications of derivative investments in a whole-portfolio context. Q.4. It is my understanding that the Chicago and Pittsburgh FHLBanks impose a zero percent capital charge against mortgages acquired under their mortgage acquisition programs. However, they are required to maintain a minimum 4 percent total capital against assets. Given the fact that the Chicago FHLBank holds over $39 billion in mortgage assets, and only $25 billion in advances, can you please explain how the Chicago FHLBank is meeting its minimum capital requirements? Similarly, Pittsburgh holds $9.8 billion, nearly 20 percent, of its assets in mortgages. How does it meet its minimum capital requirements? A.4. Prior to the passage of the Gramm-Leach-Bliley Act of 1999 (GLBA), member stock purchase requirements were uniform across the FHLBanks. Each member had to purchase subscription stock in its FHLBank that was at least as great as the larger of either (1) $500; (2) 1 percent of the member's aggregate unpaid loan principal; or (3) 5 percent of the member's aggregate amount of outstanding advances. 8 With the passage of GLBA and its requirement that the FHLBanks convert to a risk-based, permanent capital structure, the FHLBanks were granted authority, subject to Finance Board approval, to develop their own stock purchase requirements for their members. Irrespective of how stock purchases requirements are defined, the FHLBanks are required to maintain a minimum of 4 percent total capital against assets. The Finance Board approved all of the FHLBanks' new capital plans in 2002. To date, 6 of the 12 FHLBanks have implemented their revised capital plans (Seattle, Indianapolis, Pittsburgh, Cincinnati, Dallas, and Des Moines). The remaining 6 FHLBanks are expected to implement their new capital plans by the end of 2005. Under the new capital plans, the FHLBanks impose on their members stock purchase requirements that are dependent on either the member's size, for example, measured by total assets, mortgage assets, or borrowing capacity, or on the level of business activity that member has with the FHLBank. In fact, all FHLBanks use member-based stock purchase requirements; all also use activity-based requirements for at least one or more activities. In cases where the FHLBanks impose a zero percent_stock purchase requirement for a given activity, capital to support the assets acquired by the FHLBank because of that activity must come either from the membership stock purchase requirement, or other 8" "Aggregate unpaid loan principal" means the aggregate unpaid principal of a subscriber's or member's home mortgage loans, home-purchase contracts and similar obligations. (See 12 CFR § 925.1). ock, such as stock dividends or member voluntary 5.9 tock held by members, regardless of how it is obect to the same waiting period once it notifies the s desire to redeem stock: ter a member has given notice of its intention to reunder the pre-GLBA capital plans, and for Class A the GLBA capital plans; r a member has given notice of its intention to refor Class B stock issued under the GLBA capital rting a member activity may not be redeemed until has been completed. Further, no FHLBank may 1 stock if doing so would result in that FHLBank's et minimum capital standards. Thus, it makes little ether the FHLBank is using membership, activityuntary stock to meet its capital requirement supsets, since the degree of permanence is not related to is acquired. mpanying table indicates, the FHLBank of Chicago ital stock of $3.3 billion as of December 31, 2002. Of capital stock requirements assessed on the members ank accounted for 45.2 percent of total capital, while ck holdings accounted for 49.1 percent. Retained earnpercent of the FHLBank's total capital. similarly illustrates how the FHLBank of Pittsburgh s operations. As of December 31, 2002, total capital .9 billion. Of this, 91.1 percent came from stock ressessed on members, 5.4 percent came from voluntary s, and 3.5 percent came from retained earnings. an Bank Act allows members to voluntarily acquire "excess stock," for example, required to be purchased by membership requirements or activity-based re |