10-K 1 a20161231-10xk.htm 10-K Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-K

S ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2016
OR
£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____

Commission File No. 000-51401
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Federal Home Loan Bank of Chicago

(Exact name of registrant as specified in its charter)
 
Federally chartered corporation
  
36-6001019
 
 
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. Employer
Identification No.)
 
 
200 East Randolph Drive
Chicago, IL
  
60601
 
 
(Address of principal executive offices)
  
(Zip Code)
 
Registrant's telephone number, including area code: (312) 565-5700

Securities to be registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Class B Capital Stock, par value $100 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filings requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x     

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)
Large Accelerated Filer o         Accelerated Filer o     Non-accelerated Filer x     Smaller Reporting Company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

Registrant's stock is not publicly traded and is only issued to members of the registrant. Such stock is issued and redeemed at par value, $100 per share, subject to applicable regulatory and statutory limits. At June 30, 2016, the aggregate par value of the stock held by current and former members was $2,076,177,804. As of February 28, 2017, including mandatorily redeemable capital stock, registrant had 16,852,200 total outstanding shares of Class B Capital Stock.


1

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Federal Home Loan Bank of Chicago

TABLE OF CONTENTS


PART I
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
PART II
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
PART III
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
PART IV
Item 15.
Item 16.
 
 
 

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)



Item 1. Business.

Where to Find More Information

The Federal Home Loan Bank of Chicago a maintains a website located at www.fhlbc.com where we make available our financial statements and other information regarding us and our products 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 Terms can be found on page 123.


Introduction

We are a federally chartered corporation and one of 11 Federal Home Loan Banks (the FHLBs) that, with 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 Federal Housing Finance Agency (FHFA), an independent federal agency in the executive branch of the United States (U.S.) government.

As a cooperative, we do business with our members and, under limited circumstances, our former members, as well as providing support for the members of other FHLBs through our role operating the Mortgage Partnership Finance® (MPF®) Program. All federally-insured depository institutions, insurance companies engaged in residential housing finance, credit unions, and community development financial institutions 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; our capital stock is not publicly traded.

As of December 31, 2016, we had 426 full time and 14 part time employees.

“Mortgage Partnership Finance”, “MPF”, “MPF Xtra”, “Downpayment Plus”, and "Community First" are registered trademarks of the Federal Home Loan Bank of Chicago.


Mission Statement

Our mission is to partner with our member shareholders in Illinois and Wisconsin to provide them competitively priced funding, a reasonable return on their investment in the Bank, and support for community investment activities.
                                                                       

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

3

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Membership Trends

The following table presents the geographic locations of our members by type of institution:

 
December 31, 2016
 
December 31, 2015
 
Number of Institutions
 
 
 
Number of Institutions
 
 
 
Illinois
 
Wisconsin
 
Total
 
Percent
 
Illinois
 
Wisconsin
 
Total
 
Percent
Commercial banks
345

 
179

 
524

 
72
%
 
350

 
196

 
546

 
74
%
Thrifts
57

 
24

 
81

 
11
%
 
63

 
26

 
89

 
12
%
Credit unions
39

 
40

 
79

 
11
%
 
32

 
36

 
68

 
9
%
Insurance companies
29

 
11

 
40

 
5
%
 
25

 
9

 
34

 
5
%
Community Development
   Financial Institutions
3

 
1

 
4

 
1
%
 
2

 
1

 
3

 
%
Total
473

 
255

 
728

 
100
%
 
472

 
268

 
740

 
100
%


The following table presents our members by asset size. Community Financial Institution size is determined by our regulator the FHFA, as FDIC-insured institutions with an average of total assets over the prior three years which is less than an amount specified annually by the FHFA. For 2014-2016 an institution's average total assets must be less than $1.148 billion. See the Glossary of Terms on page 123 for further details.

As of December 31,
 
2016
 
2015
Member Asset Size:
 
 
 
 
Community Financial Institutions
 
92.40
%
 
89.85
%
Larger Non-CFI Institutions
 
7.60
%
 
10.15
%
Total
 
100
%
 
100
%


During 2016, we lost 37 members due to mergers and acquisitions.  Although 29 of these members were acquired by other members in our district, eight were acquired by out-of-district institutions.

We gained 25 new members by adding five commercial banks, 13 credit unions, six insurance companies and one community development financial institution during 2016, as we continue to work toward our goal of building a stronger cooperative by adding new members.

In addition to having access to the Bank as a source of standby liquidity, 83% of our total number of members used one or more of our credit products such as advances, standby letters of credit, or the MPF Program at some point during the years ending 2016 and 2015.

Business Overview

Our mission-focused business is different from that of a typical financial services firm. As a cooperative, we use our resources to support member utilization of the cooperative, and to support the communities in which members operate. Our strategy revolves around two goals:

Maintaining the member-focused Bank, which involves all areas of the Bank coming together to deliver excellent products and services to our members. Being member-focused means applying the resources of the Bank to enhance the value of membership.

Building the MPF business, which is rapidly becoming accepted by most of the other FHLBs as the mortgage aggregation platform for the FHLB System. We have the opportunity and responsibility to manage the products, operations and administration of a platform that provides community lending institutions across the U.S. with access to the secondary mortgage market.


4

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


The following table represents our view of the mission-focused business we do as a cooperative bank.

Average par value for the year ended December 31,
 
2016
 
2015
Advances
 
$
42,535

 
$
33,282

Mortgage assets (Acquired Member Assets - AMA)
 
4,727

 
5,357

Primary mission assets
 
$
47,262

 
$
38,639

 
 
 
 
 
Consolidated obligations
 
$
71,356

 
$
65,703

Core mission asset ratio
 
66.2
%
 
58.8
%
 
 
 
 
 
Supplemental mission assets and activities as of December 31,
 
2016
 
2015
MPF Program Loans held by other third party investors
 
$
16,972

 
$
15,399

Member standby letters of credit
 
10,828

 
6,678

Mission related liquidity
 
7,437

 
4,244

Small Business Administration investments
 
1,974

 
2,253

Housing authority standby bonds purchased and commitments outstanding
 
337

 
445

MPF Loan delivery commitments
 
417

 
279

Advance commitments
 
16

 
168

Member derivatives
 
82

 
84

Community First Fund loans and commitments
 
41

 
40

Supplemental mission assets and activities
 
$
38,104

 
$
29,590



We provide credit to members principally in the form of secured loans called advances (inclusive of forward starting advances), as well as through standby letters of credit. We provide liquidity for home mortgage loans to members approved as Participating Financial Institutions (PFIs) through the MPF Program. We also serve as a critical source of standby liquidity for our members.

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 liability of all the FHLBs. Consolidated obligations are not obligations of the U.S. government, and the U.S. 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.

The FHFA has issued an advisory bulletin which provides guidance relating to a core mission asset ratio by which the FHFA will assess each FHLB’s core mission achievement. The FHFA will assess core mission achievement by using a ratio of primary mission assets, which includes advances and mortgage loans acquired from members (also referred to as acquired member assets), to consolidated obligations. The core mission asset ratio will be calculated annually at year-end as part of the FHFA’s examination process, using annual average par values. Our core mission asset ratio for the year ended December 31, 2016, was 66.2%.

On January 20, 2016, the FHFA issued a final rule making captive insurance companies ineligible for FHLB membership, which became effective February 19, 2016.  Under this rule, our three captive insurance company members will have their memberships terminated by February 2021.  As a result of this recent regulatory change, our core mission asset ratio would be negatively impacted if our advances decrease once our three captive insurance company members have their membership terminated and their advances mature.

Member-Focused Business

Member credit products, which include advances, standby letters of credit, and other extensions of credit to borrowers, are discussed in detail below.

Advances

We provide credit to members principally in the form of secured loans, called advances. Our advances to members:


5

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


serve as a reliable source of funding and liquidity;
provide members with enhanced tools for asset-liability management;
provide interim funding for those members that choose to sell or securitize their mortgages;
support residential mortgages held in member portfolios;
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 businesses, farms, agri-businesses, and community development activities.
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 value the types of collateral eligible to be pledged to us and apply a margin to secure our advances to members, based on our assessment of the member's creditworthiness and financial condition; and
we conduct periodic collateral reviews with members 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 Establishing Credit Limits on page 63.

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 that have interest rates that reset periodically at a fixed spread to an FHLB discount note rate-based index, LIBOR, Federal Funds, or some other index. Depending upon the type of advance selected, the member may have an interest-rate cap embedded in the advance to limit the rate of interest the member would have to pay.

Putable Advances: We issue putable, fixed- and floating-rate advances in which we maintain the right to terminate the advance at predetermined exercise dates at par.

Callable Advances: We issue callable, fixed-rate advances in which members have the right to prepay the advance on predetermined dates without incurring prepayment or termination fees.

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 at the close of business. (2) Fixed amortizing advances have maturities that range from one year to 30 years, with the principal repaid over the term of the advances monthly, quarterly, or semi-annually. (3) Fixed Rate with Floating Spread advances are designed to meet our members’ liability duration needs at lower cost than regular fixed rate advances.

We also offer features designed to meet our members' business needs such as the following:

Symmetrical prepayment feature where the member would either pay a prepayment fee or prepay the advance below par upon termination, depending on the structure of the advance at the time of termination.

Commitment feature, called “forward-starting advances", to fund an advance on a negotiated funding date at a predetermined interest rate.

Expander feature, which allows a member one or multiple opportunities to increase the principal amount of the advance.

The FHLB Act authorizes us to make advances to eligible non-member housing associates. By regulation, such housing associates must: (i) be approved under Title II of the National Housing Act; (ii) be chartered institutions having succession; (iii) be subject to the inspection and supervision of some governmental agency; (iv) lend their own funds as their principal activity in the mortgage field; and (v) have a financial condition such that advances may be safely made to it. We must approve a housing

6

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


associate applicant in order for it to be eligible to borrow. We currently have approved four non-member housing associates that are eligible to borrow from the Bank. We had $36 million in advances outstanding to non-member housing associates at December 31, 2016, and $10 million at December 31, 2015.

Competition

Demand for our advances is affected by, among other things, the cost of other sources of funding available to our members, including our members' customer deposits. We compete with suppliers of both secured and unsecured wholesale funding. These competitors may include investment banks, commercial banks, and other FHLBs when our members' affiliated institutions are members of other FHLBs. Under the FHLB Act and FHFA 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 credit markets.

The availability of alternative funding sources influences the demand and pricing 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 include the rates we charge, required capital stock purchases, and 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.

In addition, our competitive environment continues to be impacted by the Federal Reserve’s low interest-rate environment and the extent to which our members use our advances primarily as a back-up source of liquidity as opposed to part of their primary funding strategies. For further discussion of the impact of these and other factors on demand for our advances, see Risk Factors on page 18.

Standby Letters of Credit

We provide members with standby letters of credit (also referred to herein as letters of credit) to support obligations to third parties to facilitate residential housing finance, community lending, to achieve liquidity, and for asset-liability management purposes. In particular, members often use letters of credit as collateral for deposits from federal and state governmental agencies. Letters of credit are generally available for terms up to 20 years or for a one year term renewable annually. If we are required to make payment for a beneficiary's draw, these amounts either must be reimbursed by the member immediately or may be converted to an advance. Our underwriting and collateral requirements for letters of credit are the same as the underwriting and collateral requirements for advances. Letters of credit are not subject to activity capital stock purchase requirements. If any advances were to be made in connection with these standby letters of credit, they would be made under the same standards and terms as any other advance. For more details on our letters of credit see Note 17 - Commitments and Contingencies to the financial statements.

Mortgage Partnership Finance® Program

Introduction

We developed the MPF® Program to provide an additional source of liquidity to our members and to allow us to invest in mortgages to help fulfill our housing mission. The MPF Program is a secondary mortgage market structure under which we acquire eligible mortgage loans from or through PFIs, and in some cases we purchased participations in pools of eligible mortgage loans from other FHLBs (collectively, MPF Loans). MPF Loans are conventional and government mortgage loans secured by one-to-four family residential properties with maturities ranging from 5 to 30 years or participations in such mortgage loans that are acquired under the MPF Program.

Since resuming the purchase of MPF Loans held in portfolio from members in our district in June 2015 after receiving regulatory approval, our MPF Loans held in portfolio are limited to the lesser of five times retained earnings or 15% of total assets during the first two years of such purchases. As of December 31, 2016, the retained earnings limit was $15.1 billion and the assets limit was $11.8 billion; and our actual MPF Loans held in portfolio amount was $5.0 billion. After two years of purchases, unless advised otherwise by FHFA, the limit for our investment in MPF Loans held on our balance sheet will be the lesser of eight times retained earnings or 20% of total assets.


7

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


In 2008, the first non-portfolio product that we introduced was the MPF Xtra® product under which we purchase MPF Loans from PFIs and concurrently sell them to the Federal National Mortgage Association (Fannie Mae). We earn a nominal fee over time from the difference between the price that we pay the PFI and the price that Fannie Mae pays us.

In 2014, we introduced two new mortgage products as part of the MPF Program product suite. Under the MPF Direct product, we purchase non-conforming (jumbo) mortgage loans from PFIs and concurrently sell them to a third party investor. We also introduced the MPF Government MBS product under which we aggregate Government Loans in order to issue securities guaranteed by the Government National Mortgage Association (Ginnie Mae) that are backed by such Government Loans.

MPF Product
Mortgage Type
Loan Balance
Retained in Our Held for Investment Portfolio?
Servicing
MPF Original, MPF 35, MPF 100; MPF 125 and MPF Plus
Conventional
Conforming
Yes, but may sell participation interests
Servicing Retained and Released
MPF Government
Government
Conforming
Yes, but may sell participation interests
Servicing Retained and Released
MPF Xtra
Conventional
Conforming
Sold to Fannie Mae
Servicing Retained and Released
MPF Direct
Conventional
Non-conforming (jumbo - up to $2,500,000)
Sold to Third Party Investor
Servicing Released
MPF Government MBS
Government
Conforming
Securitized in Ginnie Mae MBS
Servicing Retained and Released

MPF Program Design

We have entered into agreements with other participating FHLBs under which we and they (together, the MPF Banks) acquire MPF Loans from member PFIs and we provide programmatic and operational support in our role as MPF Provider for which we receive a fee. The MPF Program portfolio products were designed to allocate the risks of MPF Loans among the MPF Banks and PFIs. For MPF Loans held in portfolio, the MPF Banks are responsible for managing the interest rate risk, prepayment risk, credit risk in excess of any PFI credit enhancement obligation, and liquidity risk associated with such investment.

We developed five MPF Loan products in which PFIs share in the associated credit risk of conventional MPF Loans held in portfolio which meet the FHFA Acquired Member Assets (AMA) regulation requirements (MPF Original, MPF 35, MPF 100, MPF 125 and MPF Plus). Government Loans purchased under the MPF Government product 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); Rural Housing Service of the Department of Agriculture (RHS); or Department of Housing and Urban Development (HUD) (collectively, Government Loans).

In addition to our portfolio MPF products, PFIs sell eligible MPF Loans to us through the MPF Program infrastructure and we concurrently sell them to Fannie Mae under the MPF Xtra product and to third party investors under the MPF Direct product. Under our MPF Government MBS product, PFIs sell us Government Loans that we intend to hold in our portfolio for a short period of time until such loans are pooled into Ginnie Mae MBS. Other MPF Banks that offer these three products to their PFIs thereby allow their PFIs to sell MPF Loans directly to us. See Mortgage Standards on page 10 and MPF Servicing on page 11.

In connection with each mortgage loan sale to our third party investors, we make customary warranties regarding the eligibility of the mortgage loans. If an eligibility requirement or other warranty is breached, the applicable third party investor could require us to repurchase the MPF Loan. Such a breach is normally also a breach of the originating PFI's representations and warranties under the MPF Program Participating Financial Institution Agreement (PFI Agreement) or the MPF Program Guide, MPF Selling Guide, and MPF Servicing Guide (together, the MPF Guides), and we can require the PFI to repurchase that MPF Loan from us.

Under the MPF Xtra product and the MPF Government MBS product, PFIs retain the right and responsibility for servicing these MPF Loans or sell the servicing to an eligible servicer as similarly done for the MPF products held in our portfolio. For further details see MPF Servicing on page 11.

If a PFI that is a member of another MPF Bank wishes to sell or service MPF Loans under the MPF Xtra, MPF Direct, or MPF Government MBS products, its MPF Bank must authorize it and agree to enforce its PFI Agreement for our benefit, which would include enforcing the PFI's obligation to repurchase ineligible MPF Loans and to indemnify us for certain losses.


8

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


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. MPF Banks generally acquire whole loans from their respective PFIs or they may acquire participations from another MPF Bank. Under the MPF Xtra, MPF Direct, and MPF Government MBS products, we acquire whole loans from PFIs of other MPF Banks with that MPF Bank’s permission.

PFI Eligibility

Members and eligible housing associates may apply to become PFIs of their respective MPF Bank. The member and its MPF Bank sign a PFI Agreement that provides the terms and conditions for the sale of MPF Loans, including required credit enhancement, and for the servicing of MPF Loans. All of the PFI's obligations under the PFI Agreement are secured in the same manner as other obligations of the PFI, under its 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 held in our portfolio, PFIs retain a portion of the credit risk on the MPF Loans acquired by an MPF Bank by providing credit enhancement (CE Amount) which may be either a direct liability to pay credit losses up to a specified amount or a contractual obligation to provide supplemental mortgage guaranty insurance (SMI). Each MPF Loan delivered by a PFI is linked to a Master Commitment so that the cumulative CE Amount, if applicable, can be determined for each Master Commitment. The PFI's CE Amount covers losses for conventional 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 fee for managing credit risk (CE Fee) and in some instances, all or a portion of the CE Fee may be performance-based. As MPF Loans held in our portfolio have paid down, our payments to PFIs of CE Fees have become immaterial to our financial results. For further details, see MPF Risk Sharing Structure in Note 2 - Summary of Significant Accounting Policies to the financial statements.

PFIs must comply with the MPF Program requirements contained in the MPF Guides which include: eligibility requirements for PFIs, anti-predatory lending policies, loan eligibility, 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 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.

When a PFI fails to comply with the selling or servicing requirements of the PFI Agreement, the MPF Guides, applicable law, or the terms of mortgage documents, the PFI may be required to provide an indemnification covering related losses or to repurchase the MPF Loans which are impacted by such failure if it cannot be cured.

MPF Products

Nine MPF Loan products have been developed to date: MPF Original, MPF 35, MPF 100, MPF 125, and MPF Plus products, which are conventional portfolio products; the MPF Government product, which is also a portfolio product; and the MPF Xtra, MPF Direct, and MPF Government MBS products, in which MPF Loans acquired are not retained in our portfolio.


9

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


The following is an MPF Product comparison table as of December 31, 2016:

Product Name
First Loss Account Size
PFI Credit Enhancement Description g
Credit Enhancement Fee to PFI
Credit Enhancement Fee Offset a
Servicing Fee Retained
by PFI
MPF Original
3 to 6 basis points/added each year based on the unpaid balance
Equivalent to AA
0 to 11 basis points/year - paid monthly
No
25 basis points/year
MPF 100
100 basis points fixed based on the size of the loan pool at closing
After FLA to AA
7 to 10 basis points/year - paid monthly; performance-based after 2 or 3 years
Yes - After first 2 to 3 years
25 basis points/year
MPF 125
100 basis points fixed based on the size of the loan pool at closing
After FLA to AA
6 to 10 basis points/year - paid monthly; performance-based
Yes
25 basis points/year
MPF Plus
An agreed upon amount not less than expected losses
0-20 bps after FLA and SMI to AA
13-14 basis points/year in total, with a varying split between performance-based (delayed for 1 year) and a fixed rate; all paid monthly
Yes
25 basis points/year
MPF 35
An agreed upon amount not less than expected losses
After FLA to AA
9-14 basis points/year in total, with a varying split between performance-based (delayed for 1 year) and a fixed rate; all paid monthly
Yes
25 basis points/year
MPF Government
N/A
N/A f

N/A
N/A
44 basis points/year plus 2 basis points/year b
MPF Xtra c
N/A
N/A
N/A
N/A
25 basis points/year
MPF Direct d
N/A
N/A
N/A
N/A
N/A
MPF Government MBS e
N/A
N/A f
N/A
N/A
Based on Note Rate
a 
Future payouts of performance-based CE Fees are reduced when losses are allocated to the FLA.
b 
For Master Commitments issued prior to February 2, 2007, the PFI is paid a monthly government loan fee equal to 0.02% (2 basis points) per annum based on the month end outstanding aggregate principal balance of the Master Commitment which is in addition to the customary 0.44% (44 basis points) per annum servicing fee that continues to apply for Master Commitments issued after February 1, 2007, and that is retained by the PFI on a monthly basis, based on the outstanding aggregate principal balance of the Government Loans.
c 
MPF Loans acquired under the MPF Xtra product are concurrently sold to Fannie Mae and are not retained in our portfolio.
d 
MPF Loans acquired under the MPF Direct product are concurrently sold to third party investors and are not retained in our portfolio.
e 
MPF Loans acquired under the MPF Government MBS product are intended to be included in our held for sale portfolio for a short period of time until pooled into Ginnie Mae MBS.
f 
For Government Loans, PFIs provide the required credit enhancement by delivering loans that are guaranteed or insured by a department or agency of the U.S. government.
g 
For a description of the PFI Credit Enhancement see Setting Credit Enhancement Levels on page 66.


See Note 2 - Summary of Significant Accounting Policies to the financial statements for more detailed discussions of the MPF Risk Sharing Structure of the various MPF products.

Mortgage Standards

PFIs are required to deliver mortgage loans that meet the underwriting and eligibility requirements in the MPF Guides, unless a PFI was previously granted waivers that exempt a PFI from complying with specified provisions of the MPF Guides. The

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


underwriting and eligibility guidelines in the MPF Guides applicable to the conventional MPF Loans held in our portfolio are broadly summarized as follows:

Mortgage characteristics. MPF Loans must be qualifying conforming conventional, fixed-rate, up to 30 years fully amortizing mortgage loans, secured by first liens on owner-occupied one-to-four unit single-family residential properties and single-unit second homes. MPF Loans may not exceed conforming loan size limits in effect at the time they are acquired and must meet the requirements of a qualified mortgage as defined by applicable law.

Loan-to-Value Ratio and Primary Mortgage Insurance. The maximum loan-to-value ratio (LTV) for conventional MPF Loans is 95%, though AHP mortgage loans may have LTVs up to 100%. Conventional MPF Loans with LTVs greater than 80% are insured by primary mortgage insurance (PMI) from a mortgage guaranty insurance (MI) company.

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

Government Loans have the same parameters as conventional MPF Loans except that their LTVs may not exceed the LTV limits set by the applicable government agency and they must meet the requirements to be insured or guaranteed by the applicable government agency. For MPF products in which MPF Loans are not held in our portfolio, PFIs are required to deliver mortgage loans that meet the applicable investor or government agency eligibility and underwriting requirements.

Ineligible Mortgage Loans. The following types of mortgage loans are not eligible for delivery under the MPF Program: (1) mortgage loans not meeting the MPF Program eligibility requirements as set forth in the MPF Guides and agreements; and (2) mortgage loans that are classified as high cost, high rate, or Home Ownership and Equity Protection Act loans, or loans in similar categories defined under predatory lending or abusive lending laws.

Quality Assurance Process

In our role as MPF Provider, we conduct a quality assurance review of a selected sample of MPF Loans for each PFI periodically. Subsequently, we perform periodic reviews of a sample of conventional MPF Loans to determine whether the reviewed loans complied with the MPF Program requirements at the time of acquisition. If the PFI is unable to cure any material defect in a loan, the PFI is obligated to repurchase the loan but may be permitted to provide an indemnification for losses arising from such loan or we may reserve our remedies or waive the repurchase demand if the loan is currently performing. See Mortgage Repurchase Risk on page 67 for a further description of our repurchase risk.

MPF Loan Participations

At December 31, 2016, 42% of the total unpaid principal balance of MPF Loans we own represents participations in MPF Loans 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 Lead Bank), us in our role as MPF Provider, and other MPF Banks purchasing a participation interest. The Lead Bank is responsible for monitoring PFI creditworthiness, managing the PFI's pledged collateral securing its obligations under the PFI Agreement and enforcing the PFI Agreement for the benefit of itself and participating MPF Banks.
 
The risk sharing and rights of the Lead Bank and participating MPF Bank(s) are as follows:

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; and

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 and not its participation percentage for any individual MPF Loan.

MPF Servicing

The PFI or its servicing affiliate can retain the right and responsibility for servicing MPF Loans it delivers, which includes loan collections and remittances, default management, loss mitigation, foreclosure and disposition of real estate acquired through foreclosure or deed in lieu of foreclosure. With respect to the MPF Xtra and MPF Government MBS products, we are contractually obligated to Fannie Mae and Ginnie Mae, respectively, with respect to servicing of the related MPF Loans under certain servicing options. In both cases, our contractual agreements recognize that eligible third party servicers, including PFIs, will act as servicers of such MPF Loans. We also offer a servicing released option for the MPF Xtra and MPF Government MBS

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


products in which the servicing rights for such MPF Loans are sold to an approved servicer that will be directly responsible to Fannie Mae or Ginnie Mae, respectively, for the servicing responsibilities. The MPF Direct product is servicing released only and we do not have any responsibilities related to the servicing of MPF Loans delivered under the MPF Direct product.

Upon liquidation of any MPF Loan, the servicing PFI submits a realized loss calculation which is reviewed by our service provider and adjusted for any losses arising from the PFI's failure to perform in accordance with the MPF Guides.

If there is a loss on a conventional MPF Loan held in our portfolio, the loss is allocated to the Master Commitment and shared between us, any participating MPF Bank and the PFI in accordance with the risk-sharing structure.

We monitor the PFI's compliance with MPF Program requirements throughout the servicing process. Minor servicing lapses may result in charges to the PFI. Major servicing lapses 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 servicer.

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 servicer, which is permitted with the consent of the MPF Bank(s) involved.

Competition

Given the increase of products in the MPF product suite, we face competition in numerous markets including the markets for conventional loans, non-conforming loans, government loans, and loans with credit risk sharing arrangements. We face this competition in acquiring MPF loans with various features (i.e. mandatory or best efforts loan delivery, servicing retained or released options) from other participants in the mortgage secondary market. Secondary market participants include, but are not limited to, dealers, banks, hedge funds, money managers, insurance companies, large mortgage aggregators, private investors, and other GSEs such as Fannie Mae and Freddie Mac. Some of these competitors have greater resources, larger volumes of business, and longer operating histories. As a result, our ongoing revenue derived from MPF Loan products may be affected by the volume of business done by our competitors. We primarily compete on the basis of transaction structure, price, products, and services offered.

Other Activities

Investments

We maintain a portfolio of investments for liquidity purposes 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 overnight Federal Funds sold, and securities purchased under agreements to resell, entered into with or issued by highly rated institutions and other eligible counterparties. For further discussion of unsecured credit exposures related to our short-term investment portfolio, see Unsecured Short Term Investments on page 72.

Our longer-term investment securities portfolio includes securities issued by the U.S. government, U.S. government agencies, and GSEs, as well as investments in Federal Family Education Loan Program (FFELP) student loan asset backed securities (ABS), and mortgage-backed securities (MBS) that are issued by GSEs or that were rated “AAA/Aaa” or “AA/Aa” 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. For a discussion of how recent market conditions have affected the carrying value and ratings of these securities, see Investment Securities by Rating on page 70. For this purpose, GSE includes Fannie Mae, Freddie Mac, and the Federal Farm Credit Banks Funding Corporation. Securities issued by GSEs are not guaranteed by the U.S. government.

Under FHFA 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;


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


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, that are investment quality, (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;

interest-only or principal-only stripped securities;

residual-interest or interest-accrual classes of securities;

fixed-rate MBS or eligible ABS, or floating-rate MBS or eligible ABS, 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; and

non-United States dollar-denominated securities.

FHFA regulations further limit our investment in MBS and ABS by requiring that these investments may 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. For purposes of calculating the limit on our MBS/ABS portfolio, we value our investments in accordance with FHFA regulations based on amortized cost for securities classified as held-to-maturity or available-for-sale and on fair value for trading securities. Regulatory capital consists of our total capital stock (including the mandatorily redeemable capital stock) plus our retained earnings. This limitation does not apply to newly issued Ginnie Mae securities that have been created through the MPF Government MBS product that are temporarily owned by the Bank.

The Finance Board (predecessor to the FHFA) adopted a resolution temporarily allowing FHLBs to increase their investments in MBS issued by, or comprised of loans guaranteed by, Fannie Mae or Freddie Mac (Agency MBS) by an additional 300% of regulatory capital. Although this expanded authority expired in 2010, we are permitted to hold these investments until they mature or are sold.

As we transitioned our primary business to advances, the FHFA previously temporarily waived our regulatory investment limitations to permit us to reinvest a portion of the proceeds from prepayments and maturities of our mortgage assets to purchase MBS issued by GSEs and approved our purchase of FFELP student loan ABS. For further discussion of how this may impact us, see Risk Factors on page 18. As of December 31, 2016, we held total MBS and ABS investments of $17.4 billion, which was 3.46 times our total regulatory capital.

Derivative Activities

We engage in most of our derivatives transactions with major broker-dealers as part of our interest rate risk management and hedging strategies, as further discussed in Item 7A. Quantitative and Qualitative Disclosures About Market Risk on page 75. We also enter into interest rate derivatives directly with our members in order to provide them with access to the derivatives market. We intend to enter into offsetting derivatives transactions with non-member counterparties in cases where we are not using the interest rate derivatives for our own hedging purposes.

The FHFA's regulations and our internal asset and liability management policies all establish guidelines for our use of interest rate derivatives. These regulations prohibit the speculative use of financial instruments authorized for hedging purposes. They also limit the amount of counterparty credit risk allowed. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk on page 75.

Community Investment Activities

We provide financing and direct funding tools that support the affordable housing and community lending initiatives of our members that benefit very low, low, and moderate income individuals, households, businesses 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 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. By regulation, we are required to contribute 10% of our income before assessments to fund AHP. Of that required contribution, we may allocate up to the greater of $4.5 million or 35% to provide funds to members participating in our homeownership set-aside programs.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Direct grants are available primarily under our competitive AHP to members in partnership with community sponsors and may be used to fund the acquisition, rehabilitation, and new construction of affordable rental or owner-occupied housing. We awarded competitive AHP subsidies of $26 million for the year ended December 31, 2016, and $36 million for the year ended December 31, 2015, for projects designed to provide housing to 2,260 and 3,131 households, respectively.

In addition, direct grants are available to members under our Downpayment Plus® homeownership set-aside programs and may be provided to eligible homebuyers to assist with down payment, closing, counseling, or rehabilitation costs in conjunction with an acquisition. During the years ended December 31, 2016 and 2015, we awarded $16 million and $16 million through our Downpayment Plus programs to assist 2,703 and 2,728 very low to moderate income homebuyers.

During 2017, we anticipate having $37 million available in total for our Downpayment Plus programs and grants through our competitive AHP.

Community Investment Program (CIP)/Community Economic Development Advance (CEDA) Program and related letters of credit - We offer two programs where members may apply for advances or letters of credit to support affordable housing 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, industrial and manufacturing facilities, agricultural businesses, healthcare, educational centers, public or private infrastructure projects, or commercial businesses. As of December 31, 2016, and 2015, we had $824 million and $623 million respectively, in advances outstanding under the CIP and CEDA programs and related letters of credit outstanding of $164 million and $184 million.

Community First® Fund - Our Board of Directors approved $50 million in 2011 to supplement our current affordable housing and community investment programs, which became the foundation for the Community First Fund (the Fund). The Fund is an innovative revolving credit facility designed to provide low cost, longer term financing to Community Development Financial Institutions, community development loan funds, and state housing finance authorities promoting affordable housing and economic development in our district. We approved our first loans under the Fund in 2014 and as of December 31, 2016, had $34 million in funded loans outstanding and $8 million in unfunded loan commitments.

Deposits

We accept deposits from our members, institutions eligible to become members, any institution for which we are providing correspondent services, other FHLBs, and 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 48.

Funding

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, and the issuance of capital stock. Consolidated obligations, which consist of bonds and discount notes, are the joint and several liability of the FHLBs, although the primary obligation is with the individual FHLB that receives the proceeds from issuance. Consolidated obligations are issued 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 U.S. government. See Funding on page 49 for further discussion.

Subordinated Debt Payoff

As approved by the Finance Board (predecessor to the FHFA), we issued $1 billion of 10-year subordinated notes in 2006, and during 2013, we purchased $56 million of these notes in the open market. On June 13, 2016, our remaining $944 million subordinated notes matured and we paid the holders of our subordinated notes in full in accordance with the terms of their notes.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Competition

We compete with the U.S. 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 domestic 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 lesser amounts of debt issued at the same cost than otherwise would be the case. For example, a change in the types or an increase in the amounts of U.S. Treasury issuance may affect our ability to raise funds because it provides alternative investment options. Furthermore, to the extent that investors perceive Fannie Mae and Freddie Mac or other issuers as having a higher level of government support, their debt securities may be more attractive to investors than FHLB System debt.

The FHLBs have traditionally had a diversified funding base of domestic and foreign investors, although investor demand for our debt depends in part on prevailing conditions in the financial markets. For further discussion of market conditions and their potential impact on us, see Risk Factors on page 18 and Funding on page 49.

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.

Business Environment

Our financial condition and results of operations are influenced by the interest rate environment, global and national economies, local economies within our districts of Illinois and Wisconsin, and the conditions in the financial, housing, and credit markets. In particular, our net interest income is affected by several external factors, including market interest rate levels and volatility, credit spreads and the general state of the economy.  We endeavor to manage our interest rate risk by entering into fair value hedge relationships utilizing interest rate derivative agreements to hedge a portion of our advances, available for sale securities, and debt.   We also enter into cash flow hedge relationships utilizing derivative agreements to hedge the cash flow risk attributable to the rolling nature of our short-term consolidated discount notes.  Additionally, we enter into economic hedges using derivative agreements to hedge our mortgage-related assets, which are sensitive to changes in mortgage rates.

Our profitability is significantly affected by the interest rate environment.   We earn relatively narrow spreads between yields on assets and the rates paid on corresponding liabilities.  A large portion of our advance business is based on our funding costs plus a narrow spread. We also expect our ability to generate significant earnings on capital and short-term investments will be affected by the Federal Reserve’s policy of setting the short-term Federal Funds rate.  Short-term interest rates also directly affect our earnings on invested capital.

Our operating results are affected not only by rising or falling interest rates, but also by the particular path and volatility of changes in market interest rates and the prevailing shape of the yield curve. A flattening of the yield curve tends to compress our net interest margin, while steepening of the curve offers better opportunities to purchase assets with wider net interest spreads. The performance of our MPF Loans held for investment portfolio is particularly affected by shifts in the 10-year maturity range of the yield curve, which heavily influences mortgage rates and potential refinancings. Yield curve shape can also influence the pace at which borrowers refinance or prepay their existing loans, as borrowers may select shorter-duration mortgage products in a refinancing. In addition, our higher yielding private label MBS portfolio continues its expected runoff. As higher coupon MPF Loans mature along with higher yielding private label MBS, the return of principal cannot be invested in assets with a comparable yield, resulting in a decline in the aggregate yield on the remaining MPF Loans held for investment portfolio and investment securities and a possible decrease in our net interest margin.

Lastly, the volume related to our MPF Xtra and MPF Direct programs as well as our Ginnie Mae MBS issuances also are influenced by the interest rate environment, global and national economies, local economies within our districts of Illinois and Wisconsin, and the conditions in the financial, housing and credit markets.

Oversight, Audits, and Legislative and Regulatory Developments

Regulatory Oversight

We are supervised and regulated by the FHFA, an independent federal agency in the executive branch of the U.S. government. The FHFA's operating and capital expenditures are funded by assessments on the FHLBs; no tax dollars or other appropriations support the operations of our regulator. To assess our safety and soundness, the FHFA 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 FHFA.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


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 (Secretary) 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 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.

Pursuant to FHFA regulations, we plan to publish the results of our annual severely adverse economic conditions stress test to our public website at www.fhlbc.com between November 15 and November 30.

Regulatory Audits

The Comptroller General has authority under the FHLB Act to audit or examine us and to decide the extent to which we are fairly and effectively fulfilling 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.


Recent Legislative and Regulatory Developments

FHFA Final Rule on Acquired Member Assets. On December 19, 2016, the FHFA published the final Acquired Member Assets (AMA) rule, which governs an FHLB’s ability to purchase and hold certain types of mortgage loans from its members. The final rule, effective January 18, 2017, has, among other things:

expanded the types of assets that will qualify as AMA to include mortgage loans insured or guaranteed by a department or agency of the U.S. government that exceed the conforming loan limits and certificates representing interests in whole loans under certain conditions;

enhanced the credit risk sharing requirement by allowing an FHLB to utilize its own model to determine the credit enhancement for AMA loan assets and pool loans in lieu of a nationally recognized statistical ratings organization (NRSRO) ratings model. The assets delivered must now be credit enhanced by the member up to the FHLB determined “AMA investment grade” instead of a specific NRSRO rating; and

retained the option to allow a member to meet its credit enhancement obligation by purchasing loan level supplemental mortgage insurance (SMI) or pool level insurance once an FHLB has established standards for qualified insurers.

We do not anticipate that the final rule will have a negative impact on the volume of AMA loan assets or on our costs of operation.

FHFA Final Rule on New Business Activities. On December 19, 2016, the FHFA issued a final rule effective January 18, 2017, that, among other things, reduces the scope of new business activities (NBAs) for which an FHLB must seek approval from the FHFA. In addition, the final rule establishes certain timelines for FHFA review and approval of NBA notices. The final rule also clarifies the protocol for FHFA review of NBAs. Under the final rule, acceptance of new types of legally permissible collateral by the FHLBs would not constitute a new business activity or require approval from the FHFA prior to acceptance. Instead, the FHFA would review new collateral types as part of the annual exam process.

We do not anticipate that the final rule will materially impact us.

FHFA Proposed Rule on Minority and Women Inclusion. On October 27, 2016, the FHFA proposed amendments to its Minority and Women Inclusion regulations that, if adopted, would clarify the scope of the FHLBs’ obligation to promote diversity and ensure inclusion. These proposed amendments update existing FHFA regulations aimed at promoting diversity and the inclusion and utilization of minorities, women, and individuals with disabilities in all our business and activities, including management, employment and contracting.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


The proposed amendments would:

require the FHLBs to develop standalone diversity and inclusion strategic plans or incorporate diversity and inclusion into their existing strategic planning processes and adopt strategies for promoting diversity and ensuring inclusion;
encourage the FHLBs to expand contracting opportunities for minorities, women, and individuals with disabilities through subcontracting arrangements;
require the FHLBs to amend their policies on equal opportunity in employment and contracting by adding sexual orientation, gender identity, and status as a parent to the list of protected classifications; and
require the FHLBs to provide information in their annual reports to the FHFA about their efforts to advance diversity and inclusion through capital market transactions, affordable housing and community investment programs, initiatives to improve access to mortgage credit, and strategies for promoting the diversity of supervisors and managers.

We submitted a joint comment letter with the other FHLBs and the Office of Finance on December 27, 2016, which primarily related to the proposed rule’s enhanced reporting and contract requirements. The proposed rule, if adopted, may substantially increase the amount of tracking, monitoring, and reporting that would be required of each FHLB.

FHFA Proposed Rule on Indemnification Payments. On September 20, 2016, the FHFA issued a re-proposed rule that, if adopted, would establish standards for identifying whether an indemnification payment by an FHLB or the Office of Finance to an officer, director, employee, or other entity-affiliated party in connection with an administrative proceeding or civil action instituted by the FHFA is prohibited or permissible. Under the proposed rule, those payments with respect to an administrative proceeding or civil action instituted by the FHFA are only permitted if they relate to:

premiums for professional liability insurance or fidelity bonds for directors and officers, to the extent that the insurance or fidelity bond covers expenses and restitution, but not a judgment in favor of the FHFA or a civil money penalty;
expenses of defending an action, subject to an agreement to repay those expenses in certain instances; and
amounts due under an indemnification agreement entered into on or prior to September 20, 2016.

The proposed rule also outlines the process a board of directors must undertake prior to making any permitted indemnification payment for expenses of defending an action initiated by the FHFA.

We submitted a joint comment letter with the other FHLBs and the Office of Finance on the proposed rule on December 21, 2016. We are continuing to assess the effect of the proposed rule but we do not anticipate that, if adopted, it would materially affect us.

European Union (EU) Market Abuse Regulation. The EU issued updated Market Abuse Regulations (MAR) that became effective July 3, 2016 and which contain rules on insider dealing, unlawful disclosure of inside information and market manipulation for debt and equity securities on European securities exchanges, which differ in certain respects from U.S. regulations. MAR applies to issuers with securities admitted to trading on the EU exchanges, including EU exchanges on which FHLB consolidated obligations are listed. We anticipate that the most significant effect of the MAR on us will be more stringent and detailed recordkeeping, creation of detailed lists on parties who have access to inside information, and notification requirements.

Taxation and AHP Assessments

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. In lieu of taxes, we set aside funds for our AHP at a calculated rate of 10% of income before assessments. For details on our assessments, see Note 11 - Affordable Housing Program to the financial statements.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Item 1A.    Risk Factors.

Business Risks

A prolonged downturn in the U.S. housing markets and other economic conditions, and related U.S. government policies may have an adverse impact on the business of many of our members, and our business and results of operations.

Our business and results of operations are sensitive to the U.S. housing and mortgage markets, as well as international, domestic and district-specific market and economic conditions. Although U.S. economic activity appeared to be expanding at a moderate pace in 2016 and the Federal Reserve raised interest rates for the second time in a decade in mid-December, the Federal Reserve continues to monitor global economic and domestic inflation and employment developments closely. If these conditions deteriorate, our business and results of operations could be adversely affected.

In 2016, conditions in the U.S. housing market continued to improve, as evidenced by the level of decreased unemployment, home price appreciation and lower delinquency rates. If adverse trends reappear in the mortgage lending sector and general business and economic conditions deteriorate significantly, these factors could result in deterioration of our members' credit characteristics, which could cause them to become delinquent or to default on their advances and other credit obligations. As of February 28, 2017, we have not experienced any member payment defaults. In addition, declines in real estate prices or loan performance trends or increases in market interest rates could result in a reduction in the fair value of our collateral securing member credit and the fair value of our mortgage-backed securities investments. This change could increase the possibility of under-collateralization and the risk of loss in case of a member's failure, or increase the risk of loss on our mortgage-backed securities investments because of additional credit impairment charges. Also, deterioration in the residential mortgage markets could negatively affect the value of our mortgage loan portfolio and result in possibly additional realized losses if we are forced to liquidate our mortgage portfolio. Moreover, a negative trend in the housing and mortgage markets could result in a decline in advance levels and adversely affect our financial condition, results of operations, or ability to pay dividends or redeem or repurchase capital stock.

We face competition for advances and access to funding, which could adversely affect our business.

Our primary business is making advances to members. We compete with other suppliers of wholesale funding, both secured and unsecured, including investment banks, commercial banks, the Federal Reserve, and, in certain circumstances, other FHLBs with which members have a relationship through affiliates. While our advances increased significantly from 2013 through 2016, we do not anticipate that our advances will continue to increase at the same level over the longer term. As many members continue to have sufficient levels of liquidity and funds through deposits and investments, decrease the size of their balance sheets to improve their capital positions, diversify or have access to alternative funding sources, our advance levels could decrease.

We may make changes in policies, programs, and agreements affecting members' access to advances and other credit products, the MPF Program, the AHP, and other programs, products, and services. As a result of these changes some members may choose to obtain financing from alternative sources. For example, we may make changes to our collateral guidelines, including changes in the value we assign to collateral which members are required to pledge to secure their outstanding obligations, including advances. To the extent that members view this tightening of credit and collateral requirements as unfavorable, we may experience a decrease in our levels of business which may negatively impact our results of operations or financial condition. Further, many competitors are not subject to the same regulations as us, which may enable those competitors to offer products and terms that we are not able to offer. Any change made in pricing our advances to compete with these alternative funding sources may decrease our profitability on advances. Additionally, as we manage our refunding risk to rely less on short-term discount notes, any resulting increase in advance pricing may decrease demand for our advances. A decrease in advance demand or a decrease in profitability on advances could adversely impact our financial condition and results of operations.

The FHLBs also compete with the U.S. government, Fannie Mae, Freddie Mac, and other government-sponsored enterprises (GSEs), as well as corporate, sovereign, and supranational entities, including the World Bank, for funds raised through the issuance of unsecured debt in the domestic 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. Increased competition could adversely affect our ability to access funding, reduce the amount of funding available to us, or increase the cost of funding available to us. For example, a change in the types or an increase in the amount of US Treasury issuances may affect our ability to raise funds because it provides alternative investment options. In addition to the extent investors perceive Fannie Mae or Freddie Mac or other issuers as having higher levels of government support, their debt securities may be more attractive to investors than FHLB System debt. To the extent that the FHLB System experiences lower debt funding requirements, including in response to lower advance demands, our debt funding costs could increase. Any of these results

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


could adversely affect our financial condition, results of operations, or ability to pay dividends or redeem or repurchase capital stock.

The Bank and our members are subject to and affected by a complex body of laws and regulations, which could change in a manner detrimental to our business operations and financial condition.

We are a GSE organized under the authority of the FHLB Act and are governed by Federal laws and regulations of the FHFA. From time to time, Congress has amended the FHLB Act and adopted other legislation in ways that have significantly affected the FHLBs and the manner in which the FHLBs carry out their housing finance mission and business operations. New or modified legislation enacted by Congress or regulations adopted by the FHFA could have a negative effect on our ability to conduct business or our costs of doing business.

The FHFA’s extensive regulatory authority over the FHLBs includes, without limitation, the authority to liquidate, merge, consolidate, or redistrict the FHLBs. The FHFA also has authority over the scope of permissible FHLB products and activities, including the authority to impose limits on those products and activities. For example, the FHFA in 2016 adopted regulatory changes that disqualified captive insurance companies from FHLB membership, and this may negatively impact our advance levels as our advances with captive insurance companies mature. We can not predict whether the FHFA may issue future FHLB membership rule changes that could impact other classes of members. Currently, the FHFA is under the leadership of a single director, but if that structure were to change legislatively to a multi-director board or commission, the effect of such changes would be difficult to predict.

Changes in our statutory or regulatory requirements or policies or in their application could result in changes in, among other things, our membership base, our cost of funds; liquidity requirements; retained earnings and capital requirements; accounting policies; debt issuance limits; dividend payment limits; the form of dividend payments; capital redemption and repurchase limits; permissible business activities; advance pricing and structure; compliance requirements; and the size, scope, or nature of our lending, investment, or MPF Program activities; all and any of which could be detrimental to our business operations and financial condition.

In addition, as Congress continues to consider possible reforms to the U.S. housing finance system, including the resolution of Fannie Mae and Freddie Mac, any future legislation could directly or indirectly impact GSEs that support the U.S. housing market, including the FHLBs. See Recent Legislative and Regulatory Developments on page 16 for more information about recent regulatory developments. Also, there are additional uncertainties in the legislative and regulatory environment resulting from the change in Administrations.

Moreover, new or modified legislation or regulations governing or impacting our members may affect our ability to conduct business or cost of doing business with our members. For example, the Bank and its members have been impacted by the evolving regulations under the Dodd-Frank Act, which made significant changes to the overall regulatory framework of the U.S. financial system, and may continue to be impacted by any future modifications to such requirements. .

Furthermore, changes in statutory or regulatory requirements have also contributed to consolidation in the financial industry and may result in a reduction of our membership base. We lost 37 members due to mergers and acquisitions in 2016. Twenty nine of these members were acquired by other members in our district and eight were acquired by out-of-district institutions. As the financial services industry continues to experience significant consolidation, and to the extent new or modified legislation, the low interest rate environment, and financial technology issues negatively impact our members, we may lose a member or members whose business and capital stock investments are significant to our business. As a result, our financial condition and results of operation could be adversely affected.

Changes in the perception, status or regulation of GSEs and the related effect on debt issuance could reduce demand or increase the cost of the FHLBs' debt issuance and adversely affect our earnings.

The FHLBs are GSEs organized under the authority of the FHLB Act and are authorized to issue debt securities to fund their operations and finance housing development in the United States. During the financial crisis, the FHLBs debt pricing came under pressure as investors perceived GSE debt securities, including those securities issued by Fannie Mae and Freddie Mac, as bearing increased risk. This increased perception of risk resulted from the negative financial performance of Fannie Mae and Freddie Mac and the FHFA's action to place them into conservatorship in 2008. In addition, credit impairment of private-label MBS resulted in a negative effect on certain FHLBs’ financial performance in the past. More broadly, negative news articles, industry reports, and other announcements pertaining to the housing GSEs could create pressure on all GSE pricing, which could adversely impact us.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


In addition, FHFA regulations require us to perform annual stress tests under various scenarios and make the results of a severely adverse economic conditions test publicly available. The results of the stress test, or the public’s reaction to the results, could adversely impact us.

Furthermore, as the U.S. Congress continues to consider GSE and housing finance reforms, the FHLBs’ funding costs and access to funds could be adversely affected as a result of the uncertainty surrounding the timing and pace of any possible changes. Additionally, investor concerns about U.S. agency debt and the U.S. agency debt market may also adversely affect the FHLBs' competitive position and result in higher funding costs, which could negatively affect our earnings.

Failure to scale the size or composition of our balance sheet and our cost infrastructure to member demand for our products may have a material adverse effect on our results of operations and financial condition.

In 2015, we resumed purchasing MPF Loans to be held in our portfolio. During 2016, new MPF Loan purchases exceeded pay downs of our legacy MPF Loan portfolio. However, to the extent our new MPF Loan purchases are insufficient to offset pay downs in the future, our balance sheet would decrease over time. The same risk applies to our investment securities portfolio in light of our regulatory limitations on purchasing MBS and ABS investments. If our increase in expenses outpaces our increase in income, or if we were to become a smaller sized institution, or the composition of our balance sheet significantly changes in some manner, we would be presented with challenges, such as reducing our cost infrastructure and creating a balance sheet with earning assets that would support that cost infrastructure while providing for future dividends at an appropriate level. Structuring such a balance sheet would be more challenging in a low interest rate environment. In addition, as we incur development and operating costs related to new products and initiatives, we may not generate enough member demand and volume to recover such costs. For example, costs related to operating some of our MPF products exceed the revenue generated by these products to date by an amount that is not currently material but which could become so in the future. If we are unable to successfully transition our balance sheet and cost infrastructure to an appropriate composition and size scaled to member demand, our results of operations and financial condition may be negatively impacted.

Restrictions on the redemption, repurchase, or transfer of our capital stock could result in an illiquid investment for the holder.

Under the GLB Act and FHFA regulations, and our Capital Plan, our capital stock is subject to redemption upon the expiration of a five-year redemption period. Only capital stock in excess of a member's or former member's minimum investment requirement that was subject to a redemption request, capital stock of a member that has submitted a notice to withdraw from membership, or capital stock held by a member whose membership has been terminated may be redeemed at the end of the applicable redemption period. Further, we may elect to repurchase excess stock from time to time at our sole discretion without regard to the five-year redemption period. Beginning on January 26, 2017, we began repurchasing all excess class B2 membership stock on a weekly basis at par value, although members may continue to request repurchase of excess stock in addition to the automatic weekly repurchase.

If the redemption or repurchase of capital stock would cause us to fail to meet our minimum capital requirements or cause the member or former member to fail to maintain its minimum investment requirement, then such redemption or repurchase would be prohibited by FHFA regulations and our Capital Plan. We also may decide to suspend the redemption of capital stock if we reasonably believe that such redemptions would cause us to fail to meet our minimum capital requirements. All repurchases of excess stock, including automatic weekly repurchases, remain subject to our regulatory capital requirements, certain financial and capital thresholds, and prudent business practices. Accordingly, there is no guarantee that we will be able to redeem capital stock held by a shareholder even at the end of the redemption period or to repurchase excess capital stock.

In addition, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our Capital Plan requires our approval before a member or nonmember shareholder may transfer any of its capital stock to another member or nonmember shareholder, we cannot provide assurance that a member or nonmember shareholder would be allowed to transfer any excess capital stock to another member or nonmember shareholder at any time.

In addition, approval from the FHFA for redemptions or repurchases would be required if the FHFA or our Board of Directors were to determine that we incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, there can be no assurance that the FHFA would grant such approval or, if it did, upon what terms it might do so.

For further discussion of our minimum capital requirements, see Note 13 - Capital and Mandatorily Redeemable Capital Stock (MRCS) to the financial statements.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Limitations on the payment of dividends and repurchase of excess capital stock or future changes to our capital stock requirements may adversely affect the effective operation of our business model.

Our business model is based on the goal of maintaining a balance between our housing mission and our objective to provide a reasonable return on our members' investment in the cooperative. We work to achieve this balance by delivering low-cost credit to help our members meet the credit needs of their communities while striving to pay a reasonable dividend on our Class B2 membership stock and a higher dividend on Class B1 activity stock in order to recognize those members that are using advances, which contributes to the overall health of the entire cooperative. See Dividend Payments on page 57. Typically, our capital grows when members are required to purchase additional capital stock as they increase their advances borrowings and our capital declines when we purchase excess capital stock from members as their advances decline such as through our automatic weekly repurchase program.

Under FHFA regulations, the FHLBs may pay dividends on their stock only out of previously retained earnings or current net income, and our ability to pay dividends is subject to statutory and regulatory restrictions and is dependent upon our ability to continue to generate net income. Further, the level of our dividend payments is restricted by our retained earnings and dividend policy as further described under Retained Earnings & Dividends on page 57. If we are unable to maintain a reasonable level of net income, we may become unable to pay dividends or maintain a higher dividend on Class B1 activity stock or the level of dividends could be significantly reduced.

To the extent that current and prospective members determine that our dividend is insufficient or our ability to pay future dividends or repurchase excess capital stock becomes limited, we may be unable to expand our membership and 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.

In addition, during 2015 and 2016, we have made substantial changes to our Capital Plan to reduce the cost of membership and assist members in using the Bank in a manner most appropriate to their business. More specifically, the Bank has reduced the minimum stock requirement in the annual calculation for membership, lowered the cap on membership stock for any one member, decreased the activity stock requirement for advances and reduced the threshold at which Class B2 membership stock converts to Class B1 activity stock, as further discussed in Capital Rules on page 53. In addition, since 2013 the Bank has offered the Reduced Capitalization Advance Program (“RCAP”), which reduces a member’s activity stock requirement for certain advances as further discussed in Reduced Capitalization Advance Program on page 54. To the extent that we are unable to maintain these lower capital stock requirements and continue to offer RCAP, member utilization of the Bank may be impacted, which in turn may adversely affect our results of operations and financial condition.

Members' rights in the event of a liquidation, merger, or consolidation of the Bank may be uncertain.

Under the GLB Act, holders of Class B Stock own the retained earnings, surplus, undivided profits, and equity reserves of the Bank. Our Capital Plan provides that, with respect to a liquidation of the Bank, after payment to creditors, Class B Stock will be redeemed at par, or pro rata if liquidation proceeds are insufficient to redeem all of the capital stock in full. Any remaining assets will be distributed on a pro rata basis to those members that were holders of Class B Stock immediately prior to such liquidation. With respect to a merger or consolidation affecting us, members will be subject to the terms and conditions of any plan of merger and/or terms established or approved by the FHFA. Our Capital Plan also provides that its provision governing liquidation or merger is subject to the FHFA's statutory authority to prescribe regulations or orders governing liquidation, reorganization, or merger of an FHLB. Although our members would have an opportunity to ratify any merger agreement in a voluntary merger between us and another FHLB, we cannot predict how the FHFA might exercise its authority with respect to liquidations or reorganizations, or whether any actions taken by the FHFA in this regard would be inconsistent with the provisions of our Capital Plan or the rights of holders of Class B Stock in the retained earnings of the Bank.

Compliance with regulatory contingency liquidity guidance could restrict investment activities and adversely impact net interest income.

We are required to maintain sufficient liquidity through short-term investments in an amount at least equal to our anticipated cash outflows under two hypothetical scenarios for the treatment of maturing advances as described in Liquidity Measures on page 48. This regulatory guidance is designed to provide sufficient liquidity and to protect against temporary disruptions in the capital markets that affect the FHLB System's access to funding. To satisfy this liquidity requirement, we maintain increased balances in short-term investments, which may earn lower interest rates than alternate investment options and may, in turn, negatively impact net interest income.

In certain circumstances, we may need to fund overnight or shorter-term investments and advances with discount notes that have maturities that extend beyond the maturities of the related investments or advances. Net interest income on investments

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


and advances may be reduced. Also, to the extent that short-term advance pricing is increased, our short-term advances may be less competitive, which may adversely affect advance levels and our net interest income.

If additional regulatory liquidity requirements are issued in the future, our business activities and operations could be adversely affected.

Failure to meet minimum regulatory capital requirements could affect our ability to conduct business and could adversely affect our earnings.

We are subject to certain minimum capital requirements under the FHLB Act, as amended, and FHFA rules and regulations that include total capital, leverage capital, and risk-based capital requirements. If we are unable to satisfy our minimum capital requirements, we could be subject to certain capital restoration requirements and prohibited from paying dividends and redeeming or repurchasing capital stock without the prior approval of the FHFA, which could adversely affect a member's investment in our capital stock. Furthermore, any suspension of dividends and/or capital stock repurchases and redemptions could decrease member confidence, which in turn could reduce advance demand and net income should members elect to use alternative sources of wholesale funding. As a result of a risk-based capital shortfall, investors could perceive an increased level of risk or deterioration in our performance, which could result in a downgrade in our outlook or our short- or long-term credit ratings. For further discussion of our minimum regulatory capital requirements, see Note 13 - Capital and Mandatorily Redeemable Capital Stock (MRCS) to the financial statements.

FHFA regulations annually require us to perform stress tests under various scenarios and make the results of a severely adverse economic conditions test publicly available. The severity of the required scenarios is subject to the FHFA’s discretion. We use such stress tests as part of our capital planning process and evaluate the adequacy of capital resources available to absorb potential losses arising from those risks. While we believe that our capital base is sufficient to support our current operations given our risk profile, future required scenarios and the results of the stress testing process may affect our approach to managing and deploying capital.

Government measures to stimulate the economy and help borrowers refinance home mortgages may adversely impact the value of the assets we hold and our results of operations and financial condition.
 
Our business and results of operations are significantly affected by the fiscal and monetary policies of the federal government and its agencies, including the Federal Reserve Board, through its regulation of the supply of money and credit in the United States. The Federal Reserve's policies directly and indirectly influence the yield on interest-earning assets.

After the financial crisis of 2008 and subsequent economic downturn, the Federal Reserve maintained several measures to depress short-term and longer-term interest rates to stabilize the U.S. housing and financial markets. Although the Federal Reserve Board concluded its so-called "quantitative easing" asset purchase program in late 2014 and raised interest rates for the second time in a decade in December 2016, it has maintained its existing policy of reinvesting principal payments from its agency debt and agency MBS.

These measures as well as other government measures could adversely impact us in various ways, including through lower market yields on investments and elevated prepayments on our higher yielding MPF Loans and securities. Given our current limitations on purchasing ABS and MBS investments, we are subject to reinvestment risks. As a result, our net interest income, financial condition, and results of operations could be adversely impacted.

During the last economic downturn, federal and state government authorities, as well as private entities that include financial institutions and residential mortgage loan servicers, promoted programs designed to provide homeowners with assistance in avoiding residential mortgage foreclosures. During that same period, settlements involving banking regulators, the federal government, states' attorney generals, and large mortgage servicers focused on loan modifications and principal write downs. 

Loan modification programs, as well as future legislative, regulatory, or other actions, including amendments to the bankruptcy laws, could result in the modification of outstanding mortgages loans.  If such loan modification efforts result in a significant number of prepayments on mortgage loans underlying our investments in MBS, particularly during a low interest rate environment, our income could be reduced as we reinvest the proceeds at a lower rate of return or decrease the scale of our balance sheet.  Our income could also decline if regulatory requirements are put in place requiring us to offer a refinancing option for our MPF Loans held in portfolio.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


A decline in mortgage originations, any shift from a mortgage loan refinancing market to a purchase money market, and the loss of certain PFIs in the future may negatively impact our business.

Some forecasts suggest that mortgage originations are expected to decline in the near future, with the bulk of new originations coming from non-bank originators who are not members of the FHLBs and therefore not eligible to participate in our MPF Program. To the extent these forecasts are accurate, we may experience a decrease in volume available to purchase from our PFIs. Forecasts also predict a shift from a mortgage loan refinancing market, in which our PFIs are more active, to a purchase money market. To the extent these forecasts are accurate and our PFIs do not shift to originating purchase money mortgage loans, we may incur a decrease in volume available to purchase from our PFIs.

In 2015, we resumed purchasing MPF Loans to be held in our portfolio. During 2016, the top five PFIs, in the aggregate, accounted for 77% of our MPF on balance sheet purchases. To the extent we lose our business with these PFIs and cannot attract comparable replacements, our business may be adversely affected.

The loss of key personnel or difficulties recruiting and retaining qualified personnel could adversely impact our business and financial results.

Much of our future success depends on the continued availability and service of senior management personnel. The loss of any of our executive officers or other key senior management personnel could harm our business. Additionally, we must continue to recruit, retain and motivate management and other employees sufficiently, both to maintain our current business and to execute our strategic initiatives. If we are unable to recruit, retain and motivate employees sufficiently to maintain our current business and support our projected growth, our business and financial performance may be adversely affected.

Market Risks

To the extent that our legacy MPF Loan portfolio decreases and as our investment securities mature, we may experience a future reduction in our net interest income, which may negatively impact our results of operations and financial condition.

We are currently unable to make additional investments in MBS and ABS under FHFA regulatory limits as discussed in Investments on page 12. Additionally, although during 2016, new MPF Loan purchases exceeded pay downs of our legacy MPF Loan portfolio, our new MPF Loan purchases may be insufficient to offset anticipated pay downs of our legacy MPF Loan portfolio in the future. Moreover, any new investments we purchase may not be on as favorable terms or generate as much income as our maturing investments. Thus, our overall earning potential may be negatively impacted as investment securities decrease over time and to the extent that decreases in our legacy MPF Loan portfolio are not offset by new MPF Loan purchases.

A sustained period of low interest rates, rapid changes in interest rates, or an inability to successfully manage interest-rate risk could have a material adverse effect on our net interest income.

We realize net interest income primarily from the spread between interest earned on our outstanding advances, MPF Loans, and investments less the interest paid on our consolidated obligations and other liabilities. Our business and results of operations are affected significantly by the fiscal and monetary policies of the U.S. government and its agencies, including the Federal Reserve Board's policies, which are difficult to predict.  Therefore, our ability to anticipate changes regarding the direction and speed of interest rate changes, or to hedge the related exposures, significantly affects the success of our asset and liability management activities and our level of net interest income. We use a number of measures in our efforts to monitor and manage interest rate risk, including income simulations and duration, market value, and convexity sensitivity analyses.

Given the unpredictability of the financial markets, capturing all potential outcomes in these analyses is difficult. Key assumptions include, but are not limited to, loan volumes and pricing, market conditions for our consolidated obligations, interest rate spreads and prepayment speeds, implied volatility of options contracts, and cash flows on mortgage-related assets. These assumptions are inherently uncertain and they cannot precisely estimate net interest income and the market value of equity. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Volatility and disruption in the credit markets may have resulted in a higher level of volatility in our interest-rate risk profile and could negatively affect our ability to manage interest-rate risk effectively.

Interest rate changes can exacerbate prepayment and extension risk, which is the risk that mortgage-based investments will be refinanced by the borrower in low interest-rate environments or will remain outstanding longer than expected at below-market yields when interest rates increase. Decreases in interest rates typically cause mortgage prepayments to increase and may result in lower interest income and substandard performance in our mortgage portfolio as we experience a return of principal that

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


we re-invest in a lower rate environment. In addition, while these prepayments would reduce the asset balance, the associated debt may remain outstanding at above-market rates. Thus, a sustained period of low interest rates could have a material adverse effect on our net interest income. Conversely, when interest rates increase, we may experience extension risk, which is the risk that our mortgage-based investments will remain outstanding longer than expected at below-market yields. Therefore, any rapid change in interest rates could adversely affect our net interest income. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk on page 75 for additional discussion and analysis regarding our sensitivity to interest rate changes and the use of derivatives to manage our exposure to interest-rate risk.

We depend on the FHLBs' ability to access the capital markets in order to fund our business.

Our primary source of funds is the sale of FHLB consolidated obligations in the capital markets, including the short-term capital markets due to our increased reliance on discount note funding. Our ability to obtain funds through the sale of consolidated obligations depends in part on prevailing market conditions, such as investor demand and liquidity in the financial markets, which are beyond the control of the FHLBs. The severe financial and economic disruptions during the most recent financial crisis, and the U.S. government's dramatic measures enacted to mitigate the effects, affected the FHLBs' funding costs and practices. Our ability to operate our business, meet our obligations, and generate net interest income depends primarily on the ability of the FHLB System to issue debt frequently to meet member demand and to refinance our existing outstanding consolidated obligations at attractive rates, maturities, and call features, when needed. A significant portion of our advances are issued at interest rates that reset periodically at a fixed spread to an FHLB discount note rate-based index, so member demand for such advances may decrease to the extent that the FHLB System is unable to continue to issue debt at attractive rates.

The sale of FHLB consolidated obligations can also be influenced by factors other than conditions in the capital markets, including legislative and regulatory developments and government programs and policies that affect the relative attractiveness of FHLB consolidated obligations. For example, recent regulations related to capital and liquidity have impacted how debt dealers are managing their balance sheets. Although dealer capacity for FHLB consolidated obligations has occasionally been somewhat constrained as a result, it has not negatively impacted our funding costs and we have been able to adapt our issuance patterns so that it has not yet impeded our ability to meet our funding needs. We believe this is primarily driven by continued strong investor demand for FHLB debt. However, to the extent that such regulatory changes or other developments impact dealer demand or capacity for FHLB debt, our funding costs and/or access to the capital markets may be adversely affected.

We have a significant amount of discount notes outstanding with maturities of one year or less. We are exposed to liquidity risk if there is any significant disruption in the short-term debt markets. If a disruption were prolonged, we may not be able to obtain funding on acceptable terms. Any significant disruption that would prevent us from re-issuing discount notes for an extended period of time as they mature may require us to recognize into income up to $310 million of currently open deferred hedge costs out of accumulated other comprehensive income. Without access to the short-term debt markets, the alternative longer-term funding, if available, would increase funding costs and could cause us to increase advance rates, potentially adversely affecting demand for advances. If we cannot access funding when needed on acceptable terms, our ability to support and continue operations could be adversely affected. As a result, our inability to manage our liquidity position or our contingency liquidity plan to meet our obligations, as well as the credit and liquidity needs of our members, could adversely affect our financial condition and results of operations, and the value of FHLB membership.

In addition, we are sensitive to maintaining an appropriate liquidity and funding balance between our financial assets and liabilities, and we measure and monitor the risk of refunding such assets as liabilities mature (refunding risk). In measuring the level of assets requiring refunding, we take into account their contractual maturities. In addition, we make certain assumptions about their expected cash flows. However, our earnings and our ability to conduct our business may be adversely impacted to the extent we insufficiently maintain an appropriate liquidity to funding balance between our financial assets and liabilities.

Our funding costs and/or access to the capital markets and demand for certain of our products could be adversely impacted by any changes in the credit ratings for FHLB System consolidated obligations or our individual credit ratings.

FHLB System consolidated obligations are rated Aaa/P-1 with a stable outlook by Moody's and AA+/A-1+ with a stable outlook by S&P. Rating agencies may from time to time change a rating or issue negative reports. Because all of the FHLBs have joint and several liability for all FHLB consolidated obligations, negative developments at any FHLB may affect these credit ratings or result in the issuance of a negative report regardless of an individual FHLB's financial condition and results of operation. In addition, because of the FHLBs' GSE status, the credit ratings of the FHLBs and the FHLB System are directly influenced by the long-term sovereign credit rating of the U.S. government.  For example, downgrades to the U.S. sovereign credit rating and outlook may occur if the U.S. government fails to adequately address, based on the credit rating agencies' criteria, its fiscal budget process or statutory debt limit. As a result, similar downgrades in the credit ratings and outlook on the FHLBs and FHLB System consolidated obligations would mostly likely occur even though they are not obligations of the United States.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Future downgrades may result in higher FHLB funding costs and/or disruptions in access to the capital markets and our ability to maintain adequate liquidity. Any reduction in our individual Bank ratings may also trigger additional collateral posting requirements under certain of our derivative instruments. Further, member demand for certain of our products, such as letters of credit, is influenced by our credit rating and a downgrade of our credit rating could weaken member demand for such products.

Additionally, we are highly dependent on using derivative instruments to obtain low-cost funding and to manage interest rate risk. Negative credit rating events might also have an adverse affect on our ability to enter into derivative instruments with acceptable terms, increasing the cost of funding or limiting our ability to manage interest rate risk effectively.

To the extent that we cannot access funding when needed or enter into derivatives on acceptable terms to effectively manage our cost of funds and exposure to interest rate risk or demand for our products falls, our financial condition, and results of operations could be adversely impacted.

We are subject to various risks on our FFELP ABS investments.

Our FFELP ABS investments are securitizations of student loans that are guaranteed by guarantee agencies whose guaranties are reinsured by the U.S. Department of Education, or re-securitizations of such FFELP ABS. As of December 31, 2016, we held $4.6 billion of FFELP ABS investments.

We are subject to basis risk on these FFELP ABS because the Department of Education is responsible for making interest subsidy payments at a rate that is different from the rate on our FFELP ABS investments. Beginning in 2012, the Department of Education permitted holders of FFELP loans to permanently change this interest subsidy payment index rate from the previous 3-month commercial paper rate to a 1-month LIBOR rate plus a spread. Most FFELP ABS, including those we hold, pay a floating interest rate at 3-month LIBOR plus a spread. All FFELP ABS that the Bank holds now reflect an interest subsidy payment rate of 1-month LIBOR plus a spread. Although the change in interest subsidy payments from a 3-month commercial paper rate to a 1-month LIBOR rate reduces the volatility in basis risk now that both the ABS and interest subsidy rates are indexed to LIBOR, we remain subject to basis risk to the extent that these different LIBOR tenors do not move together in the future.

Because the loans backing our FFELP ABS investments are supported by the U.S. Department of Education, the ratings of FFELP ABS are generally constrained by the sovereign credit rating of the U.S. government.  In addition, ratings may be impacted by changes in rating agency criteria. For example, rating agencies recently re-evaluated their methodology around the receipt of final payment on student loans in response to borrower assistance plans which have resulted in slower repayment, in some cases beyond the debt’s original maturity date. To the extent that there are future downgrades to the U.S. sovereign credit rating or other rating agency actions which impact the ratings of our FFELP ABS, it may negatively impact the value of our investments.

We are also subject to servicing risk on these FFELP ABS because a guarantee agency may refuse to honor its guarantee if the servicer does not satisfy specific origination and servicing procedures, as prescribed by various U.S. federal and guarantor regulations. If default rates increase on the student loans backing our FFELP ABS, the yield and value on our securities may be negatively impacted to the extent guarantees are not honored by the guarantee agencies.

Credit Risks

Our financial condition and results of operations, and the value of Bank membership, could be adversely affected by our exposure to credit risk.

We are exposed to credit risk principally through advances or commitments to our members, MPF Loans and related exposures, derivatives counterparties, unsecured counterparties, and issuers of investment securities or the collateral underlying them. We assume secured and unsecured credit risk exposure associated with the risk that a borrower or counterparty could default, and we could suffer a loss if we are unable to fully recover amounts owed on a timely basis. In addition, we have exposure to credit risk because fair value of an obligation may decline as a result of deterioration in the creditworthiness of the obligor or the credit quality of a security instrument. We have a high concentration of credit risk exposure to financial institutions and mortgage assets.

A credit loss, if material, could have an adverse effect on our financial condition and results of operations. We follow guidelines established by our Board of Directors and the FHFA on unsecured extensions of credit, whether on- or off-balance sheet, which limit the amounts and terms of unsecured credit exposure to highly rated counterparties, the U.S. government, other FHLBs, and partners of our Community First Fund. However, there can be no assurance that these activities will prevent losses due to defaults on these assets.


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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Advances. Although the U.S. economy and housing markets continued to improve in 2016, some financial institutions, including some of our members, remain under financial stress exposing us to greater risk that one or more of our members may default on their outstanding obligations to us, including the repayment of advances.

To protect against credit risk for advances, we require advances to be collateralized and have policies and procedures in place to reasonably estimate the value of the collateral. In order to remain fully collateralized, we may require a member to pledge additional collateral, when deemed necessary. This requirement may adversely affect those members that lack additional assets to pledge as collateral. If members are unable to secure their obligations, our advance levels could decrease.

If a member defaults on its obligations, or the FDIC, or any other applicable receiver, fails either to promptly repay all of that failed institution's obligations or to assume the outstanding advances, then we may be required to liquidate the collateral pledged by the failed institution. The volatility of market prices and interest rates could affect the value of the collateral we hold as security for the obligations of our members. The proceeds realized from the liquidation of pledged collateral may not be sufficient to fully satisfy the amount of the failed institution's obligations or the operational cost of liquidating the collateral. Default by a member with significant outstanding obligations to us could adversely affect our results of operations and financial condition.

As we continue to work toward building a stronger cooperative and increasing advances by adding new members, we are actively focusing on institutions that have not traditionally been a large part of our membership, such as insurance companies, community development financial institutions, and housing associates. As we increase our membership to include more non-federally insured members and increase credit outstanding to such members, we face uncertainties surrounding the possible resolution of those members, in part due to our lack of experience in dealing with their regulators and any receivers and other liquidators that may be involved in the resolution of these members.

Also, as we update our collateral loan eligibility criteria to accept more complex loan structures and additional commercial loan property types, we face risks relating to valuing and liquidating collateral with these characteristics. Although we will closely monitor our credit and collateral agreement processes, we may experience credit losses and our business may be adversely affected if we are unable to sufficiently collateralize our risk exposures in the event of potential default by or resolution of these members.

Derivatives Counterparties. Our hedging strategies are highly dependent on our ability to enter into derivative instrument transactions with counterparties on acceptable terms to reduce interest-rate risk and funding costs. If a counterparty defaults on payments due to us, we may need to enter into a replacement derivative contract with a different counterparty, which may be at a higher cost, or we may be unable to obtain a replacement contract. We may also be exposed to collateral losses to the extent that we have pledged collateral and its value changes.

The insolvency of one of our largest derivatives counterparties combined with an adverse change in the market before we are able to transfer or replace the contracts could adversely affect our financial condition and results of operations. Further, to the extent that we have pledged collateral under the requirements of the derivative contract and the fair market value of the collateral increases above the value of the derivatives contract, we may experience delays in having our collateral returned or could experience losses if the counterparty fails to return the collateral.

If we experience further disruptions in the credit markets, it may increase the likelihood that one of our derivatives counterparties fails to meet their obligations to us. See Note 9 - Derivative and Hedging Activities to the financial statements for a description of derivatives credit exposure.

Rating agencies may from time to time change our rating or issue negative reports, which may adversely affect our ability to enter into derivative transactions with acceptable counterparties on satisfactory terms in the quantities necessary to manage our interest-rate risk and funding costs. A reduction in our credit rating or of the FHLB System credit rating may also trigger additional collateral requirements under our derivative contracts. This could negatively affect our financial condition and results of operations and the value of FHLB membership.

Federal Funds. We invest in Federal Funds sold in order to ensure the availability of funds to meet members' credit and liquidity needs. Because these investments are unsecured, our credit policies and FHFA regulations restrict these investments to short-term maturities and certain eligible counterparties. If the credit markets experience further disruptions, it may increase the likelihood that one of our Federal Funds counterparties could experience liquidity or financial constraints that may cause them to become insolvent or otherwise default on their obligations to us. For further discussion on our Federal Funds investments, see Unsecured Short Term Investments on page 72.

Securities Purchased Under Agreements to Resell. We also invest in securities purchased under agreements to resell in order to ensure the availability of funds to meet members' liquidity and credit needs.  These investments are secured by marketable securities held by a third-party custodian.  If the credit markets experience disruptions, it may increase the likelihood

26

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


that one of our counterparties could experience liquidity or financial constraints that may cause them to become insolvent or otherwise default on their obligations to us.  If the collateral pledged to secure those obligations has decreased in value, we may suffer a loss.  See the table in Investment Securities by Rating on page 70 for a summary of counterparty credit ratings for these investments.

Our MPF Program products have different risks than those related to our traditional advances products, which could adversely impact our results of operations.

The MPF Program, as compared to our advances products, is more susceptible to credit losses. As the U.S. housing market continued to improve during 2016, our allowance for credit losses on our MPF Loan portfolio continued to decline consistent with the general positive trends in the housing markets and smaller portfolio of legacy MPF Loans held on our balance sheet. However, to the extent that economic conditions weaken and regional or national home prices decline, we could experience higher delinquency levels and loss severities on our MPF Loan portfolio in the future. We are exposed to losses on our conventional MPF Loans held in our portfolio through our obligation to absorb losses up to the FLA and to the extent those losses are not recoverable from PFIs from withholding performance based CE Fees (Recoverable CE Fees). Our FLA exposure as of December 31, 2016 is $121 million. The next layer of losses after the FLA is allocated to the PFI, or SMI, as applicable, through the CE Amount. If losses accelerate in the overall mortgage market, we may experience increased losses that are allocated to us through the FLA or that may otherwise exceed the PFI's CE Amount and Recoverable CE Fees. Further, the PFIs may experience credit deterioration and default on their credit enhancement obligations, which, to the extent not offset against collateral provided by the PFIs, could cause us to incur additional losses and have an adverse effect on our results of operations.

Under the MPF Government product, we absorb any associated credit losses if we are unable to recover from the servicer or the insuring or guarantying government agency. We have the same risk with respect to the MPF Government MBS loans we acquired from our members unless the servicing was sold under our servicing released option in which the new servicer assumes our Ginnie Mae issuer responsibilities.

We are exposed to mortgage repurchase liability in connection with our sale of MPF Loans to Fannie Mae under the MPF Xtra product, to third-party investors under the MPF Direct Product, and to Ginnie Mae for MPF Loans securitized in Ginnie Mae MBS. If a loan eligibility requirement or other warranty is breached, these third parties could require us to repurchase the MPF Loan or provide an indemnity. If the PFI from which we purchased an ineligible MPF Loan is viable, we can require the PFI to repurchase that MPF Loan from us or indemnify us for related losses. Under the MPF Direct product, if a PFI is insolvent, our repurchase liability is limited to a PFI’s failure to deliver the required loan documentation and excludes repurchases for breaches of loan level representations and warranties. In addition, if we purchase the ineligible MPF Loan from a PFI of another MPF Bank, the MPF Bank will indemnify us for any losses we may incur. As of December 31, 2016, we had $45 million of repurchase requests and indemnifications outstanding to PFIs related to MPF Xtra loans and no outstanding repurchase requests or indemnifications for our MPF Direct and MPF Government MBS products. Because repurchase requests from third-party investors may be made up until full repayment of a loan rather than when a purported defect is first identified, repurchase requests received as of a particular date may not reflect total repurchase liability for loans outstanding as of that date. In certain circumstances, third-party investors may not make a repurchase or indemnification request until a loan becomes past due or defaults. PFIs are also required to repurchase ineligible MPF Loans we hold in our portfolio, as further discussed in Mortgage Repurchase Risk on page 67.
Some of our PFIs from whom we may request repurchase or seek indemnification may be highly leveraged and may be adversely affected by economic and housing market conditions and disruptions in the financial and credit markets, which may impact their ability to fulfill their indemnification or repurchase obligations to us. Although we require members to pledge collateral to secure all outstanding credit obligations, only in certain cases do we require PFIs to collateralize repurchase obligations and indemnifications given their credit condition and size of their repurchase obligation or indemnification. In the event that a PFI becomes insolvent or otherwise defaults on its repurchase or indemnification obligation to us and we cannot offset the credit loss amount against collateral provided by the PFI or, alternatively, the FDIC, we could experience losses on MPF Loans.
We also have geographic concentrations of MPF Loans secured by properties in certain states. To the extent that any of these geographic areas experience significant declines in the local housing markets, declining economic conditions, or a natural disaster, we could experience increased losses. For further information on these concentrations, see Geographic Concentration on page 67.

For a description of the MPF Program, our obligations with respect to credit losses and the PFI's obligation to provide credit enhancement and comply with anti-predatory lending laws, see Mortgage Partnership Finance Program on page 7.


27

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


In certain circumstances, we rely on other FHLBs to manage credit risk related to our former members and credit enhancement and servicing obligations of PFIs located outside of our district, and if those FHLBs failed to appropriately manage this credit risk or enforce a PFI's obligations, we could experience losses.

In certain circumstances, for example when a member leaves the Bank due to a merger and the acquiring entity is a member of another FHLB, the other FHLB will hold and manage the former member's collateral covering advances and any other amounts still outstanding to us. The other FHLB will either subordinate to us all collateral it receives from the member, we may enter into an inter-creditor agreement, or we may elect to accept an assignment of specific collateral in an amount sufficient to cover our exposure. If the other FHLB were to inappropriately manage the collateral, we could incur losses in the event that the former member defaults.
We hold a significant portfolio of participation interests in mortgage loans acquired under the MPF Program from other FHLBs. PFIs located in other FHLB districts provide servicing and credit enhancement for these MPF Loans and we rely on the FHLB from the district in which the PFI is located to manage the related credit risk and enforce the PFI's obligations. If there were losses arising from these MPF Loans and the other FHLB were to fail to manage the risk of PFI default or enforce the PFI's obligations, we could incur losses in the event of a PFI default.

Increased delinquency rates, loan modifications, or legal actions could result in additional credit losses on mortgage loans that back our private-label MBS investments, which could adversely affect the yield on or value of these investments.

Prior to 2007, we invested in private-label MBS, which are backed by subprime, prime, and alternative documentation or Alt-A mortgage loans. Although we only invested in AAA rated tranches when purchasing these MBS, a majority of these securities were subsequently downgraded and sustained realized or projected credit losses due to economic conditions and housing market trends. Although market prices for many of these private-label MBS have improved recently, the depth and duration of prior trends continues to affect the market value for some of our private-label MBS. See Investment Securities on page 69 for a description of these securities.

It is not possible to predict the magnitude of additional OTTI charges in the future, because that will depend on many factors, including increased delinquency rates, loan modifications or legal actions. If positive trends in the housing markets and housing prices reverse or are less than projected, there may additional credit losses from other-than-temporary impairments. In addition, we have geographic concentrations of private-label MBS secured by mortgage properties that exceed 10% in California (38%). To the extent that this geographic area experiences further declines in the local housing markets or economic conditions or a natural disaster, we could experience increased losses on these investments.

We are jointly and severally liable for the consolidated obligations of other FHLBs.

Under the FHLB Act, we are jointly and severally liable with other FHLBs for consolidated obligations issued through the Office of Finance. If another FHLB defaults on its obligation to pay principal or interest on any consolidated obligation, the FHFA has the ability to allocate the outstanding liability among one or more of the remaining FHLBs on a pro rata basis or on any other basis that the FHFA may determine. The likelihood of triggering our joint and several liability obligation depends on many factors, including the financial condition and financial performance of other the other FHLBs. For example, to the extent one or more FHLBs had significant unsecured credit exposures outstanding at the time of counterparty failure, the affected FHLBs may fail to meet their obligations to pay principal or interest on consolidated obligations. If we were required by the FHFA to make payment on consolidated obligations beyond our primary obligation, our financial condition, and results of operations could be negatively affected.

Operational Risks

Our information systems may experience an interruption or breach in security.

Our operations rely on the secure processing, storage, and transmission of a large volume of personally identifiable information of mortgage loan borrowers, such as names, residential addresses, social security numbers, credit rating data, and other consumer financial information. We rely heavily on communications, information systems and internet to conduct our business. The continued occurrence of high-profile data breaches at other institutions provides evidence of an external environment with increasing attack vectors and sophistication to personal data infiltration. Other companies have also reported breaches and other attacks, some severe, which have involved targeted attacks intended to disable or degrade service, or sabotage systems. This environment demands that we continuously improve our design, implementation and monitoring of security controls. Despite these efforts, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information that we or our vendors store and manage. We are also subject to the risk that our employees may intercept and transmit unauthorized confidential or proprietary information. Improper disclosure of this information could harm our reputation, lead to legal exposure to borrowers, or

28

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Additionally, cyberattacks, whether through computer hacking, vandalism, malware, or computer viruses may lead to shutdowns or disruptions in our systems. Our cyber risk and other insurance might not be sufficient to cover us against claims related to security incidents, breaches, cyberattacks and other related events. Attempting to protect our information technology networks and systems may cause us to incur increasing costs, including costs to deploy additional personnel and protection technologies, to train employees, and to engage third party security experts and consultants.

We rely on quantitative models to manage risk, to make business decisions, and to value our assets and liabilities. Our business could be adversely affected if those models fail to produce reliable results.

We make significant use of both internal and external business and financial models to measure and monitor our risk exposures; including interest rate, prepayment, and other market risks, as well as credit risk. We also use models in determining the fair value of financial instruments when independent price quotations are not available or reliable. The information provided by these models is also used in making business decisions relating to strategies, initiatives, risk management, transactions, and products, and for financial reporting. Models are inherently imperfect predictors of actual results because they are based on available data and assumptions about factors such as future loan demand, prepayment speeds, default rates, severity rates, and other factors that may overstate or understate future experience. When market conditions change rapidly and dramatically, the assumptions used for our models may not keep pace with changing conditions. Inaccurate data or assumptions in these models are likely to produce unreliable results. For example, uncertainty in the housing and mortgage markets may increase our exposure to the inherent risks associated with the reliance on internal models that use key assumptions to project future trends and performance. Although we regularly adjust our internal models in response to changes in economic conditions and the housing market and rely on our vendors to adjust our external models, the risk remains that our models could produce unreliable results or estimates that vary considerably from actual results.

If these models fail to produce reliable results, we may not make appropriate risk management or business decisions, which could adversely affect our earnings, liquidity, capital position, and financial condition. Furthermore, any strategies that we employ to attempt to manage the risks associated with the use of models may not be effective.

Failures or interruptions in our information systems and other technology, including as a result of cyber attacks, may adversely affect our ability to effectively conduct and manage our business.

Our business is dependent upon our ability to interface effectively with other FHLBs, members, PFIs, and other third parties. Our products and services involve a complex and sophisticated operating environment supported by operating systems, which may be purchased, custom-developed, or out-sourced. Maintaining the effectiveness and efficiency of the technology used in our operations is dependent on the continued timely implementation of technology solutions and systems necessary to effectively manage the Bank and mitigate risk, which may require significant capital expenditures. If we are unable to maintain these technological capabilities, including retention of key technology personnel, we may not be able to remain competitive and our business, financial condition, and results of operations may be significantly compromised. To the extent that the measures we take to protect the security of our information systems do not prevent a failure or breach, including events resulting from a cyber attack, we may be unable to manage our business effectively or experience losses, reputational damage, or other harm. To date, we have not experienced any material effect or losses related to significant interruptions in our information systems, cyber attacks or other breaches.

Failures or interruptions in our internal control, or operating processes generally, may harm our financial condition, results of operations, and reputation.

Failures in our controls over financial reporting could result from human error, fraud, breakdowns in information and computer systems or lapses in operating processes. Moreover, lapses in our operating processes, including manual processes, could result from human error and could affect our overall operations. If significant control failure were to occur, or if a significant lapse in any operating process were to occur, it could materially impact our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse, or repair the negative effects of such failures or operational interruptions. If we are unable to correct material weaknesses or deficiencies in internal controls in a timely manner, our ability to record, process, summarize and report financial information accurately and within the time periods specified in the rules and forms of the SEC could be adversely affected. A failure in our internal control over financial reporting or a lapse in our operating processes could cause our members to lose confidence in our reported financial information, in our processes, or in us as a whole, subject us to government enforcement actions, and generally, materially, and adversely impact our business and financial condition.


29

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


We purchase a significant portion of our data center services, including disaster recovery capabilities, from third-party vendors, and if our vendors fail to adequately perform the contracted services in the manner necessary to meet our needs, our business, financial condition, and results of operations may be harmed.

We have engaged various vendors to provide us with data center outsourcing services that include hardware, software support, and technology services. Any failure, interruption, or breach in security of these systems, or any disruption of service, could result in failures or interruptions in our ability to conduct business. There is no assurance that if or when such failures do occur, that they will be adequately addressed by us or the third party vendors on whom we rely. The occurrence of any failures or interruptions could have a material adverse effect on our business, financial condition, and results of operations.

The performance of our MPF Loan portfolio depends in part upon third parties and defaults by one or more of these third parties on its obligations to us could adversely affect our results of operations or financial condition.

Mortgage Servicing. We rely on PFIs and third-party servicers to perform mortgage loan servicing activities for our MPF Loans held in portfolio. With respect to the MPF Xtra and MPF Government MBS products, we are contractually obligated to Fannie Mae and Ginnie Mae, respectively, with respect to servicing of the related MPF Loans under certain servicing options.

Servicing activities include collecting payments from borrowers, paying taxes and insurance on the properties secured by the MPF Loans, advancing principal and interest under scheduled remittance options, maintaining applicable government agency insurance or guaranty, reporting loan delinquencies, loss mitigation, and disposition of real estate acquired through foreclosure or deed-in-lieu of foreclosure. If current housing market trends negatively decline, the number of delinquent mortgage loans serviced by PFIs and third party servicers could increase. Managing a substantially higher volume of non-performing loans could create operational difficulties for our servicers. In the event that any of these entities fails to perform its servicing duties, we could experience a temporary interruption in collecting principal and interest or even credit losses on MPF Loans or incur additional costs associated with obtaining a replacement servicer if the servicer fails to indemnify us for its breaches. Similarly if any of our servicers become ineligible to continue to perform servicing activities under MPF Program guidelines, we could incur additional costs to obtain a replacement servicer. If a PFI servicer fails to perform its servicing responsibilities, we can potentially recover losses we incur from the collateral pledged to us under our Advances, Collateral Pledge and Security Agreement with the PFI; however, the amount of collateral pledged thereunder is not sized to cover a specific amount related to servicing obligations. If a third-party servicer is not one of our members, we would not have this additional remedy.

We offer servicing released alternatives for all of our MPF Loan products but currently we only have one servicing aggregator for particular products. If a servicing aggregator that is established as an approved servicer for the MPF Program exited the business or was not offering attractive servicing released premiums, or if we should decide to terminate our relationship with the servicer, our MPF Loan volume could be negatively impacted until we could engage replacement servicers.

Master Servicing. We act as master servicer for the MPF Program. In this regard, we have engaged a vendor for master servicing, Wells Fargo Bank N.A., which monitors the servicers' compliance with the MPF Program requirements and issues periodic reports to us. While we manage MPF Program cash flows, if the vendor should refuse or be unable to provide the necessary service, or if we should decide to terminate our relationship with the vendor, we may be required to engage another vendor which could result in delays in reconciling MPF Loan payments to be made to us or increased.








30

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Item 1B.    Unresolved Staff Comments.

Not applicable.


Item 2.    Properties.

As of February 28, 2017, we occupy 95,105 square feet of leased office space at 200 East Randolph Drive, Chicago, Illinois 60601.  We also maintain 5,518 square feet of leased space for an off-site back-up facility 15 miles northwest of our main facility, which is on a separate electrical distribution grid.


Item 3. Legal Proceedings.

On October 15, 2010, the Bank instituted litigation relating to 64 private label MBS bonds purchased by the Bank in an aggregate original principal amount of $4.29 billion. Of the three cases that were filed by the Bank, only the action filed in the Circuit Court of Cook County, Illinois remains active. As of February 28, 2017, the remaining litigation covers three private-label MBS bonds in the aggregate original principal amount of $65 million.

In this action, the Bank asserts claims for untrue or misleading statements in the sale of securities, signing or circulating securities documents that contained material misrepresentations, and negligent misrepresentation. The Bank seeks the remedies of rescission, recovery of damages, and recovery of reasonable attorneys' fees and costs of suit. As of February 28, 2017, Morgan Stanley & Co., Incorporated, and certain of its affiliates, remain as the sole defendants in the Illinois action.

The Bank may also be subject to various other legal proceedings arising in the normal course of business. After consultation with legal counsel, management is not aware of any other proceedings that might have a material effect on the Bank's financial condition or results of operations.



Item 4. Mine Safety Disclosures.
Not applicable.


31

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


PART II

Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.

Our members and under limited circumstances, former members, own our capital stock. Former members may continue to hold our capital stock when they have withdrawn from membership or have merged with out-of-district institutions. Our members elect our directors. We conduct our business almost exclusively with our members. Our stock can only be acquired and redeemed or repurchased at a par value of $100 per share. Our stock is not publicly traded and no market mechanism exists for the exchange of stock outside our cooperative structure.

We issue only one class of capital stock, Class B stock, consisting of two sub-classes of stock, Class B1 stock and Class B2 stock which, under our Capital Plan has a par value of $100 per share. As of February 28, 2017, we had 16,852,200 shares of capital stock outstanding, including mandatorily redeemable capital stock recorded as a liability, and we had 748 stockholders of record. For details on our Capital Plan, on member withdrawals and other terminations, and related amounts classified as mandatorily redeemable capital stock, see Note 13 - Capital and Mandatorily Redeemable Capital Stock (MRCS) to the financial statements.

Information regarding our cash dividends declared in each quarter in 2015 and 2016, and information regarding regulatory requirements and restrictions on dividends, is set forth in the Retained Earnings & Dividends section on page 57.

The following table presents, by type of institution, the outstanding capital stock holdings of our members and former members. Our capital stock may be redeemed upon five years' notice from the member to the Bank, subject to applicable conditions. For a description of our policies and related restrictions regarding capital stock redemptions and repurchases, see Capital Resources on page 53.

As of
 
December 31, 2016
 
December 31, 2015
Commercial banks
  
$
1,148

  
$
1,094

Thrifts
  
270

  
282

Credit unions
  
164

  
139

Insurance companies
  
128

  
434

Community Development Financial Institutions
  
1

  
1

Total GAAP capital stock
  
1,711

  
1,950

Stock reclassified as mandatorily redeemable capital stock (liability)
 
301

 
8

Total regulatory capital stock outstanding
 
$
2,012

 
$
1,958



We repurchased capital stock from members totaling $1.2 billion during 2016 and $324 million in 2015.

32

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Item 6.    Selected Financial Data.

Computation of Ratio of Earnings to Fixed Charges


For the years ended December 31,
 
2016
 
2015
 
2014
 
2013
 
2012
Net income (loss)
 
$
327

 
$
349

 
$
392

 
$
343

 
$
375

Total assessments
 
37

 
39

 
44

 
33

 
42

Interest expense
 
803

 
744

 
841

 
1,061

 
1,344

Earnings, as adjusted
 
$
1,167

 
$
1,132

 
$
1,277

 
$
1,437

 
$
1,761

 
 
 
 
 
 
 
 
 
 
 
Fixed charges:
 
 
 
 
 
 
 
 
 
 
Interest expense
 
803

 
744

 
841

 
1,061

 
1,344

Total fixed charges
 
$
803

 
$
744

 
$
841

 
$
1,061

 
$
1,344

 
 
 
 
 
 
 
 
 
 
 
Ratio of earnings to fixed charges
 
1.45

 
1.52

 
1.52

 
1.35

 
1.31




33

fhlbchicagologo2a17.jpg
Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Selected Financial Data
As of or for the years ended December 31,
2016
 
2015
 
2014
 
2013
 
2012
 
Selected statements of condition data
 
 
 
 
 
 
 
 
 
 
Investments a
$
28,060

 
$
28,324

 
$
32,745

 
$
36,402

 
$
40,750

 
Advances
45,067

 
36,778

 
32,485

 
23,489

 
14,530

 
MPF Loans held in portfolio, gross
4,970

 
4,831

 
6,072

 
7,724

 
10,474

 
Less: allowance for credit losses
(3
)
 
(3
)
 
(15
)
 
(29
)
 
(42
)
 
Total assets
78,692

 
70,671

 
71,841

 
68,797

 
69,584

 
Consolidated obligation discount notes, net
35,949

 
41,564

 
31,054

 
31,089

 
31,260

 
Consolidated obligation bonds, net
36,903

 
22,582

 
34,251

 
31,987

 
32,569

 
Mandatorily redeemable capital stock (MRCS) recorded as a liability
 
 
 
 
 
 
 
 
 
 
Capital stock
1,711

 
1,950

 
1,902

 
1,670

 
1,650

 
Retained earnings
3,020

 
2,730

 
2,406

 
2,028

 
1,691

 
Total capital
4,695

 
4,652

 
4,526

 
3,765

 
3,448

 
Other selected data at period end
 
 
 
 
 
 
 
 
 
 
MPF off-balance sheet loans outstanding - FHLB System b
16,972

 
15,399

 
14,474

 
13,964

 
11,348

 
MPF off-balance sheet loans outstanding - FHLBC PFIs b
8,196

 
7,785

 
7,608

 
7,492

 
6,645

 
FHLB systemwide consolidated obligations (par)
989,311

 
905,202

 
847,175

 
766,837

 
687,902

 
Number of members
728

 
740

 
751

 
759

 
762

 
Total employees (full and part time)
440

 
422

 
405

 
355

 
329

 
Selected statements of income data
 
 
 
 
 
 
 
 
 
 
Net interest income after provision for (reversal of) credit losses
$
455

 
$
503

 
$
528

 
$
452

 
$
563

 
Noninterest income
76

 
23

 
32

 
(1
)
 
(35
)
 
Noninterest expense
167

 
138

 
124

 
75

c 
111

 
Net income
327

 
349

 
392

 
343

 
375

 
Other selected data during the periods ended
 
 
 
 
 
 
 
 
 
 
MPF off-balance sheet loan volume funded - FHLB System b
4,266

 
3,154

 
2,037

 
4,671

 
6,941

 
MPF off-balance sheet loan volume funded - FHLBC PFIs b
1,853

 
1,437

 
975

 
2,214

 
3,636

 
Selected ratios (rated annualized)
 
 
 
 
 
 
 
 
 
 
Total regulatory capital to assets ratio
6.40
%
 
6.63
%
 
6.01
%
 
5.38
%
 
4.81
%
 
Market value of equity to book value of equity
108
%
 
108
%
 
114
%
 
116
%
 
102
%
 
Core mission asset ratio d
66.2
%
 
58.8
%
 
n/a

 
n/a

 
n/a

 
Investments - % of total assets
36
%
 
40
%
 
46
%
 
53
%
 
59
%
 
Advances - % of total assets
57
%
 
52
%
 
45
%
 
34
%
 
21
%
 
MPF Loans held in portfolio, net - % of total assets
6
%
 
7
%
 
8
%
 
11
%
 
15
%
 
Dividend rate class B1 activity stock-period paid
2.75
%
 
2.31
%
 
1.58
%
 
0.55
%
 
0.25
%
 
Dividend rate class B2 membership stock-period paid
0.60
%
 
0.50
%
 
0.45
%
 
0.30
%
 
0.25
%
 
Return on average assets
0.42
%
 
0.49
%
 
0.55
%
 
0.53
%
 
0.54
%
 
Return on average equity
7.18
%
 
7.65
%
 
9.35
%
 
9.69
%
 
12.90
%
 
Average equity to average assets
5.87
%
 
6.35
%
 
5.83
%
 
5.48
%
 
4.19
%
 
Net yield on average interest earning assets
0.59
%
 
0.72
%
 
0.74
%
 
0.71
%
 
0.84
%
 
Return on average Regulatory Capital spread to three month LIBOR index
5.96
%
 
7.55
%
 
9.61
%
 
9.74
%
 
11.67
%
 
Cash dividends
$
37

 
$
25

 
$
14

 
$
6

 
$
5

 
Dividend payout ratio
11.31
%
 
7.16
%
 
3.57
%
 
1.75
%
 
1.32
%
 
a 
Include investment securities, interest bearing deposits, Federal Funds sold, and securities purchased under agreements to resell.
b 
MPF off-balance sheet loans are MPF Loans purchased from PFIs and concurrently resold to Fannie Mae or other third party investors under the MPF Xtra and MPF Direct products or pooled and securitized in Ginnie Mae MBS under the MPF Government MBS product. See Mortgage Partnership Finance Program beginning on page 7.
c 
In 2013 we reversed a $50 million charge (originally recorded as an expense in 2011) after we received approval from the FHFA and our Board of Directors to implement the Community First Fund as a revolving credit facility. See page 14 in Item 1. Business for more information.
d 
On July 14, 2015, the FHFA issued an advisory bulletin that provides guidance relating to a core mission asset ratio by which the FHFA will assess each FHLB's core mission achievement. See page 5 in Item 1. Business for more information.


34

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Information

Statements contained in this report, including statements describing the objectives, projections, estimates, or future predictions of management, may be “forward-looking statements.” These statements may use forward-looking terminology, such as “anticipates,” “believes,” “expects,” “could,” “estimates,” “may,” “should,” “will,” their negatives, or other variations of these terms. We caution that, by their nature, forward-looking statements involve risks and uncertainties related to our operations and business environment, all of which are difficult to predict and many of which are beyond our control. These risks and uncertainties could cause actual results to differ materially from those expressed or implied in these forward-looking statements and could affect the extent to which a particular objective, projection, estimate, or prediction is realized. As a result, undue reliance should not be placed on such statements.

These forward-looking statements involve risks and uncertainties including, but not limited to, the following:

changes in the demand by our members for advances, including the impact of the availability of other sources of funding for our members, such as deposits; 

limits on our investments in long-term assets;

the impact of new business strategies, including our ability to develop and implement business strategies focused on maintaining net interest income; the impact of our efforts to simplify our balance sheet on our market risk profile and future hedging costs; our ability to successfully transition to a new business model, implement business process improvements, and scale our size to our members' borrowing needs; the extent to which our members use our advances as part of their core financing rather than just as a back-up source of liquidity; and our ability to implement product enhancements and new products and generate enough volume in new products to cover our costs related to developing such products;

the extent to which amendments to our Capital Plan, including our ability to implement reduced membership stock and advances activity stock requirements and continue to offer the Reduced Capitalization Advance Program for certain future advance borrowings, and our ability to continue to pay enhanced dividends on our activity stock, impact borrowing by our members;

our ability to meet required conditions to repurchase and redeem capital stock from our members (including maintaining compliance with our minimum regulatory capital requirements and determining that our financial condition is sound enough to support such repurchases), and the amount and timing of such repurchases or redemptions;

general economic and market conditions, including the timing and volume of market activity, inflation/deflation, unemployment rates, housing prices, the condition of the mortgage and housing markets, increased delinquencies and/or loss rates on mortgages, prolonged or delayed foreclosure processes, and the effects on, among other things, mortgage-backed securities; volatility resulting from the effects of, and changes in, various monetary or fiscal policies and regulations, such as those determined by the Federal Reserve Board and Federal Deposit Insurance Corporation; impacts from various measures to stimulate the economy and help borrowers refinance home mortgages; disruptions in the credit and debt markets and the effect on future funding costs, sources, and availability;

volatility of market prices, rates, and indices, or other factors, such as natural disasters, that could affect the value of our investments or collateral; changes in the value or liquidity of collateral securing advances to our members;

changes in the value of and risks associated with our investments in mortgage loans, mortgage-backed securities, and FFELP ABS and the related credit enhancement protections;

changes in our ability or intent to hold mortgage-backed securities to maturity;

changes in mortgage interest rates and prepayment speeds on mortgage assets;

membership changes, including the withdrawal of members due to restrictions on our dividends or the loss of members through mergers and consolidations; changes in the financial health of our members, including the resolution of some members; risks related to expanding our membership to include more institutions with regulators and resolution processes with which we have less experience;

increased reliance on short term funding and changes in investor demand for consolidated obligations and/or the terms of interest rate derivatives and similar agreements, including changes in the relative attractiveness of consolidated obligations

35

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


as compared to other investment opportunities; changes in our cost of funds due to concerns over U.S. fiscal policy, and any related rating agency actions impacting FHLB consolidated obligations;

political events, including legislative, regulatory, judicial, or other developments that affect us, our members, our counterparties and/or investors in consolidated obligations, including, among other things, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and related regulations and proposals and legislation related to housing finance and GSE reform; changes by our regulator or changes affecting our regulator and changes in the FHLB Act or applicable regulations as a result of the Housing and Economic Recovery Act of 2008 (Housing Act) or as may otherwise be issued by our regulator; the potential designation of us as a nonbank financial company for supervision by the Federal Reserve;

recent regulatory changes to FHLB membership requirements by the FHFA;

the ability of each of the other FHLBs to repay the principal and interest on consolidated obligations for which it is the primary obligor and with respect to which we have joint and several liability;

the pace of technological change and our ability to develop and support technology and information systems, including our ability to protect the security of our information systems and manage any failures, interruptions, or breaches in our information systems or technology services provided to us through third-party vendors;

our ability to attract and retain skilled employees;

the impact of new accounting standards and the application of accounting rules, including the impact of regulatory guidance on our application of such standards and rules;

the impact of the application of audit independence rules to our independent auditor;

the volatility of reported results due to changes in the fair value of certain assets and liabilities; and

our ability to identify, manage, mitigate, and/or remedy internal control weaknesses and other operational risks.

For a more detailed discussion of the risk factors applicable to us, see Risk Factors on page 18.

These forward-looking statements are representative only as of the date they are made, and we undertake no obligation to update any forward-looking statement as a result of new information, future events, changed circumstances, or any other reason.




36

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Executive Summary

2016 Financial Highlights

We recorded net income of $327 million in 2016 compared to $349 million in 2015.
Net interest income for 2016 was $456 million, which included $47 million of income from investment security prepayments during the period. For 2015, net interest income was $508 million, which included $75 million of income from investment security prepayments during the period. While our legacy investment portfolio continues to pay down, investments that were indexed to 3-month LIBOR benefited from the increase in 3-month LIBOR rates. Separately, debt hedged with 3-month LIBOR swaps was negatively impacted by higher 3-month LIBOR rates. In addition, we issued a greater portion of long-term debt in 2016 at higher rates.
Noninterest income was $76 million in 2016 compared to $23 million for 2015 due in large part to higher amounts of private-label mortgage backed securities litigation settlements ($38 million in 2016, compared to $13 million received from such settlements during 2015) and increases in gains from our derivative and hedging activities of $17 million.
Noninterest expense was $167 million for 2016 compared to $138 million for 2015, driven mainly by an increase in compensation and benefits related expenses.
Assets were $78.7 billion in 2016 compared to $70.7 billion at year-end 2015. Growth in advances and a small net increase in MPF Loans held in portfolio helped offset the declines in investment securities.
Advances outstanding were $45.1 billion in 2016, up 23% from the previous year-end level of $36.8 billion, reflective of member demand for competitive funding to support investment and loan growth opportunities.
MPF Loans held in portfolio increased to $5.0 billion in 2016 compared to $4.8 billion for 2015 as new MPF Loan purchases began to outpace pay down and maturity activity.
Total investment securities decreased 14% in 2016 to $21.0 billion, as our investment portfolio continued to pay down.
Retained Earnings were $3.0 billion at year-end 2016, up from $2.7 billion at the end of 2015 and we remain in compliance with all of our regulatory capital requirements.
Letter of Credit commitments increased to $10.8 billion in 2016 from $6.7 billion at year-end 2015.

Summary and Outlook

Focused on Members

Consistent with our commitment to serve our members, the Board of Directors announced several changes in 2016 designed to help our members obtain value from the Bank in a manner most appropriate for their business. In 2016, the Board reduced the minimum stock requirement in the annual calculation for membership; lowered the cap on membership stock for any one member; and decreased the activity stock requirement for advances.

These changes lowered our members’ investment requirements in the Bank without affecting borrowing capacity and, in turn, created excess stock that was no longer required by the Bank. In November 2016, we announced we would automatically repurchase all excess stock on a weekly basis beginning on January 26, 2017. This change permits us to more effectively manage our balance sheet with a goal to provide a reasonable return on members’ capital stock in the long term.

On January 24, 2017, our Board of Directors increased the dividend declared per share on both sub-classes of capital stock. Based on our financial results for the fourth quarter of 2016, the Board declared a cash dividend of 3.00% (annualized) for Class B1 activity stock (an increase of 20 basis points compared to the prior quarter) and a cash dividend of 0.85% (annualized) for Class B2 membership stock (an increase of 25 basis points compared to the prior quarter).

Focused on Funding Solutions

Reliable access to both short-term liquidity and long-term funding is a principal benefit of membership in the Bank. In June 2016, we announced that most advance funding terms were available under our popular Reduced Capitalization Advance Program (RCAP), which affords members the opportunity to borrow new advances with an activity stock requirement of 2%. This change, when combined with our customized solutions, flexible funding strategies, and highly competitive rates, contributed to substantial growth in advances. At year-end 2016, advances were $45.1 billion, up 23% from year-end 2015. More members also took advantage of our letters of credit, which were $10.8 billion, up 61% from year-end 2015.


37

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Focused on the Secondary Mortgage Market

The Bank provides members access to the secondary mortgage market through the MPF Program. MPF origination volumes for on and off balance sheet products for the Bank were $3.1 billion for 2016, an increase of 78% from year-end 2015. The re-introduction of the on balance sheet products contributed to this substantial increase. In addition to the loan sale proceeds and servicing fee income members can receive, members can also earn income for providing credit support for loans sold to us through those products; during 2016, participating financial institutions earned $2 million in such credit support income.

Focused on Community Investment

Supporting our members’ community investment activities is core to our mission. In 2016, more than 200 members reserved over $18 million in Downpayment Plus (DPP®) funding on behalf of approximately 3,000 homebuyers in members’ communities. Over $26 million was granted through the Bank’s competitive Affordable Housing Program (AHP) to help finance 46 affordable housing projects located primarily in Illinois and Wisconsin.

The Bank has also committed $41 million of the $50 million revolving Community First Fund at year-end 2016 as part of our effort to provide direct support to community development financial institutions (CDFIs) and community development loan funds.

Finally, in response to several devastating storms in central and northern Wisconsin last year, the Bank announced a $500,000 Community First Disaster Relief Program where eligible individuals and business owners in the FEMA disaster areas can access grants through our members.


38

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Results of Operations


Net Interest Income

Net interest income is the difference between the amount we recognize into interest income on our interest earning assets and the amount we recognize into interest expense on our interest bearing liabilities. These amounts were determined in accordance with GAAP and were based on the underlying contractual interest rate terms of our interest earning assets and interest bearing liabilities as well as the following items:

Net interest paid or received on interest rate swaps that are accounted for as fair value or cash flow hedges;
Amortization of premiums;
Accretion of discounts and OTTI reversals;
Amortization of hedge adjustments;
Advance and investment prepayment fees; and
MPF credit enhancement fees.

The tables on the following page present the increase or decrease in interest income and expense due to volume or rate variances. The calculation of these components includes the following considerations:
 
Average Balance: Average balances are calculated using daily balances. Amortized cost basis is used to compute the average balances for most of our financial instruments, including available for sale securities and MPF Loans held in portfolio that are on nonaccrual status. Fair value is used to compute average balances for our trading securities and financial instruments carried at fair value under the fair value option.

Total Interest: Total interest includes all components of net interest income, if applicable, as discussed above.

Yield/Rate: Effective yields/rates are based on average daily balances and includes all components of net interest income as discussed above. Yields/rates are calculated on an annualized basis.

Any changes due to the combined volume/rate variance have been allocated ratably to volume and rate.



39

fhlbchicagologo2a17.jpg
Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


2016 compared to 2015

 
 
2016
 
2015
 
Increase (decrease) due to
For the years ended December 31,
 
Average Balance
 
Total Interest  
 
Yield/ Rate
 
Average Balance
 
Total Interest  
 
Yield/ Rate
 
Volume
 
Rate
 
Net Change
Investment securities
 
$
21,874

 
$
719

 
3.29
%
 
$
24,408

 
$
805

 
3.30
%
 
$
(84
)
 
$
(2
)
 
$
(86
)
Advances
 
42,545

 
290

 
0.68
%
 
33,306

 
181

 
0.54
%
 
62

 
47

 
109

MPF Loans held in portfolio
 
4,721

 
218

 
4.62
%
 
5,323

 
256

 
4.81
%
 
(28
)
 
(10
)
 
(38
)
Federal funds sold and securities purchased with agreements to resell
 
6,238

 
25

 
0.40
%
 
6,254

 
8

 
0.13
%
 

 
17

 
17

Other interest bearing assets
 
1,501

 
7

 
0.47
%
 
1,466

 
2

 
0.14
%
 

 
5

 
5

Interest income on assets
 
76,879

 
1,259

 
1.64
%
 
70,757

 
1,252

 
1.77
%
 
99

 
(92
)
 
7

Consolidated obligation discount notes
 
43,303

 
359

 
0.83
%
 
36,274

 
294

 
0.81
%
 
58

 
7

 
65

Consolidated obligation bonds
 
28,050

 
411

 
1.47
%
 
28,955

 
396

 
1.37
%
 
(14
)
 
29

 
15

Subordinated notes
 
423

 
24

 
5.67
%
 
944

 
54

 
5.72
%
 
(30
)
 

 
(30
)
Other interest bearing liabilities
 
831

 
9

 
1.08
%
 
 
 
 
 


 
9

 

 
9

Interest expense on liabilities
 
72,607

 
803

 
1.11
%
 
66,173

 
744

 
1.12
%
 
66

 
(7
)
 
59

Net yield on interest-earning assets
 
$
76,879

 
$
456

 
0.59
%
 
$
70,757

 
$
508

 
0.72
%
 
$
40

 
$
(92
)
 
$
(52
)


Net interest income changed mainly due to the following:
 
Interest income from investment securities declined primarily due to the reduction in average balances as securities matured or paid down. We expect the decline in average balances and related interest income on our investment securities to continue to decline due to FHFA regulatory limits on the amount of investment securities that we may hold on our balance sheet as discussed in Investments on page 12.

Interest income from advances primarily increased due to higher member demand. Higher member demand was primarily driven by our Reduced Capitalization Advance Program (RCAP). Specifically, our RCAP makes the net borrowing cost for new advances more attractive to members by allowing them to borrow using less activity based capital stock. Interest income on advances also increased due to higher interest rates, primarily resulting from Federal Reserve Bank's actions at year end 2015.

Interest income from MPF Loans held in portfolio declined primarily due to the reduction in average balances as MPF Loans continued to paydown during 2016; however, the decline in interest income on MPF Loans held in portfolio in 2016 was smaller compared to the decline in 2015. This is because MPF Loan purchases outpaced MPF Loan paydowns in the second half of 2016, which resulted in a small net increase in the current balance of MPF Loans held in portfolio. Additionally, the paydown of our higher interest rate MPF Loans held in portfolio contributed to the decline in interest income from MPF Loans held in portfolio.

Interest expense on our consolidated obligations primarily increased due to overall higher average balances required to match the increased advance lending to our members in 2016. Towards year end we began to replace shorter term discount notes with higher rate long term consolidated obligations, however the impact on average balances for the year was insignificant. The increase in consolidated obligation interest expense was slightly offset by the retirement of our higher cost subordinated debt, which matured in the second quarter of 2016.

For details of the effect our fair value and cash flow hedge activities had on our net interest income during 2016 see Trading Securities, Derivatives and Hedging Activities, and Instruments Held at Fair Value Option on page 43.





40

fhlbchicagologo2a17.jpg
Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


2015 compared to 2014

 
 
2015
 
2014
 
Increase (decrease) due to
For the years ended December 31,
 
Average Balance
 
Total Interest  
 
Yield/ Rate
 
Average Balance
 
Total Interest  
 
Yield/ Rate
 
Volume
 
Rate
 
Net Change
Investments
 
$
24,408

 
$
805

 
3.30
%
 
$
28,568

 
$
870

 
3.05
%
 
$
(127
)
 
$
62

 
$
(65
)
Advances
 
33,306

 
181

 
0.54
%
 
25,056

 
158

 
0.63
%
 
52

 
(29
)
 
23

MPF Loans held in portfolio
 
5,323

 
256

 
4.81
%
 
6,762

 
327

 
4.83
%
 
(70
)
 
(1
)
 
(71
)
Federal funds sold and securities purchased with agreements to resell
 
6,254

 
8

 
0.13
%
 
8,975

 
5

 
0.06
%
 
(2
)
 
5

 
3

Other interest bearing assets
 
1,466

 
2

 
0.14
%
 
1,493

 
2

 
0.13
%
 

 

 

Interest income on assets
 
70,757

 
1,252

 
1.77
%
 
70,854

 
1,362

 
1.92
%
 
(147
)
 
37

 
(110
)
Consolidated obligation discount notes
 
36,274

 
294

 
0.81
%
 
28,889

 
269

 
0.93
%
 
69

 
(44
)
 
25

Consolidated obligation bonds
 
28,955

 
396

 
1.37
%
 
37,014

 
518

 
1.40
%
 
(113
)
 
(9
)
 
(122
)
Subordinated notes
 
944

 
54

 
5.72
%
 
944

 
54

 
5.72
%
 

 

 

Interest expense on liabilities
 
66,173

 
744

 
1.12
%
 
66,847

 
841

 
1.26
%
 
(44
)
 
(53
)
 
(97
)
Net yield on interest-earning assets
 
$
70,757

 
$
508

 
0.72
%
 
$
70,854

 
$
521

 
0.74
%
 
$
(103
)
 
$
90

 
$
(13
)


Net interest income changed mainly due to the following:

Interest income from investment securities declined primarily due to the decline in average balances as securities matured or paid down. The decline in average balances and related interest income on our investment securities was due to FHFA regulatory limits on the amount of investment securities that we could hold on our balance sheet as discussed in Investments on page 12. Additionally, during 2015 and 2014, our ability to make new investments that had a term to maturity in excess of 270 days was restricted.

Interest income from advances increased primarily due to increased member demand for advances during 2015. The following were key factors resulting in the increased demand by members for advances.

The funding needs of our members in Illinois and Wisconsin increased as the economic activity in our district continued to improve.

The benefits we offer our members through our Reduced Capitalization Advance Program (RCAP), which is designed to make the net cost of borrowing through advances more attractive to members.

Interest income from MPF Loans held in portfolio continued to decline as expected due to the net decrease in our outstanding MPF Loans held in portfolio. Though we had a net decrease in our outstanding MPF Loans at year end, we resumed purchasing MPF Loans again during 2015.

Interest expense decreased as our higher rate debt matured or was called and replaced with lower-rate funding during 2015. Additionally, we benefited from increasing the mix of discount notes as compared to bonds concurrent with market rates declining on average for our short term discount notes during 2015.

For details of the effect our fair value and cash flow hedge activities had on our net interest income during 2015 see Trading Securities, Derivatives and Hedging Activities, and Instruments Held at Fair Value Option on page 43.




41

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Noninterest income

For the years ended December 31,
 
2016
 
2015
 
2014
Trading securities
 
$
(2
)
 
$
(3
)
 
$
(19
)
Derivatives and hedging activities
 
1

 
(16
)
 
(7
)
Instruments held under fair value option
 
5

 
8

 
13

Trading Securities, Derivatives and Hedging Activities, and Instruments Held Under Fair Value Option
 
4

 
(11
)
 
(13
)
Litigation settlement awards
 
38

 
13

 
27

MPF fees from other FHLBs
 
17

 
11

 
10

Other, net
 
17

 
10

 
8

Noninterest income
 
$
76

 
$
23

 
$
32


Trading Securities, Derivatives and Hedging Activities, and Instruments Held Under Fair Value Option

Noninterest income on trading securities, derivatives and hedging activities, and instruments held under the fair value option
were not significant to our statements of income over the last three years. For further details see Trading Securities, Derivatives and Hedging Activities, and Instruments Held at Fair Value Option on page 43.

Litigation settlement awards

On October 15, 2010, we instituted litigation relating to 64 private label MBS bonds we purchased in an aggregate original principal amount of $4.29 billion. In the past three years, we received payments for settlements with some of the defendants. We continue to pursue litigation related to these matters with respect to three private label MBS with an aggregate original principal amount of $65 million. We cannot predict to what extent we will be successful in this remaining litigation. See Item 3. Legal Proceedings on page 31 for further details.

MPF fees from other FHLBs

Other FHLBs pay us a membership fee to participate in the MPF Program and a fee for us to provide services related to their on balance sheet MPF Loans, which offsets a portion of expenses we incur to run the program.

Other, net

Other, net consists primarily of fee income we earn from our off balance sheet MPF Loan products, and fees we earn on a variety of functions we perform for our members.


42

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Federal Home Loan Bank of Chicago
(Dollars in tables in millions except per share amounts unless otherwise indicated)


Trading Securities, Derivatives and Hedging Activities, and Instruments Held at Fair Value Option

The following table shows the impact of Trading Securities, Derivatives and Hedging Activities, and Instruments Held Under Fair Value Option on our results of operations.

 
 
Advances
 
Investments
 
MPF Loans
 
Discount Notes
 
Bonds
 
Total  
Year ended December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
 
Amortization/accretion
 
$
8

 
$
(10
)
 
$
(9
)
 
$
(2
)
 
$
(13
)
 
$
(26
)
Net interest settlements a
 
(68
)
 
(112
)
 

 
(193
)
 
72

 
(301
)
Total recorded net interest income
 
(60
)
 
(122
)
 
(9
)
 
(195
)
 
59

 
(327
)
Fair value hedges - ineffectiveness net gain (loss)
 
7

 
1

 

 

 
(1
)
 
7

Cash flow hedges - ineffectiveness net gain (loss)
 

 

 

 
5

 

 
5

Economic hedges - net gain (loss)
 
7

 

 
6

 
(3
)
 
(21
)
 
(11
)
Total recorded derivatives & hedging activities
 
14

 
1

 
6

 
2

 
(22
)
 
1

Trading securities - hedged
 

 
(2
)
 

 

 

 
(2
)
Instruments held under fair value option
 
(7
)
 

 
(4
)
 
(2
)
 
18

 
5

Total net effect gain (loss) of hedging activities
 
$
(53
)
 
$
(123
)
 
$
(7
)
 
$
(195
)
 
$
55

 
$
(323
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Year ended December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
 
Amortization/accretion
 
$
9

 
$
(13
)
 
$
(13
)
 
$
(2
)
 
$
(10
)
 
$
(29
)
Net interest settlements a
 
(83
)
 
(133
)
 

 
(240
)
 
212

 
(244
)
Total recorded net interest income
 
(74
)
 
(146
)
 
(13
)
 
(242
)
 
202

 
(273
)
Fair value hedges - ineffectiveness net gain (loss)
 
1

 
(13
)
 

 

 
(23
)
 
(35
)
Cash flow hedges - ineffectiveness net gain (loss)
 

 

 

 
3

 

 
3

Economic hedges - net gain (loss)
 
(3
)
 

 
3

 
6

 
10

 
16

Total recorded derivatives & hedging activities
 
(2
)
 
(13
)
 
3

 
9

 
(13
)
 
(16
)
Trading securities - hedged
 

 
(1
)
 

 

 

 
(1
)
Instruments held under fair value option
 
(2
)
 

 
(1
)
 
2

 
9

 
8

Total net effect gain (loss) of hedging activities
 
$
(78
)

$
(160
)

$
(11
)

$
(231
)

$
198


$
(282
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Year ended December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Amortization/accretion
 
$
5

 
$

 
$
(17
)
 
$
(2
)
 
$
(14
)