Another Quasi-Governmental Agency that’s Lending Hundreds of Billions to Troubled Banks

Daniel Gross on another GSE we haven’t heard much about:

Freddie and Fannie’s Healthy Cousin, by Daniel Gross: The Federal Reserve’s extraordinary efforts to help investment banks have effectively put the taxpayer on the hook for enormous potential losses…, we could end up paying tens or hundreds of billions…

But the actual amount of credit extended so far through these public-rescue efforts pales in comparison with the credit that has quietly been extended to banks in the past year—another lifeline that taxpayers could end up paying dearly for. … For the past 12 months, an obscure agency created by President Herbert Hoover during the Great Depression has come to the rescue of the banking industry. It is called the Federal Home Loan Banks.

Like Fannie Mae and Freddie Mac, the FHLB (here’s … a brief history, and an overview) is a government-sponsored enterprise. But it differs from the wounded giants in some significant ways. Instead of being owned by public shareholders, as Fannie and Freddie are, the 12 independent regional FHLBs are owned by their 8,100 members. Banks large and small, representing about 80 percent of the nation’s financial institutions, own shares in the FHLB and share in the profits.

The FHLB has a simple business model…. Basically, it funnels cash from Wall Street to banks on Main Street. Member banks present mortgages they’ve issued—high-quality ones, not junky subprime ones—as collateral to the FHLB and borrow money so they can have more cash to lend. To finance its activity, the FHLB sells debt to big investors in the capital markets. As with Fannie and Freddie, the FHLB benefits from a unique status. … While the FHLB takes pains to note that “Federal Home Loan Bank debt is not guaranteed by, nor is it the obligation of, the U.S. government,” there’s an assumption afoot in the marketplace that were the FHLB to encounter serious trouble, the government would step in. In return for this special treatment, the FHLB provides some vital public services. Twenty percent of its net earnings are used to help cover interest on debt issued by the Resolution Funding Corp., which paid for the Savings & Loan bailout. The FHLB also channels one-tenth of its profits to affordable-housing loans and grants.

During the mortgage boom, FHLB quietly did its job and avoided many of Fannie and Freddie’s excesses. … Subprime holdings were minimal. And since commercial banks were able to raise capital from Wall Street to make any kinds of loans they wanted, they didn’t have all that much need for the FHLB’s services. As the chart … shows, the number of loans extended to member banks rose modestly in the boom years, up 7 percent in 2005 and only 3 percent in 2006. …

But last year the mortgage house of cards began to collapse. And as Wall Street’s securitization machine, which had enabled banks to raise cash with alacrity, broke down, banks staged their own run on the FHLB. …. Since … the broken-down Wall Street mortgage securitization machine was sold for scrap, FHLB loans to member banks …[rose] to $914 billion at the end of this June. In the past 12 months, FHLB loans to its members have risen by 43 percent, representing an additional $274 billion in real credit provided by the system to its member banks. That sum dwarfs the actual amount of credit extended to investment banks by the Fed—or by the government to Fannie and Freddie.

Does the increase in FHLB’s balance sheet mean taxpayers may be on the hook for another trillion dollars in mortgage debt? It’s unlikely. FHLB has a much better track record than Fannie and Freddie. Because it maintains high standards, it has never suffered a credit loss on a loan extended to a member. It doesn’t spend hundreds of millions of dollars each year on executive compensation or lobbying, as Fannie and Freddie did. And it didn’t lower standards … as a way of increasing market share…. Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists.

Why does the FHLB exist at all?:

The Housing Giants in Plain View, by William R. Emmons, Mark D. Vaughan and Timothy J. Yeager , FRB St. Louis, July 2004: …The Federal Home Loan Bank System was the first housing GSE. The FHLBanks were established by Congress in 1932 to advance funds against mortgage collateral. At the time, the country was in the midst of an unprecedented wave of depositor runs. Depository institutions faced the risk that loans would have to be liquidated at fire-sale prices to pay off anxious depositors. The FHLBanks enabled their members, primarily savings and loan associations and savings banks, to obtain cash quickly should depositors come calling. This access to ready cash reduced the liquidity risk of mortgage lending, thereby freeing FHLB members to originate more home loans.

The FHLBanks also allowed the thrifts to offer better terms on mortgage loans. At the time, there was no secondary market for mortgages; so, thrift institutions were forced to hold loans until maturity. Consequently, they made only very short-term loans—three to five years at most. Moreover, these loans were nonamortizing “balloons”—upon maturity, the borrower either repaid the loan in full or paid a fee to renew the loan. Few families had the incomes necessary to get funding under these terms; so, few families owned their own homes. The FHLBanks stepped in and provided a source of long-term stable funding, thereby allowing member institutions to separate the credit risk and the liquidity risk of mortgage lending. …

Many of the conditions that were present when the FHLB was created have now eased or been eliminated (e.g. by the FDIC which resolves the depositor run problem, at least for small depositors, financial innovation, etc.). So why does the FHLB still exist?:

Although advances against mortgage collateral remain the focus of FHLBank activities, the justification for this focus has widened beyond support for home ownership. Now, the system sees its mission as including support for community banking. Community banks are relatively small institutions that specialize in making loans to and taking deposits from small towns or city suburbs. Community bankers find FHLB membership and services attractive… FHLB advances are dependable and convenient… Indeed, the FHLBanks offer a wide variety of maturities, from overnight to over 20 years.

The FHLB web site adds:

In a time when cash deposits in community banks are dwindling, the funds provided by the Federal Home Loan Banks guarantee a stable source of funds for mortgages and community lending. Without the Federal Home Loan Banks, most depository institutions would not have access to medium- and long-term sources of funding.

By supporting community-based financial institutions, the Federal Home Loan Bank System helps to strengthen communities.

What are the costs of the FHLB? Going back to the St. Louis Fed article:

Many economists believe that the implicit subsidization of the housing GSEs distorts the allocation of scarce funds in the capital markets. Left alone, these markets would allocate funds to the business and household borrowers capable of putting them to the best use. Cheaper funding for the housing GSEs means more new homes, more larger homes and higher rates of home ownership. On the other hand, this distortion might lead to fewer funds being available for business investment, possibly resulting in slower economic growth. …

Three problems are clearly associated with housing GSEs…: moral-hazard problems related to risk-taking, incomplete pass-through of subsidies intended for mortgage borrowers, and risk-shifting to the Federal Deposit Insurance Corp.

Moral Hazard

When a firm can take risks, enjoy the full benefits and avoid the full costs, economists say a moral hazard is present. The hazard is that the firm will respond to these incentives by increasing risk to imprudent levels. Moral hazard is a problem for the housing GSEs. Because the capital markets view their debt as virtually free of default risk, Freddie, Fannie and the FHLBanks can enjoy all the upside of risk-taking and little of the downside. … The burden of the extra risk does not, of course, go away just because the housing GSEs do not bear it. Indeed, taxpayers ultimately would bear the extra risk if the federal government were to stand behind a failing GSE.

Taxpayer exposure to risk-taking by housing GSEs is not limited to potential losses from default. Risk-taking by housing GSEs could undermine the stability of the financial system because so many banks depend on them for liquidity. Commercial banks hold more than one-half of their securities portfolios—a key source of emergency liquidity—in the form of mortgage-backed securities and GSE debt. Moreover, the portion of commercial bank loans backed by real estate is at an all-time high. Banks are comfortable holding mortgage-related securities because these securities can be sold quickly with minimal transaction costs, and banks are comfortable holding real-estate-backed loans because these loans can be pledged against advances from the FHLBanks or sold to Freddie or Fannie. A severe shock to one or more of the housing GSEs could lead to a market lockup, in which investors become reluctant to hold GSEs’ direct or indirect obligations. This could, in turn, lead to a temporary suspension of mortgage purchasing, mortgage securitizing or mortgage “advancing,” thereby forcing the Federal Reserve to intervene to re-liquefy the mortgage markets.

Incomplete Pass-Through of Subsidies

Who actually benefits from the subsidy—homeowners or the employees and shareholders of GSEs? As noted, the implicit guarantee against default lowers housing-GSE funding costs. Lower funding costs can be used to reduce mortgage rates for homeowners or to raise employee salaries or dividends for housing-GSE shareholders. Estimates vary about the division of the subsidy; one recent study estimated that the subsidy to Freddie and Fannie lowered mortgage interest rates by about 7 basis points (0.07 percent), yielding a savings to homeowners of about $44 billion. At the same time, the gain to Freddie’s and Fannie’s shareholders was estimated at $72 billion. …

Shifting Risk to the FDIC

Of the three housing GSEs, the FHLBanks are the least likely to increase their own risk. The shareholders of the 12 regional FHLBanks are also the customers. Therefore, the cost of excessive risk-taking by an FHLBank would fall on the same parties that enjoy the benefits. Still, the FHLB System may create moral hazard through another channel by implicitly encouraging its members to ramp up risk.

Advances from the FHLBanks may encourage risk-taking at member institutions because the FHLBanks have little incentive to demand higher interest rates when the credit risk of a borrowing bank increases. Advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance. Because advances carry no credit risk, the individual Home Loan banks can set terms that are largely independent of the failure risk of the borrower. Put another way, borrowing from the FHLB enables a bank to avoid any market-imposed penalty for failure risk. Moreover, the FDIC, which covers losses to insured depositors in the event of a bank failure, cannot make up the difference by hiking deposit-insurance premiums. Many observers believe that the current cap—27 cents a year per $100 of deposits—is too low to deter risk-taking. In short, greater risk-taking by FHLB members implies a higher failure rate over time. A higher failure rate, in turn, implies greater losses to the deposit-insurance fund. Taxpayers ultimately stand behind this fund.

Unless someone can identify the substantial government failure that this program solves, show that the FHLB provides liquidity insurance banks cannot get from the discount window or through other means, or make the case that the private sector, even with all of the recent financial innovation, would not make the necessary array of financial services available to smaller communities without the implicit government guarantee standing behind the FHLB, and further make the case that financial services, like telephone service or electricity, are essential services that all communities should have, then we should follow the recommendations we’ve heard for Fannie and Freddie and slowly eliminate the implicit government support of this institution.

Originally published at Economist’s View and reproduced here with the author’s permission.