The Federal Home Loan Banks to the Rescue!

For those who have been speculating on how the government might bail out participants in the collapsing US subprime mortgage market, an unlikely savior has stepped forward: the Federal Home Loan Banks (FHLB).

Compared to their limelight-hogging cousins — the Federal Reserve, Freddie Mac, and Fannie Mae — the FHL Banks don't get much press. But from March to September, the amount of loans these banks have made to their 8,125 members has risen some $200 billion to stand at $822 billion, a whopping 32% jump in just six months.[1]

This large increase in government-sponsored lending to financially troubled banks is unfortunate. It threatens to spread the consequences of poor choices made by lenders, regulators, and borrowers to all taxpayers, including those who made every effort to avoid the whole mess to begin with.

The Function and History of the FHL Banks

The FHL Banks were established in the midst of the Great Depression to provide a stable source of funding for member thrifts, otherwise known as savings & loan associations. Much like the Federal Reserve Act that established the Fed, the Federal Home Loan Bank Act chartered twelve regional institutions through which funds would flow to member banks. Whereas the Fed regulated and lent to commercial banks, the FHL Banks dealt with institutions that focused on mortgage origination, or thrifts. To this day the public mission of the FHLB is the provision of

cost-effective funding to members for use in housing, community, and economic development; to provide regional affordable housing programs, which create housing opportunities for low- and moderate-income families; to support housing finance through advances and mortgage programs; and to serve as a reliable source of liquidity for its membership.

The FHLB is a welfare-state institution to the bone.

The FHL Banks raise money by issuing bonds and notes in domestic and international markets. Investors assume that FHLBank debt has a federal government guaranty, even though none is mentioned explicitly in the Federal Home Loan Bank Act. Bond rating agencies Moody's and Standard & Poor's bless FHLB with their very best Aaa/AAA ratings. These factors enable the institution to raise debt at rates only a fraction above government treasury bonds, and below the rates at which the average thrift can raise money.

Flush with cash, the FHL Banks advance this money to members. This money is granted on demand, as long as members maintain an acceptable level of financial health and deposit collateral (usually mortgages) to back the loans. The FHLB member list currently includes such luminaries as Citibank, Wachovia, Washington Mutual, and Countrywide. For members, this cheap funding is a godsend. Thrifts have historically depended on deposits from savers for funds, lending this money out as mortgages. Savers are fickle, turning to whichever institution offers the best rates and security. They require good service and a voice at the end of the phone. And they have been known to leave thrifts en masse, with an old-fashioned bank run as the result.

Thrifts also depend on medium- to long-term bonds and debentures for funding, or even issues of stock. More recently they have turned to short-term financing like commercial paper, a form of debt that remains outstanding for no more than a few months. The paper is typically rolled over when it expires, allowing the thrift to continue lending. Like fickle savers, debt investors pay close attention to interest rates and the financial health of the issuer. Stockholders watch earnings statements closely. FHL Banks, on the other hand, provide member thrifts with a steady and hassle-free flow of credit at subsidized rates.

The FHL Banks have a spotty past, due in part to the Savings & Loans crisis of the 1980s. The administrations of Jimmy Carter and Ronald Reagan enacted regulatory changes to the thrift industry that gave thrift officials the freedom to lend to a wider range of borrowers. Federal loan insurance to the tune of $100,000 for each thrift depositor was left untouched. This insurance was provided by the Federal Savings and Loans Insurance Corporation (FSLIC), and FSLIC was managed by the FHLB Board.

As Murray Rothbard writes in Making Economic Sense, the liberalization of lending rules coupled with a guarantee on deposits encouraged the thrifts to embark on a campaign of risky lending. With the first $100,000 of a depositor's balance guaranteed by FSLIC, the thrifts enthusiastically lent to whatever questionable projects they saw worthy. Whether it returned 300% or went bust, either way the thrift stood to lose nothing. Many of the thrifts owners started going bankrupt when the loans they had made failed. FSLIC was required to pay all the thrifts' insured depositors back. Because the value of the failed assets on which it foreclosed were worth far less than deposits, FSLIC itself became insolvent to the tune of some $87 billion.[2] Only multiple billion-dollar top-ups with taxpayer money allowed it to pay off all depositors.

When FSLIC was finally wound up, the responsibility for insuring thrift deposits was moved from the FHLB Board and assumed by the Federal Deposit Insurance Corporation (FDIC). Historically, FDIC had been responsible for insuring bank deposits; now it insures both banks and thrifts. More on FDIC later.

As for the FHL Banks, they have also undergone a facelift. No longer limiting their membership to just thrifts, in 1989 commercial banks and credit unions were given carte blanche to join the FHLB system and accept advances for mortgages. From then to now, the number of members has risen from 3,217 to 8,125. Some 5,870 of these are banks; only 1,245 are thrifts. Even more astonishing is that FHLB advances to members have risen from only $79 billion in 1991 to $822 billion last month.[3]

And now…

In August, lending markets collapsed. Many mortgage originators had been using unsecured commercial paper to fund a portion of their mortgages. The mortgages were then packaged and sold as mortgage-backed securities (MBS), the commercial paper paid off with the proceeds. This summer, falling housing prices shook the market's confidence in MBS, and investors in commercial paper suddenly refused to lend, worried that mortgage originators would be unable to pay them back. Estimates say that as much as $100 billion in unsecured commercial paper has disappeared from the market since August. Mortgage originators hooked on commercial paper as well as other forms of medium- and long-term financing had to look elsewhere for a portion of their funding. With plummeting stock prices, funding via the stock market was out of the question.

This is when the good old neighborhood FHLBank stepped in. Countrywide Financial, the nation's largest and most notorious thrift, had some $7 billion of unsecured commercial paper outstanding on December 31, 2006. According to its recent third quarter report, Countrywide's short-term lenders have fled, leaving the firm with little over $1 billion in commercial paper outstanding.

Countrywide's borrowings from the FHL Banks have almost doubled though, rising from $28 billion to $51 billion. The FHLB now accounts for 26% of Countrywide's funding, up from 15% in December and 2% in 2002, when the firm first started to tap the FHLB.[4] At rates of 5%, this new lending is far cheaper than what the firm would have been forced to pay were it to continue its dependence on commercial paper markets, depositors, bond markets, or the stock market. According to Reuters, Countrywide would have had to pay anywhere between 6–12% to roll over its commercial paper in August.

It is not just Countrywide that has turned to the FHL Banks. Many of the banks and thrifts have. Washington Mutual's borrowing jumped from $16 billion last quarter to $43.7 billion this quarter while World Savings Bank (a subsidiary of financial giant Wachovia) has borrowed $68 billion, up from $28.5 billion only a few months ago. Both are large mortgage originators. Year-to-date increases in FHLB advances to members have increased by the greatest amount ever. On a percentage basis this sort of growth has not been seen since the 1990s.

FHL Banks Influence and Distort Markets

When government entities such as the FHL Banks lend at interest rates below the market rate, they create distortions in the economy. Resources are allocated away from other sectors of the economy towards housing. Whole subdivisions are built that would not have been built at market rates. When conditions return to normal as is happening right now, many of these ventures are exposed as malinvestments, the capital tied up in them moving to more appropriate sectors of the economy. A continued setting of rates below the market rate by the FHL Banks only delays this eventual realization.

The FHLB system is hardly fair. Those with privileges — the member banks — get to borrow at rates below what the market would pay. Customers of these member banks are also privileged in that they can take out low-rate mortgages. This privilege is not free, though; it comes at the expense of all other taxpayers. Should the system experience some sort of setback, the implicit federal-government guarantee suggests that taxpayers will foot the bill — a select few bureaucrats, lenders, and house buyers benefiting at their expense.

When the FHL Banks make advances to members like Countrywide, in return they require sufficient collateral to back these loans. This collateral usually takes the form of mortgages and mortgage-backed securities. Should Countrywide go broke, the FHL Banks would take possession of Countrywide's pledged collateral, saddling their own books with a bunch of mortgage loans. If the FHL Banks were to sell these assets and not recoup their capital, as senior secured creditor they would have first lien on Countrywide's remaining assets.[5] The FHLBank's government-granted "super lien" comes at the expense of others with a call on Countrywide's assets, including holders of unsecured commercial paper, bonds, stocks, and insured depositors.

Insured depositors are the wards of FDIC. Before August, FDIC would have had significant priority on the assets of a failed bank, selling off that bank's assets to pay insured depositors. Unsecured commercial paper holders, bond investors, stockholders, and other creditors could only take what was left. The exodus of debt investors from the funding of mortgage originators like Countrywide and their replacement by FHL Banks at the head of the queue fundamentally changes this order. FDIC now only gets its pickings after the FHL Banks and the additional $200 billion in financing they have provided. This makes it more likely that, in the case of multiple bank failures, FDIC will not get a large enough slice of the pie to pay off insured depositors.[6]

Protected by their "super lien", the FHL Banks do not put themselves at risk by stepping in and lending to iffy members. They put FDIC at risk. And as we know from FSLIC's demise in the 1980s, any failure of FDIC would probably be funded by taxpayers to the tune of billions.

If things got bad, FDIC's $50 billion in reserves would allow it to pay off many of its depositors. But how many, and for how long? Considering that FDIC insures some $4 trillion in deposits, its $50 billion in reserves (about 1.2% of the total) is only a drop in the bucket.

At the end of the day

Many will say that the FHL Banks are simply fulfilling their mandate of providing liquidity when members call for it. According to this theory, the mass desertion of investors from commercial paper and other forms of debt can only be an example of market error, something that government agencies like the FHL Banks must fix with low rates and easy credit.

On the other hand, maybe the thousands of informed investors who fled debt markets did so not irrationally, but because they realized the party was over and that, if bankruptcies hit the fan, they would be the ones left holding the bag.

Likewise, government agencies may not be the shrewd market-saving operators they are made out to be. If the party finally ends, they will be the ones holding the bag. But why should they care? They have the taxpayer.

John Paul Koning is a freelance writer based in Toronto, Canada. See his archive. Send him mail. Comment on the blog.

Notes

[1] See also "Pinched By Credit Crunch, Banks Turn to Depression-Era Relic."

[2] From this 1991 article in the American Institute of CPAs.

[3] Figures and information from Chapter 1 of the paper "The Causes and Effects of Commercial Bank Participation in the Federal Home Loan Bank System" , an excellent primer on the FHL Banks, and FHLB Quarterly and Annual Reports.

[4] Informal polls of bank supervisors at the Federal Reserve and FDIC indicate that anything over 15% shows an unsafe and unsound dependence on advances. For source, see note 5.

[5] See the paper, "Should the FDIC Worry about the FHLB? The Impact of Federal Home Loan Bank Advances on the Bank Insurance Fund", by Yeager, Vaughan, and Bennett for a full explanation.

[6] For a further example of this effect, see the pamphlet "How the FLHB Could Cost the FDIC" by the St Louis Fed.

John Paul Koning