June 26, 2011
Is the Federal Home Loan Bank System, which issues more debt securities than any other entity in the country besides the federal government, taking too many risks?
The FHLB was established during the Great Depression to provide low-cost “advances” to financial institutions so they could push money out into communities. And over the years it has advanced hundreds of billions of dollars to its almost 8,000 member banks (it had $804 billion in outstanding debt at the end of the first quarter) and never suffered a loss. Now some wonder if it is going too far out on the financial limb.
As demand for advances has declined amid the slowdown in mortgage lending, the 12 regional Federal Home Loan Banks have excess capital that needs to be returned to members or put to work. A rising portion of that money is going into the securities markets.
Edward J. DeMarco, acting director of the Federal Housing Finance Agency, which regulates the FHLBs as well as mortgage giants Fannie Mae and Freddie Mac, has spent much of the past year warning the FHLBs about the dangers of investing in securities.
At yearend 2009, the FHLBs’ combined investment portfolio of $284.3 billion accounted for 28 percent of total assets. By the end of 2010, the portfolio had grown to $330.4 billion and represented nearly 38 percent of total assets. The Federal Home Loan Banks of Chicago, Seattle, Cincinnati, and Indianapolis all have more than 50 percent of their assets in investments. The banks of Boston and Topeka appear to be on course to cross the 50 percent line in the near future.
Like Fannie and Freddie, the FHLBs are government-sponsored enterprises. They are cooperatives controlled by the member banks, but in the minds of many investors, their debt carries the implied guarantee of the U.S. government. While no one suggests that problems at the FHLBs could rival the near-collapse of Fannie and Freddie and the subsequent government bailout, the sheer size of their balance sheets is a sufficient cause for regulator concern.
DeMarco says reliance on investments presents a threat to the safety and soundness of the FHLBs. “The long-term purpose of the Federal Home Loan Banks is not to be running an investment book , but to be making advances,” DeMarco said in an interview. “The Federal Home Loan Banks have not experienced losses from advances. They have gotten into trouble from their investment portfolios.”
“It sounds like they are doing the same thing that Fannie and Freddie did,” says Edward Pinto, former chief credit officer for Fannie Mae and now a resident scholar at the American Enterprise Institute. “These things pose risks for the taxpayers when there is a very small benefit.”
Several Federal Home Loan Banks had losses on “private label” mortgage-backed securities during the housing crisis – losses that caused some to fall below minimum capital requirements. As a result, several had to suspend dividend payments and began refusing to return excess capital – leaving already-struggling member banks with sizeable non-performing assets on their books in the midst of the crisis.
The majority of U.S. banks and other lenders, from small one-branch community banks to Bank of America, are FHLB members. Buying capital stock entitles them to take advances. Because the FHLBs can borrow at lower rates than private institutions, they make advances at preferential rates.
“Investments are what have gotten them into trouble in the past, and they are back at the same old game,” said Alexandria, Va.-based banking consultant Bert Ely. “Should the system put itself at risk by continuing the type of security investments that have caused them so much trouble in the past?” he asked. “Unfortunately, history tends to repeat itself.”
Officials at the Federal Home Loan Banks were reluctant to speak on the matter. A spokeswoman for the Indianapolis bank declined to comment on DeMarco’s complaints. At the Cincinnati bank, spokesman John Byczkowski emailed a statement saying: "If the Finance Agency gives us a directive, our board of directors will take it seriously."
David Jeffers, executive vice-president for the Council of Federal Home Loan Banks, a trade group that represents the banks, said they “invest prudently while providing a reasonable rate of return on capital.” Investment portfolios are important, he added, “because demand for advances changes cyclically, but the fixed costs of doing business rise each year.”
Bankers that rely on the FHLBs for liquidity didn’t seem concerned. Glen Marshall, president and CEO of First Resource Bank in Exton, Pa., said he considers the FHLBs investments as a way to maintain their own liquidity against the day when banks like his need more advances.“It’s their job to be there for the next time they need to backstop the liquidity of member banks,” he said.
Other bankers see increased investment activity as a necessity resulting from current market conditions. “These are not normal times, and I think the banks are doing the right thing,” said Joseph Pierce, president and CEO of Farmer’s State Bank in Lagrange, Ind. “They need to put those funds to work somewhere. I don’t think they are chasing yield to the point of making unsound investments”
But DeMarco, who has been acting director of the FHFA since September 2009, has shown a willingness to be aggressive in pursuing his policies. He is widely expected to remain as chief operating officer of the agency when a permanent director is confirmed. (President Obama’s nominee for the position, Joseph A. Smith, was cleared by the Senate Banking Committee last year but like other Obama administration nominees for top financial regulatory positions, hasn’t had a confirmation vote in the full Senate.)
”As the regulator I expect that there will be movement over time so that advances return to being the substantial activity of the banks,” DeMarco said. “They are financial institutions, and they need to have liquidity on their balance sheet. That’s not what this is about. The issue is how dominant a share of the portfolio those liquid assets are.”
Why the Housing Market Needs More Foreclosures (The Fiscal Times)
Reforming Fannie and Freddie: A $6 Trillion Problem (The Fiscal Times)
Fixing the Mortgage Market Could Hurt Consumers (The Fiscal Times)