[Senate Hearing 108-834]
[From the U.S. Government Publishing Office]
S. Hrg. 108-834
OVERSIGHT OF
THE FEDERAL HOME LOAN BANK SYSTEM
=======================================================================
HEARING
before the
SUBCOMMITTEE ON FINANCIAL INSTITUTIONS
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
THE OPERATIONS OF THE FEDERAL HOME LOAN BANK SYSTEM, FOCUSING ON THE
RESPONSIBILITY THAT CONGRESS HAS PLACED WITH THE FEDERAL HOME LOAN
BANKS TO ENHANCE THE LIQUIDITY OF FINANCIAL INSTITUTIONS, PARTICULARLY
AS THE FEDERAL HOME LOAN BANK MEMBERS MEET SUCH COMMUNITY NEEDS AS
PROMOTING HOMEOWNERSHIP
__________
SEPTEMBER 9, 2003
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /senate /senate05sh.html
______
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Sarah A. Kline, Democratic Counsel
Jonathan Miller, Democratic Professional Staff
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
______
Subcommittee on Financial Institutions
ROBERT F. BENNETT, Utah, Chairman
TIM JOHNSON, South Dakota, Ranking Member
ELIZABETH DOLE, North Carolina ZELL MILLER, Georgia
LINCOLN D. CHAFEE, Rhode Island THOMAS R. CARPER, Delaware
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
RICK SANTORUM, Pennsylvania JACK REED, Rhode Island
CHUCK HAGEL, Nebraska EVAN BAYH, Indiana
JIM BUNNING, Kentucky DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho
Michael Nielsen, Staff Director
Naomi Camper, Democratic Legislative Assistant
(ii)
?
C O N T E N T S
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TUESDAY, SEPTEMBER 9, 2003
Page
Opening statement of Senator Bennett............................. 1
Senator Johnson.............................................. 3
Senator Corzine.............................................. 10
Senator Hagel................................................ 12
Senator Reed................................................. 14
Senator Bunning.............................................. 16
Prepared statement....................................... 46
Senator Allard............................................... 17
Prepared statement....................................... 46
Senator Miller............................................... 20
Senator Sarbanes............................................. 34
WITNESSES
Wanye A. Abernathy, Assistant Secretary for Financial
Institution, U.S. Department of the Treasury................... 4
Prepared statement........................................... 46
John T. Korsmo, Chairman, Federal Housing Finance Board.......... 6
Prepared statement........................................... 50
Response to written questions of Senator Sarbanes and Senator
Carper..................................................... 77
Norman B. Rice, President and Chief Executive Officer, Federal
Home Loan Bank of Seattle...................................... 21
Prepared statement........................................... 56
Michael Middleton, Vice President, Federal Home Loan Bank of
Atlanta, Chairman and Chief Executive Officer, Community Bank
of Tri-County, Waldorf, MD..................................... 24
Prepared statement........................................... 60
Shelia C. Bair, Dean's Professor of Financial Regulatory Policy,
Isenberg School of Management, University of Massachusetts..... 27
Prepared statement........................................... 64
Response to written questions of Senator Sarbanes............ 100
Terry Smith, President, Federal Home Loan Bank of Dallas......... 30
Prepared statement........................................... 67
David W. Hemingway, Director, Federal Home Loan Bank of Seattle,
Executive Vice President, Zions First National Bank, Salt Lake
City, UT....................................................... 32
Prepared statement........................................... 75
Additional Material Supplied for the Record
Letter to John W. Snow, Secretary, U.S. Department of the
Treasury from George J. Parseghian, Chief Executive Officer and
President, Freddie Mac dated July 14, 2003..................... 116
``Is the Federal Home Loan Bank System Forsaking its Roots?'' by
Shelia C. Bair, dated June 2003................................ 117
(iii)
OVERSIGHT OF
THE FEDERAL HOME LOAN BANK SYSTEM
----------
TUESDAY, SEPTEMBER 9, 2003
U.S. Senate,
Subcommittee on Financial Institutions, Committee on
Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:05 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Robert F. Bennett (Chairman of
the Subcommittee) presiding.
OPENING STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. The hearing will come to order. We
appreciate the witnesses' being here and look forward to
hearing their testimony, and making this a worthwhile hearing.
One of the fundamental roles of Congress and this
Subcommittee is to provide periodic oversight, and that is why
we are here today. We have no specific legislation before us.
But it has been a considerable amount of time since Congress or
the Banking Committee has held an oversight hearing on the Home
Loan Bank System, and we recognize that periodic oversight
helps keep houses in order.
President Eisenhower, when he was a general, used to say
that areas that are not periodically inspected tend to
deteriorate. Those of us who have been in the military know
what periodic inspections are like, and we do not want to make
this hearing quite like that.
This is not to say that this particular house is not in
order or that it has tended to deteriorate. But we have not
looked at any part of the Home Loan Bank System since Gramm-
Leach-Bliley where we made adjustments to the membership rules,
collateral options for advances, and the capital requirements
of the System. Since Gramm-Leach-Bliley, our banking and
finance system has continued to evolve to meet the demands of
an important and ever changing marketplace.
We have had consolidations that have brought efficiencies
and synergies that have undoubtedly played a major part in the
sustained success we have been experiencing in the housing and
housing financing market. I believe the Home Loan Banks, along
with the other housing GSE's, have played a vital role in
funding this growth.
My own State of Utah is a net borrower. Utah's future
housing growth and economic vitality depends upon the capital
that can come partly from Home Loan Banks and others that can
access Wall Street and bring investment to my State. The role
of the Home Loan Banks and other housing GSE's play in
communities across the Nation is, in my opinion, invaluable.
We are currently experiencing what I hope, and still
believe, is just a hiccup in our housing GSE system, but given
the importance of the housing finance system and the billions
of dollars that move daily through the GSE's from investors all
around the world and then into our communities, even this
little hiccup requires Congress to act to ensure that safety
and soundness and the confidence of the markets in the GSE
system is maintained and, we would hope, be even strengthened.
This is a good time for Congress to take a look at the
entire system, and while this Subcommittee does not have
jurisdiction over all of the GSE's, we do have the
responsibility for the Federal Home Loan Banks, and that is why
we are concentrating there today.
Since Gramm-Leach-Bliley, several issues have emerged in
the Home Loan Bank System that Congress has not reviewed, and
these issues relate directly to safety and soundness and the
mission of the System. So we will begin to create a record on
these issues here this afternoon.
The issues are: one, whether or not the Home Loan Banks
should register with the SEC; two, whether or not a member
institution of the System should be permitted to be a member of
more than one regional Home Loan Bank; three, at what level
should the Home Loan Banks be permitted to participate in the
secondary mortgage market; and, four, whether or not we should
have a single regulator for all of the housing GSE's. And all
of these issues are closely related to the safety and soundness
and the mission of the System.
I understand, to put it somewhat mildly, that these issue
remain unagreed upon, both inside and outside the System, and I
believe that all would agree that each of them could have a
major impact on housing finance, homeownership costs, and,
therefore, the economy, particularly the economy at this point
where housing has led the recovery. That usually is not the
case. Housing is usually the last thing to recover. But in this
very unusual recession and recover, housing has been one of the
strongest parts. That is another reason why we need to pay
attention.
In bringing up the final question of whether Congress
should create a single regulator for all of the GSE's, I want
to make sure that I acknowledge the efforts of Chairman Korsmo.
Mr. Chairman, you have put forth tremendous effort to
strengthen the regulation of each institution individually as
well as the System as a whole through a more thorough
examination regime, and I congratulate you for that.
Mr. Korsmo. Thank you, sir.
Senator Bennett. Regardless of the quality of regulation,
there are those who believe that all the housing GSE's should
operate under a coordinated regulator with appropriate
authority, believing that separate can never be equal, at least
in perception of the markets. I will continue to reserve
judgment on that, but we are going to hear from Treasury
Secretary Snow tomorrow before the House. I expect he will
address that issue, and we will look at his testimony with
great interest.
Secretary Abernathy, we welcome you back to the Committee,
where you served so ably for such a long period of time. I
suspect you will feel the same way and reserve judgment until
after your boss has spoken. But if you want to surprise us----
[Laughter.]
--we would be happy to have you surprise us.
Senator Johnson, I appreciate very much your attendance,
not only at this hearing but your diligence in this issue in
the past, and we would be delighted to hear from you.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Thank you, Chairman Bennett, and welcome
to Secretary Abernathy and Mr. Korsmo. I thank you, Mr.
Chairman, for holding this afternoon's hearing on oversight of
the Federal Home Loan Bank System. I cannot think of a more
timely hearing given recent attention on Government Sponsored
Enterprises and debate over the nature and scope of their
regulatory agency.
Today is a good opportunity to take stock of the role,
mission, and regulation of the Home Loan Banking System. I
apologize in advance if my schedule will not allow me to stay
for the entire hearing. As usual, I have competing and
overlapping obligations, and I know that we are in good hands
under your leadership.
The Federal Home Loan Banks play a critical role in our
Nation's housing finance and community lending system. Since
the Home Loan Banks were created in 1932 with the mission of
helping to make homeownership more affordable, the positive
impact and the mission of the Bank has grown significantly.
In my State of South Dakota, the Home Loan Banking System
has provided critical funding for community lending needs.
Until a recent flight to safety of financial assets, our small
community banks faced serious funding issues, related in part
to the continued erosion in the value of deposit insurance. The
Home Loan Banks provided advanced services to counteract those
funding shortfall, ensuring that South Dakota consumers had
access to loans that they needed to keep our rural areas
economically viable.
I should also note that since 1990, South Dakota has
received $8.6 million from the Federal Home Loan Bank of Des
Moines' affordable housing program. This investment has
assisted 66 affordable housing projects throughout our State.
Mr. Chairman, today's hearing is also well-timed because it
is not in response to a crisis. The Committee has important
responsibility to conduct regular oversight, and this is
especially important with respect to the Federal Home Loan
Banking System because of the central role that it plays in
today's financial marketplace. Few would dispute that the Banks
play a different role than they did back in the 1930's. Some
do, however, dispute whether these new activities fall within
the proper mission of the Banks. That is a legitimate question.
I am pleased we will have a chance to hear from a variety of
witnesses today.
In addition, we should also consider whether the Federal
Housing Finance Board has the tools it needs to regulate what
have become increasingly complex and sophisticated financial
institutions. At least one witness has advocated that the Home
Loan Banks share a regulator with the other housing GSE's. This
hearing could not be better timed to hear both sides of that
debate as we move toward consideration of possible changes in
the regulation of Fannie Mae and Freddie Mac.
Finally, some of us here have had the chance to hear from
SEC Chairman Donaldson this morning about the implementation of
Sarbanes-Oxley. I hope that the witnesses will describe for the
Subcommittee their experience with any corporate governance
reforms and their position on disclosure proposals currently
under discussion.
Chairman Bennett, thank you for holding today's hearing,
and I look forward to hearing from these excellent witnesses.
Senator Bennett. Thank you very much.
Secretary Abernathy, we will start with you.
STATEMENT OF WAYNE A. ABERNATHY
ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS
U.S. DEPARTMENT OF THE TREASURY
Mr. Abernathy. Thank you, Mr. Chairman, Senator Johnson,
Members of the Subcommittee. Thank you for this opportunity to
testify this afternoon on the Federal Home Loan Bank System. I
would like to focus on three topics this afternoon: First, the
need for the Federal Home Loans Banks to register with the
Securities and Exchange Commission under the terms of the
Securities Exchange Act of 1934; second, I would like to talk
about multidistrict membership; and, third, Treasury's current
review of the Federal Home Loan Bank System.
The observance of good, fundamental practices of corporate
governance is a high priority for this Administration. For more
than a year, the Administration has been urging that all GSE's
comply with the same corporate disclosure requirements of the
Securities Exchange Act of 1934. We are pleased that Fannie Mae
has complied with this request. Freddie Mac has also agreed,
though we are disappointed to learn that Freddie Mac may not be
registering until sometime in 2004. The sooner they register,
the better.
The Administration has continued to urge that the Federal
Home Loan Banks also move forward with voluntary registration.
Some have argued that the unique characteristics of the Banks
lessen the need for registration under the 1934 Act. All of
these facts are important and must be, and I believe can be,
taken into account.
However, the differences do not change the fundamental fact
that the Home Loan Banks are significant participants in our
capital markets. Investors should have the same information
regarding the condition of the Home Loan Banks as they have for
other significant participants in the capital markets.
At the end of June, the Federal Home Loan Banks had
outstanding consolidated obligations of $713 billion. The
individual Banks are each large financial institutions. As of
year-end 2002, the largest Bank, the Bank of San Francisco, had
$135 billion in total assets. The smallest, the Bank of Topeka,
had $33 billion in total assets, while the average was $58
billion in total assets. Even the smallest would rank among the
top 40 commercial banks in the United States.
Investors would benefit from the added oversight of the
SEC, both in terms of reviewing financial disclosures and
through uniform enforcement of current standards. And investors
would have a basis for making comparable evaluations of the
variety of institutions that are competing for their investment
dollars. Our system of securities regulation should offer
investors nothing short of that standard.
The continued operation of the Banks outside of the SEC-
administered corporate disclosure regime is inconsistent with
our objectives of a sound and resilient financial system. We
understand that the Banks have some remaining concerns with how
certain aspects of their business operation would be treated. I
would remind all concerned that the Federal Home Loan Banks are
not the only corporate institutions in America that have unique
characteristics. Given the flexibilities that the SEC has to
address individual circumstances, we are confident that the
Banks' concerns can be worked out.
We appreciate the discussions that several of the Banks
have had with the SEC earlier this year, and we look forward to
these discussions being renewed in the immediate future, within
a context of acceptance of the public interest that would be
served by the Federal Home Loan Banks registering under the
1934 Act.
We understand that the Board of Directors of the Bank of
Cincinnati recently announced that the Bank will be taking the
next step in the process. In a recent letter to Secretary Snow,
HUD Secretary Martinez, and Chairman Korsmo, the Board of
Directors of the Federal Home Loan Bank of San Francisco
expressed their goal ``to enable the Federal Home Loan Banks to
become role models for corporate transparency.'' That is our
goal as well, to which registration under the Securities
Exchange Act of 1934 is essential.
Let me just talk about multidistrict membership, in
context. While there continues to be debate over a number of
Home Loan Bank activities, one current issue, the question of
multidistrict membership, raises particular concern. The
appropriate forum for the resolution of this issue must be kept
in mind. As the Treasury Department has written in a comment
letter to the Finance Board, regardless of whether allowing
multidistrict membership is wise, a plain reading of the
statute finds little room to conclude that the Finance Board
has the legal authority to approve it. It provides, and I quote
from the statute,
An institution eligible to become a member under this
section may become a member only of, or secure advances from,
the Federal Home Loan Bank of the district in which is located
the institution's principal place of business, or of the Bank
of a district adjoining such district, if demanded by
convenience and then only with the approval of the Board.
I have played with that language many times trying to make
sure how does that ``or'' work, and I have thought of it in
terms of my children at home. I can say to my son, ``You may
have your army toys in your room or you may have it in the
playroom.'' To my mind, that is one room. If I wanted to say it
could be either one of those two and both of them, I would say,
``You can have your toys in your room and the playroom.'' But
if I use an ``or,'' it brings into my mind there is only one
place where those are going to be located. The statute provides
for an ``or,'' and it seems pretty clear to us.
Now, to say this is not to render a policy point of view.
There are compelling arguments on both sides of the question.
Clearly, our financial system has changed dramatically since
1932. In the intervening years, however, Congress has revised
the governing statutes on several occasions. But they have
never changed that particular requirement. It is to the
Congress that these arguments should be offered and where any
change in the statute will have to be made.
The third point I would like to raise. Earlier this year, I
requested the Office of Financial Institutions Policy at
Treasury to conduct an in-house review of the Federal Home Loan
Bank System, with particular but not exclusive, consideration
of the effect of the changes enacted as part of the Gramm-
Leach-Bliley Act of 1999. As I announced at that time, the
review would consider the following points: how these changes
have affected the ability of the Federal Home Loan Banks to
meet their statutory mission; implications for the financial
strength of the Banks individually and the System in general;
how the business operations of the Banks contribute to
accomplishing their statutory mission; issues regarding
governance structure and management, including executive
compensation; effect of new capital structures on operations;
and other issues regarding the strength of the System and the
structure of Federal oversight.
We are now about 4 months into that process, nearing
completion of our first phase. Again, I would like to emphasize
that Treasury's review of the Federal Home Loan Bank System is
part of what we normally do at Treasury, and what I envision
for our current review is a more specific look at how the
changes made to the Federal Home Loan Bank System as part of
the GLBA have been implemented. Treasury is not primarily a
regulatory agency. We see as part of our important function,
however, providing executive branch oversight of the activities
of the independent financial regulators, and this study is part
of meeting that obligation and responsibility.
The Federal Home Loan Bank System presents policymakers
with issues that deserve continued attention. We must continue
to evaluate the System to ensure that it is achieving the
objectives set forth by Congress, meeting the needs of our
communities that might not be otherwise met.
Thank you again for providing me this opportunity to
present our views before you today and to discuss these
important issues, and I would be glad to answer any questions.
Senator Bennett. Thank you very much for your testimony.
Chairman Korsmo, we appreciate your being here and look
forward to hearing from you.
STATEMENT OF JOHN T. KORSMO
CHAIRMAN, FEDERAL HOUSING FINANCE BOARD
Mr. Korsmo. Thank you, Chairman Bennett, Ranking Member
Johnson, and distinguished Members of the Subcommittee, I
appreciate the opportunity to speak with you today about the
Federal Housing Finance Board and the Federal Home Loan Bank
System. I have a brief opening statement, but I have also
brought prepared testimony with more thorough discussion of
several key topics affecting the Federal Home Loan Banks I have
been asked to address.
Senator Bennett. Without objection, your testimony shall
appear in the record.
Mr. Korsmo. Thank you, Mr. Chairman.
Many important issues are facing the Nation's Government
Sponsored Enterprises, including, certainly, the Federal Home
Loan Banks. In the interest of time, I highlight the aggressive
steps we have taken at the Federal Housing Finance Board, the
System's regulator, first, to strengthen the agency's oversight
capabilities and, second, to improve financial disclosures by
the Federal Home Loan Banks through voluntary registration with
the Securities and Exchange Commission.
These initiatives will benefit not just the Federal Home
Loan Banks and their more than 8,000 member institutions, but
also the investors who purchase their debt, and ultimately the
homebuying public and the taxpayers.
Soon after President Bush named me Chairman in December
2001, I determined that the Finance Board lacked many of the
necessary resources to effectively oversee the Federal Home
Loan Banks for safety and soundness and achievement of their
housing finance mission. Just one example demonstrates this
point. At the time, the Finance Board had only eight bank
examiners on staff to review and supervise 12 financial
institutions with, at the time, more than $700 billion in
assets, more than $30 billion in capital, and some $650 billion
in outstanding debt. Yet, at the same time, the agency had
eight people in its Office of Public Affairs. The relative
allocation of resources simply did not meet the agency's
statutory mandates.
I immediately addressed these problems beginning with the
recruitment of new leadership for the agency's Office of
Supervision. After a national search, the Finance Board hired a
new Director and a new Deputy Director of Supervision, who,
between them, have 40 years of Federal bank regulatory
experience.
Mr. Chairman, I appreciate your comments about the
improvements we have made in our supervisory and examination
function. I should say that while often much is made of the
times that my Finance Board colleagues and I do not agree, on
this issue, as on most issues, my colleagues deserve equal
credit for our initiatives in this area. My fellow Finance
Board members and I acting together increased the resources
available for supervision, expanding our examination staff to
17 full-time examiners. Our goal is to have 24 in place by the
end of this calendar year and 30 by the end of the next budget
year.
We are now conducting more thorough examinations, focusing
on the Banks' risk assessment processes, internal control
systems, and systems of corporate governance. And we are
communicating the results of those examinations more
effectively to the Banks. Now our examinations recognize that
banking, even AAA-rated, GSE banking, is a business of managing
risks, and the responsibility of bank supervisors is to ensure
that the institutions they regulate understand those risks and
that they monitor and control them through prudent practices.
On the subject of enhanced financial disclosures, last
summer I formed a working group with the Finance Board and the
Federal Home Loan Banks to review the issues associated with
voluntary registration of the Banks with the Securities and
Exchange Commission.
Earlier this year, I concluded that voluntary registration
is indeed the best approach to enhancing public disclosure of
the governance and finances of these important institutions. I
reached this conclusion based on two premises.
First, the Banks' long-term access to global capital
markets will be enhanced by providing investors in consolidated
obligations with maximum reliable transparency into the
finances and governance of each of the 12 Banks. Markets
function best, especially in times of stress, when needed
information is readily available and reliable.
Second, as public trusts, these 12 GSE's have a duty to
contribute both to the smooth functioning of capital and
mortgage finance markets and to public confidence that the
benefits of GSE status are used wisely.
The Federal Home Loan Banks and the staff of the SEC have
held numerous meetings to address the process for voluntary
registration. In fact, another meeting was held only yesterday.
It is now time, I believe, to bring this process to a positive
conclusion.
I note that this summer the boards of the Federal Home Loan
Bank of San Francisco and the Federal Home Loan Bank of
Atlanta, as Secretary Abernathy mentioned, resolved that if SEC
registration was the determined course of action, then the
Federal Housing Finance Board should adopt a regulation
requiring it.
In response to those requests, tomorrow at our regularly
scheduled meeting the Federal Housing Finance Board will
consider a proposed regulation requiring the Banks to register
a class of their securities with the SEC.
The proposed rule provides for a lengthy, 120-day comment
period, during which, I hope, the Banks will each meet with the
SEC to work out the necessary details to effectuate
registration and begin meeting the periodic financial reporting
requirements of the 1934 Act.
Mr. Chairman, distinguished Members of the Subcommittee, I
focused on these two areas of safety and soundness oversight
and improved financial disclosures because of their importance
to the strength and resiliency of the Federal Home Loan Banks.
Certainly we are dealing with many other issues at the Finance
Board, which are addressed in my written testimony, and I
welcome the opportunity to discuss any and all of them with
you.
Thank you again for your time this afternoon. I look
forward to addressing your questions.
Senator Bennett. Thank you very much.
The Federal Home Loan Bank System has traditionally focused
on providing advances to their members. In the last couple of
years, Home Loan Banks have initiated a program of directly
acquiring loans from their members. At what level should the
Home Loan Banks participate in the secondary market in this
way, in your opinion? And should securitization be considered
as an option for the Banks?
Do either one of you want to go first on that question?
Mr. Abernathy. I am happy to proceed, Mr. Chairman. Let me
deal with the securitization issue first, if I may.
Senator Bennett. Certainly.
Mr. Abernathy. I think it is important to understand the
nature of the Federal Home Loan Bank System as a cooperative
system. It is different than a lot of other systems. They were
put together as a cooperative system. The Banks are owned by
their members. They are governed by their members. The Banks
have this joint and several liability responsibility to shore
up and assist each of the other members.
I think that is important to keep in mind when you are
looking at the question of securitization. These institutions
were created to serve their membership, and in our view,
anything that would suggest that they should be securitizing
something for sale outside of that membership is something that
is outside of the concept of the Federal Home Loan Bank System
as it is presently constituted.
On the other hand, I think with regard to some of the
innovative programs that have been established that are
currently in operation, those are all kept within the System.
They provide an important source of liquidity to the member
banks, and by that I mean the member banks of the Federal Home
Loan Bank System, the ones that are members of each of the Home
Loan Banks. And as far as we can see, they are providing an
important service both with regard to the individual banks and
the people who are most impacted, the people who take out the
mortgages and buy and sell their homes based upon that
financing.
Mr. Korsmo. Mr. Chairman, do you want me to respond?
Senator Bennett. Yes.
Mr. Korsmo. Secretary Abernathy has outlined the concerns
in the larger context very well. I think it is appropriate to
mention that right now Federal Housing Finance Board
regulations do not permit Federal Home Loan Banks to issue or
guarantee mortgage-backed securities. There has been no request
from any Bank or from any Bank's Board of Directors to seek
such approval.
I think if the question does come before us, obviously we
will have to look at the whole question of legal authority and
the safety and soundness basis for making a judgment. I do not
know if there is anything more to say about that at this point,
but that goes to the point of your question.
Senator Bennett. I want to go back to the first part of my
question. At what level should the Banks participate in the
secondary market in this way? Because, again, traditionally, as
you pointed out, Secretary Abernathy, the Banks exist to serve
their members. Now they have gone in the direction of acquiring
loans from the members as opposed to making advances to the
members. And is there a financial level for this activity that
would raise any concern on your part, or do you assume that
that would be fine and this is where we go?
Mr. Abernathy. Well, I think perhaps the most flexible
definition of how far they should go would be how far their
capital and resources can appropriately finance the risk that
would be involved with purchasing the mortgages from their
entities. But so far, the requirements for purchasing the
mortgages from their member banks has been that the mortgages
must be just as good as if they were being held for collateral,
in which case it is difficult to say that they are taking on
much more of a risk than they would by holding these merely as
collateral.
I think that is an important requirement, that the quality
of the loans they purchase be of a high level so that they can
manage that risk appropriately.
Senator Bennett. Looking ahead to the debate as to whether
or not they should be allowed to compete directly with Fannie
Mae and Freddie Mac, is that the same level of safety that is
required for Fannie and Freddie?
Mr. Korsmo. In fact, sir, I would argue it is higher. The
risk-based capital standards under which the Federal Home Loan
Banks act are actually higher. I think Secretary Abernathy is
right in portraying this particular aspect of the Banks'
function, which is indeed providing more direct liquidity for
mortgage lending. Advances, of course, are fungible, and to
some extent, while they have to be collateralized with approved
collateral that meets the standards of our regulations, the
reality is that while advances remain by far the most
significant aspect of Federal Home Loan Bank portfolios, the
growth of acquired member asset programs truly reflect a member
need.
Senator Bennett. Okay. Quickly, because my time has
expired, but I want to follow up before we have lost the
thought. Assuming that you are correct that the standard for a
Home Loan Bank is higher than the standard for the other GSE's,
does that mean if you get into direct competition that in the
Home Loan Bank System they would like to lower the standard to
that that exists with Fannie and Freddie?
Mr. Abernathy. I think there is direct competition. I think
everybody recognized that when they made their most recent
filing with the SEC. They listed who their competitors were,
and they indicated they are the Federal Home Loan Banks. But
they are a competition at a certain level. It is a competition
for those higher quality----
Senator Bennett. Yes. At a certain level do we see----
Mr. Abernathy. In a different form, I should mention.
Senator Bennett. Would we see a lowering of the standard
that you have just described? Do you think that is going to
happen?
Mr. Korsmo. I would certainly hope not. That would not be
the view of this regulator, anyway, to permit it, and right now
the statute would not.
Mr. Abernathy. I think there is a certain value in making
sure that the mortgages purchased are very similar to the
collateral requirements.
Senator Bennett. Okay. Thank you.
Senator Johnson has left, so, Senator Corzine, you came in
next on the minority side. We will turn to you.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman, for holding this
important and timely hearing.
I guess I have to ask the following question: What is the
basis to say that the standards of the Home Loan Bank are
superior to the ones for other GSE's? Is it a risk-based model?
Does it take into account the prepayment exposures and convects
the exposures that are so difficult to manage in all financial
institutions, in my perspective? And, second, what type of off-
balance-sheet exposures, if any, letters of credit or other
forms, exist in the Home Loan Bank System? And how can we be
certain that those are factored into the risk-based models?
Mr. Korsmo. Certainly, sir, I am not exactly sure where to
start on that question, but certainly we could assure you that
the oversight that we provide and the constraints that the
regulatory environment that we have created or the Finance
Board has created are extremely strict. These are very
conservative institutions. They are driven by a very
conservative model and driven by, as I mentioned, a very
conservative regulatory structure.
Senator Corzine. Was the Treasury prepared to make that----
Mr. Abernathy. I do not know that I would have phrased it
the same way as Chairman Korsmo with regard to the Federal Home
Loan Banks having a higher quality of portfolio. Fannie and
Freddie were created particularly to establish secondary
markets, and their mandate is broader. They are required to go
into more markets than the Federal Home Loan Banks are. Because
the Federal Home Loan Banks are required to have a very high
level of collateral for the advances they give, and their
program was designed to match that standard with regard to the
loans they purchase, they are only targeting a certain segment
of the home mortgage market.
Fannie and Freddie were required to address a much broader
range, in fact, with a particular emphasis on middle to lower
income. And so because of that you would expect that they would
be taking on what might be considered riskier mortgages, but
they also have hedging and other types of strategies to manage
that risk. And so as institutions, I would not like to have on
the record the concept that Fannie and Freddie are riskier
institutions than the Federal Home Loan Banks. They are
required to have a broader portfolio, I think is the point I
would make.
Mr. Korsmo. I would certainly agree with that, but I would
mention that the leverage requirements of our risk-based
capital regulation are higher in the sense that we have a 4-
percent leverage requirement versus the 2.5 that applies, I
believe, to Fannie and Freddie. I really am not terribly
familiar with the Fannie and Freddie model, frankly.
Senator Corzine. They have a minimum of 2.5, and then they
have a risk-based standard.
Mr. Korsmo. Right, exactly.
Senator Corzine. As an add-on.
Mr. Korsmo. You also asked about off-balance-sheet items.
Our regulations require that derivatives be used only for
hedging. Federal Home Loan Banks cannot use them for investment
purposes. Eighty-two percent of the derivative use makes a
perfect match with advances in consolidated obligations. So,
again, I think the short answer is that the regulatory
environment that we have created is very strict, and I think
there is no question about that these institutions operate in a
very high plane in terms of safety and soundness, which, after
all, is our primary mission as the Federal Housing Finance
Board.
Senator Corzine. As an individual that has looked at risk-
based models off and on, it is hard to know, except through
practical experience through time and different stresses,
whether those models are as effective as one might always
imagine in circumstances. I am not challenging whether it is or
not, but I think it is very hard to say whether one model is
better than another given the complexity of so many of the
financial instruments. It really is a test of those that
oversee, from my perspective, anyway, the building of those
models, that they have the capacity to make a judgment about
whether they are fully impacting all the issues.
Thank you, Mr. Chairman.
Senator Bennett. Thank you.
Senator Hagel.
COMMENTS OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you.
Gentlemen, welcome. We appreciate your appearance today. As
each of you may be aware, some of my colleagues on this
Committee and I introduced legislation before the August break
that would reform oversight for two of the other GSE's, Fannie
and Freddie. And my question to each of you is: Do you think we
should explore including the Finance Board in that legislation
as well? Secretary Abernathy?
Mr. Abernathy. Well, if I could, Senator, Secretary Snow is
going to speak directly to that point tomorrow, and I certainly
do not want to front-run him, presenting any views. But I will
say this: We looked carefully at your legislation as we were
evaluating those issues, and so we have taken very much into
account your legislation and the reasoning behind it. And I
believe that has been an excellent contribution to the debate.
But with regard to whether or not we should include them, I
would like to save that for Secretary Snow's statement
tomorrow, if I may.
Senator Hagel. Do you know if the Secretary will address
that issue tomorrow in the House?
Mr. Abernathy. That is in the whole panoply of things that
he is presenting. That is right. We are looking at the GSE's in
their totality, the housing GSE's, all of them together.
Senator Hagel. So you do not want to venture any
speculation on whether we should take the Finance Board and
include that?
Mr. Abernathy. I will be happy to after Secretary Snow
does.
[Laughter.]
I will let him make the news.
Senator Hagel. He is Gramm-trained, you can tell, cannot
you, Mr. Chairman?
[Laughter.]
Mr. Korsmo.
Mr. Korsmo. At the risk of being the second duck in this
shooting gallery, for a different reason, obviously I think the
primary role of any regulator is to ensure the safety and
soundness of those institutions it regulates. I think to the
extent that we create as strong as possible regulatory
oversight, not just for the 12 GSE's that I oversee but for all
14, I think that is important. Given the fact that I am the
Chair of a five-person Board who is reluctant to take a
position that has not been adopted by that Board, I guess I
would also be reluctant to speculate as to where the best site
is for that oversight function to take place. I think it is an
important debate. Let me leave it at that. I look forward as
well, needless to say, to hearing the Secretary's comments
tomorrow.
Senator Hagel. Spoken like a true Chairman. Thank you.
Well, obviously, we will be talking to Secretary Snow and
you, Mr. Secretary, about this, as well as the Federal Home
Loan Bank officials, and we would welcome at the appropriate
time your input, which I am sure we will receive.
Mr. Chairman, you have developed a very impressive array of
additions and completions since you have been Chairman on the
Finance Board--objectives, responsibilities--and I think it had
redounded, as the Chairman noted and others here today, to more
confidence in your organization's oversight, safety, soundness,
and credibility. Any additional changes, thoughts, practices,
activities, or actions that you are anticipating that you can
tell this Committee about to further enhance the effectiveness
of the Finance Board?
Mr. Korsmo. Yes, sir. Thank you for asking that question.
Obviously, I would hate to make it sound like all it takes is
more dollars. We have the luxury as an independent financial
regulator that is a nonappropriated agency and can, in essence,
adopt its own budget and pass the cost of that budget on to
those we regulate.
We are in the process really of a 2-year program to enhance
and improve our oversight capacity. It is not something that
can change overnight. The difficulty of adding to a staff,
frankly, has been an important lesson to us. We had budgeted
for this fiscal year to increase our number of examiners, for
example, to 24. The reality is we have been unable to hire that
many top-quality people and integrate them into our system fast
enough.
That having been said, we are continuing that process. We
are going to add in this year's budget accountants, some
financial analysts who will be assigned specific
responsibilities with each of the Banks. I would be remiss if I
did not touch quickly on our initiatives in the area of board
governance. Board governance has in the last year or so become
a watch word, and it has been a focus for the Finance Board as
well. We have recently conducted a systemwide audit of board
governance at each of the 12 Federal Home Loan Banks. We have
an ongoing process to review board governance. We are
scheduling a hearing tentatively for October 15, next month,
where we will hear from the Banks and from other interested
parties about recommended changes, both statutory that we could
recommend and regulatory that we could implement that would
improve the job that our boards of directors do.
All of those come together, I think, to create a picture.
We are not where we want to be, but we are headed in the right
direction.
Senator Hagel. Thank you.
Mr. Chairman, thank you.
Senator Bennett. Thank you.
Senator Reed.
COMMENTS OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman, and,
gentlemen, thank you for being here today.
Both of you have alluded to, at least in your testimony,
the multidistrict membership banks issue. Mr. Secretary, do you
have a position on that issue?
Mr. Abernathy. In our view, the question begins with is
there authority for the Federal Housing Finance Board to make a
determination. In our view, the statute does not leave that
issue to the Finance Board to decide. It has really left that
issue with Congress. The statute seems pretty clear that a bank
has perhaps an either/or choice, but it is still one district.
Senator Reed. Would you urge that Congress give the Board
that authority?
Mr. Abernathy. We have not addressed the question of
whether it is wise to do that or not, and I think at some point
we need to do that. And, in fact, if Congress wants to take
that issue on, we would be glad to take a look at it and
perhaps come back with recommendations.
Senator Reed. Thank you.
Chairman Korsmo, do you have a position?
Mr. Korsmo. Let me just say that, first of all, no action
by the Finance Board in this area is planned, and while I
appreciate Secretary Abernathy's plain reading of the statute,
sometimes a plain reading is not enough. As a regulator, I
think I would be remiss in suggesting that the Federal Home
Loan Bank Act does not provide broad authority to the Federal
Housing Finance Board to take any action to the extent that it
goes to meeting the primary mission, that is, ensuring the
safety and soundness of the Banks.
Unfortunately, sometimes when all one does is recite that
circumstance and talk about how the financial services industry
has changed and the membership in the Bank System has changed,
it has taken for support for a particular policy position. I
want to make clear here, because I think there may be some
question based on comments others have made about my position,
I am neither an advocate of nor an opponent of multidistrict
membership. The Chairman alluded earlier to there are many
unagreed-upon issues in this system. This is certainly one of
them. I think you will find disagreement even among the
boards--on boards of directors of individual banks as how to
best deal with the changing circumstances in the housing
finance industry.
It is an issue that, as I say, at this point we have no
plans to take action on.
Senator Reed. I think we can mark you down as scrupulously
noncommittal.
Mr. Korsmo. Thank you. Yes, sir.
Senator Reed. Chairman Korsmo, I am concerned about the
process that the Finance Board has followed to make some
important decisions, specifically the shared funding program
operated by the Chicago Home Loan Bank Board. As I understand
it, the staff approved under Section 955.2, and this would be
for the purchase of interest in whole loans. But as I
understand the Section, it only authorizes purchase of whole
loans, not interest, or certain types of State and local
housing finance agency bonds. Is that correct?
Mr. Korsmo. No, sir. I think a broader reading of the
regulation, again, particularly as it exists on the books now,
is that the Banks have authority to purchase mortgage assets
both in the form of whole loans and----
Senator Reed. Interest loans.
Mr. Korsmo. Thank you. I am losing my train of thought
here. Interest in loans as well.
Senator Reed. Can I just work my way through here? Because
my notes indicate that the only reference to interest in whole
loans was in the preamble of the regulation.
Mr. Korsmo. That is correct, sir.
Senator Reed. Which was a response to a comment made.
Mr. Korsmo. That is correct, sir, but our general counsel
and Office of Supervision's reading of that was that the
regulation did indeed provide the authority for banks to apply
for new business activity--excuse me, permission to engage in
this activity.
I think that it would be good to understand the process,
however.
Senator Reed. May I make one other point?
Mr. Korsmo. Yes, sir.
Senator Reed. Apparently, in July of this year, the Finance
Board put this issue out for comment. Is that correct?
Mr. Korsmo. Yes, we put out a draft of a revised AMA reg,
yes, sir, for comment.
Senator Reed. So why would you ask for comment after the
approval of the program, which you say----
Mr. Korsmo. The comment was not on this particular item,
although broadly speaking, of course, commenters on this
particular proposal, the revision of the entire AMA reg,
certainly could have commented on this particular provision.
But it was the provision as a whole that was being put forward
for comment.
Let me just mention that at our meeting tomorrow, because
of the confusion that has developed over what exactly our
proposal was and what it entailed, when it was unanimously
adopted by the Board on June 18 at our regular meeting, we
have--in consultation with my colleagues--all agreed that we
will withdraw the proposed regulation, revise it to perhaps
clarify what our intentions were in the regard not just of the
item that you have mentioned, but some other areas that have
been misunderstood as to intention, and reissue--assuming
Finance Board adoption of a reissued proposed draft--that for
comment.
Senator Reed. Well, thank you, Mr. Chairman. I think this
raises a very specific issue, but a more general issue of the
process of approving and interpretation of your own regulations
and public comments on proposed changes. We hope you would act
on those general issues.
Mr. Korsmo. Yes, sir, I recognize your concern in this
area, and we will take it into consideration.
Senator Bennett. Thank you very much.
If Secretary Abernathy is right and the law is clear, the
law is clear. So, I think you better, if you are going to argue
with that, have the firm legal position rather than a general
statement that, well, we have the right to do whatever is best
for the System. Just an editorial comment as I listen to this
back and forth.
COMMENTS OF SENATOR JIM BUNNING
Senator Bunning. Mr. Chairman, I would like to put in
opening remarks.
Senator Bennett. Without objection, it will appear in the
record.
Senator Bunning. Secretary Abernathy, does the Treasury
believe that all GSE's, including the TVA, should register with
the SEC?
Mr. Abernathy. I would have to say, Senator, when we made
the statement with regard to all GSE's, it was a general
blanket statement. We did not limit it. With regard to the TVA
itself, that is not one type of entity that I have been looking
very closely at with regard to----
Senator Bunning. To GSE, though?
Mr. Abernathy. Senator, our view is that entities that are
putting significant capital into the markets should be
providing the full set of disclosures that other capital
participants are required to follow.
Senator Bunning. Would $30 billion be a----
Mr. Abernathy. That is significant to me.
Senator Bunning. It is significant, okay. I just want to
make sure that is the Treasury's position, then; that all GSE's
should----
Mr. Abernathy. That is our position, yes.
Senator Bunning. Thank you very much.
Do you believe all--this is for either--housing GSE's
should have the same regulator?
Secretary Abernathy.
Mr. Abernathy. If I could take a pass on that, Senator, and
the reason why is tomorrow Secretary Snow is going to be
addressing that very issue, and I would prefer to let him
address it first.
Senator Bunning. And obviously you will take the same pass.
Mr. Korsmo. As a sitting regulator, I will take the same
pass, please.
Senator Bunning. I just had a very good meeting with the
Federal Home Loan Bank Board of Cincinnati. They have agreed to
voluntarily register alternative of their securities with the
SEC. Some of the other banks I just was surprised that in your
statement you said San Francisco seems to be now more
cooperative in registering.
Mr. Abernathy. They certainly seem to be laying the
predicate for doing so, but they have not yet made that same
commitment that the Cincinnati Bank has. And I certainly would
like to praise the Cincinnati Board for making that
determination.
Senator Bunning. Does that trouble you, though, that just 1
out of 12 would come forward and voluntarily register?
Mr. Abernathy. I remain troubled until we have all of them
registered, frankly, because we do not have the information
about those entities that we need to have otherwise.
Mr. Korsmo. Senator, in fairness to some of the other
Banks, there has been a varying degree of participation. In
fact, all 12 of the Banks have been actively engaged in the
process of discussing this issue. There was a meeting
yesterday, I believe, of the committee representing 10 Banks,
but representing specifically the New York, the San Francisco,
and the Pittsburgh bank with SEC officials. I know the Chicago
Bank is also going through the process of preparing some draft
documents for the SEC to look at.
While certainly the Cincinnati Bank deserves being singled
out for particular praise in their willingness to move ahead in
this project, I would be reluctant to characterize the
involvement of any of the Banks as being dilatory. They have
all, to one degree or another, have recognized their
responsibility to provide enhanced disclosures to the
marketplace. At this point, we are debating what form that is
going to take.
Senator Bunning. Well, you both realize that registration
with the SEC was the red flag for Freddie. When they were
trying to get prepared to register with the SEC is when the big
red flag went up for them. I hope that is not the case in any
Federal Home Loan Bank Board or any area of the country, but to
register with the SEC you have to undergo certain registration
scrutinies, and I want to make sure, if somebody is reluctant
because of that, you should know that as the chief regulator.
Mr. Korsmo. That is correct, sir, and my sincere hope is
that the reluctance is based on principle and not on any
reluctance that some action or practice would be revealed which
would embarrass the Banks. I can assure you that the job we are
doing as the safety and soundness overseer and supervisor is
sufficient to assure that that is not the case.
Senator Bunning. Last, but not least, I disagree with your
definition of ``or.''
[Laughter.]
I have more than one child, and I would make comparisons
equally as distinguishing as you did in either/or or and/or,
and I would be with the Chairman on that regulation. Thank God
I am not a lawyer. I do not get confused with the facts, you
know.
[Laughter.]
But I believe ``or'' means exactly what it says. Thank you.
Senator Bennett. Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you. I have a statement
I would like to have put in the record.
Senator Bennett. Without objection, it will be placed in
the record.
Senator Allard. I have a question for Mr. Abernathy. In
your testimony, you noted that investors in GSE securities
should have access to the same corporate disclosures as they
have for other companies who publicly offer their securities
for investment. In your opinion, how do the current disclosures
compare?
Mr. Abernathy. The most significant thing that I think that
we obtain by having the Federal Home Loan Banks register with
the SEC, even if they did not disclose an additional piece of
information that they are currently not disclosing is the
timing, by registering with the SEC, that the timing of
disclosures will be the same to provide comparability for
investors, the standards for disclosure and the standards for
review of those disclosures will become the same, and it is a
high standard, and those who are doing those particular reviews
will be the same.
The penalties for false filings would become the same, and
it is that high standard that I think has elicited the point
that Senator Bunning mentioned. Before Freddie Mac agreed, and
they did agree to register the SEC, they were, for a time,
saying there would be nothing new that would be disclosed if we
agreed to this regime. Then, they agreed to it and discovered
maybe it does mean a higher standard. Maybe it does mean that
what we are required to comply with is more meaningful. We
think that would probably be similar with regard to the Federal
Home Loan Banks, not that there is anything hidden, but that it
provides a more rigorous standard of comparability,
particularly.
Senator Allard. Chairman Korsmo, you mentioned in your
testimony, the Federal Housing Finance Board is a
nonappropriated agency and enacts its own budget and assesses
the Banks for the cost of its operation. How important is this
authority in your ability to carry out your mission?
Mr. Korsmo. It is extremely important. I think I am still
too early in my tenure, frankly, and not having served in a
situation where that was not the case, it is hard for me to
make a comparison. But I think the fact that we can structure a
budget responsibly that provides us the resources we believe we
need to carry out our responsibilities is significant. Again,
given the fact I have never operated under a different system
makes it difficult for me to compare, but I will say that it
certainly makes our job easier.
Senator Allard. Now, that I have given you both softball
questions, I would like to hear the pros and cons from each one
of you about this proposal to have a consolidated approach to
regulation. One regulator for all financial institutions. I
would like to hear your pros, and I would like to hear your
cons.
Mr. Abernathy. Well, if I could take a pass, Senator.
Secretary Snow is, I understand this is an important issue, and
I am uncomfortable and have not been able to lay it out for you
like I would like to lay the issues before you, but at the risk
that if I presented the pros and cons, I am not very good at
hiding where I think the weight of the good opinion rests.
Rather than laying out the pros and cons and disclosing where I
think we are, I will leave that for Secretary Snow, if I might.
Senator Allard. Well, then, let me put it this way--you
both have the same response about the mission of safety and
soundness; would you talk a little about that?
Mr. Abernathy. I think the mission of safety and soundness
needs to be understood in a large context, and that is not just
with regard to the safety and soundness of an institution
itself, but also with regard to the markets in which it
operates, and that is an important responsibility for the
regulators. That is the way our bank regulators operate, and I
think that is the way our GSE regulators should operate.
They are looking at the safety and soundness, not just of
the institutions, but of the financial system that those
institutions are participants in. That is obviously the most
important function the regulator has.
Senator Allard. I think the farm loans or the home loan, at
Farmer Mac, as well as the Fannie Mae and Freddie Mac have all
had in the past, at some time or another, some problems with
bad debt. Do you think it is the appropriate role of Government
to come in and bail them out when they have debt problems like
that or is it that you do not have any choice? Are we
absolutely required to?
Mr. Abernathy. I do not think that we are required to. I
think that we have tried to make it very clear, and----
Senator Allard. Well, let me put it this way. Does the
``too big to fail'' principle come in line, and we simply have
to bail them out in order to sustain the economy?
Mr. Abernathy. Yes. I think, on many occasions, we have
tried to emphasize the fact that there is no Federal guarantee
standing behind any of the obligations of the Government
Sponsored Enterprises. And those who invest in their debt or in
their stocks, where they are publicly traded stocks, they have
to evaluate just what is the risk involved with those
securities and should not take into account thoughts that there
is some Federal guarantee.
Now, what would happen if one of those institutions was on
the point of failure? Frankly, we have good regulators,
hopefully, to prevent that from happening, to make sure that
there is adequate levels of capital maintained by each of these
institutions and that the----
Senator Allard. How do we make sure that happens?
Mr. Abernathy. The best way to do that, I think, is by a
system of ongoing, on-site examination. We have a lot of
enthusiasm for the steps that Chairman Korsmo has brought to
pass on the Federal Housing Finance Board to beef up that
examination pool.
Senator Allard. Does that mean bringing all of the
regulators into one, uniform approach?
[Laughter.]
Mr. Abernathy. Well, I will let Secretary Snow give his
views on that, if I may.
Senator Allard. Mr. Korsmo, would you respond to that.
Mr. Korsmo. Obviously, Secretary Abernathy has a larger
responsibility, and my context is to focus on the Federal Home
Loan Bank System, and I have ducked the question as
effectively, as Secretary Bunning will tell you, perhaps not as
effectively, but I have made the effort.
Let me say one thing, however, I think there is a----
Senator Bennett. At least as often.
Mr. Korsmo. At least as often. Thank you, Mr. Chairman.
[Laughter.]
Let me say one thing, in terms of a pro and con, I think
the argument in favor of a single regulator will be how will
the larger market look at the particular Government Sponsored
Enterprise who is not subject to the same regulatory oversight
in terms of site, as opposed to quality that is not included in
that process.
The flip side of that, of course, is the familiarity that a
particular regulator can develop with the policies, practices,
and institutions over which that regulator has responsibility
is certainly easier if it is focused on a particular entity. I
think there is some concern, and I do not mean to speculate on
this part, but I think there is some concern among the Federal
Home Loan Banks what would happen to us if we were buried, if
you will, with Fannie Mae and Freddie Mac.
And I think that is perhaps a legitimate concern, but I too
will wait for Secretary Snow's view tomorrow.
Senator Allard. Mr. Chairman, I was going to yield some
time for my colleague, the Senator from Kentucky, but I see my
time has expired.
Senator Bennett. Senator Miller has joined us, so we will
go to Senator Miller and then come back to Senator Bunning.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. I do not think I want to just get here and
start to speak. Let me listen for a while, Mr. Chairman.
Senator Bennett. Okay.
Senator Bunning. I just have one question, Mr. Chairman.
Senator Bennett. Sure. Senator Bunning.
Senator Bunning. Secretary Abernathy, you made the
statement about oversight and watching closely those entities,
GSE's particularly. I am going to bring the TVA back to you.
They are unregulated by anyone. No one, except these three
commissioners, has anything to say about TVA. They sell up to
$30 billion worth of debt. It is AAA because everybody else
thinks that it is backed by the full faith and credit of the
U.S. Government.
FERC, who oversees almost every other entity in electric
generation, has not one thing to say about the TVA. I suggest
that the Treasury makes very sure that if you are going to
include people in oversight and regulation that you look at a
GSE called the TVA, which is unregulated and governed by three
people.
Senator Allard. That is a powerful argument, Senator. Thank
you. We will look at it.
Senator Bennett. Thank you, both.
Secretary Abernathy, you made note in your comments that
Freddie Mac has so far failed to register, in spite of the fact
that they promised.
Senator Allard. And I will say, if I could, Mr. Chairman,
we have no doubt about Freddie Mac's willingness and intention
to comply. We are eager to see it happen as soon as possible,
but we have no doubts that they will comply.
Senator Bennett. Very good.
Thank you, both. We appreciate your testimony here today,
and we appreciate your service to the Nation in the various
positions that you hold.
Mr. Abernathy. Thank you, Mr. Chairman.
Senator Bennett. We will look forward, with great interest,
to Secretary Snow's answers to the questions you have so
artfully dodged here today.
[Laughter.]
Mr. Abernathy. Thank you, Mr. Chairman.
Mr. Korsmo. Thank you, Mr. Chairman.
Senator Bennett. We now move to our second panel.
We are going to hear from them in this order, regardless of
where their name tags go. We will hear first from Norman B.
Rice, who is the President and CEO of the Federal Home Loan
Bank of Seattle; Mike Middleton, the President and CEO of the
Community Bank of Tri-County, Waldorf, Maryland. Senator
Sarbanes had hoped to be here, Mr. Middleton, to introduce you
to the Committee, and he may yet appear. If he does, we will
take appropriate notice of that.
Sheila Bair, who is the Dean's Professor of Financial
Regulatory Policy at the Isenberg School of Management at the
University of Massachusetts. Sheila is well known to this
Committee and its Members and staff; Terry Smith, President of
the Federal Home Loan Bank of Dallas; and David Hemingway,
Executive Vice President of Zions First National Bank in Salt
Lake City, Utah.
I must exercise the hometown prerogative of introducing Mr.
Hemingway to the Committee. He has been a witness before the
Committee before on other issues and is very knowledgeable. I
do recall a conversation with one of my colleagues in the House
about an issue where Zions Bank was involved, and the House
Member said to me, ``Now, let us see, was that Roger Zion that
owns that bank?''
And I said, ``No, it was Brigham Young that started that
bank.''
[Laughter.]
And Zion has a reference to something other than a family.
With that, we welcome you all, and, Mr. Rice, we will start
with you.
STATEMENT OF NORMAN B. RICE
PRESIDENT AND CHIEF EXECUTIVE OFFICER
FEDERAL HOME LOAN BANK OF SEATTLE
Mr. Rice. Good afternoon, Mr. Chairman and Members of the
Subcommittee. I am Norman B. Rice, President and Chief
Executive Officer of the Federal Home Loan Bank of Seattle, and
I would like to thank Chairman Bennett and the Subcommittee for
the opportunity to provide my perspective on the critical role
the Federal Home Loan Banks play in building strong communities
and healthy economies across America.
The 12 Federal Home Loan Banks have a long history of
service and accountability to the more than 8,000 financial
institutions we serve, to the millions of individuals and
families we help realize the American Dream of homeownership,
and to the regulators and Congress who oversee our system.
It is not the history of our Banks that I want to talk
about this afternoon. Where we have been and what we have
accomplished as a Bank System is significant and well
documented. My focus is on the relevance of the Bank System
today--and in the future--and the essential role we play on
behalf of our financial institution members, and the economic
health of our country.
I will start with what I consider to be the most important
element of the Federal Home Loan Banks. We are a cooperative.
Our members own the Bank System, and we are accountable to
them. These are the Banks, credit unions, thrifts, and other
institutions that give our communities critically needed access
to credit. These are the risk-takers whose leadership and
resources build stronger towns, cities and, to a very real
extent, a stronger Nation.
They are able to do that as part of a cooperative that
provides each member, small and large, the same access to a
stable, low-cost, and reliable source of wholesale funding. No
other housing GSE or financial institution can replicate our
System's unique partnerships of bank, member, and community.
As I sit here before you today, the Federal Home Loan Banks
and the housing GSE's are facing significant challenges and
changes regarding their business practices, regulatory
structure, and mission-based programs and activities. In the
weeks and months ahead, as this Subcommittee and other Members
of Congress debate the future of the Federal Home Loan Banks
and the housing GSE's, I would like to offer some questions and
principles for you to consider in your discussion, as well as
clear evidence of the powerful impact our bank system has on
the economic health of our country.
Over the course of any week, I am asked by a number of
people what the Federal Home Loan Bank of Seattle is and what
it does. And my short answer is this: We help ensure that
Americans have homes and a stable local economy. That is a good
quick response for anyone unfamiliar with the Home Loan Banks,
but for the purpose of our discussion today, I would like to
offer a more comprehensive--and slightly different--way to look
at the value and the benefits provided by the Bank System.
Imagine, if you will, our country with the 12 Home Loan
Banks and then consider the following: The Bank System extends
nearly a half-trillion dollars in advances, what we call loans,
to our member financial institutions annually, strengthening
those local economies, and homeownership. Imagine those dollars
gone.
Since 1991, the Federal Home Loan Banks have awarded $1.6
billion in Affordable Housing Programs grants, helping to
create 360,000 low-income housing units across the country.
Imagine those homes gone.
Since 1990, the Bank System has provided nearly $36 billion
in reduced-rate, long-term loans for low-income housing and
economic development. Imagine those dollars, and homes, and
businesses gone.
Now, imagine the collective impact on our national economy.
I would urge you to ask yourselves how would your local banks
compete if they did not have access to the capital markets?
Where would your constituents go to get loans to buy homes and
run their businesses? Now, go one step further. If the housing
GSE's did not exist today, what would you put in their place? I
believe you would come back to something that looked a lot like
the Federal Home Loan Bank System as it is, and here is why.
The Bank System is funded entirely through private capital.
The cooperative is built by private owners who have put more
than $36 billion of their own money at risk to capitalize the
system. The Bank System is cooperatively owned to support,
rather than compete, with the private marketplace. Our stock is
not publicly traded, and we do not have third-party investors
pulling out value. The Bank System is organized by region,
ensuring that each Bank is connected and responsive to local
markets.
The Bank System pays its fair share of taxes. The Home Loan
Banks carry a special tax burden that cannot be sheltered and
is equivalent to a Federal corporate tax rate. The Bank System
has been required, since 1989, to pay off the REFCORP debt and
provide 10 percent of its net income in support of low-income
housing. This is the single largest private source of housing
subsidy in the United States.
The Bank System is a critical source of liquidity through
all parts of the economic cycle. So this country's network of
community banks relies on our capacity to access the capital
markets on their behalf.
The Bank System has the capacity to innovate and keep pace
with an evolving financial services industry. This is why we
offer mortgage purchase programs. Our members have told us they
can better serve homebuyers and local markets if there is more
competition in the secondary mortgage market. It is no accident
that our program volume has accelerated from zero to almost
$100 billion.
As you can see, it is not a difficult task to illustrate
the benefits provided by the Home Loan Banks. Today, as one of
the 12 Presidents within the System, I stand committed to work
with you to further the mission and the vision of our Bank
System and meet the evolving needs and issues facing our
housing GSE's.
On the matter of consolidation of GSE regulators, whether
or not Congress determines that a single regulator is the
appropriate direction or not, all three housing GSE's must have
strong, consistent regulatory oversight to ensure both safety
and soundness and mission achievement. There can be no debate
on this point.
And that means it is time to straighten out the wide
variety of requirements and oversight regarding the housing
GSE's. For example, why did two housing GSE's have lower
capital requirements than the 12 Home Loan Banks which carry
less credit risk? Why is there inconsistent mission oversight,
with the Home Loan Banks delivering cash grants, while the
other housing GSE's hit a different set of affordable housing
goals?
What public policy goal is advanced when roadblocks are put
in front of our Bank System, when we respond to our members'
stated desire to have greater competition in the secondary
mortgage market, and when, in fact, those roadblocks actually
hinder our ability to drive more funding to our member
financial institutions and their communities? I have heard it
called ``mission creep,'' but from my point of view, it is more
like ``mission leap.'' When our mortgage purchase programs are
allowed to grow, they allow us to take significant steps toward
fulfilling our mission and not walking away from it.
I want to be clear today that I believe the onus for
strengthening our system lies not only with Congress and
regulators, but also with the Home Loan Banks themselves. We
need to continue to step up and accept the risk in our System
and our industry and embrace the fact that more intense public
oversight is inevitable. We welcome that public oversight
because, if done smartly, it will strengthen our Bank System,
ultimately, and the economy of this country.
In closing, I would like to leave you with five principles
that I believe should inform your discussions and decisions in
the months to come:
One, private capital is the most effective cushion to guard
the public against the risks inherent in our enterprises. As a
cooperative, the Home Loan Banks are capitalized by their
customers who monitor risk-taking in a way that third-party
shareholders cannot.
Two, insist on competition among housing GSE's, rather than
competition with the private financial services industry.
Three, demand that more of the value created by the housing
GSE's be delivered to the housing finance system and consumers,
rather than private investors.
Four, demand consistent strong and smart regulatory
oversight for all housing GSE's and recognize the critical
differences between the Bank System and publicly traded housing
GSE's.
And last, but not least, demand an intense focus on our
mission, hold us accountable, and keep in mind what America
would look like if the Federal Home Loan Banks did not exist.
That concludes my remarks, and I thank you, again, for
allowing me to testify today, and I will be happy to answer
questions at the appropriate time.
Senator Bennett. Thank you very much. We appreciate that.
Mr. Middleton.
STATEMENT OF MICHAEL MIDDLETON
VICE-CHAIRMAN, FEDERAL HOME LOAN BANK OF ATLANTA
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
COMMUNITY BANK OF TRI-COUNTY, WALDORF, MARYLAND
Mr. Middleton. Good afternoon, Chairman Bennett, Senator
Bunning, Senator Miller and, hopefully soon, Senator Sarbanes.
[Laughter.]
Thank you for the opportunity to discuss something that----
Senator Bennett. You are among friends, even if he is not
here.
[Laughter.]
Mr. Middleton. He is a good friend.
Thank you for the opportunity to discuss something that is
very important to my business and my community, which is the
Federal Home Loan Bank System. I am Michael Middleton, Chairman
and CEO of the Community Bank of Tri-County, which is a $300-
million community bank located in Waldorf, Maryland.
I serve as Maryland's elected Director to the Federal Home
Loan Bank of Atlanta's Board, and I am honored to serve as Vice
Chairman on that Board. I am also a Member of the Board of the
Council of the Federal Home Loan Banks.
I am testifying today on behalf of the Federal Home Loan
Bank of Atlanta. Mr. Chairman, while I have covered details in
my written testimony, I would just like to highlight some of
the more important issues.
As a member and a long-time user of the Federal Home Loan
Bank advances, as well as other products, as well as a Director
to the Atlanta Bank, I have gained a broad perspective on the
system, and I hope it will be of use to the Subcommittee.
The Community Bank of Tri-County serves southern Maryland.
Our customer base draws from a broad economic range. We tailor
our services and our products to meet the needs of our
communities, while competing with larger regional and national
financial institutions.
At my bank, we take our CRA responsibilities very
seriously. Many community banks, are faced with the challenges
of meeting their CRA requirements. And the Federal Home Loan
Banks provide us with the tools and the skills to meet those
challenges.
The Federal Home Loan Bank System helps level the
competitive playing field in many, many ways. As GSE's, the 12
Federal Home Loan Banks were created to stabilize and improve
the availability of funds to support homeownership. Today,
capitalized by the cooperative stock of its member owners, the
Banks still fulfill that mission. The Banks and their members
are the largest source of residential and community development
credit in the United States.
Through the work of many on this Committee, including
Senators Hagel, Johnson, and Bayh, to modernize the Federal
Home Loan Bank System in the Gramm-Leach-Bliley Act, it helped
direct and expand the reach of the Banks and their members by
providing critical residential community development credit to
rural and urban communities.
I believe it is important to note that the Federal Home
Loan Bank is the only institution in the United States that
fulfills this mission. The Banks are a stable, low-cost,
reliable source of short- and long-term funding. For the many
small and medium-sized community banks, the Federal Home Loan
Banks are essential because direct borrowing from the capital
markets is not a
viable option for us.
The Bank System enables us to remain independent and to
continue to be an economic engine in our communities. That, of
course, translates into jobs.
The Federal Home Loan Banks developed their programs in
response to their members. For example, in response to member
demand, the Atlanta Bank now offers both the MPP and the MPF
Acquired Member Assets Program. The Bank's members that use
these programs are pleased that they have yet another financial
tool in delivering competitive credit products.
Like the advance programs, the AMA programs, again, help
level the competitive playing field for community banks. At my
bank, Community Bank of Tri-County, we rely on Atlanta's
programs to deliver financial service to our communities. Like
many other areas, our communities need more affordable housing,
improved medical school, and volunteer and rescue support
facilities. The Federal Home Loan Bank is often an invisible,
but vital, partner fulfilling these needs.
Community Bank has partnered with nonprofit CDC's in using
the Federal Home Loan Bank programs to create layered funding
that supports affordable housing and infrastructure
development. We do this with programs, like the AHP, or the
Atlanta Bank's EDGE program. These, and similar Federal Home
Loan Bank programs, make affordable housing and community
development projects economically feasible in communities such
as mine.
A good example of this is the Yardley Hills project in
Calvert County, Maryland. I am sure Senator Sarbanes is
familiar with that section of Maryland. That project, as an
example, used $2.7 million in complex, layered funding through
our partnership with the Atlanta Bank's AHP.
In another project, we used the EDGE program to provide the
Jarboe Family Head Start Center in St. Mary's County with
permanent funding, when other traditional banking sources of
larger regional banks became unavailable.
The Federal Home Loan Banks also helped their members
provide other needed forms of community development credit.
Community Financial Institutions, CFI's, may now pledge, as
collateral for advances, small business, small farm, and small
agribusiness loans. This may allow smaller institutions,
particularly in rural areas, to better serve the community
development credit needs of their neighborhoods and their
farmers.
I strongly believe that the Federal Home Loan Bank System
is able to provide these important benefits because of its
dynamic membership of both large and small institutions and its
regional, decentralized, and cooperative structure. I can say,
unequivocally, that without the Federal Home Loan Banks and the
programs they provide, it would be far more difficult for my
bank, and the thousands of other community banks, to remain
independent, competitive, and capable of extending important
housing and community development credits.
I have given you examples of why the Federal Home Loan Bank
System is so vital for community banks like mine, but I am also
a Member of the Board of Directors of the Federal Home Loan
Bank in Atlanta, and that imposes additional important
responsibilities.
The Atlanta Bank and its Board support the Administration's
position that housing GSE's should provide complete and
transparent financial disclosures that constitute the best of
class. That is why we, along with other Federal Home Loan
Banks, have been working with all relevant parties to resolve
the specific issues presented by the Federal Home Loan Bank
statutory mission, cooperative structure, and joint several
liability.
In fact, the Atlanta Bank will file its annual financial
reports for 2003 in SEC 10-K format.
Senator Bennett. Could you summarize?
Mr. Middleton. Thank you.
I will tell you what. This is the summary.
Senator Bennett. All right.
Mr. Middleton. I am sorry if I have taken too much time of
the Committee.
As a director, I want the Atlanta Bank to meet the highest
standards of disclosure. At the same time, and this is an
important distinction, as a director, I have an obligation to
the member owners of the FHLB to be certain that the
disclosures are administered in a manner that would not impair
the mission or the operation of the Bank or increase its cost
of funds.
Again, as a director, if I vote to voluntarily register the
Atlanta Bank's equity with the SEC, not only do I assume
additional personal, civil, and criminal liabilities for the
relevant statutes, but I also assume a liability to our members
for my decision to voluntary register.
Thus, it is most compelling that the critical issues have
been satisfactorily resolved and sustainable written agreements
reached. Reasonably known issues, critical accounting issues,
must be resolved in a way that all Federal Home Loan Banks and
their members can rely on going forward without the threat of
quarter-to-quarter, year-to-year reconsideration with each SEC
filing.
And there I will abbreviate my text. Thank you, Senator.
Senator Bennett. Thank you very much.
Mr. Middleton. It has been a great opportunity.
Senator Bennett. Yes. We will be happy to put the entire
statement in the record.
Mr. Middleton. Thank you.
Senator Bennett. Ms. Bair, again, welcome to the Committee,
where you are well-known and spent a good portion of your
career working on both sides of the aisle.
STATEMENT OF SHEILA C. BAIR
DEAN'S PROFESSOR OF FINANCIAL REGULATORY POLICY
ISENBERG SCHOOL OF MANAGEMENT
UNIVERSITY OF MASSACHUSETTS
Ms. Bair. Thank you, Mr. Chairman. It is good to be back.
Senator Bunning and Miller, thank you for being here.
It is a pleasure to appear before you today to assist you
in your oversight of the Federal Home Loan Bank System. It is
in the spirit of System supporter that I come to you this
morning to raise two issues that I believe warrant your
attention: Multidistrict membership and expansion of the
System's mortgage acquisition programs.
These issue are important because their resolution will
help determine the future of the System and its long-term
stability. They are examined in detail in a paper I recently
completed that was funded by a grant to the School of
Management from the Fannie Mae Corporation, which I would like
to submit for the record.
Senator Bennett. Without objection, it will be put in the
record.
Ms. Bair. Thank you.
Ms. Bair. Thank you. The conclusions reached in the paper
are my own and do not reflect the views of the research
sponsor.
After summarizing my paper, I will make some general
observations about the FHLB systems regulatory structure in
relation to efforts underway to improve safety and soundness
regulation of Fannie Mae and Freddie Mac.
Recent industry consolidations have prompted some to call
for allowing members to belong to more than one district
Federal Home Loan Bank.
My primary objection to multidistrict membership is that
Congress, not the FHFB, should decide whether such a
fundamental change should be made to the System's historic
regional and cooperative nature. I am also concerned that
multidistrict membership could have a destabilizing influence
on the System. Multidistrict membership would allow large
institutions to ``shop'' their advance activity among multiple
FHLBanks, but because all of the FHLBanks raise funds in the
same way, their ability to compete, based on price, will be
limited. As a consequence, they will likely compete on
collateral and credit standards. Allowing one member to have
multiple relationships with FHLBanks would also increase
operational risk, since the System lacks safeguards to obviate
the multiple pledging of collateral or the prospect of
competing blanket liens. Moreover, allowing multiple
memberships could increase large borrow activity in the System
as a whole, thus, exacerbating large borrower concentrations.
Nearly 24 percent of all advance activity is already
concentrated in the System's 10 top borrowers.
Multidistrict membership would, by definition, help only
institutions large enough to take advantage of it, and
fundamentally alter the basic concept of the System--a
cooperative of regional banks existing to serve the funding
needs of institutions headquartered in their districts.
Moreover, given the seismic consolidation activity that
occurred in the 1980's, which the System weathered quite well,
it is difficult to see why current consolidation activity
should provide the impetus for such a dramatic restructuring.
The System's mortgage acquisition programs also primarily
benefits the System's largest members. Begun in 1997 as a small
pilot capped at $750 million, these programs have grown
exponentially. The System now holds $90 billion worth of
mortgages in portfolio, representing over 10 percent of its
assets.
There is nothing in the System's legislative history or
authorizing statute that grants authority for direct mortgage
purchases, and the other two major housing GSE's--Fannie Mae
and Freddie Mac--were established and chartered by Congress
expressly for that purpose. Congress, not the individual
FHLBanks or the FHFB, should decide whether it wants the System
to be a major player in the secondary mortgage market, and if
so, the terms and limitations that should apply.
The risk associated with mortgage acquisition are
distinctly different from those associated with the System's
traditional role of making fully collateralized advances.
Advances have prepayment penalties and call features that allow
the FHLBanks to effectively manage their interest rate risks.
Different, more complex, tools are needed for the interest
rate/prepayment risk presented by mortgages held in portfolio.
Operational risk is also significant. There is a serious
question as to whether the System has sufficient numbers of
qualified staff or infrastructure needed to manage even the
day-to-day risk associated with secondary mortgage market
participation. Regarding credit risk, the mortgage acquisition
program's proponents boast that the originators, not the
FHLBanks, retain the credit risk. In truth, the originators
provide credit enhancements that are only as good as the
FHLBanks require them to be based on their own interpretation
of historical default data, which again is outside the
traditional mission and expertise. It is telling that a recent
FHFB proposed rulemaking, now withdrawn, would have eliminated
one of the program's most important tools in managing credit
risk; the requirement that pools of purchased mortgage assets,
achieve an investment grade rating from an independent rating
agency.
No adequate public policy basis has been advanced for the
System's foray into this new, riskier line of business. Though
promotional materials for the programs claim that they are
designed to help smaller institutions, available data suggests
that they are being run overwhelmingly for the benefit of large
originators. According to trade journal reports, the top five
mortgage originators sold $42.7 billion in mortgages to the
FHLBanks in 2002. Assuming the accuracy of this report, these
five institutions would account for almost all of the $45.7
billion in FHLBank mortgage acquisitions in 2002.
Questions about the capability of the System to manage new
risks associated with multidistrict membership and mortgage
acquisition programs are heightened by longstanding weaknesses
in the FHFB examination process, identified by the GAO in 1998
and again in 2002. Though the FHFB has taken a number of steps
to address these weaknesses, including increasing the number of
examiners and putting greater focus on major risk and the
quality of controls at FHLBanks, the GAO found, in a report
released last February, that it is still too soon to evaluate
the effectiveness of these measures. We heard from Chairman
Korsmo earlier that they are now up to 17 examiners, with plans
to increase that total to 24 by 2004, and I believe he said 30
by the end of 2005. However, according to its fiscal year 2003
budget, only $9.7 million of its $27 million budget was
allocated for the Office of Supervision. By way of comparison,
Treasury's two bank regulatory bureaus, the Office of the
Comptroller of the Currency and the Office of Thrift
Supervision, were typically assigned teams of 20 to 30
examiners to each of its large institutions, and will spend 70
to 80 percent of their budgets in direct support of
supervision.
More fundamentally, the structure of the FHFB suffers from
many of the same defects now being scrutinized at the Office of
Federal Housing Enterprise Oversight. It is a small, low-
profile agency that simply cannot attract and retain the
quality of staff that it needs. It exists outside the financial
regulatory mainstream and, thus does not benefit from the
routine, day-to-day interaction that occurs among the major
bank regulatory agencies. It is responsible for only 12 banks,
plus the Office of Finance, and narrow constituent base that
creates the perception of ``captive regulator.'' Other major
financial regulators have a much broader regulatory base, and
their actions are generally reflective of the views and
interests of diverse and competing constituencies. When a
regulator's jurisdiction is confined to a small group of
closely aligned institutions, the pressure and input it
receives can become narrowly focused and one-sided. It becomes
difficult for that regulator to stay objective and ``above the
fray.''
Should a new agency be created at the Treasury Department
for oversight of Fannie Mae and Freddie Mac, I believe it would
be a stronger agency if it also included oversight of the FHLB
System. The new regulator would have a bigger, better view of
the housing finance market and would be in a better position to
evaluate the advantages and dangers of the major housing GSE's
competing directly with each other in the same lines of
business. From the standpoint of systemic risk and taxpayer
exposure, it is just as important to the Government for the
FHLB System to have quality safety and soundness oversight, as
it is for Fannie and Freddie. At year-end 2002, the System had
$668 billion in outstanding debt, compared to Fannie's $884
billion and Freddie's $644 billion. It enjoys the same implied
Government guarantee, with an even more generous line of credit
from the U.S. Treasury.
The competitive impact on FHLB funding costs should also be
weighed in the balance when considering whether to merge the
FHFB into the new agency. The creation of a credible, high-
quality GSE regulator within the Treasury will likely receive a
positive reaction in the capital markets, which could reduce
Fannie and Freddie's funding costs. If the FHLB System is left
out, that could widen spreads between FHLBank securities and
those issued by the enterprises. Wider spreads would in turn
mean the higher cost of funds for the FHLBanks, which would
adversely impact the price of advances and ultimately raise
costs for homeowners.
Strong momentum is building with the creation of a
credible, high-quality regulator within the Treasury Department
to replace OFHEO. Now would be a propitious time for the
Congress to consider whether oversight of the FHLB System
should also be placed under this new regulator. To be sure,
there are important policy determinations that Congress needs
to make regarding the FHLB System's mission and future, and it
is important not to impede the momentum behind the transfer of
OFHEO's safety and soundness functions. However, concurrent
action could assure quality regulation of all three major
housing GSE's and prevent a widening of spreads which could
further weaken the System.
Thank you, Mr. Chairman.
Senator Bennett. Thank you very much.
Mr. Smith, we appreciate your being here.
STATEMENT OF TERRY SMITH
PRESIDENT, FEDERAL HOME LOAN BANK OF DALLAS
Mr. Smith. Mr. Chairman, Senator Sarbanes, Senator Bunning,
I appreciate the opportunity to speak to you today about the
Federal Home Loan Banks. My name is Terry Smith. I am the
President of the Home Loan Bank of Dallas. I am pleased to
provide an update on the Bank's activities and our progress
implementing the Home Loan Bank provisions of Gramm-Leach-
Bliley. My written statement includes an overview of a range of
issues related to those banks, and since my colleagues are
addressing some of those same issues, I will limit my oral
remarks and ask that the remainder of my statement be accepted
for the record.
Senator Bennett. It shall be printed in the record.
Mr. Smith. Thank you.
I would like to stress four points related to the Federal
Home Loan Banks.
First, the Banks are a valuable resource for more than
8,000 member financial institutions, representing 78 percent of
all FDIC-insured depository institutions. Those members,
primarily community banks and thrifts, use the Banks' advances
and housing
programs to meet the mortgage and community lending needs of
their local markets and use our affordable housing programs to
make housing more affordable for thousands of low-income
families in those communities. This is our primary purpose, and
we are proud of our accomplishments.
Second, the Banks continue to be financially strong and
conservatively managed cooperative institutions. The Banks are
well capitalized, maintaining capital asset ratios between 4
and 5 percent. The Banks' advances are fully collateralized,
allowing the Banks to maintain their enviable record of never
having suffered a credit loss on a member advance in their 71-
year history.
The Banks also manage interest rate risk very
conservatively, using derivatives in a very precise and prudent
way to minimize the difference between the maturities of their
assets and liabilities. These risk management practices enable
each of the Banks individually to maintain a AAA rating and for
the Banks collectively to enjoy the same high ratings on their
consolidated obligations, the debt of the 12 banks issued
jointly.
Third, the Banks' cooperative corporate structure
reinforces our conservative approach to risk management and
eliminates many of the incentives that a publicly traded
company might have to increase its risk profile in hopes of
achieving higher returns for its shareholders. There is no
stock compensation for management, directors, or employees of
the Banks.
Only members may purchase a Bank's capital stock, which
they do in order to obtain access to the Bank's products, and
not primarily as a stand-alone investment. The price of a
Bank's capital stock does not fluctuate, but can only be
purchased or repurchased at its par value.
Members expect stability, reliability and consistency of
dividends, and credit product pricing, rather than a high
yield. And our boards of directors are structured to ensure
that outcome.
No members of management serve on the board of directors. A
majority of each bank's directors are elected representatives
of member institutions, primarily from community financial
institutions, who have a vested interest in the Bank's long-
term viability and stability. The remaining directors are
public interest directors appointed by the Finance board.
Fourth, the Banks are subject to rigorous safety and
soundness oversight and regulation. Finance Board regulations
govern every facet of the Bank's operations, from advances
pricing to eligible collateral, to risk management, to capital
plans, to directors' responsibilities, and so on.
The Finance Board also collects and monitors financial and
risk management data from the Banks each month, performing
ongoing reviews of various aspects of the Bank's operations and
conducts annual on-site examinations of all 12 Home Loan Banks.
When Congress enacted the Gramm-Leach-Bliley Act in 1999,
it included several provisions related to the Banks'
operations. The new law provided for universal voluntary
membership and equal access to the Banks for all types of
financial institutions. It established a framework for more
permanent capital structure that includes total leverage- and
risk-based capital requirements for the Bank for the first
time.
It also expanded the types of collateral the community
banks can pledge to secure advances which has allowed those
institutions to take greater advantage of their access to the
Banks and to meet the credit needs of their communities.
These changes have, and will continue to have, a positive
impact on the Banks' ongoing ability to fulfill their statutory
role and to do so safely and soundly.
I would be happy to answer questions of the Committee at
the appropriate time.
Senator Bennett. Thank you.
Mr. Hemingway.
STATEMENT OF DAVID W. HEMINGWAY
DIRECTOR, FEDERAL HOME LOAN BANK OF SEATTLE
EXECUTIVE VICE PRESIDENT
ZIONS FIRST NATIONAL BANK, SALT LAKE CITY, UTAH
Mr. Hemingway. Thank you. Good afternoon, Chairman Bennett
and Senator Sarbanes.
My name is David Hemingway, and I am Executive Vice
President of Zions First National Bank, based in Salt Lake
City, Utah. I am also a Member of the Board of Directors of the
Federal Home Loan Bank of Seattle.
I would like to thank Chairman Bennett and the Subcommittee
for the opportunity to speak this afternoon on behalf of the
Federal Home Loan Bank System.
First, I would like to discuss why Zions Bank and other
regional and community financial institutions across our
country use the Home Loan Banks and then address the issue of
corporate governance and the responsibility within the Bank
System.
In 1932, the Bank System was created to provide liquidity
to the savings and loan industry. At that point in history,
there was no secondary market for mortgages, and the S&L's
needed a way to borrow against the mortgages in their
portfolio, so the Federal Home Loan Bank System was created,
providing low-cost advances to meet the needs of community
financial institutions and their customers.
This need for liquidity in our Nation's network of
community banks is as real today as it was in 1932, and the
only housing GSE that can meet this need is the Federal Home
Loan Bank System. Let me briefly explain how this works.
Banks accept deposits, as you all know, and then make loans
with a portion of those deposits. The deposits not invested in
loans are invested in securities, such as U.S. Treasury notes.
There is no rule that says, in the real world, that
deposits will always be greater than the loans outstanding in a
financial institution. These fluctuate from day-to-day. There
is also no rule that says depositors cannot withdraw their
funds at will simply by writing checks.
So, in the case of Zions First National Bank having the
balance in Zions' checking account at the Federal Reserve Bank
of San Francisco, where banks have their checking accounts in
the Federal Reserve System, having that balance increase or
decrease by $200 to $300 million in a day is not unusual. And a
bank is trying to manage its checking account the same way as
you might be managing your own checking account, and a
fluctuation of a couple of hundred million dollars is something
to be noticed.
Zions has a $1-billion liquidity line from the Federal Home
Loan Bank of Seattle. Now, this line of credit from the Federal
Home Loan Bank overdraft protection is secured with mortgages,
first mortgages, in Zions First National Bank's loan portfolio
of about $1.2 billion. When Zions' depositors withdraw $300
million in a day, and I assure you this does happen on a
regular basis, we call up the Federal Home Loan Bank of Seattle
and borrow $300 million overnight to replace those deposits
until they can be replenished in the normal course of business.
Now, no other GSE or
financial partner can provide or does provide this type of
service.
Another area where the Bank System is unique is in
providing liquidity in the form of low-cost and long-term loans
to regional and community banks that do not have access, and I
think the important part here, is do not have access to the
capital markets which most community banks do not have access
or even smaller regional banks.
Developers of low-income housing projects need long-term
fixed-rate loans. The only source of long-term low-cost
liabilities for a community bank is the Bank System advance. I
have often said that the Home Loan Banks are the savior of our
regional and community banks. The System, with its GSE status,
AAA rating, cooperative equity structure, and low overhead is
the best, and in many cases, the only source of low-cost long-
term liquidity for regional and community banks.
I would respectfully and forcefully request that no changes
be made to the basic structure of the Bank System which was
created to address a very real problem of liquidity for our
country's financial institutions, a problem that the Federal
Home Loan Banks continue to solve every day.
I will now address the issue of corporate governance and
the responsibility within the Bank System.
As both a community banker, for the better part of three
decades, and as an elected board member of the Seattle Bank,
the issue of board governance is of paramount importance to the
financial institutions and communities we serve, and to me,
personally.
As a director, I have been elected by the bankers of Utah
to watch over their investment in the Seattle Bank. While I am
not alone in that role--I share it with 17 other directors, and
the management team of the company--I consider it my job to
ensure that the financial management of this $47-billion bank
is effective over the long-term, including proper stewardship
of our shareholders' capital. That is a staggering
responsibility when you consider that the funding provided
within the Seattle Bank district fuels housing finance,
affordable housing initiatives, and economic development in
communities from Pago Pago to Walla Walla, Washington, to
Blanding, Utah.
When I was elected to serve as a director, I understood the
critical importance of my role and what I needed to bring to
the Board; namely, my personal integrity and accountability, my
financial services and community banking experience.
We are all aware that a quantum shift has occurred in how
American corporations, large and small, privately held or
publicly traded, must be run. We share with our regulator the
Federal Housing Finance Board, the Treasury, and Congress, the
sense of urgency that is so pervasive today regarding the need
for increased accountability, and we have worked hard over the
last several years to significantly strengthen the leadership
and oversight of our Banks.
Over the course of the last year, the Seattle Bank board
has created, adopted, and publicly disclosed a set of core
principles and guidelines relating to board governance. In
addition, we have realigned our board committee structure to
more effectively oversee all facets of the Bank's operations,
upgraded education and training for all directors, and created
a website that provides directors with faster access to a wide
range of information critical to their board roles.
Our regulator, the Federal Housing Finance Board, is also
diligent in overseeing and supporting sound corporate
governance practices across the Bank System. The Finance Board
just recently completed a horizontal review designed to assist
the Agency in directing and developing its supervisory and
regulatory initiatives. The Finance Board interviewed
management and board members and reviewed a wide range of bank
documents with respect to the board policies, practices, and
decisions.
Key questions asked by the Finance board include:
Does your board audit committee provide sufficient
oversight of internal and external auditing functions?
Is the audit function independent, reporting only to the
board, and is it supported appropriately by directors?
Does the board ensure that material risks are accurately
and consistently assessed by management and reported to the
board, in compliance with regulation and prudent practices?
I am pleased to say that Seattle Bank has ``yes'' answers
to each of these questions, but that is today. The board's job
is to ensure that we have ``yes'' answers tomorrow, the next
day and next year.
As one of 216 bank directors of the various different
Banks, I am proud to be a director of the Federal Home Loan
Bank System, and I would not have it any other way.
Mr. Chairman, that concludes my testimony. Thank you.
Senator Bennett. Thank you very much.
Senator Sarbanes, we welcome you. We, by proxy, introduced
Mr. Middleton to the Committee, but I understand you wanted to
welcome him, and we are happy to hear from you.
COMMENTS OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Mr. Chairman, I am sure it has certainly
been done adequately by you, but I just wanted to take a moment
to say that Mike Middleton is a very distinguished business
leader in our State and also a distinguished leader in the
community. He, in fact, is the Chairman of the Charles County
Economic Development Commission's Board of Directors, and I
want to just mention one thing.
He has taken, as a volunteer, an active role in teaching
ethical decisionmaking to high school students in Charles
County, and we very much appreciate that commitment on his
part. Of course, he has been a very successful head of the
Community Bank of Tri-County in Waldorf, Vice Chairman of the
Board of the Federal Home Loan Bank of Atlanta, and we are very
pleased he was able to come and be with us today.
Senator Bennett. He did you proud with his testimony.
Senator Sarbanes. Thank you.
Senator Bennett. While you have the microphone, do you want
to either make an opening statement or ask questions? Go ahead.
Senator Sarbanes. I will defer to you.
Senator Bennett. Thank you.
I thank you all. This has been a very informative
expression of how the Home Loan Bank System works.
May I go back to the issues that I outlined in my opening
statement and see if any of you have any particularly burning
opinion that you want to express on these? The first one,
whether or not the Home Loan Bank should register with the SEC,
we heard that discussed by the first panel, and some of you
have mentioned it in passing, but if you have any additional
comment that you need to make there, we would appreciate that.
Whether or not a member institution of the System should be
permitted to be a member of more than one regional Home Loan
Bank, Ms. Bair has made that very clear, as far as her
position. If some of the others want to argue with her or
support her, whatever, we would look at that.
At what level should the Home Loan Banks be permitted to
participate in the secondary mortgage market? And, again, you
have discussed that, but if you want to be more sharply focused
on that question.
And then, finally, whether or not we should have a single
regulator for all of the housing GSE's. I do not want to
recover the question of what kind of a regulator that should
be. Some of you have outlined your feelings about a regulator,
but just the overall question of whether or not Congress should
move in the direction of trying to create a single regulator.
Those are the four issues that were driving us behind the
calling of the hearing, and along with the general comments
that you have made, which I stress, again, have been very
educational and very helpful, if someone has a very specific,
pointed comment they want to make on any one of those four, now
is the time.
Mr. Rice. I would make one quick comment, as it relates to
the Mortgage Purchase Program, Mr. Chairman. At the Seattle
Bank last year, our Mortgage Purchase Program created about
$1.75 million in profit that went directly for our Affordable
Housing Programs. And at this point in time, about 42 percent
of our mortgage purchase loans are for low- and moderate-income
individuals. And just in 2 years, we have made extraordinary
gains in making sure that the return from the mortgage purchase
program goes back to the members and goes back to affordable
housing.
That is one point. And the second point is that our members
are desirous of having choice; choice to sell their mortgages,
and I think choice is fundamental in their decisionmaking,
rather than being limited.
We created a program, in direct response to our members'
needs, and we are now organizing and setting ourselves up to
run it in a safe and sound manner, to come up with some level
or cap I think is difficult. I believe the biggest issue is to
make sure we have a regulator who can oversee and make sure
that we are managing the program in a safe and sound manner.
Mr. Middleton. May I?
Senator Bennett. Mr. Middleton, yes.
Mr. Middleton. As a $300-million community bank, for us to
lend in more residential lending is just part of the business
plan. I can tell you we have been doing this for five decades,
and we have been selling to the housing GSE for the last two
decades. They have had a zero-loss experience.
Senator Bennett. Which GSE have you utilized?
Mr. Middleton. Freddie Mac.
Senator Bennett. I see.
Mr. Middleton. However, due to our volume, we get charged a
fairly significant guarantor fee. With the MPP, our credit loss
experience is reflected in the pricing, and it will allow us to
make a business decision to continue this product line in our
community because it becomes more profitable for us. So this is
a very important service to a community bank.
Senator Bennett. So you are saying that if you had the
opportunity to have a larger secondary mortgage market than
exists currently with your choice of Freddie Mac, specifically,
if you could do it through a Home Loan Bank, you would either
be able to make more money or charge less to your customer or
both?
Mr. Middleton. That is correct, sir.
Senator Bennett. I see. Any other comment?
Ms. Bair, yes, go ahead.
Ms. Bair. Just a couple of things. First and foremost, my
objection to the Mortgage Acquisition Program is that it has
not been authorized by Congress. And I think a lot of people
were looking the other way when it started as a small program.
A lot of people were assuming that because of the capital
structure of the Federal Home Loan Bank System, it could not
really grow to sizeable levels. It is, in fact, growing
exponentially, primarily the Chicago program. I think Seattle
has maybe progressed in a little more responsible fashion.
I also think one of the reasons Chicago has been able to
grow so exponentially under the existing capital structure is
the shared funding program. And to Senator Reed's question
earlier, I think there is a real process issue about the way
that shared funding came about. The regulations only refer to
purchase of whole loans.
Under shared funding, basically, a member of the Chicago
Federal Home Loan Bank securitizes the pool of mortgages,
creates two tranches, sells the senior tranche back to the
Chicago Bank, so it is not a direct securitization. A member is
used to securitize, but then the interest and the mortgages are
sold back to Chicago Bank. It can then sell those throughout
members of the System. In this way, it has been able to get a
lot of assets off of its balance sheet and get around the
capital problems it would otherwise have.
There is really no public comment. It is questionable
whether the regulations currently allow them to be purchasing
interests in whole loans, as opposed to the whole loan itself,
to Senator Reed's comment.
I believe there are just some process issues and some
significant policy issues that need to be dealt with that
really are not. These programs are really growing quite
rapidly, and I am just concerned that there is not anybody
really in charge taking a close look to make sure it is not
undermining safety and soundness. It is just not the System.
This thing keeps going. You talk about the high credit quality
of the loans.
If this is coming out of the Fannie and Freddie business I
assume it is, you know, what type of destabilizing effect would
this have on the overall market? Nobody is really looking at
that. And I think, again, a single regulator, with all three
major housing GSE's, could get a better handle about whether
this is a good thing or a bad thing, in terms of the overall
housing market.
I would also add that I think, to the extent there is a
good justification for the System being in this business, it is
for the community banks, and I wish I saw, in the numbers that
I am reading, more marketing and delivery of services to the
smaller banks, as opposed to the large originators.
Thank you.
Senator Bennett. Anyone else?
Mr. Hemingway.
Mr. Hemingway. Yes, Senator. I was going to change and talk
about a different subject.
Senator Bennett. Please, go ahead.
Mr. Hemingway. SEC registration.
Senator Bennett. Right.
Mr. Hemingway. I would like to speak from my experience as
a banker on this area, but also, as you may remember, I am also
a member of the board of directors of Farmer Mac. I have some
experience in the area of being involved with a GSE, where
Zions is a large shareholder, for an entity that is regulated
by the SEC. One of the issues that needs to be taken into
consideration is the mission of the SEC is quite different than
the mission of a safety and soundness regulator, whether it be
the Comptroller of the Currency or the Federal Housing Finance
Board or, in the case of Farmer Mac, the FCA.
The mission of the SEC is to protect investors, and
particularly small investors in public securities. The mission
of a safety and soundness regulator is to make sure that the
financial institutions that they regulate are safe and sound.
So they approach problems differently, and I will give you an
example, which raises some of the concerns here.
The example is take loan loss reserves. Anybody that has
been in banking very long knows that the regulators love to see
large loan loss reserves. They would like to see them as large
as possible because that gives protection to the Bank and to
the FDIC, ultimately, and the U.S. Government if there are
losses in the loan portfolio.
But the SEC takes an exact opposite position. They believe
that the loan loss reserves in the various different financial
institutions are too large, and they view the large loan loss
reserves being a way for financial institutions to manage their
earnings. They believe that transparency would require smaller
loan reserves. And, of course, they have the accountants, with
GAAP, who come out to enforce their views.
You get a board of directors and a management that are
being told exactly the opposite from their two regulators, if
they, in fact, have two regulators. Their safety and soundness
regulator telling them that we believe we would like to see
some higher reserves so that you will be safer and sounder or,
at the same time, the SEC is saying, no, you have too much in
reserves and, in fact, we believe that you are approaching the
point of managing earnings, which is not good for the public
markets.
This is not fiction. This is real. It is happening today.
One of the concerns I have is how we deal with two regulators,
and we deal with it in banking all the time, but it is a
problem when you get two regulators with different views, and
both of them having the power to regulate a single financial
institution.
One of the concerns, not to drag it on, but the safety and
soundness regulators, which I have already mentioned the names,
have the power to remove an executive or remove a member of the
board of directors. The SEC has the power to send you to jail.
And so, at the end of the day, the boards tend to be more
responsive to the SEC because of the more power and the threat
of criminal activity if, in fact, you do not follow their
rules.
Senator Bennett. I assume, when you go to jail, you are
also removed from the board.
[Laughter.]
Mr. Hemingway. Well, you know of an incidence in Utah where
that was not the case, but that is usually the case.
[Laughter.]
Senator Bennett. Well, let us go back to Senator Bunning's
comment, then, when he raised the suggestion that it was
potential registration with the SEC that caused Freddie Mac to
get in the situation where they restated their earnings. Do you
accept that as a cause-and-effect relationship?
Mr. Hemingway. I think there is another issue there, is
they changed accountants. You will probably recall that Arthur
Andersen was the accountant for Freddie Mac, and I am
personally not aware which of those instances caused this to
come to light; was it the new accounting firm or was it
registering with the SEC, a combination of both or neither. I
do not know, personally.
Senator Bennett. Before I turn it over to Senator Sarbanes,
does anybody have a comment on the conflicting stresses created
by the two types of regulators that Mr. Hemingway has raised?
Mr. Middleton. Senator, I support that. My company is an
SEC-registered bank as well, but we registered with the SEC
because it was in the best interest of our business plan, and I
worry about the mission of the FHLB we have a statutory mission
plan, if you will, by Congress.
Senator Bennett. Did you have an option not to register
with the SEC?
Mr. Middleton. Yes, sir, but because of the number of
shareholders, we registered. We could have restricted the
number of stakeholders had we want to do so.
Senator Bennett. I see.
Mr. Middleton. That is a choice, and that is why it is a
voluntary registration. I just worry, as a deep user of the
Federal Home Loan Bank, is that the difficulties that have to
be worked through can be worked through, and a disclosure, in
SEC format is easy to obtain, and everybody has recognized that
this is always good for a GSE, but we do need to have
sustainable, written agreements that say, here is how we are
going to interpret issues such as joint and several
obligations. This is how we are going to interpret issues such
as REFCORP. This is what happens if the mission requires
specific action--how do we serve the mission if it conflicts
with the SEC's decisions.
So there are very difficult things to work through, and I
can assure you--I am on the Audit Committee and I chair the
Finance Committee of the Atlanta Bank--we have spent a lot of
hours and a lot of resources making sure that we do this thing
in an appropriate manner because, at the end of the day,
corporate law prevails. The prudent business judgment decision
provision of the duty of care prevails. So, when we vote for
this, we must know that these critical issues are resolved so
that we will not hurt and do no harm to the System.
Senator Bennett. Okay.
Mr. Middleton. Does that help you?
Senator Bennett. That is helpful. Ms. Bair, do you want the
last word on this?
Ms. Bair. If I could just add, my sense is that the
prospect of SEC registration was added impetus to the Freddie
Mac board to get their house in order, so to speak.
I would also say I worked with the SEC for many years as
the head of Government Relations for the New York Stock
Exchange. It is a disclosure-based regulatory regime. It is not
a safety and soundness regulatory regime vis-a-vis publicly
traded companies. So, even though there have been conflicts
between the bank regulators on the loss reserves, that has been
not a safety and soundness issue for the SEC so much as it has
been a managed earnings issue, a disclosure issue.
It is also ironic, you bringing it up, because I have heard
another concern may be that the low-level retained earnings in
the System, which goes counter to where you might think the
conflict was with the SEC in the loss reserves.
But my sense is they are not a safety and soundness
regulator. They are a disclosure-based regime, and that is the
approach they take.
Senator Bennett. I see.
Senator Sarbanes.
Senator Sarbanes. Thank you, Mr. Chairman.
I would like each of the panelists very succinctly, if they
could, to state what they think is the proper regulatory
structure for the Home Loan Banks.
Senator Bennett. Mr. Rice, let us start with you and go on
down.
Mr. Rice. The proper regulatory structure is----
Senator Bennett. Here, the buck always starts in the middle
of the table.
[Laughter.]
Mr. Rice. You are right.
The proper regulatory structure is the structure, as it
exists in the Finance Board now. If it is to move, I would hope
that you would preserve the structure that is there, which has
mission and safety and soundness tied together, the notion of
respect for the cooperative, which makes it different than the
other housing GSE's, and to make sure that the return on the
investments that are made in the system go to their members,
rather than to shareholders. So, I see that structure as being
a very solid structure.
Mr. Middleton. Let us go to the users of the System, not
the community banks, but the purchasers of the consolidated
obligations. What do those users need? They need a very strong
independent regulator of a GSE, and that establishes
credibility that their investment is safe and sound.
Ms. Bair. I would hope that there is, as I said in my
written testimony and oral statement, I believe that the
broader the constituent base of the regulator, the stronger or
the better position a regulator is in to be independent and not
captive of a particular point of view. I think it will be a
stronger regulator if the Federal Home Loan Bank System, and
perhaps all other GSE's, are included in this new regulatory
entity that it looks like we are on track to create.
I would hope that this new regulator, it is not worth
doing, unless the quality and credibility of the regulatory
regime is significantly enhanced. I would hope we would be
designing a system that would parallel the supervisory quality
and professionalism that you get with OCC and OGS, including
accreditation standards for examiners, you know, the
overwhelming bulk of the budget going to safety and soundness
oversight, not mission promotion or housing promotion.
I think those are the things that the market needs to be
sure that these things that we have created that do perform,
all three, perform extremely significant and important roles in
the housing market are run in a safe and sound manner.
Senator Sarbanes. What are the roles that they perform in a
housing market?
Ms. Bair. The traditional role has somewhat been debated
because they are getting into each other's line of business
right now. But the traditional role has been for Fannie and
Freddie to purchase and either hold, in portfolio or
securitized mortgages, mortgages that come within the
conforming limits set by HUD.
The Federal Home Loan Bank System's job has been to provide
advances, loans to its members. Its focus is on the
institutions, as opposed to direct purchase of loans, which are
collateralized by mortgage assets provided by the members.
They are two distinctly different, somewhat competing
roles, and since that, you can go to two different places for
your funding. You can sell your mortgage to Fannie and Freddie
or you can get an advance from the Federal Home Loan Bank
System, but now we have a situation----
Senator Sarbanes. I understand that the majority of the
loans held by the Bank System are jumbo loans, beyond the
conforming limits; is that correct?
Ms. Bair. For collateral?
Mr. Rice. No, they are not.
Mr. Hemingway. They do not buy jumbo loans.
Senator Sarbanes. Are you telling me the Home----
Ms. Bair. I think by regulation----
Senator Sarbanes. --the Home Loan Bank system holds only
conforming loans?
Mr. Rice. Yes, that is correct.
Mr. Hemingway. The Mortgage Purchase Program will not buy
jumbo mortgages.
I believe you are talking about the Mortgage Purchase
Program----
Ms. Bair. No, he is talking about----
Senator Sarbanes. I am talking about the collateral for
securing advances.
Mr. Hemingway. Oh, excuse me.
Senator Sarbanes. What is the answer to that?
Mr. Hemingway. Whatever the bank pledges. I mean, jumbo
mortgages qualify as collateral, as do conforming mortgages. It
is whatever the Bank happens to have available to pledge. But
in the Mortgage Purchase Program, you cannot, a bank cannot
sell, a member cannot sell jumbo mortgages to the Home Loan
Bank, only conforming mortgages.
Senator Sarbanes. What about a regulator?
Mr. Smith. I would just like to echo what we heard. I think
the key point is a strong, credible, and independent regulator
for the Home Loan Bank System.
Mr. Hemingway. I would agree, a strong independent
regulator.
I would just add to it, in my banking back----
Senator Sarbanes. Those of you who are saying that, is it
your view that you now have such a regulator?
Mr. Smith. Yes.
Mr. Middleton. Yes.
Senator Sarbanes. Ms. Bair is no.
[Laughter.]
Mr. Middleton. Does it vary by the volume of the
affirmation?
[Laughter.]
Senator Sarbanes. What is your----
Mr. Middleton. It is my understanding that the credit
markets are very efficient, and they recognize that we have a
very strong, safe, and sound----
Senator Sarbanes. What is your view, expressed by some,
that the exposure to risk that the Home Loan Bank System is
engaged in is increasing and that poses a potentially
significant public policy question?
Mr. Rice. I believe----
Senator Sarbanes. Do you think there is nothing to that?
Mr. Rice. Oh, no, on the contrary. I believe that as we
progress in this program, we are adding the resources, we are
changing our models, to take into account this new business
activity, and we will add the necessary resources to maintain a
safe and sound operation.
There are a different analytics that go with it, and we are
recognizing what those are and investing in the people that are
necessary.
Senator Sarbanes. When we say ``we,'' who do you----
Mr. Rice. Our bank, I am sorry.
Senator Sarbanes. Your particular bank.
Mr. Rice. My particular bank. I cannot speak for all of the
others, but I think almost every bank that is looking at MPP
are making those decisions.
Senator Sarbanes. The fact that you just said you cannot
speak for the others leads me to my next question. I am moving
quickly here because we have limited time.
One observer described a system with joint and several
liability with different capital structure as akin to 12 people
with their shoelaces all tied together, but running at
different speeds, and concluded that one of them is bound to
fall on his face. And, of course, this leads to a number of
concerns about the problem of moral hazard, with respect to the
Home Loan Bank System.
In a system where the Banks are doing highly collateralized
advances, the issue raised by joint and several liability is
muted. That is at a lower order of concern, I think, because of
the highly collateralized advances that you are operating with.
But now the System is expanding into new areas. Proposals
to restructure the System to allow multidistrict membership
have emerged. I must say, in both instances, I, it is my own
position, that the board cannot do this without coming back to
Congress for a statutory change.
Senator Bennett. If you had been here, Secretary Abernathy
would have taken the same position.
Senator Sarbanes. Yes. If banks are put into a position of
competing with each other for members, for example, as they
would be under multidistrict membership, or for business with
each other's members, as in the Shared Funding Program, what
danger do you see in the possibility that Banks would engage in
a race to the bottom, relaxing collateral, capital standards,
and others in order to attract or retain members?
The GAO said, ``Under the joint and several structure, the
potential for moral hazard exists; that is, Federal Home Loan
Banks may have incentives to take financial risk, knowing that
their losses would be covered by other Federal Home Loan Banks
or ultimately by the Federal Government.''
What is your view of that?
Mr. Rice. That is a big question. I will take them in
pieces.
Number one, I really do believe that the way in which we
are managing mortgage purchases, and the way in which the
Finance Board reviews it, and through the examination of safety
and soundness, I do not see that risk growing. And I think that
the oversight that we have from our Board, and the way in which
we direct profitability and the like, are well served in this
process.
Senator Sarbanes. When you say ``by our board,'' you mean
the Seattle Board?
Mr. Rice. Our board of directors of the Seattle Bank. But
at the end of the day, all Banks are examined. All Banks'
capital plans have to be approved by the Finance Board. There
is oversight over all of the Banks, and I think that that
oversight is the protection that you get in managing these
programs.
The second issue that you have on multidistrict, I believe
that the degree of consolidation that has gone on in the System
necessitates some direction about modernization and accepting
what is there. Whether that is the Congress' job or not, I
think that if Congress chooses to move in that area, then I
think it can resolve that issue, but we are not moving for
multidistrict. The chairman of the Finance board is not
entertaining any notion, and I do not think there will be a
proposal before the Finance board to do so.
I forgot the last one, but I will defer to my colleagues.
Senator Sarbanes. Mr. Middleton, do you want to address any
of that?
Mr. Middleton. May I just address components of it,
Senator?
[Laughter.]
With respect to the multidistrict, the Atlanta Bank raises
a concern that we think it might introduce unhealthy
competition, but I think, in light of the reality of what is
going on in the financial markets, perhaps it should be looked
at by somebody in authority. So whatever mode that you choose
is fine.
The purchase of member assets, I can assure you that at the
Atlanta Bank we just completed an exhaustive strategic plan
that we have to do by regulation. And one of the directives
that the board gave to management and ensured that we are
properly allocating the budgeted resources that are sufficient
to assure competent staffing in place prior to any significant
growth or expansion of a new business product line. We would do
in that measure normal banking circles, because we all have a
day job at our banks.
I can assure you that we devoted a tremendous amount of
resources and discussion to the endeavor. We are not going to
eliminate risk. Our job is to manage risk. We want to manage
risk in the most prudent manner possible. So that is at the
forefront of our directorate at the Atlanta Bank.
Senator Sarbanes. Let me throw another factor into the mix
as we proceed along. As I understand it, the bulk of Federal
Home Loan Bank advances go to a small number of very large
members. The System has over 8,000 members, but the largest 1
percent of its members account for 50 percent of the advances.
In some Federal Home Loan Banks, the concentration is even
higher. In San Francisco Bank, 80 percent of the advances go to
only five institutions.
I guess that raises the question, you know, what is the
purpose of the System and why should the Home Loan Banks be
devoting or providing low-cost funding to such large
institutions which have direct access to the capital markets
themselves? Should we graduate them from the Federal Home Loan
Bank System at some point?
I mean, what is the purpose of this? I mean, from the point
of view of the institution, it is a good deal, but what is the
public purpose of it? And why are we, in effect, running
perhaps a significant public risk in order to do this?
Sheila, why do we not go to you here.
Ms. Bair. Well, I am asking the same question, Senator. I
do not understand. I believe Congress's most recent
pronouncement on the System, in Gramm-Leach-Bliley, clearly put
an emphasis on community-based smaller institutions. I do not
begrudge the ability of a large institution to use the System.
They do, they always have, and they should continue in the
traditional line of business of advances.
But to take on these new controversial business lines and
new risk, for a service that is being more predominantly used
for large mortgage originators, it does not, you know, they
have a lot of sophistication on their own to manage interest
rate risk associated with mortgage portfolios. Why do they need
the Federal Home Loan Bank System to be stepping up to the
plate and providing this service? I do not understand it
either.
I think that it is telling that even those large
originators are starting to get a little worried, I think,
because the regulatory structure that was set up assumed a
system that would continue its traditional line of business of
fully collateralized advances, which is a very low-risk
business. The lines that they are getting into now are not low-
risk businesses. And if this is the direction the System is
going to take, then they need dramatically enhanced regulatory
scrutiny, which is I think why world savings are calling for
concurrent action on the Federal Home Loan Bank System as it
appears Congress moves toward the creation of a new enhanced
regulator at Treasury for Fannie and Freddie.
Do not forget, a lot of these large and small institutions
hold a lot of system capital stock. And if the System gets in
trouble, that stock is going to be in trouble, too, which could
have systemic implications for the banking system.
Senator Sarbanes. I might note, in that regard, we just
received a letter from Washington Mutual:
The housing GSE's should have a strong regulatory oversight
structure that ensures both the safe and sound operation of the
GSE's and the fulfillment of their housing missions. The best
way to assure this goal would be for Fannie Mae, Freddie Mac,
and the Federal Home Loan Banks to be regulated by an
independent agency within the U.S. Treasury Department.
The Agency should have a single director and should be
funded through user fees, like the other bank regulatory
agencies under Treasury, with appropriate recognition of the
unique nature of the Federal Home Loan Banks as cooperatives,
compared to the other housing GSE's, which are publicly traded
companies.
Mr. Chairman, I presume this letter is in the record, but,
if not, I would like to put it in the record.
Senator Bennett. It shall appear in the record.
[The letter follows:]
Mr. Smith. Back to, in terms of the large institutions, the
first point here is to effect the housing market for consumers,
and all consumers do not use small institutions to get their
mortgages. Many consumers use large institutions. To the extent
we are able to effect the cost of funds at those larger
institutions, it then flows through to the same consumer base.
The second thing, when you look at our concentrations, our
member base mirrors the industry. If you look at the percentage
of asset distribution in the banking industry and compare it to
the Home Loan Banks, we mirror that. We are a little highly
weighted to the community institutions, the very small ones,
but essentially we mirror the industry, and the industry is
highly concentrated in its asset holdings. So, as a result,
those are the institutions that typically are going to borrow
more money.
And then, finally, in terms of our business model, the
larger institutions provide us with scale, and that scale flows
through to the small institutions. One thing you have to
remember from my testimony is our boards are primarily
controlled by elected directors from community and financial
institutions.
If there was a concern that the larger institutions were
being treated in any way better or advantageously relative to
those institutions, I think our boards would be more than happy
to tell us to knock it off.
Senator Sarbanes. Did you want to add anything, Mr.
Hemingway?
Mr. Hemingway. No.
Senator Sarbanes. I am not pressing you to do so, but I
have one other question I want to ask, Mr. Chairman.
Senator Bennett. Sure.
Senator Sarbanes. You have been very generous with the
time.
Senator Bennett. Well, this has been a worthwhile exchange.
Senator Sarbanes. Thank you.
Some time ago the Atlanta Bank issued a notice that it
would not accept as collateral any loans that included single-
premium credit insurance. As far as I know, no other bank has
yet followed suit, nor have other banks taken any of the other
steps, such as reducing prepayment penalties that one or more
of the other housing GSE's have taken, let alone some of the
moves with respect to best practices that lenders of their own
volition or perhaps because of prompting have also taken.
Isn't this an area where the Home Loan Banks can make a
real contribution to the reduction of predatory lending?
Mr. Rice. Yes.
Senator Sarbanes. Mr. Smith.
Mr. Smith. Yes.
Senator Sarbanes. Mr. Hemingway.
Mr. Hemingway. It sounds like a good idea to me.
Senator Sarbanes. Yes, well, why do you not at least do
what the Atlanta Bank----
Mr. Hemingway. I suspect it will be on the next agenda,
Senator.
[Laughter.]
Ms. Bair. Let the record show we all agree on that one.
[Laughter.]
Senator Sarbanes. Thank you very much.
Senator Bennett. Thank you, Senator.
And, again, thanks to the panel. This has been most
informative. We appreciate your patience and your persistence
in responding to the questioning of the Subcommittee.
The hearing is adjourned.
[Whereupon, at 4:28 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional materials supplied follow:]
PREPARED STATEMENT OF SENATOR JIM BUNNING
Mr. Chairman, I would like to thank you for holding this important
hearing and I would like to thank all of our witnesses for testifying
today.
The Federal Home Loan Bank System has brought the American Dream of
homeownership to millions in this country. The Cincinnati Federal Home
Loan Bank, which represents the Commonwealth of Kentucky, has helped
many in my State achieve that same dream. But with the troubles
recently experienced by Freddie Mac and given the changing world of the
Federal Home Loan Banks, it is very timely that you are holding this
hearing here today.
There are many issues facing the Home Loan Banks, multidistrict
membership, mortgage acquisition programs, SEC registration, and
regulatory structure are all questions that are before the banks today.
In the past, Members of this Committee have brought up questions about
the salaries of the Home Loan Bank presidents. I intend to bring up
some of these issues in the question and answer period.
And I thank the Chairman for bringing in these witnesses. I think
we have just about everyone connected to the Federal Home Loan Banks
covered today.
I look forward to all of your testimony and to talking about some
of these issues during the question and answer period.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I want to thank Chairman Bennett for holding this hearing to
discuss the Federal Home Loan Bank System and the integral role it
plays in providing liquidity to the U.S. housing markets. The Federal
Home Loan Banks provide the largest private source of residential
mortgage and community development credit in the United States. The
Congress, the Federal Housing Finance Board, and the Banks themselves
have the important task of assessing and updating the Federal Home Loan
Bank System in order to make the changes necessary to ensure its
continued success in fulfilling and executing its mission.
As Chairman of the Housing and Transportation Subcommittee, I have
particular interest in and appreciation for the crucial role that the
Federal Home Loan Bank System plays in promoting affordable housing in
our country. The Banks' Affordable Housing Program (AHP) is the largest
privately funded grant program for housing in the country, and key in
financing affordable housing efforts through each of the Banks. In
2002, the Federal Home Loan Banks contributed $199 million toward low-
income housing through the AHP program. The Community Investment
Program (CIP) is also instrumental in funding community and economic
development projects throughout the country.
The unique aspect of the Federal Home Loan Bank System that
contributes to its success, is the ability of each Bank to develop its
own programs in response to the needs of its membership. I am
particularly appreciative of the Rural First Time Housing Program
(RFHP), the Community Housing Program (CHP), the Rural Technical
Assistance Program (RTAP) and the Community Development Program (CDP).
These specific programs of the Federal Home Loan Bank of Topeka help
aid homeownership and community development in Colorado. The Topeka
Bank plays a vital role in providing liquidity to the independent
community banks in Colorado so that they can, in turn, address the
affordable housing andeconomic development needs of Colorado
communities.
I would like to thank each witness for appearing before the
Subcommittee today to address the Federal Home Loan Bank System and its
role in the U.S. economy. I look forward to your testimonies.
----------
PREARED STATEMENT OF WAYNE A. ABERNATHY
Assistant Secretary for Financial Institutions
U.S. Department of the Treasury
September 9, 2003
Thank you, Chairman Bennett, Ranking Member Johnson, and Members of
the Subcommittee for this opportunity to testify today on the Federal
Home Loan Bank (FHLBank) System. The Department of the Treasury is
keenly interested in the operations of the Federal Home Loan Bank
System because of the important responsibility that the Congress has
placed with the Federal Home Loan Banks to enhance the liquidity of
financial institutions, particularly as the Federal Home Loan Bank
members meet such important community needs as promoting homeownership.
The housing finance market in the United States is the broadest,
deepest, and most successful housing finance market in the world. That
market is supported by a complex financial services infrastructure,
which includes depository institutions, mortgage brokers, mortgage
bankers, mortgage insurers, and a variety of other capital market
intermediaries. Prominent among capital market intermediaries that make
up that infrastructure are the housing government sponsored enterprises
(GSE's)--Fannie Mae, Freddie Mac, and the FHLBank System.
The FHLBank System has had a long history of supporting housing
finance in America. Congress created the FHLBank System in 1932 in
response to a Depression-era liquidity crisis in housing finance. The
FHLBank Act directs the FHLBanks to make loans--called advances--to
eligible members. Advances traditionally served the role of providing
thrifts access to reliable long-term funding for mortgage lending and
as a source of liquidity to help thrifts finance deposit outflows
without calling or selling their mortgages. Over time, Congress has
expanded the System's membership base beyond thrifts, but the primary
function of advances has remained relatively constant. Today, financial
markets and our Nation's housing finance system bear little resemblance
to the one that existed when the FHLBank System was created.
It is in that light that I would like to focus on three topics this
morning: The need for the FHLBanks to voluntarily register with the
Securities and Exchange Commission (SEC) under the terms of the
Securities Exchange Act of 1934; the FHLBank Act and the activities of
the FHLBank System; and Treasury's current detailed review of the
FHLBank System.
Voluntary Registration with the SEC under the 1934 Act
The observance of good, fundamental practices of corporate
governance is a high priority of this Administration. Foremost among
such practices is regular, comparable, quality disclosure of corporate
financial conditions. A key part of that commitment is improving the
quality of corporate disclosure requirements by the GSE's, which is why
for more than a year the Administration has been urging all GSE's to
comply with the same corporate disclosure requirements of the
Securities Exchange Act of 1934, as interpreted and applied by the SEC.
Investors in GSE securities should have access to the same corporate
disclosures as they have for other companies who publicly offer their
securities for investment.
We are pleased that Fannie Mae has complied with this request to
voluntarily register and made its first disclosures under the 1934 Act
in the first quarter of 2003. Freddie Mac has also agreed to register
with the SEC, though we are disappointed to learn that Freddie Mac may
not be registering until sometime in 2004. The sooner that they
register with the SEC the better for them and their investors, though
we fully concur with their intention that such registration and the
financial disclosures that this step entails fully meet the high
standards that are required.
The Administration has continued to urge the FHLBanks to move
forward with voluntary registration with the SEC under the 1934 Act.
Some have argued that the structure of the FHLBank System and the
unique characteristics of the FHLBanks in comparison to Fannie Mae and
Freddie Mac lessen the need for registration under the 1934 Act.
Certainly there are differences: When the FHLBank System was created in
1932, it was created with geographically limited regional banks. Each
regional Home Loan Bank is cooperatively owned by its members, and its
capital stock is not publicly traded. The 12 FHLBanks raise funds in
the capital markets by issuing consolidated obligations for which they
are jointly and severally liable. All of these facts are important and
must be--and I believe can be--taken into account.
However, the differences between the FHLBanks and the other GSE's
do not change the fundamental fact that the FHLBanks are significant
participants in our capital markets by any measure, and that investors
should have the same information regarding the condition of the Home
Loan Banks as they have for other significant capital market
participants. The facts make this case dramatically:
At the end of June, the FHLBanks had outstanding consolidated
obligations of $712 billion, of which bonds with original
maturity of 1 year or longer constituted $556 billion of the
total.
The individual FHLBanks are each large financial institutions.
As of year-end 2002, the largest Home Loan Bank (the FHLBank of
San Francisco) had $135 billion in total assets, the smallest
(the FHLBank of Topeka) had $33 billion in total assets, while
the average among the 12 banks was $58 billion in total assets.
Even the smallest Federal Home Loan Bank would rank among the
top 40 commercial banks in the United States.
Federal Home Loan Bank registration under the Securities Exchange
Act of 1934 is an important step in increasing the transparency of the
FHLBanks' financial information to investors. The recent problems of
Freddie Mac and a credit rating agency's revision of its outlook for
one of the Federal Home Loan Banks from stable to negative illustrate
the need for investors to have a more accurate picture of the GSE's'
financial operations. Following Federal Home Loan Bank registration
under the 1934 Act, investors would have access to the FHLBanks'
financial information through the same forms and methods as those that
apply to other companies that sell publicly traded securities.
Investors would benefit from the added oversight of the SEC, both in
terms of reviewing the Federal Home Loan Banks' financial disclosures
and through the uniform enforcement of current standards. And investors
would have the basis for making comparable evaluations of the financial
conditions of the variety of institutions competing for their
investment dollars. Our system of securities regulation should offer
investors nothing short of that standard.
The continued operation of the FHLBanks outside of the SEC-
administered corporate disclosure regime is inconsistent with our
objective of a sound and resilient financial system. We understand that
the FHLBanks have some remaining concerns with how certain aspects of
their business operation would be treated if they registered under the
1934 Act. I would remind them and all concerned that the Federal Home
Loan Banks are not the only corporate institutions in America that have
unique characteristics. It was specifically in order to deal with the
variety of corporations in the Nation--while still preserving a high
standard of comparable disclosures--that the SEC was given its exemptive authority under the securities statutes. Given the flexibilities that
the SEC has to address the individual circumstances of the various
registrants under the 1934 Act, we are confident that the Federal Home
Loan Banks' concerns can be worked out with the SEC.
We appreciate the discussions that several of the Banks have had
with the SEC earlier in the year, and we look forward to those
discussions being renewed in the immediate future, within a context of
acceptance of the public interest that would be served by the Federal
Home Loan Banks registering under the terms of the Securities Exchange
Act of 1934. We understand that the Board of Directors of the Federal
Home Loan Bank of Cincinnati recently announced the Bank will be taking
the next step in the process of voluntary registration with the SEC. In
a recent letter to Secretary Snow, Housing and Urban Development
Secretary Martinez, and Federal Housing Finance Board Chairman Korsmo,
the Board of Directors of the Federal Home Loan Bank of San Francisco
expressed their goal ``to enable the Federal Home Loan Banks to become
role models for corporate transparency.'' That is our goal as well, to
which Federal Home Loan Bank registration under the Securities Exchange
Act of 1934 is essential.
Multidistrict Membership, In Context
In chartering each of the housing GSE's, Congress described the
markets to be served by these GSE's, the financial activities these
GSE's should undertake, and created a regulatory structure to oversee
the GSE's and their activities. While there have been and continue to
be debates over a number of Home Loan Bank activities and how these
activities fit within the statutory confines of the Federal Home Loan
Bank Act, one current issue--the question of multidistrict membership--
raises particular concern. The Federal Housing Finance Board (Finance
Board) has received a number of petitions requesting that Federal Home
Loan Bank members be permitted to join more than one Federal Home Loan
Bank. The Finance Board has analyzed this issue, obtained outside legal
counsel on its authority to authorize multidistrict membership, and
solicited views from interested parties.
All of that is well and good and appropriate. A lively discussion
of policies and programs is healthy. But the appropriate forum for the
resolution of these issues must be kept in mind. As the Treasury
Department has written in a comment letter to the Finance Board,
regardless of whether allowing multidistrict membership is wise, a
plain reading of the statute finds little room to conclude that the
Finance Board has the legal authority to approve it. It provides:
An institution eligible to become a member under this Section
may become a member only of, or secure advances from, the
Federal Home Loan Bank of the district in which is located the
institution's principal place of business, or of the bank of a
district adjoining such district, if demanded by convenience
and then only with the approval of the Board.\1\
---------------------------------------------------------------------------
\1\ 12 U.S.C. Sec. 1424(b).
This view is reinforced by the comments of Assistant Legislative
Counsel Mr. John O'Brien (a principal drafter of the Federal Home Loan
Bank Act) in response to questions regarding the Federal Home Loan Act
---------------------------------------------------------------------------
at a Senate hearing in 1932.
[I]t was not the desire, say, for members in South Carolina to
borrow of a New York bank, because it would mean too great a
concentration at the New York bank. If the New York bank
happened to do better than a South Carolina bank, all members
would go there. There is the opportunity in the bill for a
member whose principal place of business is in one district to
belong to a bank in the adjoining district, but outside of that
there is no provision. It is impossible under the terms of the
bill for a company doing business in New York to belong to a
South Carolina bank.\2\
---------------------------------------------------------------------------
\2\ Id. (citing Hearings on S. 2959 concerning creation of the
FHLBank System), 72nd Cong., 1st Sess (1932), at 199.
To say this is not to render a policy point of view. There are
compelling arguments on both sides of the question with regard to the
advisability of multidistrict membership. Clearly our financial system
has changed dramatically since the System was established in 1932 and
the predecessor to the current regulator created the 12 banks, and
determined their locations and boundaries. In the intervening years,
however, Congress has revised the governing statutes on several
occasions. It is to the Congress that these arguments should be offered
and where any change in the statute will have to be made.
To some, multidistrict membership represents a natural progression
in the modernization of the FHLBank System. We would only add our view
that if multidistrict membership is considered, it should be done
within the general context of evaluating the Federal Home Loan Bank
System's charter.
Treasury's Review of the FHLBank System
Perhaps the time for such a review is near. Earlier this year, I
requested the
Office of Financial Institutions Policy at the Treasury Department to
conduct an in-house review of the Federal Home Loan Bank System, with
particular--but not exclusive--consideration of the effect of the
changes enacted as part of the Gramm-Leach-Bliley Act of 1999 (GLBA).
As I announced at that time, the review would consider:
how these changes have affected the ability of the Federal
Home Loan Banks to meet their statutory mission;
implications for the financial strength of the Banks
individually and the System in general;
how the business operations of the Banks contribute to
accomplishing their statutory mission;
issues regarding governance structure and management,
including executive compensation;
effect of new capital structures on operations; and
other issues regarding the strength of the System and the
structure of Federal oversight.
We are now about 4 months into that process, nearing completion of
the first phase. In the first phase, the staff conducted a general
review of the literature, discussions, debates, and developments to put
a sharper focus to the questions to be examined. Now they are preparing
to go into greater detail. The initial step in the second phase will be
to discuss specific topics with the Finance Board.
Some of the issues we will be looking at in greater detail include:
Capital Structure
GLBA significantly changed the capital structure of the Federal
Home Loan Banks and provided greater flexibility in the development of
capital plans. What are the similarities and differences among the
various capital plans? How have the risk-based capital requirements
been implemented? How will new capital plans impact the Banks'
investment portfolios?
Membership
GLBA eliminated mandatory membership requirements for Federal
savings associations and permitted broader access to FHLBank membership
for community financial institutions (insured depository institutions
with less than $500 million in total assets). What has been the impact
of these changes in membership participation? Have those changes
affected governance of the Home Loan Banks?
Advances and Collateral
The GLBA provided community financial institutions with a broader
range of eligible collateral for FHLBank advances. The Finance Board
reports that as of June 30, 2003, expanded collateral from community
financial institutions represents approximately $10.6 billion of the
$486 billion in outstanding advances. How has this provision been
implemented by the FHLBanks and what factors impact community financial
institutions use of the broader range of eligible collateral?
In addition to evaluating these specific legislative changes, over
the last decade the activities of the Federal Home Loan Banks have
evolved in many ways. Some specific activities that we will be focusing
on include:
Balance Sheet Developments
How have key activities (advances, investments, and mortgage
purchases) of the System and the individual Home Loan Banks evolved
over the last decade, and what does this imply for the future of the
System?
Advance Usage
What are the characteristics of FHLBank advance users? What types
of advances are most commonly used by System members? What impact is it
having on the activities of the members and their ability to serve
their customers?
Again, I would like to emphasize that Treasury's review of the
Federal Home Loan Bank System is part of what we normally do at
Treasury, and what I envision for our current review is a more specific
look at how the changes made to the FHLBank System as part of GLBA have
been implemented. Treasury is not primarily a regulatory agency. We see
as part of our important function, however, providing executive branch
oversight of the activities of the independent financial regulators,
and this study is part of meeting that responsibility.
And before I leave this subject, with regard to regulatory
oversight of the FHLBank System, I would like to commend Finance Board
Chairman Korsmo for the increased emphasis he has placed on safety and
soundness oversight, in particular the emphasis he has placed on the
supervision and examination function. In recent years, many observers
have pointed to weaknesses in the Finance Board's supervision of the
Federal Home Loan Banks. Chairman Korsmo has given major focus to
strengthening the examination process, doubling examination staff on
the way to tripling it. I have no doubt that even further increases
will be made as necessary.
As another related aside, I would like to raise a point about a
legislative proposal regarding the membership of privately insured
credit unions in Federal Home Loan Banks. As part of that proposal,
private insurers of credit union deposits would be required to submit
annual audit reports to the National Credit Union Administration
(NCUA). In addition, upon the NCUA's request, the appropriate State
supervisory agency would be required to provide the NCUA with
examination reports of private deposit insurers. We are concerned that
the provisions related to the NCUA could give the false impression that
the NCUA has oversight authority over the private deposit insurers of
credit unions and that the Federal Government somehow stands behind the
private insurers. Not only would that be a terribly false impression
potentially harmful to depositors, but it would also remove some of the
market discipline that is so essential to the successful functioning of
any private insurance program.
Conclusion
The Federal Home Loan Bank System presents policymakers with issues
that deserve continued attention. The System has historically played an
important role in our Nation's housing finance markets. We must
continue to evaluate the System to ensure that it is achieving the
objectives set forth by Congress, meeting the needs of our communities
that might not otherwise be met.
Thank you again for providing me with the opportunity to discuss
these important issues with the Subcommittee today.
----------
PREPARED STATEMENT OF JOHN T. KORSMO
Chairman, Federal Housing Finance Board
September 9, 2003
Thank you, Chairman Bennett, Ranking Member Johnson, and
distinguished Members of the Subcommittee on Financial Institutions. I
appreciate the opportunity to speak with you today about the Federal
Housing Finance Board (Finance Board) and the Federal Home Loan Bank
System.
Many important issues are facing the Nation's Government Sponsored
Enterprises (GSE's), including, certainly, the Federal Home Loan Banks
(Banks). I highlight today the aggressive steps we have taken at the
Federal Housing Finance Board, the System's regulator, first, to
strengthen the Agency's oversight capabilities; and second, to improve
financial disclosures by the Federal Home Loan Banks through voluntary
registration with the Securities and Exchange Commission (SEC).
These initiatives will benefit not just the Federal Home Loan Banks
and their member institutions, but also the investors that purchase the
Banks' debt, the taxpayers, and ultimately, the homebuying public who
are served by the housing finance mission of the Banks.
As requested in Chairman Bennett's invitation to this oversight
hearing, I will also address the issues of multidistrict memberships in
Federal Home Loan Banks and the Banks' various Acquired Member Asset
programs (AMA).
Allow me to begin by providing a brief overview of both the Federal
Housing Finance Board and the entities we regulate, the 12 Federal Home
Loan Banks and the Office of Finance.
The Federal Housing Finance Board is an independent agency in the
executive branch of the U.S. Government, with a five-member Board of
Directors, four appointed by the President and one ex-officio member,
the Secretary of Housing and Urban Development. Created to take over
certain duties of the Federal Home Loan Bank Board by the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA),
the Finance Board's primary duty is to ensure that the 12 Federal Home
Loan Banks and the Office of Finance operate in a financially safe and
sound manner.
In addition, the Finance Board ensures that the Federal Home Loan
Banks carry out their housing finance and community lending mission and
remain adequately capitalized and able to raise funds in the capital
markets. The Federal Home Loan Bank Act requires the Finance Board to
examine and report on the condition of each Federal Home Loan Bank at
least annually. Finally, the Finance Board is a nonappropriated agency
that enacts its own budget; it assesses the Banks for the costs of its
operation.
The 12 Federal Home Loan Banks and their joint office, the Office
of Finance, serve the public by promoting the availability of housing
finance, including community lending credit, through 8,000-plus member
institutions. The 12 Banks provide a readily available, low-cost source
of funds to members and a secondary market facility for home mortgages
originated or acquired by their members. The Banks are cooperatives;
only members may own the stock of each Federal Home Loan Bank, and the
members receive dividends on their investment. Insured banks, thrifts,
and credit unions and insurance companies engaged in housing finance
can apply for membership.
The Federal Home Loan Banks play a unique role in housing finance.
They make loans, called advances, to their members and eligible housing
associates (principally State housing finance agencies) on the security
of mortgages and other collateral pledged by those members and housing
associates. Advances generally support mortgage originations, provide
term funding for portfolio lending, and may be used to provide funds to
any member ``community financial institution'' (an FDIC-insured
institution with assets of $538 million or less) for loans to small
business, small farms, and small agribusiness. Because portfolio
lenders may originate loans they are unwilling or unable to sell in the
secondary mortgage market, Federal Home Loan Bank advances serve as a
funding source for a variety of mortgages. This flexibility allows
these advances to support important housing markets, including those
focused on low- and moderate-income households.
Federal Home Loan Bank advances can provide funding to smaller
lenders that lack diverse funding sources. Smaller community lenders
often do not have access to funding alternatives available to larger
financial entities, including repurchase agreements, commercial paper,
and brokered deposits. The Federal Home Loan Banks give these lenders
access to competitively priced wholesale funding.
The Federal Home Loan Banks principally fund themselves by issuing
consolidated obligations, which are the primary obligation of a
sponsoring Bank or Banks, backed by a joint-and-several liability
guarantee of all Banks. Consolidated obligations outstanding at June
30, 2003, totaled $712.4 billion. This includes bonds (original
maturity of 1 year or longer) of $556.2 billion and discount notes
(original maturity of less than 1 year) of $156.2 billion.
Finally, a few more key figures: Total assets of the Federal Home
Loan Banks stood at $812 billion as of June 30, 2003. Advances totaled
$506.3 billion, which is 7.6 percent greater than 1 year ago. Viewed
collectively, the Federal Home Loan Banks represent the third largest
domestic banking organization.
Institutions of this size and importance to the Nation's housing
market and economy in general clearly require a robust and capable
regulator, and since President Bush named me Chairman in December 2001,
I have sought to establish the Finance Board as just that.
Improvements in Safety and Soundness Oversight
Soon after I became Chairman, my Finance Board colleagues and I
determined that the Finance Board lacked the necessary resources to
effectively carry out its primary responsibility, that of overseeing
the Federal Home Loan Banks and the Office of Finance for safety and
soundness. Just one example demonstrates this point: The Finance Board
had only eight bank examiners on staff to review and supervise a dozen
financial institutions with, at the time, more than $700 billion in
assets, more than $30 billion in capital, and some $650 billion in
outstanding debt. Yet, the Agency also had an Office of Public Affairs
with the same number of staff, eight. The relative allocation of
resources simply did not meet the Agency's statutory mandates.
In addition to being understaffed, the examination function was
also insufficiently focused on the Banks' risk assessment processes and
the Banks' internal control systems. Such shortcomings had been
identified in a 1998 General Accounting Office (GAO) report of the
Finance Board's examination program, but had not by that time been
addressed and corrected.
I immediately set out to respond to these problems, beginning with
the recruitment of new leadership for the Agency's Office of
Supervision. After a national search, the Finance Board hired a new
director and a new deputy director of supervision, who between them
have 40 years of regulatory experience with the Office of the
Comptroller of the Currency and the Federal Deposit Insurance
Corporation (FDIC).
My Finance Board colleagues and I increased the resources available
for supervision, expanding the Agency's examination staff to 17 full-
time bank examiners. Our goal is to have 24 in place by the end of this
calendar year, and 30 by the end of the next budget year.
The Finance Board is now conducting more thorough, risk-focused
examinations, and communicating the results of those examinations more
effectively to the Banks.
Examinations now recognize that banking--including AAA-rated, GSE
banking--is a business of managing risks, and the responsibility of
bank supervisors is to ensure that the institutions they regulate
understand those risks and monitor and control them through prudent
risk management practices.
To enhance analysis and oversight in the risk management area, we
have established two risk units--a Risk Modeling Division and a Risk
Monitoring Division. The Risk Modeling Division is responsible for the
development of our asset/liability modeling and for monitoring the
Bank's internal interest rate risk models. The Risk Monitoring Division
pulls together all our data and the Banks' own financial reporting into
a risk-monitoring framework.
We have hired an Associate Director for Examinations who oversees
all our safety and soundness examiners. She has more than 15 years of
bank regulatory experience with the FDIC. We also have hired a Senior
Advisor to the Director of Supervision to provide support to the Risk
Modeling and Risk Monitoring Divisions. That Senior Advisor possesses
some 30 years of bank supervision, capital markets, and capital
regulation experience with the Board of Governors of the Federal
Reserve System and the Office of Thrift Supervision.
While on-site examinations remain the primary tool of supervisors,
the Agency now complements exams with off-site monitoring and regular
communication with the Banks. Our new ``Bank Analyst Program'' charges
a member of our Office of Supervision with following an individual Bank
and reviewing monthly and quarterly financial reports for trends and
changes, while also keeping abreast of issues in the financial and
housing industries to determine their effect on each Bank.
Our Office of General Counsel has also assigned attorneys who serve
as points of contact for the examiners on particular Bank issues.
In short, the Finance Board's safety-and-soundness oversight of the
Federal Home Loan Banks has improved dramatically. We have more work
ahead of us, to be sure, but the Finance Board is a much stronger and
more capable regulatory agency than it was as recently as 12 months
ago.
The 1998 GAO report also found that Finance Board examinations
neglected the critical area of board governance at the Federal Home
Loan Banks. To address this shortcoming, and as another element of our
safety and soundness supervision, the Finance Board has undertaken a
thorough assessment of corporate governance at each of the Banks. This
effort included the first-ever horizontal review--that is, a systemwide
supervisory review of a single issue at each of the 12 Banks--which
addressed the Banks' effectiveness relative to eight indicators of
effective board governance.
Those indicators are:
Engaged Board of Directors;
Skilled Senior Management;
Thorough Strategic Planning;
Sound Risk Management;
Robust Internal Control;
Effective Audit Program;
Strong Ethical Culture;
Timely, Accurate, and Complete Communications.
The Finance Board's final report on this review includes a variety
of general recommendations for improving corporate governance. The
Agency also provided specific, confidential feedback to each of the 12
Banks.
The next step with respect to bank governance is a public hearing,
tentatively scheduled for October 15. The Finance Board will solicit
from the Banks, their member institutions, experts, and interested
members of the public any ideas for reform in this important area.
Input generated may be used in the design of proposals aimed at making
the Federal Home Loan Banks role models in corporate governance.
Earlier this year, the Finance Board undertook a second systemwide
horizontal review--that of the Federal Home Loan Banks' implementation
of the statutorily mandated Affordable Housing Program (AHP). The AHP
is a highly successful program that warrants a separate discussion and
some background.
The Affordable Housing Program (AHP)
The Federal Home Loan Bank Act requires each Bank to establish and
fund an Affordable Housing Program. Under the AHP, each Bank must
annually contribute the greater of 10 percent of its net earnings for
the previous year, or such prorated sums as may be required to ensure
that the aggregate contribution of the Banks is at least $100 million.
Actual contributions to the program were $199 million for 2002, and the
contributions have exceeded $100 million each year since 1994.
AHP subsidies must be used to fund the purchase, construction, or
rehabilitation of:
Owner-occupied housing for very low-income, or low- or
moderate-income (no greater than 80 percent of area median income)
households; or
Rental housing in which at least 20 percent of the units will
be occupied by and affordable for very low-income (no greater than
50 percent of area median income) households.
In 2002, the Finance Board adopted a regulation enabling Banks to
allocate annually the greater of $4.5 million or 35 percent of each
Bank's AHP contribution to homeownership set-asides. Part of this
increased funding authority helps Banks combine AHP subsidies with HUD
initiatives benefiting minority, immigrant, and other first-time
homebuyer families.
Since the inception of the AHP in 1990, the Federal Home Loan Banks
have contributed $1.7 billion to the program, funding 236,596 rental
units and 122,126 owner-occupied units. In 2002, the Banks committed
$286 million to AHP projects.
The Finance Board appropriately devolved operation of the AHP to
the individual Banks in the late 1990's, a valuable development because
the Banks are best equipped to assess local affordable housing needs
and build partnerships with local community groups and housing
agencies.
Correspondingly, the Finance Board's oversight responsibility has
grown with respect to the AHP to ensure proper and effective program
operation. As such, we are following up the horizontal review with a
new practice of examining each Bank's AHP once a year. These exams are
performed by examiners and analysts whose specialized training has
specifically equipped them for this task.
We are also preparing regulatory language intended to enhance the
effectiveness of the AHP by permitting Banks more latitude in
establishing the criteria to score applications. The goal is for Banks
to be more responsive to local housing conditions. We also plan to
streamline the application process to permit projects to proceed more
quickly and with lower administrative costs.
AHP is truly one of the Federal Home Loan Banks' great success
stories, and with rigorous oversight at the Federal Housing Finance
Board, I am confident it will be even more successful in the years
ahead.
Enhanced Disclosures
The other key initiative I wish to discuss today is enhancing the
quarterly and annual corporate disclosures of the Federal Home Loan
Banks.
In July 2002, the administration called on all Government Sponsored
Enterprises to comply with the corporate disclosure requirements of the
Securities Exchange Act of 1934, as interpreted and enforced by the
SEC.
Fannie Mae and Freddie Mac, the other two housing-related GSE's,
answered this call. Fannie Mae has already filed its first disclosures
under the new SEC regime.
As Chairman of the Federal Housing Finance Board, I too am
determined to hold the Federal Home Loan Banks to the highest standard
of disclosure. Accordingly, I formed a working group from the Finance
Board and the Federal Home Loan Banks to review the implications of
acceding to the Administration's request.
Early this year, I concluded that voluntary registration with the
SEC was indeed the best approach to providing enhanced public
disclosure of the operations and finances of the Federal Home Loan
Banks. I reached this conclusion based on two premises.
First, the Banks' long-term access to global capital markets will
be enhanced by providing investors in consolidated obligations with
maximum reliable transparency into the finances and governance of each
of the 12 Banks. Markets function best, especially in times of stress,
when needed information is readily available and reliable.
Second, as public trusts, these 12 GSE's have a duty to contribute
both to the smooth functioning of capital and mortgage finance markets
and to public confidence that the benefits of GSE status are used
wisely.
At my urging, Federal Home Loan Banks and the staff of the SEC have
held numerous meetings to address the process for voluntary
registration, including methods for resolving several key disclosure
and accounting questions.
The Board of Directors of the Federal Home Loan Bank of Cincinnati
actively embraced the disclosure initiative as in the best interest of
its members, voting in February to pursue voluntary registration. Last
month, the Cincinnati board resolved to ``actively engage, effective
immediately, in the process of voluntary registration with the SEC of
its member-held stock.''
This summer, too, the boards of the Federal Home Loan Bank of San
Francisco and the Federal Home Loan Bank of Atlanta resolved that if
SEC registration was the determined course of action, it is their
request that the Finance Board adopt a regulation requiring it.
In response to those requests, at its regularly scheduled meeting
tomorrow the Finance Board will consider a proposed regulation
requiring each Bank to register a class of securities with the SEC
under Section 12(g) of the Securities Exchange Act of 1934.
The proposed rule provides for a lengthy, 120-day comment period,
during which, I hope, the Banks will each meet with the SEC to work out
the necessary details to effectuate registration and begin meeting the
periodic financial reporting requirements of the 1934 Act.
The focus of the enhanced disclosure effort from the start has been
to ensure that the Federal Home Loan Banks play their part, as
Government Sponsored Enterprises, in contributing to the smooth
functioning of the capital and mortgage finance markets. In the end,
consistent and full disclosures of these institutions' finances and
corporate governance also serve the public, who stand behind their
charters as Government Sponsored Enterprises.
Acquired Member Assets (AMA)
I have been asked to address two other issues in my testimony
today. The first of these concerns regulations governing the Acquired
Member Assets programs, or AMA, of the Federal Home Loan Banks.
The 12 Federal Home Loan Banks are authorized to purchase single-
family mortgages that do not exceed the conforming loan limit
applicable to Fannie Mae and Freddie Mac, currently $322,700. The
authority granted under the current rule (12 CFR Part 955) is an
expansion and refinement of previous authority that had been granted to
the Banks by a Finance Board resolution in 1996. That authority was
challenged in 1997, a challenge rejected by a U.S. District Court in
1998. The U.S. Court of Appeals for the Fifth Circuit upheld the
District Court's ruling in 2000, affirming the Finance Board's
authority in this area.
There are currently two AMA programs--Mortgage Partnership Finance
(MPF) and Mortgage Purchase Program (MPP). MPF is the older and larger
program. Under the current AMA programs, a Bank may purchase mortgage
assets from a member institution. The programs, like advances, provide
member institutions liquidity for mortgage lending. In AMA programs,
the member manages and bears a material portion of the credit risk.
Since the programs' inception in 1996, the Banks have purchased more
than 600,000 loans. Approximately 75 percent of those loans were
purchased under MPF and 25 percent under MPP. More than 95 percent of
the total loan acquisition has occurred since 2000, the current AMA
regulation having become effective on July 17, 2000.
On July 1 of this year, the Finance Board unanimously adopted and
published for comment a proposed revision to the current AMA
regulation. The Finance Board's intent is clearly stated in the
preamble to the regulation, that is, to make the regulation more
``effective and efficient in regulating the Banks' mortgage purchase
programs.'' In the rule, the Finance Board also seeks to clarify and
simplify the language of the current rule. The proposed regulation does
not expand or alter the fundamental structure of the AMA programs.
The proposed regulatory changes also maintain or strengthen many
appropriate safety and soundness provisions of the current rule, again
reflecting the Finance Board's continued emphasis on improving its
safety and soundness oversight of the Federal Home Loan Banks.
Safety and soundness provisions maintained or strengthened under
the proposed rule include requirements that:
All AMA must be at least investment grade when acquired by the
Bank.
The Bank must have in place a process and methodology to
determine the required credit enhancement prior to acquisition of
any asset and throughout the life of the asset on the Bank's books.
The Bank must take remedial action by requiring the member to
provide additional credit enhancement or hold additional capital if
the estimated credit rating of the asset declines to below the
rating required at time of acquisition.
Insurers must be rated AA or better to provide a portion of
the credit enhancement to the member institution selling assets to
the Bank.
Banks without risk-based capital structures in place must hold
retained earnings for losses as support for the credit risk
associated with any AMA estimated to be rated below AA.
In addition, the proposed regulation incorporates Finance Board
criteria previously set forth in the preamble of the July 2000 final
AMA rule outlining the circumstances under which Banks are permitted to
acquire from members highly rated interests in pools of mortgages as an
alternative to acquiring whole loans. Among the criteria is a
requirement that all loans backing such interests must themselves be
eligible for purchase by the Bank as AMA. As with any new AMA product,
a Bank is only allowed to acquire such interests after its proposed
program has been reviewed and approved under the Finance Board's New
Business Activity regulation.
The proposal further seeks comment on whether the Finance Board
should take measures to prevent a Bank from acquiring loans or assets
backed by loans, through its AMA program, where the loans have features
or were made under circumstances that may be considered predatory or
abusive. The proposal also asks for comment on whether and how to limit
Banks' authority to acquire such loans or assets backed by such loans.
The text of the proposed regulation maintains the current
prohibition on purchases directly from affiliates of member
institutions. In response to numerous
requests from members using affiliates and subsidiaries for mortgage
origination activities, the preamble does invite comment on changing
current policy to allow affiliates owned and controlled by members to
directly sell assets to Federal Home Loan Banks.
The importance of revising Finance Board regulations to better
reflect the Agency's supervision approach argues for a constructive
exchange among the interested public, Federal Home Loan Banks, and the
Finance Board. It appears, however, that some may have misunderstood
the intention of this proposed regulation.
As a result, in agreement with my fellow Directors, I will ask the
Finance Board to vote at its regular Board meeting tomorrow to withdraw
the present rulemaking. The proposed text will be revised and clarified
to more clearly enunciate the principles I listed above, and the
resulting proposed regulation will be voted on in a subsequent meeting.
If approved by the Finance Board, the revised proposed regulation will
be published for a 90-day comment period.
Multidistrict Membership
When I became Chairman of the Finance Board in December 2001, the
multidistrict membership debate was already over a year old, having
been prompted by regulatory requests filed in 2000 and 2001 by four
Federal Home Loan Banks that had lost large members to mergers with
institutions headquartered in other Federal Home Loan Bank districts. A
Solicitation for Comments on the issue was pending and remained open
until March 2002.
When Congress created the 12 Federal Home Loan Banks 71 years ago,
it anticipated that each member thrift institution would operate where
its collateral was located, and at that time, that meant in its home
State alone. The financial world, of course, has fundamentally changed
since 1932, as has the membership base of the Federal Home Loan Banks
now that membership is voluntary for all and open to commercial banks
and credit unions, as well as thrifts and insurance companies.
With the advent of interstate banking and national holding
companies, the Federal Home Loan Banks are operating in a different
competitive environment than existed through most of their history. For
Bank member institutions organized under certain holding company
structures, multidistrict membership already exists. One hundred three
holding companies, doing business in more than one Federal Home Loan
Bank district through separately chartered subsidiaries, currently
account for 451 distinct Bank memberships. Institutions that operate in
multiple regions through a single charter, however, are precluded by
Finance Board regulations from establishing similar operating
arrangements with more than one Federal Home Loan Bank.
Let me make clear that, while it is my view that the Federal Home
Loan Bank Act both empowers and obligates the Finance Board to continue
regulating the terms of Bank membership to the extent necessary to
ensure safe and sound operation of Banks, access by Banks to capital
markets, and achievement of the Banks' housing finance mission, I am
neither an advocate nor an opponent of expanding multidistrict
membership in the Federal Home Loan Bank System.
When I became Chairman, I asked the four Banks seeking regulatory
approval for multidistrict membership to withdraw their requests to
permit a thorough, comprehensive review of the changed financial
services industry and mortgage market circumstances that give rise to
the multidistrict issue. That review has occurred without producing any
compelling reason for the Finance Board to address the question of
expanded multidistrict membership on its own initiative.
My commitment to those Banks that withdrew their pending regulatory
requests, however, was that, when the review was complete, any Bank
seeking authority to admit as a full member an institution doing
business in that Bank's district but maintaining a charter and
membership in another Federal Home Loan Bank district would be afforded
an opportunity to make its case to the Finance Board and present its
recommended solutions to the various operational challenges its
proposal would raise. In June, in fulfillment of my commitment to those
Banks, I requested the Office of Supervision and the Office of General
Counsel to draft a proposed regulation establishing a process by which
the Finance Board could receive, review, and accept or reject such
applications, should any Bank choose to make one. No Bank, however, has
made any request to the Finance Board to proceed on multidistrict
membership, the draft proposal was never completed, and no further
Finance Board action establishing a procedure is planned.
Conclusion
Chairman Bennett, distinguished Members of the Subcommittee, I
close by returning to the very reason the Federal Housing Finance Board
exists: to ensure that Federal Home Loan Banks operate in a financially
safe and sound manner, carry out their housing-finance mission, and
remain adequately capitalized and able to raise funds in the capital
markets.
Since 2002, the Finance Board has dramatically improved its ability
to perform these statutorily mandated responsibilities. The Agency's
supervision function is stronger, more thorough, and more effective.
Taken in conjunction with the initiative to enhance the financial
disclosures filed by the Federal Home Loan Banks, I believe the Finance
Board is capably representing the interests of the public and taxpayers
who stand behind the Federal Home Loan Banks and who benefit from the
successful performance of the Federal Home Loan Banks' important role
in housing finance.
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PREPARED STATEMENT OF NORMAN B. RICE
President and Chief Executive Officer, Federal Home Loan Bank of
Seattle
September 9, 2003
Good afternoon Chairman, Ranking Member Johnson, and Members of the
Subcommittee. I am Norman B. Rice, President and Chief Executive
Officer of the Federal Home Loan Bank of Seattle.
I would like to thank Chairman Bennett and the Subcommittee for the
opportunity to provide my perspective on the unique and vital role the
Federal Home Loan Banks play in building strong communities and healthy
economies across America.
The 12 Federal Home Loan Banks have a long history of service and
accountability to the more than 8,000 financial institutions we serve,
to the millions of individuals and families we help realize the
American Dream of homeownership, and to the regulators and Congress who
oversee our system.
But it is not the history of our banks that I want to talk with you
about this afternoon. Where we have been and what we have accomplished
as a Bank System is significant and well documented. But my focus is on
the relevance of the Bank System today--and in the future--and the
critically important role we play on behalf of our financial
institution members, and the economic health of our country.
I will start with what I consider to be the most important element
of the Federal Home Loan Banks--we are a cooperative. Our members own
the Bank System, and we are accountable to them.
We are truly unique in that sense. By constructing the Home Loan
Banks as a cooperative, Congress ensured that all value and benefits
from the System are passed directly back to the member financial
institutions that are the lifeblood of small business, agriculture, and
neighborhood revitalization in this country.
These are the banks, credit unions, thrifts, and other institutions
that give communities critically needed access to credit; these are the
risk-takers whose leadership and resources build stronger towns,
cities, and, to a very real extent, a stronger Nation.
You can do that in a cooperative that provides each one of its
members--small and large--the same access to a stable, low-cost, and
reliable source of wholesale funding. In turn, you cannot do what we do
in a publicly traded company where your primary focus is building
investor value for tens of thousands of individual stockholders.
It works much differently in the Federal Home Loan Bank System. We
have a business relationship with each of our members--they are both
our owners and our customers. We know them by name. We understand their
individual market needs and the needs of their communities. They are
represented on our boards and provide the leadership of our 12 banks.
No other housing GSE or financial institution can replicate this
partnership of bank, member, and community.
At the Seattle Bank, we like to use the term ``rock solid'' to
characterize our organization and the business relationship we have
with our members. It conveys a sense of accountability and commitment
to our cooperative, and the unwavering belief that a member's
investment is being managed for the long-term, not just quarter to
quarter. That is how our member financial institutions see us--as a
safe, sound partner they can use to more effectively manage their
balance sheets--in good economic times and bad--for the purpose of
better serving their local customers and communities.
Within the cooperative structure of the Bank System, it is also
important to understand the profile of our membership. The overwhelming
majority of our member financial institutions are smaller, community-
based companies. Our typical member has about $110 million in assets,
almost half of our members are located in rural areas, and most are
independently owned.
We also serve the Nation's largest lenders. Our Congressionally
mandated mission is to make bank credit available for our local
communities. Given the realities of the financial services industry,
which has consolidated enormously, it would simply be impossible to
fulfill our mission unless we also supported the largest lenders who
now account for a vast amount of lending activity. For example, the top
three U.S. lenders now account for 37 percent of all home mortgage
originations. The top 30 originators account for 60 percent of all loan
originations.
As you can see, the Bank System cooperative is a place where
financial institutions of all sizes share mutual interests and share
mutually in the benefits of their joint enterprise.
As I sit before you today, the Federal Home Loan Banks and the
housing GSE's are facing significant challenges and changes regarding
their business practices, regulatory structure and mission-based
programs and activities.
There is much to discuss and determine in the coming months, and
potentially much at stake for financial institutions, businesses,
homebuyers, and the American economy.
As this Subcommittee and other Members of Congress consider the
future of the Federal Home Loan Banks and the housing GSE's, you will
no doubt be inundated with recommendations and solutions from many
people representing many of the constituencies that have come before
you today.
As a former public policymaker, I remember that process all too
well. But in place of recommendations and solutions, I would like to
offer you two things today: Some baseline questions and principles to
consider in your discussions in the weeks and months ahead, and clear
evidence of the powerful impact the Bank System has on our country's
financial services industry, our communities, and our economy.
First, two questions that I believe appropriately frame the issues
now before Congress regarding our Bank System and housing GSE's.
What are the benefits and risks that the housing GSE's present
to taxpayers?
How are the risks best managed?
Over the course of any week in my job, I am asked by a number of
people what the Federal Home Loan Bank of Seattle is, and what it does.
For those not involved in the banking and financial services industry,
our system is, for the most part, unknown. So, I am always pleased to
provide some quick education, and pleased because of the answer I am
able to give: We help ensure that Americans have homes and healthy
local economies.
How do we do that? By connecting financial institutions of all
sizes to the capital markets. This provides our member banks with a
stable source of lower-cost funds that they use in their own
communities to support homebuyers, businesses, and farmers.
But perhaps an even better way to illustrate the benefits of the
Bank System is to imagine our country without the 12 Home Loan Banks.
Consider the following:
In 2002, the Bank System extended nearly a half trillion
dollars in advances (what we call loans) to our member financial
institutions, strengthening local economies, and increasing
homeownership. Imagine those dollars gone.
Since 1991, the Federal Home Loan Banks have awarded $1.6
billion in Affordable Housing Program grants, helping to create
360,000 low-income housing units across the country. Each of our 12
Banks annually provides 10 percent of their net income for
affordable housing. Last year, that totaled about $200 million.
Imagine those dollars gone.
In 2002, the Bank System provided nearly $9 billion in
reduced-rate, long-term Community Investment Program (CIP)
advances, used by our member financial institutions to finance
commercial and economic development initiatives that benefit low-
to moderate-income families and neighborhoods. Since CIP began in
1990, our Banks have issued nearly $36 billion in reduced-rate
loans. Imagine those dollars gone.
Now imagine the collective impact on our national economy, not to
mention individual business owners, homebuyers, and farmers.
Ask yourselves who would provide the bank credit to support your
local economies? How would your local bank compete if they did not have
access, through their regional Home Loan Bank, to the capital markets?
Where would these institutions turn, in good times and bad, to meet
loan demand despite the outflow of consumer deposits from the banking
system? Where would your constituents go to get loans to buy homes and
run their businesses?
Now go one step further: If the housing GSE's did not exist today,
what would Congress put in their place? I believe you would come back
to something that looked a lot like the Federal Home Loan Bank System.
Here's why:
The Bank System is funded entirely through private capital.
The cooperative is built by private owners who have put more than
$36 billion of their own money at risk to capitalize the Bank
System.
The Bank System is cooperatively owned to support--rather than
compete with--the private marketplace. Our stock is not publicly
traded. We are not driven by an imperative for double-digit growth
to meet expectations of the stock market. We do not have third-
party investors pulling value out. Every dollar of value created by
the Bank System is poured back into the housing finance system,
ultimately benefiting your constituents, the consumers of bank
credit. Those are bank owners, business owners, farmers,
homebuyers, nonprofit housing corporations, neighborhood social
service organizations, municipalities, and many, many others.
The Bank System has the capacity to innovate and keep pace
with an evolving financial services industry. This is why the Bank
System offers mortgage purchase programs. Our members have told us
they can better serve homebuyers and local markets if there is more
competition in the secondary mortgage markets. It is no accident
that our System's program volume has accelerated from zero to
almost $100 billion. Without question, there is a private-market
demand for competition, and we believe that competition is
healthy--it is good public policy. And it is equally important to
remember that when programs such as these boost earnings and
profitability in our banks, that provides more funding for
affordable housing and economic development in our communities. At
the Seattle Bank last year alone, our Mortgage Purchase Program
generated $1.75 million in additional AHP subsidies. My point here
is, you cannot disconnect profitability and mission with the Bank
System.
The Bank System is organized by region, ensuring that each
bank is connected and responsive to local markets. Twelve Home Loan
Banks were created to focus on local markets, to know their local
member financial institutions and create products and services that
meet their customers' needs and the affordable housing and economic
development needs of their communities.
The Bank System pays its fair share of taxes. The Home Loan
Banks carry a special tax burden that cannot be sheltered and is
equivalent to a Federal corporate tax rate. The Bank System has
been required, since 1989, to pay off the REFCORP debt and provide
10 percent of its net income in support of low-income housing. This
is the single-largest private source of housing subsidy in the
United States.
The Bank System is a reliable source of liquidity through all
parts of the economic cycle. This is the primary reason why
financial institutions join the Bank System. They rely on our
capacity to access the capital markets on their behalf. That is
why, even in a down economy, demand for advances across all of our
banks has reached nearly a half trillion dollars.
As you can see, it is not a difficult task for me to list the
benefits provided by the Bank System. Over the last 70 years, the 12
Home Loan Banks have consistently proven their relevance to our members
and their communities.
The harder question--especially in today's environment--is whether
or not the risks are being managed appropriately. While it is one thing
to say our advance and mortgage purchase programs drive profitability
and support mission-based programs and activities--which they do--it is
quite another to ensure that the risks inherent in those programs are
being managed appropriately.
My colleagues testifying on this panel today will address other key
issues regarding the Bank System, including risks associated with
financial management, governance, and regulatory oversight.
Just as I have noted some attributes and principles that should
underlie a modern housing GSE, I would like to also articulate some
basic principles as you consider GSE oversight going forward.
First of all, it would be disingenuous of me or anyone else to
state that the Home Loans Banks and other housing GSE's are far bigger
and more complex, and therefore should be held to different risk
standards. Clearly, the bar has been raised across the financial
services industry in this regard.
While history proves that we have done a great job for a long
time--not a single credit loss against advances since the inception of
the Bank System in 1932--I also understand this is 2003, not 1932, and
much more must be done. Your constituents and ours are demanding the
highest levels of accountability, and we must deliver on that.
On the matter of consolidation of the GSE regulators: Whether or
not Congress determines that a single GSE regulator is the appropriate
direction or not, all three housing GSE's must have strong regulatory
oversight to ensure both safety and soundness and mission achievement.
There can be no debate on that point.
The fact is that the three housing GSE's must manage many of the
same risks, and we share a common mission--to support homeownership by
providing the funding and the tools the Nation's housing lenders need
to be successful. That means it is time to straighten out the
hodgepodge of inconsistent requirements and oversight of the housing
GSE's.
For example, why do two housing GSE's have lower capital
requirements than the Home Loan Banks that demonstrably carry less
credit risk? Why is there inconsistent mission oversight--with the Home
Loan Banks delivering cash grants, while the other housing GSE's hit a
different set of affordable housing goals?
What public policy goal is advanced when roadblocks are put in
front of our Bank System when we respond to our members' stated desire
to have greater competition in the secondary mortgage market? And when,
in fact, those roadblocks actually hinder our ability to drive more
funding to our member financial institutions and their communities? I
have heard it called ``mission creep.'' From my point of view, it is
more like ``mission leap''--it allows us to take more significant steps
toward fulfilling our mission, not walking away from it.
While it is often frustrating to me that the Bank System's mission
and impact is understood by so few, I think it is apparent that this
Nation and your constituencies--our financial institutions and local
communities--would struggle mightily if we failed to do our job.
Today, as one of 12 presidents within the Federal Home Loan Bank
System, I stand committed to work with you to find better ways to serve
the ever-changing needs of the financial services industry and our
communities.
I want to be clear that I believe the onus for strengthening our
system lies not only with Congress and regulators, but with the Home
Loan Banks themselves. We must further step up and accept the risks in
our system and industry, and accept that more intense public oversight
is inevitable. We welcome that public oversight because, if done
smartly, it will strengthen our Bank System and, ultimately, the
economy of this country.
In closing, I would like to leave you with some principles that I
believe should inform your discussions and decisions in the months to
come:
Private capital is the most effective cushion to guard the
public against the risks inherent in our enterprises. As
cooperatives, the Home Loan Banks are capitalized by their
customers, who are risk-averse, and who monitor risk-taking in a
way that third-party shareholders cannot.
Insist on competition among housing GSE's rather than
competition with the private financial services industry.
Demand that more of the value created by the housing GSE's be
delivered to the housing finance system and consumers rather than
private investors.
Demand consistent, strong and smart regulatory oversight for
all housing GSE's--and recognize the critical differences between
the Bank System and publicly traded housing GSE's.
Demand an intense focus on our mission, hold us accountable,
and keep in mind what America would look like if the Home Loan
Banks did not exist.
Mr. Chairman, this concludes my written remarks. Thank you, again,
for allowing me the opportunity to speak with you today. I would be
happy to answer any questions you or other Members of the Subcommittee
may have.
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PREPARED STATEMENT OF MICHAEL MIDDLETON
Vice-Chairman, Federal Home Loan Bank Atlanta
Chairman and CEO, Community Bank of Tri-County, Waldorf, MD
September 9, 2003
Good afternoon Chairman Bennett, Senator Johnson, and Members of
the Subcommittee. Thank you for the opportunity to appear before you
today to discuss something that is very important to my business and to
my community--the Federal Home Loan Bank System. I am Michael
Middleton, Chairman and CEO of Community Bank of Tri-County, in
Waldorf, Maryland. I serve as Maryland's elected Director on the
Federal Home Loan Bank of Atlanta's Board of Directors and am honored
to serve as the Vice-Chairman of that Board. I am also a Member of the
Board of the Council of Federal Home Loan Banks.
I am pleased to testify today on behalf of the Atlanta Bank. I am
Chairman and CEO of a bank that is a member and long-time user of
Federal Home Loan Bank advances, as well as other products,
particularly in the community investment area. I believe this
experience, together with my 5 years of service on the board of the
Federal Home Loan Bank of Atlanta, gives me a broad perspective on the
Federal Home Loan Bank System that I hope can provide helpful insight
to the Subcommittee.
Community Bank of Tri-County has over $300 million in assets and is
a true community bank serving southern Maryland. Our customer base
draws from a broad economic range and includes rural, agricultural,
small business owners, and the families employed by high tech companies
that support three naval facilities. We try to tailor our services and
products to meet the needs of our communities while competing with
large regional and national financial institutions.
At my bank, we take our Community Reinvestment Act responsibilities
very seriously. Moderate to smaller-sized community banks are
increasingly challenged in meeting their CRA requirements. The
FHLBank's programs, explained in greater detail below, provide us with
the tools and skills to fulfill this statutory and community
responsibility. The FHLBank System helps level the competitive playing
field in many ways, enabling Community Bank to continue to be part of
the economic foundation of southern Maryland.
Background
As you may be aware, the 12 Federal Home Loan Banks are Government
Sponsored Enterprises that were created and organized under the
authority of the Federal Home Loan Bank Act of 1932. Congress created
the Federal Home Loan Banks to stabilize and improve the availability
of funds to support homeownership. Although initially capitalized with
Government funds, member banks, like mine, have contributed all the
Federal Home Loan Banks' capital for over 50 years. The Federal Home
Loan Banks have provided over 70 years of innovation and service to the
U.S. housing market, and currently have over 8,000 member institutions.
The Federal Home Loan Banks and their members (federally insured
savings associations, commercial banks, credit unions, and some
insurance companies) are the largest source of residential mortgage and
community development credit in the United States. Federal Home Loan
Banks increase the lending power of local financial institutions.
Thanks in large part to the work of Senators Hagel, Johnson, and Bayh
to include Federal Home Loan Bank modernization in the Gramm-Leach-
Bliley Act, the Federal Home Loan Banks help community financial
institutions provide critical small business, community development,
rural and agricultural loans, as well as residential mortgages. I
believe it is important to note, Senators, that the Federal Home Loan
Bank System is the only institution in the United States that fulfills
this mission.
The Federal Home Loan Banks are very different from the other
housing GSE's. They are unique in that they are cooperatives that are
jointly and severally liable for the consolidated debt issued through
the Office of Finance as their agent. As cooperatives, only member
institutions own the capital of each Federal Home Loan Bank. There is
no publicly traded stock and no established marketplace for the Federal
Home Loan Banks' capital. Further, there is no market pressure on the
price of the capital stock; it is always bought and sold at par. While
the Federal Home Loan Banks are not the only cooperatives, nor are they
the only institutions that operate with joint-and-several liability, no
other housing GSE or private sector financial institution plays the
same economic role or operates under the same overall structure as the
Federal Home Loan Banks.
It is the task of the Federal Home Loan Banks to maintain a balance
between their public policy mission and their obligation to provide
adequate returns on the capital supplied by their members. They do this
by providing a stable, low-cost, and reliable source of short- and
long-term funding. For many Federal Home Loan Bank members that are
small- or medium-sized community banks, direct borrowing in the capital
markets is not a viable option. With the disintermediation of our
deposits to Wall Street during the 1990's, a gap in funding during the
last economic expansion proved the value of the FHLBanks in assisting
us in meeting the credit needs of our local market. By providing a
necessary source of wholesale funding to help members manage liquidity,
loan demand, and interest rate risk, the Federal Home Loan Banks enable
us to remain independent and continue as an economic engine in our
community. Between 1994 and 1999, approximately 30 percent of all
wholesale funding used by banks came from the Federal Home Loan Bank
System.
As regional institutions, each Federal Home Loan Bank develops its
programs in response to the needs of its membership. For example, in
response to member demand, the Federal Home Loan Bank of Atlanta
provides its members a competitive alternative to the traditional
residential secondary mortgage market through two acquired member asset
(AMA) programs, Mortgage Partnership Finance,' and Mortgage
Purchase Program. These AMA programs provide medium- and smaller-sized
institutions with another financial tool in delivering competitive
credit products. Like the advance programs, the AMA programs help level
the competitive playing field.
Reflecting the Federal Home Loan Banks' cooperative nature, the
financial strategies of the Federal Home Loan Banks are designed to
enable them to expand and contract in response to their members' credit
needs.
Federal Home Loan Bank Programs--How They Meet Their Mission Locally
My bank relies on the Federal Home Loan Bank of Atlanta and its
programs to deliver financial services to our communities. Like much of
the country, our area needs more affordable housing. The price of
housing continues to rise and demands for land limit the availability
of workforce housing throughout our local market. Our major population
centers are growing, resulting in greater need for improved medical,
school, and volunteer fire/rescue support facilities. The Federal Home
Loan Banks are often an invisible, but vital, partner in fulfilling
these needs. We use the FHLBank to provide the critical first layer of
support upon which many layers of private and public support are built
to bring about new affordable housing and/or community growth.
Community Bank has partnered with a number of nonprofit Community
Development Corporations to support affordable housing and
infrastructure development projects through programs offered by the
Federal Home Loan Bank of Atlanta. These include the Affordable Housing
Program (AHP) and the Economic Development and Growth Enhancement
(EDGE) Program. By using AHP, EDGE, and other similar programs,
community banks like mine can make affordable housing and community
development projects economically feasible.
A good example of this is the Yardley Hills project in Calvert
County, Maryland. That project utilized over $2.7 million in complex
layered funding made available by participation in the Federal Home
Loan Bank of Atlanta's Affordable Housing Program. In another project,
we used the EDGE loan program to provide the Jarboe Family Head Start
Center in St. Mary's County, Maryland with permanent funding when other
traditional banking sources of large regional banks became unavailable.
Federal Home Loan Bank Community Investment Programs have allowed
us to partner with the USDA to provide single-family homeownership to
very low-income families with structured funding and first time
homebuyer funds.
Finally, for one of our community's volunteer fire/rescue needs, we
obtained a $2,000,000 Economic Development Program advance to provide
permanent financing for a new firehouse located in a low-income
community in La Plata, Maryland.
Senators, these projects and hundreds of others like them would not
have been economically feasible without the programs of the Federal
Home Loan Bank. They enable community banks to meet those credit needs
that often would go unmet by larger nonlocal banks. It is also
important to point out that the Federal Home Loan Banks provide the
training and technical assistance that teach smaller institutions to
use these programs--training that would otherwise be too expensive for
or unavailable to community banks.
The examples I have given with respect to my bank describe in part
the distinctive role played by the Federal Home Loan Banks in housing
finance. They make loans, called advances, to their members on the
security of mortgages and other eligible collateral. Federal Home Loan
Bank advances directly support our housing markets, including those
focused on low- and moderate-income households, as well as all aspects
of community development critical to the creation of jobs.
Federal Home Loan Banks also help their members provide other
needed forms of community development credit. Since the passage of the
Gramm-Leach-Bliley Act, Federal Home Loan Banks may now allow
``community financial institutions'' to pledge as collateral for
advances small business, small farm, and small agribusiness loans.
Expanding the types of eligible collateral that smaller financial
institutions may pledge serves a number of purposes. Many smaller
institutions, particularly in rural areas, have faced funding needs but
have not had sufficient residential mortgage collateral to secure
FHLBank advances. Expanding the eligible forms of collateral for these
institutions will help them meet these funding needs. With the help of
the Federal Home Loan Banks, small local financial institutions may now
better serve the community development credit needs of their areas.
As I indicated earlier in my testimony, the Federal Home Loan Banks
also help members meet their Community Reinvestment Act (CRA)
responsibilities. They do this through programs such as the Affordable
Housing Program (AHP), the Community Investment Program (CIP), EDGE,
and others. These programs give members access to subsidized and other
low-cost funding for affordable housing and community development
projects that benefit low- and moderate-income neighborhoods.
By supporting their member institutions, the Federal Home Loan
Banks also strengthen their communities. Each Federal Home Loan Bank is
required, by law, to allocate 10 percent of its net income to
affordable housing programs. The funds provided under this program are
grants and loans. Last year, the Federal Home Loan Banks contributed
$199 million to the AHP. Since the program's beginning in 1990, the
Federal Home Loan Banks have set aside approximately $1.7 billion in
AHP subsidies, helping to create 360,000 units for low-income families.
The Federal Home Loan Banks collectively are the largest source in the
Nation of private funding for affordable housing.
The Federal Home Loan Banks also have established a number of other
housing and economic development initiatives for their members. These
programs are funded voluntarily by the Federal Home Loan Banks separate
from AHP. The Federal Home Loan Bank of Atlanta has established a
predevelopment fund that offers recoverable grants to help finance
predevelopment expenses associated with affordable housing and economic
development projects. The Atlanta Bank also offers a training and
technical assistance initiative for community development corporations
serving the neighborhoods surrounding Historically Black Colleges and
Universities, as well as a subsidized loan program called EDGE,
mentioned earlier in this testimony, to finance targeted community
economic development projects. In addition, FHLBank Atlanta also offers
both an at-cost advance program to help members finance loans for
economic development activity, and a fund to provide matching equity
investments for members investing in New Market Tax Credits.
In addition to examples cited earlier involving my bank, EDGE loans
have helped finance a childcare center serving low-income families in
Tuscaloosa, Alabama. Training and technical assistance supported by the
Federal Home Loan Bank of Atlanta in North Carolina enabled Elizabeth
City State University, a Historically Black University, to obtain
financing through the Bank's Affordable Housing Program for the
rehabilitation of owner-occupied units damaged by Hurricane Floyd.
Other Federal Home Loan Banks have customized programs as well--
programs like assistance to potential minority-homebuyers; first-time
low-income homebuyer programs; various predevelopment and affordable
housing capacity initiatives; flood
relief assistance programs; and rural technical assistance programs to
help communities address unmet affordable housing needs by establishing
rural housing partnerships.
I strongly believe that the Federal Home Loan Bank System is able
to provide the important benefits it does because of its dynamic
membership of large and small institutions and its regional,
decentralized, cooperative structure. And, I can say
unequivocally that without the Federal Home Loan Banks and the programs
they provide, it would be far more difficult for my bank, and the
thousands of other community banks to remain independent, competitive,
and capable of extending important housing and community development
credit.
FHLBank and Director Responsibility
I have discussed the role of the Federal Home Loan Banks in meeting
their mission of providing competitive funding to their member
financial institutions to increase the availability of funds for
residential and community development lending. I have given you
examples of why the Federal Home Loan Bank System is so vital for
community banks like mine. As I stated earlier, I am also an elected
Member of the Board of Directors of the Federal Home Loan Bank of
Atlanta, and that role imposes additional important responsibilities.
As a director, I know that the Federal Home Loan Banks have
obligations in addition to the mission of being a creative funding
source for the extension of residential and community development
credit. The Federal Home Loan Banks, although being exempt from
Federal, State, and local taxation, are required to make payments to
the Resolution Funding Corporation (REFCORP) and the Affordable Housing
program (AHP). Those mandatory contributions are equivalent to a 26.5
percent effective income tax rate.
The Federal Home Loan Bank of Atlanta and its board of directors
support the Administration's position that the housing GSE's should
provide complete and transparent financial disclosures that constitute
``best of class.'' That is why we, along with the other FHLBanks, have
been working on these issues with all relevant parties to resolve the
specific issues presented by the FHLBanks' statutory mission,
cooperative structure, and joint and several liability.
As a director, I want the Atlanta Bank to meet the highest
standards of disclosure. At the same time, as a director, I have an
obligation to all the other member/owners to be certain that such
disclosures are not administered in a manner that could impair the
mission, operations, or increase the cost of funds of the Bank. If, as
a director, I agree to voluntarily register the Bank's equity with the
SEC, not only do I assume additional personal civil and criminal
liabilities under the relevant statutes, but I also assume liability
for my decision to voluntarily register. In conducting my fiduciary
duty as a corporate director consistent with the Business Judgment
Rule, I must believe that all critical issues have been satisfactorily
resolved and sustainable agreements reached before I, as a director
representing the shareholders of the Bank, am permitted to agree to
such action.
Just one example of the outstanding issues is how joint and several
liability will be handled. The Federal Home Loan Banks have always been
jointly and severally liable for each other's debt. Under SEC
registration, it is possible that each Federal Home Loan Bank could
have to create an additional on balance sheet liability reflecting the
``fair value'' of such liability for the combined debt of all the
FHLBanks. Critical accounting issues like this and others must be
effectively resolved in a manner that all the Federal Home Loan Banks
can rely on going forward without the threat of quarter-to-quarter or
year-to-year reconsideration upon each SEC filing.
Contrary to popular misconceptions, the Federal Home Loan Banks are
privately capitalized by their members and do not receive any taxpayer
assistance to operate. The Federal Home Loan Bank System debt is not
guaranteed by the Federal Government, and does not constitute an
obligation of the United States. The Federal Home Loan Banks have
operated since 1932 to help bring needed credit to the members and
communities they serve. And they have done so in a safe and sound
manner. The Federal Home Loan Banks are required by statute to obtain
sufficient collateral on advances to protect against losses, and to
accept only certain collateral on their advances. Consequently, no
Federal Home Loan Bank has ever experienced a credit loss on an
advance. At the end of 2002, for example, the Federal Home Loan Banks
had rights to collateral, either loans or securities, on a member-by-
member basis, with an estimated fair market value in excess of
outstanding advances.
The resources and services provided by the Federal Home Loan Banks
to their member institutions play a key role in the continued success
of our Nation's housing market. They play a key role in serving the
financial needs of our local communities. Without the Federal Home Loan
Banks, it would be far more difficult for our Nation to achieve these
objectives.
Thank you for the opportunity to appear before you this afternoon.
I would be pleased to answer any questions that you may have.
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PREPARED STATEMENT OF SHEILA C. BAIR
Dean's Professor of FinanciaL Regulatory Policy
Isenberg School of Management, University of Massachusetts
September 9, 2003
Chairman Bennett, Senator Johnson, Members of the Subcommittee, it
is a pleasure to appear before you today to assist you in your
oversight of the Federal Home Loan Bank System. A strong housing market
is among the Nation's top economic priorities, and the Federal Home
Loan Bank System is an indispensable component of that market. When the
Hoover Administration developed the blueprint for the System in the
throes of the Great Depression, it was based on the premise that this
cooperative was needed to assure a constant flow of funding when
deposits proved inadequate due to national or regional economic
conditions. Seventy years later, with over $500 billion in FHLB
advances outstanding, the underlying premise for the System remains
valid. The Federal Home Loan Banks play a vital role in mortgage
finance and deserve to be continued and strengthened.
Challenges Confronting the System
It is in the spirit of System supporter that I come to you this
morning to raise three issues that I believe warrant your attention:
Multidistrict membership, expansion of the System's mortgage
acquisition programs, and lack of SEC registration of FHLB securities.
These issues are important because their resolution will help determine
the future of the system and its long-term stability. They were
examined in detail in a paper I recently completed that was funded by a
grant to the School of Management from the Fannie Mae Corporation,
which I would like to submit for the record. The conclusions reached in
the paper are my own, and do not reflect the views of the research
sponsor. After discussing my paper, I will make some general
observations about the FHLB System's regulatory structure in relation
to efforts underway to improve safety and soundness regulation of
Fannie Mae and Freddie Mac.
Multidistrict Membership
Recent industry consolidations have prompted some to call for
allowing members to belong to more than one district FHLBank.
Throughout the System's history, no single institution has ever been a
member of more than one district bank and the System's authorizing
statute leaves little doubt that this is what Congress intended. The
Federal Housing Finance Board's (FHFB) efforts to allow multidistrict
membership by regulation have been highly controversial, supported by
only 5 of the System's 12 district banks. Four of the FHLBanks are
strongly opposed, with the remaining three undecided and expressing
serious reservations.
My primary objection to multidistrict membership is that Congress--
not the FHFB--should decide whether such a fundamental change should be
made to the System's historic regional and cooperative structure. I am
also concerned that multidistrict membership could have a destabilizing
influence on the System. Multidistrict membership would allow large
institutions to ``shop'' their advance activity among multiple
FHLBanks, but because all the FHLBanks raise funds in the same way,
their ability to compete based on price will be limited. As a
consequence, they will likely compete on collateral and credit
standards. In addition to diminution of credit quality, allowing one
member to have multiple relationships with FHLBanks would increase
operational risk since the System lacks safeguards to obviate the
multiple pledging of collateral or the prospect of competing blanket
liens. Moreover, allowing multiple memberships could increase large
borrower activity in the System as a whole, thus exacerbating large
borrower concentrations. Nearly 24 percent of all advance activity is
already concentrated in the System's 10 top borrowers.
Multidistrict membership would, by definition, help only
institutions large enough to take advantage of it, and fundamentally
alter the basic concept of the System--a cooperative of regional banks
existing to serve the funding needs of institutions headquartered in
their districts. Moreover, given the seismic consolidation activity
that occurred in the 1980's--which the System weathered quite well--it
is difficult to see why current consolidation activity should provide
the impetus for such a dramatic restructuring. Under a holding company
structure, separately chartered subsidiaries have been able to hold
memberships in different banks--the same arrangement commercial banks
have with the Federal Reserve Banks--which maintains consistency with
the Federal Home Loan Bank Act and the regional character of the
System.
The Mortgage Acquisition Programs
The second issue I examined--expansion of the System's mortgage
acquisition programs--also primarily benefits the System's largest
members. Begun in 1997 as a small pilot capped at $750 million, these
programs have grown exponentially. The System now holds $90 billion
worth of mortgages in portfolio, representing over 10 percent of its
assets. One FHLBank now has half its assets invested in mortgages and
only one-third of its assets in advances, the business activity that
Congress assigned it.
There is nothing in the System's legislative history or authorizing
statute that grants authority for direct mortgage purchases, and the
other two major housing GSE's, that is, Fannie Mae and Freddie Mac were
established and chartered by Congress expressly for that purpose.
Congress, not the individual FHLBanks or the FHFB, should decide
whether it wants the System to be a major player in the secondary
mortgage market, and if so, the terms and limitations that should
apply.\1\
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\1\ Congress placed specific limitations on Fannie Mae and Freddie
Mac regarding capital, safety and soundness, and mission requirements.
However, since Congress never authorized the FHLB System to enter the
secondary mortgage market, it did not specify the limitations that
should apply.
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The risks associated with mortgage acquisition are distinctly
different from those associated with the System's traditional role of
making fully collateralized advances. Advances have prepayment
penalties and call features that allow the FHLBanks to effectively
manage their interest rate risks. Different, more complex tools are
needed for the interest rate/prepayment risk presented by mortgages
held in portfolio. Operational risk is also significant--there is a
serious question as to whether the System has sufficient numbers of
qualified staff or infrastructure needed to manage even the day-to-day
risk associated with secondary mortgage market participation. The
staffs of each FHLBank and the Office of Finance are relatively small,
and they are trained in the traditional business of advances, not
mortgage acquisition and portfolio management. Regarding credit risk,
the mortgage acquisition programs' proponents boast that the
originators--not the FHLBanks--retain the credit risk. In truth, the
originators provide credit enhancements that are only as good as the
FHLBanks require them to be based on their own interpretation of
historical default data, which again, is outside their traditional
mission and expertise. It is also telling that a recent FHFB proposed
rulemaking--now withdrawn--would have eliminated one of these programs
most important tools in managing credit risk--the
requirement that pools of purchased mortgage assets achieve an
investment grade rating from an independent ratings agency.
No adequate public policy basis has been advanced for the System's
foray into this new, riskier line of business. Though promotional
materials for the programs claim that they are designed to help smaller
institutions, available data suggests that they are being run
overwhelmingly for the benefit of large originators. According to trade
journal reports, the top five mortgage originators sold $42.7 billion
in mortgages to the FHLBanks in 2002.\2\ Assuming the accuracy of this
report, these five institutions would account for almost all of the
$45.7 billion dollars in FHLBank mortgage acquisitions in 2002. If
Congress wishes to authorize yet another GSE entry into the secondary
mortgage market, it should assure itself there is a valid public policy
basis to do so. Meeting legitimate market needs of smaller, community-
based institutions might be one justification. Enriching large mortgage
originators is not.
---------------------------------------------------------------------------
\2\ Inside the GSE's (April 2, 2003), at p.6; 2002 FHLBank System
Annual Report at p.22.
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SEC Registration
In my paper, I also concluded that voluntary SEC registration would
be in the best interests of the System and its debtholders. I will not
belabor the arguments, because Assistant Secretary Abernathy has
already eloquently stated them in his testimony. Suffice it to say,
voluntary SEC registration would enhance the image of the System and
demonstrate that the FHLBanks are committed to a policy of full
disclosure.
Thoughts on Regulatory Structure
Questions about the capability of the System to manage new risks
associated with multidistrict membership and mortgage acquisition
programs are heightened by longstanding weaknesses in the FHFB
examination process, identified by the Government Accounting Office
(GAO) in 1998 and again in 2002. Though the FHFB has taken a number of
steps to address these weaknesses, including increasing the number of
examiners and putting greater focus on major risks and the quality of
controls at FHLBanks, the GAO found in a report released last February
that it is still too soon to evaluate the effectiveness of these
measures. As of February 2003, the FHFB had only 14 examiners, with
plans to increase the total number of examiners to 24 by the end of
2004. According to its fiscal year 2003 budget, only $9.7 million of
its $27 million budget was allocated for the Office of Supervision. By
way of comparison, Treasury's two bank regulatory bureaus--the Office
of the Comptroller of the Currency (OCC) and the Office of Thrift
Supervision (OTS) will typically assign teams of 20-30 examiners to
each of its largest institutions, and will spend 70-80 percent of their
budgets in direct support of supervision.
More fundamentally, the structure of the FHFB suffers from many of
the same defects now being scrutinized at the Office of Federal Housing
Enterprise Oversight. It is a small, low-profile agency that simply
cannot attract and retain the quality of staff that it needs. It exists
outside the financial regulatory mainstream, and thus does not benefit
from the, routine day-to-day interaction that occurs among the major
bank regulatory agencies. It is responsible for only 12 Banks, plus the
Office of Finance--a narrow constituent base that creates the
perception of ``captive regulator.'' Other major financial regulators
have a much broader regulatory base, and their actions are generally
reflective of the views and interests of diverse and competing
constituencies. For instance, bank regulators are constantly mediating
differences between large and small banks, those with different
business lines, geographic concentrations, or customer bases. This in
turn enhances the credibility and quality of regulatory decisionmaking.
When a regulator's jurisdiction is confined to a small group of closely
aligned institutions, the pressure and input it receives can become
narrowly focused and one-sided. It becomes difficult for the regulator
to stay objective and ``above the fray.''
Should a new agency be created at the Treasury Department for
oversight of Fannie Mae and Freddie Mac, I believe it would be a
stronger agency if it also included oversight of the FHLB System. The
new regulator would have a bigger, better view of the housing finance
market and would be in a better position to evaluate the advantages--
and dangers--of the major housing GSE's competing directly with each
other in the same lines of business. From the standpoint of systemic
risk and taxpayer exposure, it is just as important to the Government
for the FHLB System to have quality safety and soundness oversight as
it is for Fannie and Freddie. At year-end 2002, the System had $668
billion in outstanding debt, compared to Fannie's $884 billion and
Freddie's $644 billion. It enjoys the same implied government
guarantee, with an even more generous line of credit from the U.S.
Treasury. Though unlikely, a widespread failure in the System could
have staggering ramifications for U.S. taxpayers and the housing
market.
Some have argued that the FHLBanks would be overwhelmed by the
other two politically powerful GSE's if their oversight were to be
housed in the same agency. I do not believe it. With their longstanding
community bank ties, and extensive grass roots, I have no doubt the
FHLBanks can hold their own. I have also heard it argued that the
Treasury Department would be hostile to the System, which I can say
from first hand experience is not the case. On the contrary, I believe
the Treasury respects the role of the System in the housing finance
market and would not do anything to disrupt it.
The competitive impact on FHLB funding costs should also be weighed
in the balance when considering whether to merge the FHFB into the new
agency. The creation of a credible, high quality GSE regulator within
the Treasury will likely
receive a positive reaction in the capital markets, which could reduce
Fannie and Freddie's funding costs. If the FHLB System is left out,
that could widen spreads between FHLBank securities and those issued by
the Enterprises. Wider spreads would in turn mean a higher cost of
funds for the FHLBanks, which would adversely impact the price of
advances and other FHLBank services.
Conclusion
Strong momentum is building for the creation of a credible, high
quality regulator within the Treasury Department to replace OFHEO. Now
would be a propitious time for the Congress to consider whether
oversight of the FHLB System should also be placed under this new
regulator. To be sure there are important policy determinations that
Congress needs to make regarding the FHLB System's mission and future,
and it is important not to impede the momentum behind the transfer of
OFHEO's safety and soundness functions. However, concurrent action
could assure quality regulation of all three major housing GSE's, and
prevent a widening of spreads, which could further weaken the System.
Thank you Mr. Chairman. I will now be happy to answer any questions
you may have.
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PREPARED STATEMENT OF TERRY SMITH
President and CEO, Federal Home Loan Bank of Dallas
September 9, 2003
Mr. Chairman, Ranking Member Johnson, and Members of the
Subcommittee, I appreciate the opportunity to speak to you today about
the Federal Home Loan Banks. My name is Terry Smith, and I am President
and CEO of the Federal Home Loan Bank of Dallas. I am also the current
Chairman of the Bank Presidents Conference of the Federal Home Loan
Banks (FHLBanks). Along with my colleagues, I am pleased to provide an
update on the FHLBanks' activities and our progress implementing the
FHLBank provisions of the Gramm-Leach-Bliley Act (GLB Act).
Overview of the FHLBanks
The FHLBanks were created in 1932 to support America's housing
finance system. It was largely the FHLBanks' ability to raise long-term
debt in the capital markets and pass that funding along to their member
financial institutions that encouraged the development of the 30-year
fixed-rate mortgage that is the predominant financing tool in the U.S.
mortgage finance system today.
The FHLBanks continue to play a vital role in the Nation's housing
finance and community lending system. Our member institutions,
primarily community banks and thrifts, use the FHLBanks' advances
program to meet the mortgage and community lending needs of their local
markets, and use our Affordable Housing Programs to make housing more
affordable for thousands of low-income families in those communities.
These are our primary purposes, and we are proud of our accomplishments
in carrying them out.
The FHLBank System, as it is sometimes called, is comprised of 12
individual FHLBanks, their 8,080 member institutions, and the Office of
Finance which issues debt on behalf of the FHLBanks. Each FHLBank is a
separate and distinct corporate entity with its own stockholder/member
institutions and its own board of directors. While the FHLBanks issue
debt collectively and are jointly and severally liable for the
repayment of those debt obligations, there is no single controlling
corporate entity with responsibility for or authority over the
FHLBanks. The 12 FHLBanks operate independently under the authority
granted by Congress through the Federal Home Loan Bank Act (Bank Act),
as amended, and in accordance with the regulations established by and
under the regulatory oversight of the Federal Housing Finance Board
(Finance Board).
The FHLBanks are cooperative institutions that operate within
districts originally established by the Federal Home Loan Bank Board,
the predecessor to the Finance Board. Each FHLBank's capital stock is
owned only by its member institutions, and only a FHLBank's members
(plus certain nonmember housing associates such as state housing
authorities) may conduct business with an individual FHLBank.
FHLBank members must meet certain statutory eligibility criteria.
Each member must purchase the FHLBank's capital stock in order to
become a member, and must maintain capital stock holdings sufficient to
support its business activity with the FHLBank, either in accordance
with the statutory formula or, for FHLBanks that have already
implemented the capital plans required by the GLB Act, in accordance
with the individual FHLBank's capital plan.
A FHLBank's capital stock cannot be issued to or held individually
by members of a FHLBank's board of directors, its management, its
employees or the public, and is not publicly traded. There is no market
for FHLBank capital stock other than among FHLBank members. The price
of a FHLBank's capital stock cannot fluctuate, and all FHLBank capital
stock must be purchased, repurchased, or transferred only at its par
value. There are no stock options or other forms of stock-based
compensation for FHLBank management, directors, or employees.
Prior to the passage of the Financial Institutions Reform, Recovery
and Enforcement Act (FIRREA) in 1989, the FHLBanks' membership was
generally limited to thrift institutions (building and loan
associations, savings and loan associations, savings banks, homestead
associations, etc.) and a handful of insurance companies. FIRREA
expanded eligibility for membership to include commercial banks and
credit unions with a demonstrated commitment to housing finance. The
GLB Act further refined FHLBank membership rules by making federally
chartered thrifts voluntary members for the first time and eliminating
the remaining statutory differences in the terms of access between
thrift institutions and commercial banks and credit unions.
The combination of the FIRREA and GLB Act statutory changes, along
with changes in the mortgage lending market, have caused FHLBank
membership to expand exponentially in the last decade. As of June 30,
2003, the 12 FHLBanks had a total of 8,080 member institutions, which
included 6,037 commercial banks, 1,273 thrift institutions, 693 credit
unions, and 77 insurance companies.
As an indication of the role the FHLBanks play in today's financial
system, the FHLBanks' 7,310 commercial bank and thrift institution
members represent approximately 79 percent of all FDIC-insured
institutions in the country. Reflecting the structure of the depository
institutions industry, approximately 6,519 (or 89 percent) of those
FDIC-insured members are Community Financial Institutions (CFI's), as
defined by the GLB Act. (CFI's are FDIC-insured institutions with
average total assets for the 3 years ended December 31, 2002 of $538
million or less.) Altogether, approximately 7,493 member institutions
(93 percent of all members) as of June 30, 2003 were community lenders
with total assets less than $1.0 billion.
As noted previously, every member institution has made a voluntary
decision to belong to a FHLBank. Among other things, that means that
the FHLBanks must offer, and continue to provide, a membership value
proposition that members perceive as adding value to their
institutions. The value the FHLBanks provide our members is a blend of
the modest dividends we pay on members' capital stock investment, the
value of access to stand-by liquidity from the FHLBanks, availability
of short- and long-term funds at attractive rates, and access to other
products that make a community lending institution better able to
profitably serve the credit needs of its community.
The FHLBanks' primary product offerings include traditional
advances (fully secured loans to member institutions) and the more
recently introduced Acquired Member Asset (AMA) programs. Advances
represent the core of the FHLBanks' business, providing a source of
funds members can use to support mortgage lending and, for CFI's, other
community banking assets. The AMA programs, through which the FHLBanks
acquire mortgage loans originated by member institutions under risk-
sharing rules and other parameters established by Finance Board
regulations, provide a secondary market alternative for those loans. In
addition, the FHLBanks offer favorably priced advances for members'
special community lending activities under their Community Investment
Cash Advances (CICA) programs, and competitive grant programs that
provide funds for housing for low-income families under Affordable
Housing Programs (AHP) established following FIRREA.
Implementation of Gramm-Leach-Bliley Legislative Changes
Since the enactment of the GLB Act in November 1999, a principal
focus of the FHLBanks has been the implementation of the FHLBank
provisions contained in Title VI of that Act. The modifications to the
Bank Act made by the GLB Act represented the culmination of many years
of effort to reform the FHLBanks, particularly the membership rules and
capital structure. The main purposes of the FHLBank provisions were to
establish a system of universal voluntary membership, provide for a
more permanent capital structure to accommodate voluntary membership,
equalize the terms of access to the FHLBanks for all types of
institutions eligible for membership, and to expand the types of
collateral that community banks can pledge to secure advances. I am
pleased to report that the FHLBanks are in the last stages of
implementing those changes and fulfilling that purpose.
Before FIRREA, the membership of the FHLBanks was comprised almost
entirely of thrifts that were required to be members by terms of their
charter or deposit insurance. FIRREA authorized commercial banks to
become voluntary members, but most thrifts continued as mandatory
members. In addition, the terms of access to the FHLBanks for newly
eligible institutions, including capital stock purchase requirements,
differed from the requirements for thrift institutions. It quickly
became evident that this disparate treatment was inconsistent with the
cooperative structure of the FHLBanks and was not needed to ensure that
thrift institution members had adequate access to the FHLBanks. As a
result, the FHLBanks and their members urged Congress to amend the Bank
Act to provide for universal voluntary membership and equal terms of
access.
The System of total voluntary membership has been successfully
implemented. All members now have the same rights to access FHLBank
products and services. In particular, the higher capital stock purchase
requirements for advances to commercial banks and credit unions based
on their different asset mix have been eliminated, which has enabled
community bank members better access to advances and, in turn, to
better serve the credit needs of their customers. And, although FHLBank
membership is now voluntary for all, only a handful of institutions
whose business model did not benefit from FHLBank membership have taken
the opportunity to withdraw from membership.
Community banks historically have had a somewhat different
customer base than thrift institutions, often spreading their lending
activity among the various types of loans needed in the community, such
as mortgage, small business, and small farm loans. In recognition of
this fact and in order to allow the FHLBanks to better serve their
members' needs, the GLB Act authorized the FHLBanks to make advances to
CFI's secured by small business and small farm loan collateral. The
FHLBanks have successfully and responsibly implemented this new
authority, acting prudently as secured lenders to assign appropriate
lending values to the new collateral and maintain their record of never
having suffered a credit loss on an advance to a member. As a result,
the new collateral authority has enabled community bank members to
better serve their communities.
In order to implement universal voluntary membership, while at the
same time providing for capital with more permanence, the GLB Act
outlined a new capital structure for the FHLBanks. The major
differences include authorization to issue two classes of capital
stock--Class A stock redeemable with 6 months notice and Class B stock
redeemable with 5 years notice--and implementation of new leverage,
risk-based and total capital requirements. This new framework adds
permanence to the FHLBanks' capital structure by requiring them to
maintain sufficient Class B stock plus retained earnings to meet the
new risk-based capital requirements.
The GLB Act created a series of statutory deadlines for adoption of
new capital regulations by the Finance Board and adoption and
implementation of new capital plans by the individual FHLBanks. All of
the relevant deadlines have been met and the FHLBanks are well on their
way to implementing their new capital plans. In fact, six FHLBanks have
already implemented their new capital plans, I believe another FHLBank
will implement its plan later this year, and the remaining five
FHLBanks will implement their plans by mid-2005. Each FHLBank has
developed its capital plan in consultation with its members and in
accordance with the Finance Board's regulations. The plans have been
well received thus far, with only a very few members exercising their
right to withdraw from membership before implementation.
In general, the provisions of the GLB Act have been very positive
for the FHLBanks and their members. These changes have had, and will
continue to have, a positive impact on the Banks' ongoing ability to
fulfill their statutory role, and to do so safely and soundly.
Federal Home Loan Banks Financial Profile
Reflecting the expansion of their membership base, the overall
growth in the banking industry, and increased usage of FHLBank advances
and AMA programs, the 12 FHLBanks have grown considerably in the last
decade. As of June 30, 2003, the FHLBanks had combined total assets of
$809 billion. The FHLBanks' balance sheets were supported by nearly $38
billion of capital, of which more than $36 billion represented capital
stock contributed by member institutions. The FHLBanks' aggregate
capital-to-assets ratio was 4.7 percent at June 30, with capital ratios
for individual FHLBanks ranging from 4.2 to 5.6 percent.
Of the FHLBanks' total assets, $596 billion (74 percent)
represented direct funding of member assets through advances and AMA.
The FHLBanks' aggregate advances were $506 billion at June 30, representing
63 percent of their combined balance sheets, and AMA were $90 billion, accounting for about 11 percent of the FHLBanks' aggregate assets. The remaining $209 billion (26 percent) of the FHLBanks' balance sheets were comprised primarily of various highly rated investments that the FHLBanks
hold to maintain a ready supply of liquidity to satisfy member demand for
advances and AMA, and to supplement earnings to keep advances rates low
and maintain adequate returns on members' capital stock investment.
Approximately $78 billion of the FHLBanks' investments were in short-
term instruments such as Federal funds sold or commercial paper used by
the FHLBanks to warehouse liquidity to meet members' credit needs and
the FHLBanks' other day-to-day obligations.
The FHLBanks also maintain longer-term investment portfolios that
provide a source of standby liquidity and supplement earnings so the
FHLBanks can provide advances and other credit products at attractive
rates. At June 30, 2003, the FHLBanks' longer-term investment portfolio
represented about 16 percent of their total assets and included $23
billion in securities issued by the U.S. Government or U.S. agencies,
approximately $6 billion of securities issued by state or local housing
agencies to support their housing finance activities, and approximately
$98 billion of mortgage-backed securities. The FHLBanks' mortgage-
backed securities have been purchased in accordance with Finance Board
guidelines not to exceed three times an individual FHLBank's total
capital. These securities are all issued by the U.S. Government or U.S.
agencies, or rated triple-A when they are purchased by the FHLBanks.
After weathering the storm of the thrift crisis of the late 1980's
and its aftermath, the FHLBanks have been consistently profitable
throughout the past decade. Although actual earnings and rates of
return have fallen with the decline in interest rates over the last 3
years, this reduction in earnings is a natural and expected result of
the way the FHLBanks are structured and how they operate. Because the
FHLBanks are wholesale institutions investing primarily in fully
secured advances, high credit quality mortgage loans or highly rated
investment securities, they operate on very narrow interest spreads
between their cost of funds and the yields on their assets. It is
typical for a FHLBank to have a net interest spread (the difference
between the cost of its liabilities and the yield on its assets) of
about 20 basis points (0.20 percent). By way of comparison, a
commercial bank might have an interest spread closer to 400 basis
points (4.0 percent). Given the FHLBanks' small interest spreads, a
much greater proportion of the FHLBanks' earnings are derived from the
investment of capital than is the case for commercial banks.
Before paying dividends to members, the FHLBanks' earnings from
these and other sources must cover the FHLBanks' operating expenses and
assessments. These assessments include the expenses of the Finance
Board and the FHLBanks' obligations to contribute 20 percent of their
earnings toward the payment of interest on REFCORP bonds issued in the
early 1990's to help finance the cost of resolving the thrift
institution crisis, and an additional 10 percent to fund their own
regional AHP.
As interest rates have fallen (particularly short-term interest
rates such as the Federal funds rate which is now at 1.0 percent), the
return on a FHLBank's investment of its capital has necessarily fallen
as well. If a FHLBank could completely insulate itself from interest
rate risk by perfectly match funding all of its assets and maintaining
a constant interest spread as interest rates fall, it would expect its
rate of return on invested capital to fall about 75 basis points (0.75
percent) for every 100 basis point (1.0 percent) reduction in interest
rates.
Because of this dynamic, the FHLBanks' earnings and rates of return
generally rise and fall with the level of interest rates, and our
dividend rates follow suit. In the case of the Dallas Bank, we paid
dividends at an average rate of 6.36 percent in 2000 when the average
Federal funds rate was about 6.25 percent, while we expect to pay
dividends at an annual rate of 2.0 percent in the third quarter of this
year, with the Federal funds rate at 1.0 percent.
Our experience indicates that this result fits very well with our
members' investment expectations. Members do not invest in FHLBank
capital stock with the expectation of earning equity investment
returns. Rather, members' investment in FHLBank capital stock
represents a very low-risk asset with explicit returns in the form of
dividend payments that fluctuate with market interest rates, and
overall benefits that include the value of access to FHLBank funding.
The FHLBanks do not attempt and are not expected to produce rates of
return comparable to other equity investments.
Corporate Governance of the FHLBanks: The Role of the Board
of Directors
Congress established a unique ownership and governance structure
for the FHLBanks, which has served the FHLBanks well in the past and
continues to do so. The most critical feature of this structure is that
the FHLBanks are wholly owned by their members/customers. In addition,
the boards of directors of the FHLBanks are truly independent of
management. No member of management may serve as a director of a
FHLBank, and management is precluded by regulation from recruiting
directors or participating in the election of directors.
The Bank Act provides that a majority of each FHLBank's directors
be elected by its member institutions from among officers and directors
of those institutions. Members vote for directors representing member
institutions from their States. The FHLBanks' members currently elect
approximately 57 percent of the FHLBanks' directors in this way, with
the remaining directors being appointed by the Finance Board.
Not only are members assured of the ability to elect the majority
of their FHLBank's directors, but the Bank Act also provides that no
member may cast a number of votes greater than the average number of
shares all the members in its specific state are required to hold. This
prevents large members holding relatively large amounts of a FHLBank's
capital stock from dominating director elections and, in practice,
means that the majority of each FHLBank's elected directors generally
represent the small institutions that make up the great majority of all
members.
The statutory framework that controls the composition of the
FHLBanks' boards of directors ensures that each FHLBank's board of
directors will have a balance of interests represented. With no members
of management on the board of directors, directors are in a position to
independently oversee management actions. The members that contribute
capital and benefit from the FHLBank's products and services are
assured a majority of the directors. The director election voting
preferences for small members ensure that larger members cannot
dominate the board of directors and that a FHLBank's policies will not
be detrimental to small members. Finally, the large contingent of
appointed directors ensures that the FHLBanks will appropriately
consider their public policy obligations.
Finance Board regulations require that the FHLBanks' boards of
directors not only fulfill the typical corporate director duties of
care and loyalty, but that they also carry out specific
responsibilities. These duties include, but are not limited to, the
responsibility to select and oversee management, the responsibility to
ensure the establishment and maintenance of an adequate internal
control system, the responsibility to adopt a risk management policy, a
strategic business plan, and a member products policy that details the
Bank's credit and pricing policies, and the responsibility to approve
the FHLBank's annual operating budget and quarterly dividends.
In carrying out their responsibilities, the boards of directors
typically establish and act through committees. Finance Board
regulations require each FHLBank's board of directors to have an audit
committee with very specific regulatory responsibilities, including
direct oversight of the FHLBank's internal and external audit
functions. The boards of directors also typically establish other
committees to facilitate their oversight of management. Committees vary
from FHLBank to FHLBank, but typically include risk management, human
resources, and housing oversight functions. The various elements of the
FHLBanks' corporate governance structure combine to provide boards of
directors that are active, knowledgeable, and engaged, and that are
fully aware of their responsibilities and take them seriously.
Regulatory Oversight of the FHLBanks
The combination of this governance structure and the regulatory
oversight provided by the Finance Board make the FHLBanks among the
most intensively audited entities in the country. As noted above, each
FHLBank has its own independent internal auditor, who actively and regularly audits all FHLBank operations and reports directly to the board of directors. In addition, each FHLBank's financial statements are reviewed by an
outside accounting firm (currently PricewaterhouseCoopers). Finally,
the Finance Board's ``primary duty'' under the Bank Act is ``to ensure
that the Federal Home Loan Banks operate in a financially safe and
sound manner.''
The Finance Board is not limited by funding constraints in carrying
out its declared focus of ensuring the FHLBanks' safety and soundness
because its funding is provided by assessments on the FHLBanks that are
not subject to review or challenge by the FHLBanks. The Finance Board
not only has regulatory authority over the FHLBanks that extends beyond
that which is typically afforded a safety and soundness regulator--the
GLB Act extended to the Finance Board the regulatory enforcement powers
of both the Federal banking regulatory agencies and the Office of
Federal Housing Enterprise Oversight (OFHEO) and--but also has wide-
ranging authority over many aspects of FHLBanks' operations.
Finance Board regulations govern every facet of the FHLBanks'
operations, from advances pricing to eligible collateral to risk
management to capital plans to directors' responsibilities to new
business activities. The Finance Board also collects and monitors
financial and risk management data from the FHLBanks each month,
performs ongoing reviews of all aspects of the FHLBanks' operations and
conducts annual on-site examinations of all 12 FHLBanks. While the
FHLBanks do not always enjoy being subjected to regulatory scrutiny,
all believe that it is essential that the FHLBanks have a strong,
independent regulator with the resources to ensure the FHLBanks' safety
and soundness.
Risk Management of the FHLBanks
As 12 independent institutions, all the FHLBanks are responsible
for their own risk management activities. Each FHLBank has its own risk
profile and approaches management of its risks in a slightly different
way. However, there are a number of factors that are held in common
across the FHLBanks that enable each FHLBank individually, as well as
the Consolidated Obligations (CO's) issued by the 12 FHLBanks
collectively in the capital markets, to be rated triple-A.
The cooperative structure of the FHLBanks eliminates many of the
incentives a publicly traded company might have to raise its risk
profile, and in fact discourages FHLBanks from taking excessive risk.
Just as FHLBank members do not expect equity investment returns on
their capital stock investment in a FHLBank, they also do not expect
equity investment risk in that investment. Members purchase FHLBank
capital stock in order to obtain access to FHLBank funding products,
and must maintain capital stock investments in the FHLBank as long as
they maintain advances outstanding. That is, members provide the
capital that supports their
advances transactions with the FHLBanks. In that environment, members
expect stability, reliability, and consistency of returns and credit
product pricing. These member expectations are reflected in the
oversight provided by each FHLBank's board of directors, a majority of
which is comprised of directors representing and elected by member
institutions.
In large part due to the incentives created by the FHLBanks'
cooperative structure, risk aversion and conservative risk management
practices are ingrained in the corporate culture. That same
conservative approach to risk management is also reflected in both the
legal restrictions and the Finance Board's regulatory regime. For
instance, the Bank Act and the Finance Board's implementing regulations
clearly describe and mandate the various limitations on the types of
collateral the FHLBanks may accept to secure advances. Regulations
limit the types, amounts, and required credit ratings on both short and
long term investments the FHLBanks make with surplus funds. Finance
Board regulations include separate additional restrictions on the
aggregate amount, ratings, and characteristics of mortgage-backed
securities the FHLBanks may purchase and hold.
In addition, Finance Board regulations require that each FHLBank
maintain a Risk Management Policy, reviewed at least annually and
readopted at least every 3 years by its board of directors, which
identifies specific risk management practices and limits for the
individual FHLBank. These practices and limits are monitored by the
FHLBanks' internal audit departments, which report their findings
directly to the FHLBanks' boards of directors. The Finance Board also
monitors FHLBank compliance with these and other regulatory
requirements through monthly call reports, constant off-site
monitoring, and annual on-site examinations. The FHLBanks are also
subject to very conservative capital requirements imposed by statute in
the GLB Act and by Finance Board regulations implementing those
statutory requirements. These requirements specify that FHLBanks must
have total capital equal to at least 4.0 percent of their total assets,
and must have sufficient permanent capital (as defined by the GLB Act)
to meet a risk-based capital regime established by Finance Board
regulation.
The FHLBanks minimize credit risk by ensuring that advances are
fully secured, that their investments are limited to issuers or
securities that are highly rated at the time the investments are made,
and that their AMA have appropriate risk-sharing features. No FHLBank
has ever suffered a credit loss on an advance to a member in the
FHLBanks' 71 year history. As of June 30, 98 percent of the FHLBanks'
investment securities have long-term ratings of triple-A or the
corresponding highest short-term ratings. In addition, due in large
part to the risk sharing structure of the AMA programs, the FHLBanks'
loss experience on AMA assets has been very favorable.
Since each FHLBank's primary activity is to serve as a financial
intermediary, the FHLBanks are also subject to market (or interest
rate) risk. To the extent the individual maturities of a FHLBank's
assets are not exactly matched by the individual maturities of its
liabilities, the FHLBank's future earnings stream is subject to
fluctuation due to changes in the relationship between yields on its
assets and the cost of its liabilities. Complicating the picture is the
fact that the FHLBanks hold assets (such as mortgage loans and
securities) or have issued liabilities (such as callable debt) that can
be repaid prior to their stated maturities. Further complicating the
issue is the fact that the FHLBanks' narrow interest spreads do not
provide a large margin of error.
To manage these risks, each FHLBank uses sophisticated financial
models to continually assess the magnitude of the risk to the FHLBank's
estimated market value or earnings from various changes in interest
rates. This information is reported to the FHLBank's board of directors
on a regular basis and to the Finance Board as often as monthly, and is
summarized in the FHLBanks' combined financial statements.
Reflecting the FHLBanks' conservative approach to interest rate
risk management, the 12 FHLBanks' ``duration gaps,'' or (generally) the
difference between the estimated average maturity of a FHLBank's assets
and the estimated average maturity of its liabilities, ranged from
negative 1.4 months to positive 1.6 months as of June 30, 2003. A
duration gap of 1.6 months generally means that the weighted average
expected maturity of a FHLBank's assets is 1.6 months longer than the
weighted average expected maturity of its liabilities.
The FHLBanks use interest rate derivatives extensively to maintain
their conservative interest rate risk profile. While much has been
written about the potential risks that can be created by the improper
use of derivatives, the manner in which the FHLBanks use derivatives is
a key component of their risk management activities. A couple of facts
are germane to an understanding of the FHLBanks' use of derivatives.
First, Finance Board regulations prohibit the use of derivatives
for speculative purposes. That means that every derivative instrument
entered into by a FHLBank is designed to hedge (that is, reduce) an
identified risk. Second, a majority of the FHLBanks' interest rate
derivative transactions are structured to exactly offset another
specific transaction. For instance, a FHLBank may use an interest rate
swap to convert the interest payments on a particular fixed rate
advance to a floating rate, so that the net payment stream will float
in a manner that matches the debt the FHLBank has issued to fund the
advance. Similarly, much of the debt the FHLBanks issue is long term,
fixed rate, and often callable. The FHLBanks typically convert a large
portion of this fixed rate debt to floating rates by executing exactly
offsetting interest rate swaps simultaneously with the issuance of the
debt. Approximately 82 percent of the FHLBanks' outstanding derivatives
as of June 30, 2003 represented these two types of transactions.
While the use of interest rate derivatives is critical to managing
the FHLBanks' interest rate risk, derivatives can cause problems if not
managed appropriately. The FHLBanks mitigate these risks in several
ways. The appropriateness of the FHLBanks' derivatives activities for
risk management purposes are validated internally by the use of
internal valuation models, by internal audits that often employ
external experts to validate a FHLBank's valuation model and hedging
practices, by external audits of the FHLBank's derivative valuations,
and through the Finance Board's annual on-site examination process.
The use of derivatives can also increase credit and operational
risks that must be managed carefully. For instance, derivatives pose
credit risk created by the potential for default by derivative
counterparties. The FHLBanks mitigate this risk by engaging in
derivatives transactions only with highly rated counterparties, and
maintaining bilateral collateral agreements with each counterparty that
require that the net fair value of derivatives positions be calculated
periodically and collateral exchanged to the extent that the FHLBank is
exposed to risk of default beyond some small threshold.
It should be noted that the magnitude of the potential counterparty
credit risk of a derivatives portfolio has little to do with the
aggregate notional amount of the derivatives. The potential credit risk
is represented by the net fair value of the portfolio of derivatives
between a FHLBank and a particular counterparty. For instance, the
aggregate notional amount of the FHLBanks' interest rate derivatives as
of June 30, 2003, was $694 billion. However, the net fair value of
those derivatives represented a fair value loss to the FHLBanks (not
including offsetting fair value gains on hedged instruments) of $16
billion.
Each FHLBank's credit exposure created by its derivatives portfolio
is determined by netting the current fair value of the derivatives by
counterparty, as provided in the FHLBanks' bilateral collateral
agreements. After taking that step, the FHLBanks' total aggregate
counterparty credit exposure was $2.2 billion before taking into
consideration collateral held to offset that exposure. After taking
collateral into consideration, the FHLBanks' aggregate net exposure was
$435 million, about one-third of the FHLBanks' aggregate retained
earnings. Of the FHLBanks' aggregate net exposure, $125 million of the
exposure was to triple-A rated counterparties, $228 million to double-A
rated counterparties, and $82 million to single-A rated counterparties.
One of the primary operational risks related to derivatives is the
risk of inaccurate accounting for those instruments, particularly since
the implementation of Statement of Financial Accounting Standard 133,
Accounting for Derivatives and Certain Hedging Transactions (SFAS 133)
in 2001. That statement requires generally that derivatives be carried
on the balance sheet at fair value, prescribes the appropriate income
recognition for changes in fair value of derivatives, and specifies
criteria that must be met in order for hedged instruments to qualify
for hedge accounting.
The FHLBanks have gone to great lengths to apply SFAS 133
appropriately and ensure that all derivatives accounting complies with
generally accepted accounting practices (GAAP). Prior to implementation
of the accounting standard, the FHLBanks' controllers formed an inter-
FHLBank task force, which included representatives from the FHLBanks'
external audit firm, to catalogue the various types of derivatives
transactions on the books of the FHLBanks, identify the appropriate
accounting treatment for each, and develop an accounting guide used
across the 12 FHLBanks to ensure consistency. This task force has
remained in place since the implementation of the standard to ensure
ongoing accounting consistency and compliance with GAAP. In addition,
the FHLBanks' external audit firm reviews each FHLBanks' derivatives
accounting as part of its quarterly reviews and annual audits of their
financial statements.
FHLBank Financial Reporting and Disclosure
There has been much discussion recently about the appropriate forum
for the FHLBanks' financial reporting and disclosure. We believe that
it is most important to focus carefully on the precise nature of the
issue under consideration. All 12 FHLBanks are fundamentally committed
to provide complete and state of the art disclosure consistent with the
unique characteristics of the FHLBanks as established by Congress.
Under the FHLBanks' current financial reporting and disclosure
regime, the FHLBanks' combined financial statements are required by
Finance Board regulation to comply with most Securities and Exchange
Commission (SEC) reporting requirements, except those specifically
excluded by the regulation. The individual FHLBanks' financial
statements are required to be consistent in form and content with the
combined financial statements. Both the FHLBanks' combined statements
and their individual financial statements comply with GAAP as certified
by the FHLBanks' external auditor. In addition, all 12 FHLBanks are
evaluating ways to enhance their financial reporting and disclosure in
accordance with evolving best practices. As part of that consideration,
for instance, it is my understanding that all 12 FHLBanks are currently
preparing to voluntarily comply with the requirement for attestation of
internal controls as set forth in Section 404 of the Sarbanes-Oxley
Act, and evaluating the applicability of other aspects of that
legislation.
The matter under discussion is not disclosure, but rather the
request by the Chairman of the Finance Board and others within the
Administration that the FHLBanks voluntarily register with the SEC. The
FHLBanks take these requests very seriously and have devoted a great
deal of time and resources to considering the appropriate application
of SEC standards--designed for publicly traded companies--to
cooperatives whose capital stock is not traded, has a fixed value and
is only held by member financial institutions. In order for our boards
of directors to carry out their legal fiduciary duty, they must
carefully consider the potential effects of voluntary registration on
the FHLBanks, their members and the fulfillment of the FHLBanks'
mission.
We are involved in ongoing discussions with SEC staff on how
voluntary registration of the FHLBanks would be implemented. While some
key threshold issues appear to have been resolved in a workable way,
other important issues remain to be resolved, as does the form of the
agreement between the FHLBanks and the SEC that would memorialize the
resolution of those issues.
Conclusion
Over its long history, the Federal Home Loan Banks have played a
vitally important role in supporting their member financial
institutions' ability to meet the housing finance and credit needs of
their local communities. The FHLBanks remain
economically strong today and continue to serve a vital function for
their financial institution members and the communities they serve.
PREPARED STATEMENT OF DAVID W. HEMINGWAY
Director, Federal Home Loan Bank of Seattle
Executive Vice President, Zions First National Bank
September 9, 2003
Good afternoon Chairman Bennett, Ranking Member Johnson, and
Members of the Subcommittee. I am David Hemingway, Executive Vice
President of Zions First National Bank, based in Salt Lake City, Utah,
and a Member of the Board of Directors of the Federal Home Loan Bank of
Seattle.
I would like to thank Chairman Bennett and the Subcommittee for the
opportunity to speak this morning on behalf of the Federal Home Loan
Banks and
address the critically important issue of corporate governance and
responsibility within the Bank System.
As both a community banker for the better part of three decades,
and an elected member of the board of directors of the Federal Home
Loan Bank of Seattle, the issue--and practical application--of board
governance is of paramount importance to the financial institutions and
communities we serve every day, and to me, personally. Simply put, I am
accountable for the safety and soundness of the Seattle Bank.
While I am not alone in that role--I share it with 17 other
directors and the management team of the company--I consider it my job
to ensure that the financial management of this $47 billion bank is
effective over the long-term, including proper stewardship of our
shareholders' capital.
That is a staggering responsibility when you consider that the
funding provided within the Seattle Bank district fuels housing
finance, affordable housing initiatives and economic development in
communities from Pago Pago to Walla Walla, Washington. Our nearly 400
member institutions rely on the Federal Home Loan Bank of Seattle to be
their partner in helping their communities and local economies not only
survive, but thrive.
Across the Federal Home Loan Bank System, we partner with nearly
8,000 community financial institutions in extending affordable credit
to communities in every region of the United States. The Federal Home
Loan Banks hold nearly $800 billion in assets, provide nearly a half
trillion dollars in advances annually, issue about $200 million in
affordable housing grants yearly, and hold nearly $100 billion in
mortgage assets.
So when elected to serve as a director of the Federal Home Loan
Bank of Seattle, I understood the critical importance of my role and
what I needed to bring to the board--namely, my personal integrity and
accountability, and my financial services and community banking
expertise.
Over the last several years, we have witnessed corporate failures
of historic proportions--financial disasters brought on by a
combination of inept business practices, poor leadership and financial
oversight, and fraudulent and unethical behavior. We are all well aware
that a quantum shift has occurred in how American corporations--large
and small, privately held or publicly traded--will be run. Must be run.
The term used most these days is ``corporate governance.'' It is
now in our business vernacular; it makes headlines in The Wall Street
Journal; it comes out of the mouths of network anchors on a frequent
basis. But I believe there is another way to state it, and it goes
something like this: Those who get to exercise the power must be
accountable to those who are affected by it.
We share with our regulator, the Federal Housing Finance Board, the
Treasury, and Congress the sense of urgency that is so pervasive today
regarding the need for increased accountability and responsibility. And
we have worked hard over the last several years to significantly
strengthen the leadership and oversight of our banks.
While we fully understand that corporate governance is a process; a
discipline that can--and must be--constantly improved, I am personally
and professionally encouraged by the intensity of our efforts and the
progress being made.
Over the course of the last year, the Seattle Bank board has
created, adopted, and publicly disclosed a set of Core Principles and
Guidelines relating to board governance, realigned our board committee
structure to more effectively oversee all facets of the bank's
operations, upgraded our education and training program for directors,
and established a website that provides directors with faster access to
a wider range of information critical to their board roles.
Our Core Principles and Guidelines provide us with a corporate
governance roadmap, if you will, keeping us focused on:
Assuring that policies, risk assessments, internal controls
and decisions are effective in managing risk and are administered
fairly.
Operating in an independent and active manner.
Setting the strategic direction of the bank and managing
progress against goals.
Determining if management is capable and if the business is
being properly managed.
Evaluating our own board effectiveness.
Our regulator, the Federal Housing Finance Board, is also diligent
in overseeing and supporting sound corporate governance practices
across the Bank System. The Finance Board just recently completed a
horizontal review designed to assist the Agency in directing and
developing its supervisory and regulatory initiatives. The
comprehensive review provided all 12 banks with a valuable resource for
identifying practices that contribute to effective governance programs.
The Finance Board interviewed management and board members, and
reviewed a wide range of bank documents with respect to board policies,
practices, and decisions.
I offer these comments to underscore the ongoing value of having
boards and bank management teams focused on enhancing corporate
governance standards, and a regulator performing its supervisory duty
in a way that provides additional information and resources that
further enhance the safety and soundness of the Bank System. As we all
know, it is one thing to say your house is in order and quite another
to prove it. As a director--and a member and owner of the Seattle
Bank--it is my job to prove it.
Does your board audit committee provide effective oversight of the
internal and external audit functions? Is the audit function
independent, reporting only to the board, and is it supported
appropriately by directors? Does the board ensure that material risks
are accurately and consistently assessed by management and reported to
the board in compliance with regulation and prudent business practice?
Are all directors working responsibly in carrying out their duties? Are
board and management actively involved in strategic planning?
I am pleased to say the Seattle Bank has ``yes'' answers to these
questions posed by the Finance Board in its recent horizontal review.
But that is today. Our job is to ensure that we have ``yes'' answers
tomorrow, the next day, and the day after that. Which is a much tougher
proposition. But that is our job.
We are fortunate within the Federal Home Loan Bank System when it
comes to corporate governance and responsibility. We were never
starting from scratch. We have had the advantage of enhancing practices
and standards that have, for more than 70 years, protected the Bank
System against even a single member credit loss.
But I would emphasize again that we are fully aware that a new era
has dawned in American business--one that looks on corporate governance
as an ongoing, rigorous discipline that demands, at all times, review
and accountability.
As one of 216 directors of the Bank System cooperative, I wouldn't
have it any other way.
Mr. Chairman, this concludes my written testimony. Thank you,
again, for allowing me the opportunity to speak with you today. I would
be happy to answer any questions you or other Members of the
Subcommittee may have.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES AND SENATOR
CARPER FROM JOHN T. KORSMO
Q.1.a. I would just like to ask several questions regarding
your examination and supervision of the Federal Home Loan
Banks. What has been your total budget for the last 5 years? Of
that amount, what percentage has been spent on safety and
soundness supervision? Of the amount spent on safety and
soundness, please specify what percentage is spent on:
Examination personnel; Examiner travel; Examiner training; and
Systems support? For each of the last 5 years, what has been
the total number of examiners? What is the average examiner's
pay? The range of examiner's pay?
A.1.a. The following tables provide answers to the questions
listed above.
Q.1.b. For each examiner currently employed by the FHFB,
specify education level, years of examination experience, and
whether or not they are accredited.
A.1.b. The examination staff, including the Deputy Director of
the Office of Supervision, averages more than 17 years of
professional experience in banking, mortgage finance, and bank
examinations. All examiners are commissioned examiners or have
a professional accreditation, and many have both.
Q.1.c. How many safety and soundness examinations have you
conducted in the last 12 months? How many examiners were
assigned to each examination? How often do you conduct safety
and soundness examinations of each bank? How many on-site
examinations did you conduct during the last 12 months? How
often do you conduct on-site examinations of each bank? What
was the length of time spent on each on-site examination? How
many examination staff conducted each on-site examination?
A.1.c. The Finance Board has a statutory requirement to examine
each FHLBank at least annually as set forth in Section 1440 of
the Federal Home Loan Bank Act. Accordingly, the Finance Board
conducts annual on-site examinations of each FHLBank and the
Office of Finance.
The Finance Board's Office of Supervision has a
comprehensive program to supervise, monitor, and examine the
FHLBanks. Each FHLBank is assigned an examiner-in-charge who
oversees the implementation of a supervisory strategy and
monitors that FHLBank on a regular basis. In addition to
examination staff, accountants, financial analysts, and
economists monitor trends that have the potential to affect all
FHLBanks. Further, an analyst designated for each FHLBank
analyzes the FHLBank's quarterly and annual financial results
and monitors developments at the FHLBank. The Office of
Supervision also has a risk modeling division that is charged
with evaluating and validating the FHLBanks' risk modeling
results and assumptions. Finally, the Office of Supervision has
a risk monitoring division that, among other duties, is charged
with monitoring the quality of data submitted by each of the
FHLBanks.
Finance Board supervision of the FHLBanks is predicated on
the principle that banking is a business of managing risks.
Indeed, FHLBanks must continually manage risks in selling debt,
underwriting advances, evaluating collateral, acquiring
mortgages and mortgage backed securities, setting dividend and
retained earnings policies, managing liquidity positions,
swapping cashflows, and using derivatives to hedge market
risks. Decisions in each of those areas are made separately by
each FHLBank pursuant to the
policy direction and risk limits established by the FHLBank's
Board of Directors.
It has not always been this way. Until the passage of the
Gramm-Leach-Bliley Act (GLBA) in 1999, the Finance Board was
actively involved in a number of key operating decisions for
the FHLBanks--such as setting dividend payouts and preparing
the FHLBanks' combined quarterly and annual financial
statements. Finance Board examinations were little more than
checklists designed to assess the FHLBanks' compliance with
Finance Board regulations.
Today, day-to-day operating decisions are properly the
responsibility of the individual FHLBank, pursuant to the
policy direction established by its Board of Directors. Our
examiners do not substitute their judgment, on individual
business decisions, for the decisions made by the FHLBank's
management or board. However, our examiners review the
framework within which those decisions are made. In particular,
our examiners evaluate the risk management policies and
controls established by the FHLBank's Board of Directors and
assess the adequacy and effectiveness of the FHLBank's policies
and practices in identifying, measuring, monitoring, and
controlling risks.
FHLBank examinations are typically conducted over an 8-week
period, with the on-site portion of the examination lasting 4
weeks. During the period prior to the on-site portion of the
examination, Finance Board examiners spend several weeks
conducting preliminary analyses and reviews of FHLBank records,
and defining the scope of the on-site portion of the
examination. During the on-site portion of an FHLBank
examination, a team typically consisting of 6 to 10 staff
members from the Finance Board travel to the FHLBank to conduct
the examination.
In the period following the on-site portion of the
examination, Office of Supervision staff prepares and presents
examination findings to the FHLBank's Board of Directors. The
FHLBank's Board of Directors is responsible for reporting back
to the Finance Board its actions taken in response to the
findings in the examination report. Finance Board staff conduct
quarterly follow up reviews to monitor the progress of the
FHLBank in addressing the findings of the report of
examination.
Over the past year, both the number of examination staff
on-site and the length of examinations have generally
increased. Our efforts to hire well-qualified examiners are
beginning to realize results, as measured by the number of
examiners we are able to devote to each examination, and by the
quality of the examinations. Examination statistics over the
year are as follows:
The length of an FHLBank examination is typically 8
weeks, including 4 weeks on-site. As warranted, the on-site
period is extended. In one 2003 examination, for example,
the on-site portion lasted 6 weeks.
During 2003, the number of staff on-site at the
FHLBanks during an examination normally ranged from 6 to
10. The Office of Supervision devotes more staff to an
examination as conditions warrant.
During 2002, all 12 FHLBanks and the Office of Finance
were examined.
During 2003, all 12 FHLBanks and the Office of Finance
will be examined. To date, 10 FHLBanks have been examined
during 2003.
During 2003, we installed a ``resident examiner'' (an
examiner operating full-time on-site) for 6 weeks prior to
the scheduled examination for one FHLBank.
During 2003, the Finance Board also conducted System-
wide (or ``horizontal'') reviews of the effectiveness of
board governance and of the operations of the Affordable
Housing Program (AHP) at the 12 FHLBanks.
Q.1.d. Without revealing the names of individual institutions,
how many examinations identified ``problem'' areas? What were
these problem areas?
A.1.d. All FHLBank examinations in 2002 and 2003 identified
matters that required the attention of the management and Board
of the FHLBank. Not all of these matters would necessarily be
``problems.'' There were instances, however, where the
seriousness of the examination ``findings'' resulted in the
Finance Board seeking specific action by an FHLBank's Board of
Directors.
There are eight ``findings'' categories defined in the
endnotes of each safety and soundness report of examination.
They are identified in such a way as to convey the seriousness
or nature of the ``finding.''
All examinations conducted in 2002 and 2003 identified
matters that resulted in ``recommendations'' from the Finance
Board to the FHLBank. ``Recommendations'' represent the mildest
``findings'' included in a report of examination. Most
examinations also resulted in ``findings'' that included
``weaknesses,'' ``exceptions,'' ``resolved violations,'' and
``violations.'' In six FHLBanks, the examination ``findings''
or related supervisory activities resulted in the Finance Board
seeking specific corrective or preventative action by the
FHLBank's Board of Directors. In those cases, the FHLBank was
required to address deficiencies in:
Risk assessment and controls programs;
Board and management oversight;
Affordable Housing Program oversight;
Risk modeling;
Credit analysis;
Strategic planning; or
Documentation of hedging activities.
Q.1.e. Over the past 5 years, how many enforcement actions has
the FHFB taken against the FHLBanks? Please list each action.
A.1.e. Prior to the passage of the Gramm-Leach-Bliley Act in
1999 (GLBA), the Finance Board's statutory enforcement
authorities were limited to suspension and removal powers over
any director, officer, employee, or agent of any FHLBank or
joint office, for example, the Office of Finance. GLBA gave to
the Finance Board enforcement powers similar, but not
identical, to those of the banking agencies. In particular, the
Finance Board was granted statutory cease and desist authority.
As is typical of any banking regulator/supervisor, the
Board enforces regulations and the safe and sound conduct of
its regulated entities in three ways. In the majority of cases
we detail statutory or regulatory violations and operating
deficiencies in an examination report or, if the violation or
deficiency is noted through our off-site monitoring of the
FHLBank, by formal notification to the FHLBank. Our examination
reports are sent to each board member of the FHLBank, and
presented in detail at a meeting of the full board of directors
shortly after the completion of the on-site examination. Where
appropriate, we require the FHLBank to take remedial actions.
We check the sufficiency of those actions by requiring a
response from the FHLBank and by following up during the on-
site portion of the next examination of the FHLBank. In
virtually every case where such operating deficiencies or
violations have been cited, the FHLBank board and management
have corrected the deficiencies or violations in the normal
course of business.
If an unsafe or unsound condition or practice that
threatens the safety of an FHLBank were to be noted, the Office
of Supervision would take a formal enforcement action to
correct and/or reverse the condition or practice. Over the past
5 years, there have been numerous occasions when our examiners
or analysts have noted operating deficiencies at the FHLBanks.
Less frequently, they have noted situations where the FHLBanks
have violated statutes or regulations. There have not been
occasions where our examiners have cited violations or
deficiencies that have risen to a level that would threaten the
safe and sound operation of an FHLBank. Consequently, no formal
enforcement actions have needed to be taken against any
FHLBanks.
Between those situations where normal course-of-business
operating deficiencies and/or violations have been cited, and
where unsafe or unsound conditions or practices have been
noted, we employ ``preemptive'' supervisory strategies.
Specifically, we strongly encourage an FHLBank's Board of
Directors to exercise its fiduciary responsibilities by taking
action to assure the safe and sound operation of the FHLBank.
Where we believe it necessary, we communicate to the board of
directors our view that it needs to intercede more actively.
That exercise of responsibility and authority by an FHLBank's
board normally takes the form of a board resolution and follow-
up action plan, together with regular reporting by management
to the board or to an appropriate committee thereof. It is also
customary for us to receive, as part of our supervisory
activities, copies of those resolutions and copies of status
reports regarding progress. In addition, we offer comments on
the sufficiency of those actions plans and/or progress reports.
Over the past 5 years, and particularly over the past 12
months, we have worked with the boards of directors of the
FHLBanks to improve their operations or to correct ongoing
deficiencies. In most cases, particularly in the past 12
months, our efforts have been aimed at enlisting the boards of
directors to improve the risk management practices of their
institutions. A brief description of those actions is provided
below. In several cases, our actions took the form of notifying
an FHLBank's board that the implementation of its approved
capital plan should not move forward until noted and cited
deficiencies had been corrected.
In one case, the Board of Directors of an FHLBank
postponed the scheduled conversion to its new capital
structure until the examination-cited deficiencies in the
FHLBank's planning and risk management practices were
addressed to our satisfaction.
In response to our supervisory concerns, an FHLBank's
Board of Directors postponed conversion to its new capital
structure until the FHLBank had enhanced its risk
assessment and risk management practices.
At our behest, an FHLBank postponed its capital
conversion and suspended dividends in light of operating
losses and risk management deficiencies.
Based on discussions with the Office of Supervision,
the Board of Directors of an FHLBank agreed to analyze and
revise its retained earnings and dividend policies before
declaring or paying dividends.
Based on examination-cited deficiencies in risk
assessment and risk management practices, two FHLBanks'
boards of directors have limited growth and committed to
maintaining their capital positions until those
deficiencies have been corrected. One of those FHLBanks has
also committed to suspend requests for new business
activities.
Based on examination-cited deficiencies in the
administration of its Affordable Housing Program, the Board
of Directors of an FHLBank contracted for an independent
third-party review of its program.
Again, these actions, while not specifically characterized
as formal enforcement actions, are examples of recent instances
where the Finance Board has used its available supervisory
tools to promote the safe and sound operation of the FHLBanks.
As is normal for any bank regulator, the actions taken by
boards of directors as a result of discussions with us are part
of a supervisory effort aimed at preventing, rather than
reacting to, unsafe and unsound conditions.
Q.2.a. The Pittsburgh FHLBank suffered a very bad second
quarter. Based on its most-recent financial reports, its
annualized return on assets is 0.02 percent. Its capital stands
at $2.25 billion, or 4.2 percent of assets, barely above the
regulatory minimum. Its second-quarter dividend was subsidized
with $10 million from retained earnings. How do you explain the
Pittsburgh FHLBank's poor performance?
A.2.a. After reporting net income of $15.3 million for the
first quarter of the year, Pittsburgh's net income fell to $2.4
million for the second quarter. Three principal factors
depressed the FHLBank of Pittsburgh's earnings in the second
quarter.
First, low market rates adversely affected the Pittsburgh
FHLBank's net income. To the extent that an FHLBank invests
member capital primarily in short- or intermediate-term
instruments, the rate of return on these investments, and thus
the return on its equity, will move in tandem with short-term
interest rates.
Second, as assets prepaid faster than debt was retired,
compressed interest margins reduced net income. The Pittsburgh
FHLBank experienced higher than expected prepayment on
mortgages and securities backed by mortgages in the second
quarter. The Pittsburgh FHLBank was using previously issued
long-term debt to support its operations. That debt, issued
principally in 1994 and 2000, carries relatively high interest
rates, ranging from approximately 4.0 to 6.3 percent,
reflecting market rates at the time of issuance. In the lower
interest-rate environment during the second quarter, margins
were compressed and earnings declined. Margins will continue to
be squeezed until that debt is retired or asset yields rise.
The Pittsburgh FHLBank has reported that the higher cost debt
will begin to roll off in July 2004.
Third, during the second quarter, the recognition of
substantial premium amortization expenses associated with the
prepayment of mortgage loans significantly reduced the
Pittsburgh FHLBank's net income.\3\
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\3\ If a mortgage with a coupon rate that matches the current
market rate sells for $100, then a mortgage with a coupon rate above
the current market rate will sell for more than $100, since it offers
higher cashflows. The amount in excess of $100 is the ``premium''
associated with that mortgage.
---------------------------------------------------------------------------
There are three components to mortgage premium
amortization.
When a loan is purchased at a premium (normally due to
an interest rate on the loan that is above the current
market level), accounting rules require the holder to
amortize the premium over the loan's expected life. This
represents regular amortization of the premium.
When a loan is prepaid, any unamortized premium
associated with that particular loan must be written off
immediately because that that loan is no longer on the
institution's books and the mortgage's cashflow ceases.
The amortization of the premium associated with loans
remaining in portfolio must be adjusted to reflect current
prepayment speeds. When interest rates fall and prepayment
rates rise, amortization rates increase. This is normally
referred to as ``catch-up'' amortization.\4\
---------------------------------------------------------------------------
\4\ Statement of Financial Accounting Standards No. 91, Non-
Refundable Fees and Costs Associated with Originating or Acquiring
Loans and Initial Direct Costs of Leases (SFAS 91), governs the
accounting for mortgage premiums and discounts.
The Pittsburgh FHLBank currently limits its exposure to
accelerated premium amortization by using interest-rate
floors.\5\ The Pittsburgh FHLBank has reported to the Finance
Board that it is reevaluating the most effective hedge vehicles
available and is limiting growth in its net premium exposure.
---------------------------------------------------------------------------
\5\ As employed by the FHLBanks, a floor is an interest-rate
exchange agreement where the FHLBank pays a fixed fee up front and the
counterparty pays the FHLBank the difference between 3-month LIBOR and
some specified interest rate if 3-month LIBOR falls below that
specified rate. Thus, the FHLBank buying a floor expects the gains from
the floor to offset premium amortization when interest rates fall.
Q.2.b. Why did FHFB supervisors allow the Bank to pay a
---------------------------------------------------------------------------
subsidized dividend given its poor performance?
A.2.b. Prior to the passage of GLBA, the Finance Board approved
dividends paid by the FHLBanks. GLBA devolved the
responsibility to set dividends to the FHLBank boards of
directors. One focus of the Finance Board's supervision of the
FHLBanks has been to ensure that the FHLBanks' boards of
directors exercise this authority appropriately and in
compliance with Finance Board regulations.
Finance Board regulations prohibit an FHLBank from paying a
dividend if it would result in the FHLBank failing to meet any
of its capital requirements (See 12 CFR Sec. 931.4). The
FHLBank of Pittsburgh met all of its capital requirements after
the payment of the second-quarter dividend. However, we have
communicated our concerns to the Pittsburgh FHLBank about their
paying a dividend in excess of their quarterly net income.
In August 2003, the Office of Supervision issued Advisory
Bulletin 03-08 instructing each FHLBank to adopt a retained
earnings policy that specifically assesses the adequacy of
retained earnings in light of alternative future financial and
economic scenarios, and prioritizes retained earnings over
dividends. On October 8, 2003, the Finance Board, during an
open board meeting, took the position that an FHLBank should
not use retained earnings to pay a dividend to its members
unless and until that FHLBank meets the standards set in
Advisory Bulletin 03-08.
We monitor dividends and retained earnings in our
supervisory program. The Finance Board has expressed to the
FHLBanks its concern about the relatively low levels of
retained earnings at a number of the FHLBanks. Advisory
Bulletin 03-08, mentioned above, requires:
Each FHLBank to assess the adequacy of its retained
earnings in an analytically rigorous fashion using a
variety of truly stressful scenarios;
The Board of Directors of each FHLBank to review the
analysis of retained earnings of that FHLBank, and
Each FHLBank to establish a formal retained earnings
policy.
We will review those analyses and retained earnings
policies during our 2004 examinations.
Q.2.c. What will happen if bank regulators mark down the
Pittsburgh Bank stock?
A.2.c. A write-down of the Pittsburgh FHLBank's capital would
occur only if the capital stock were impaired and this
impairment were viewed as other than temporary. The Pittsburgh
FHLBank's stock is not impaired. Members can purchase and
redeem stock in the FHLBank of Pittsburgh at par.
Q.2.d. Please describe the supervisory steps you will take when
an FHLBank's capital falls below required levels. At what point
do you take supervisory action? Do you wait until the minimum
capital requirement is violated?
A.2.d. As a practical matter, because of their portfolio
composition, FHLBanks should not fall out of compliance with
the minimum capital requirements. An FHLBank that approaches
its regulatory capital minimum should be able to sell assets
(or not roll over short-term asset positions) to remain in
capital compliance.
In addition, Finance Board regulations prohibit the payment
of any dividend by any FHLBank if the payment would result in
that FHLBank failing to meet any of its minimum capital
requirements (See 12 CFR Sec. 931.4). Finance Board regulations
also prohibit any FHLBank from redeeming or repurchasing any
capital stock if the FHLBank would fail to meet any minimum
capital requirement after the redemption (See 12 CFR
Sec. 931.7(c)). Furthermore, an FHLBank may not redeem or
repurchase any capital stock without the prior written approval
of the Finance Board if the Finance Board or the Board of
Directors of the FHLBank has determined that the FHLBank has
incurred or is likely to incur losses that result in or are
likely to result in charges against the capital stock of the
FHLBank (capital impairment) (See 12 CFR Sec. 931.8(a)).
The Finance Board also has in place a comprehensive
regulatory structure to facilitate prompt supervisory action
before any FHLBank would violate the minimum capital
requirements. First, the FHLBanks must submit monthly, as well
as more extensive quarterly, call reports to the Finance
Board.\6\ Second, the Finance Board has designated an examiner-
in-charge (EIC) for each FHLBank. The EIC assignment is for a
multiyear period to provide continuity of supervision of each
FHLBank.\7\ EIC's have formal contact with their designated
FHLBank no less frequently than quarterly, and more frequently
if conditions warrant. Third, the Finance Board has designated
12 financial analysts, each to serve as the principal analyst
for one FHLBank. The analysts can alert the EIC, senior
management, or the Board of Directors of the Finance Board
about deteriorating trends at any FHLBank.
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\6\ The call report is the principal way an FHLBank reports
financial information to the Finance Board. There are both monthly and
quarterly reporting requirements. Balance sheet, investments, income
statement, advances, leverage, derivatives, capital compliance, and
credit concentration information is required monthly.
\7\ Those appointed to EIC positions are senior bank examiners, all
of whom had extensive experience at other financial institution
regulatory agencies before joining the Finance Board.
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If, despite these regulatory and supervisory protections,
an FHLBank's capital were to fall below required levels, the
Finance Board would take formal enforcement actions with
provisions to address the capital deficiency.
Q.3.a. Looking at System financial statements for the second
quarter of this year, several FHLBanks had losses attributable
to ``derivatives and hedging operations.'' For example, Boston
and Pittsburgh each had $14 million in losses, Atlanta had $72
million, and Chicago and Topeka each had $23 million. Of these
Banks, several had reduced net income from the prior quarter--
for example, Boston went from $22 million in the first quarter
of 2003 to $19 million, Pittsburgh from $15 million to $3
million, and Topeka from $17 million to $11 million. Atlanta
had a slight dip and Chicago had a slight increase in income.
My understanding is that the average Return on Assets for the
FHLBank System is generally around 1 percent, but for the last
quarter it was only 0.2 percent, with one Bank earning only
0.02 percent. Are derivative losses responsible for the overall
drop in earnings?
A.3.a. Net realized and unrealized losses on derivatives and
hedging activities were approximately $138 million in the
second quarter of 2003, $111 million higher than in the first
quarter of 2003. Because those losses flow through the income
statement, they affect the level of reported net income. Those
losses, therefore, contributed to the overall drop in reported
FHLBank earnings in the second quarter. However, two points
warrant elaboration. First, the drop in overall earnings to
approximately 0.2 percent of assets was not as steep as the
question suggests. The return on average assets for the
FHLBanks ranged from 0.25 percent to 0.47 percent for the 1988-
2002 period. It is not ``generally around 1 percent.'' Second,
in isolation, the realized and unrealized gain or loss on
derivatives and hedging activities offers an incomplete picture
of an institution's hedging activities.
When a financial institution reports a ``loss'' on
derivatives and hedging activities, the loss often arises
because accounting rules prohibit the recognition in income of
simultaneous gains on the balance sheet items being hedged. For
example, losses or gains on derivatives used to hedge the risks
associated with held-to-maturity securities flow through the
income statement. Under generally accepted accounting practices
(GAAP), however, fluctuations in the value of the held-to-
maturity assets being hedged with those derivatives are not
recognized in income unless the fluctuation in value is deemed
to reflect ``other than temporary'' impairment. In other words,
an institution's GAAP income may be affected by the asymmetry
of accounting rules that require the marking to market of the
derivative, but not the held-to-maturity assets being hedged.
In the case of ``securities held at fair value,'' changes
in their market value appear on the income statement as an
``unrecognized gain or loss on securities held at fair value.''
To the extent derivatives are used to hedge against changes in
the market value of
securities held at fair value, the income-statement categories
``unrealized gain or loss on securities held at fair value''
and realized or unrealized ``gains or losses on derivatives and
hedging activities'' tend to move in opposite directions.
Consequently, a given change in interest rates will tend to
generate gains on one set of instrument and losses on the
other. To gauge the overall effect, one must consider the net
effect of the change in value of the derivatives and of the
securities held at fair value. The following table provides
that information for the FHLBanks during the second quarter and
the first half of 2003.
For the second quarter of 2003, the combined effect of
gains/losses on derivatives and the unrealized gain/loss on
securities held at fair value was to contribute $16 million to
income before REFCORP and AHP assessments of $613 million. For
the first half of 2003, the combined effect of gains/losses on
derivatives and the unrealized gain/loss on securities held at
fair value was to decrease income before REFCORP and AHP
assessments by $31 million resulting in a total of $1.2
billion. In each case, the net effect was less than 3 percent
of income before assessments for REFCORP and AHP.
Thus, in isolation, the gain or loss on derivatives and
hedging activities offer an incomplete picture of the
effectiveness of an institution's hedging strategies. As bank
supervisors, we are principally concerned with whether an
FHLBank has a well conceived, properly documented, and
prudently implemented hedging program that is designed to limit
or reduce risk and that is subject to rigorous internal
controls and oversight.
Q.3.b. How can we be sure that the Home Loan Banks are using
derivatives to hedge risk instead of to speculate?
A.3.b. At June 30, 2003, the FHLBanks had notional derivatives
of $693.8 billion. The total net exposure at fair value was
$2.2 billion.
A focus of our supervisory policy, on-site examinations,
and off-site monitoring is to review FHLBank derivatives
activities for compliance with our rule prohibiting their use
for speculative purposes. The following factors mitigate
against the speculative use of derivatives by the FHLBanks.
Finance Board rules specifically require that all
derivative transactions must either qualify as hedging
instruments pursuant to generally accepted accounting
principles in the United States (GAAP) or the FHLBank must
demonstrate the nonspeculative use (See 12 CFR Sec. 956.6).
All derivative contracts with a single counterparty
must be governed by a single master agreement to facilitate
the netting of obligations, such as International Swaps and
Derivatives Association (ISDA) agreements.
Finance Board rules require that all derivative
contracts be marked to market and subsequent collateral
adjustments occur no less frequently than monthly.
The Finance Board receives information on the
derivatives of the FHLBanks through monthly and quarterly
sections of the call report.
A critical element of the on-site examination of each
FHLBank is a review of the policies and procedures dealing
with derivatives, as well as a review of the internal
controls, documentation, accounting, board of director
oversight, and segregation of duties dealing with
derivatives transactions.
Each year as part of its annual audit, each FHLBank
undergoes a review of the accounting for its derivative
instruments by the FHLBank's independent external auditor.
Appropriate risk limits at the individual FHLBanks are a
critical factor in controlling the use of derivatives for
speculative purposes. Some of these limits are regulatory, for
example, limits on duration of equity contained in the Finance
Board's Financial Management Policy. Other limits are properly
adopted and monitored by the FHLBank itself, subject to asset-
liability committee and board of director approval. Duration of
equity and value at risk, as well as other measures, such as
market-value sensitivity to a variety of risk measures, are
effective ways to assess the extent to which derivatives hedge
risk exposure. The Finance Board regularly reviews compliance
with both regulatory and internal risk limits as part of
annual, on-site examinations.
The Finance Board examiners also assess whether the
FHLBanks have appropriate policies, procedures, and controls in
place regarding their use of derivatives at the instrument
level. Key elements of such policies, procedures, and controls
include a process for developing and approving hedging
strategies and controls over implementation of those
strategies. We expect those controls to include risk limits,
identification of individuals within the FHLBank approved to
conduct a trade, requirements for documenting hedge
transactions, including risk analytics showing the specific
risk exposure(s) reduced by the trade, and procedures to be
followed if ever risk limits are violated.
The aforementioned steps limit the likelihood of
unauthorized use of derivatives by any FHLBank. Nevertheless, a
number of Finance Board initiatives should provide additional
transparency and enhance oversight of FHLBank derivative
activity. For example, the Finance Board has requested
proposals for purposes of acquiring an Enterprise Risk
Management system to enhance further our supervision of the
FHLBanks. This sophisticated computerized asset-liability
management software should enable the Finance Board to generate
a ``second opinion'' of risk exposure calculations generated by
the FHLBanks, to compare risk exposures of the FHLBanks using a
common set of methodologies and assumptions, and to measure
additional risk exposures as the need arises. In the coming
months, the Finance Board also expects to issue further
guidance regarding market-risk management information that will
be reported to the Finance Board for supervisory and monitoring
purposes, providing additional information on the risk
implications of derivative investments in a whole-portfolio
context.
Q.4. It is my understanding that the Chicago and Pittsburgh
FHLBanks impose a zero percent capital charge against mortgages
acquired under their mortgage acquisition programs. However,
they are required to maintain a minimum 4 percent total capital
against assets. Given the fact that the Chicago FHLBank holds
over $39 billion in mortgage assets, and only $25 billion in
advances, can you please explain how the Chicago FHLBank is
meeting its minimum capital requirements? Similarly, Pittsburgh
holds $9.8 billion, nearly 20 percent, of its assets in
mortgages. How does it meet its minimum capital requirements?
A.4. Prior to the passage of the Gramm-Leach-Bliley Act of 1999
(GLBA), member stock purchase requirements were uniform across
the FHLBanks. Each member had to purchase subscription stock in
its FHLBank that was at least as great as the larger of either
(1) $500; (2) 1 percent of the member's aggregate unpaid loan
principal; \8\ or (3) 5 percent of the member's aggregate
amount of outstanding advances.
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\8\ ``Aggregate unpaid loan principal'' means the aggregate unpaid
principal of a subscriber's or member's home mortgage loans, home-
purchase contracts and similar obligations. (See 12 CFR Sec. 925.1).
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With the passage of GLBA and its requirement that the
FHLBanks convert to a risk-based, permanent capital structure,
the FHLBanks were granted authority, subject to Finance Board
approval, to develop their own stock purchase requirements for
their members. Irrespective of how stock purchases requirements
are defined, the FHLBanks are required to maintain a minimum of
4 percent total capital against assets.
The Finance Board approved all of the FHLBanks' new capital
plans in 2002. To date, 6 of the 12 FHLBanks have implemented
their revised capital plans (Seattle, Indianapolis, Pittsburgh,
Cincinnati, Dallas, and Des Moines). The remaining 6 FHLBanks
are expected to implement their new capital plans by the end of
2005.
Under the new capital plans, the FHLBanks impose on their
members stock purchase requirements that are dependent on
either the member's size, for example, measured by total
assets, mortgage assets, or borrowing capacity, or on the level
of business activity that member has with the FHLBank. In fact,
all FHLBanks use member-based stock purchase requirements; all
also use activity-based requirements for at least one or more
activities. In cases where the FHLBanks impose a zero percent
stock purchase requirement for a given activity, capital to
support the assets acquired by the FHLBank because of that
activity must come either from the membership stock purchase
requirement, or other outstanding stock, such as stock
dividends or member voluntary stock purchases.\9\
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\9\ The Home Loan Bank Act allows members to voluntarily acquire
``excess stock,'' for example, stock that is not required to be
purchased by membership requirements or activity-based requirements.
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All capital stock held by members, regardless of how it is
obtained, is subject to the same waiting period once it
notifies the FHLBank of its desire to redeem stock:
6 months after a member has given notice of its
intention to redeem stock under the pre-GLBA capital plans,
and for Class A stock under the GLBA capital plans;
5 years after a member has given notice of its
intention to redeem stock for Class B stock issued under
the GLBA capital plans.
Stock supporting a member activity may not be redeemed
until that activity has been completed. Further, no FHLBank may
redeem capital stock if doing so would result in that FHLBank's
failure to meet minimum capital standards. Thus, it makes
little difference whether the FHLBank is using membership,
activity-based, or voluntary stock to meet its capital
requirement supporting its assets, since the degree of
permanence is not related to how the stock is acquired.
As the accompanying table indicates, the FHLBank of Chicago
had total capital stock of $3.3 billion as of December 31,
2002. Of this amount, capital stock requirements assessed on
the members of the FHLBank accounted for 45.2 percent of total
capital, while voluntary stock holdings accounted for 49.1
percent. Retained earnings were 5.8 percent of the FHLBank's
total capital.
The table similarly illustrates how the FHLBank of
Pittsburgh capitalized its operations. As of December 31, 2002,
total capital stock was $1.9 billion. Of this, 91.1 percent
came from stock requirements assessed on members, 5.4 percent
came from voluntary stock holdings, and 3.5 percent came from
retained earnings.
Q.5. As I understand it, one result of treating Shared Funding
interests as ``acquired member assets'' under the AMA rule is
that such assets are not subject to the FHFB's requirement that
MBS investments not exceed 300 percent of capital. Please
indicate to what extent the Chicago FHLBank's investments in
Shared Funding interests, combined with its other MBS
investments, exceed this [three times capital] cap?
A.5. The Chicago FHLBank has not exceeded the three times
capital limit on MBS investments.
As of August 31, 2003, the FHLBank of Chicago had $4.2
billion in mortgage-backed securities, $682 million in Shared
Funding assets, and capital of $4.3 billion. As such, the total
of mortgage backed securities and Shared Funding assets was
approximately 112 percent of capital.
As a general matter, the FHLBank of Chicago has not
substantially increased its investment in mortgage-backed
securities over the last few years even though capital has
increased substantially. The quarterly average of mortgage-
backed securities reached its highest dollar amount in the
fourth quarter of 2002 at $4.8 billion when average capital was
$3.3 billion. The ratio of mortgage-backed securities to
capital, based on annual averages from 2000 to 2002, fell from
271 percent in 2000, to 206 percent in 2001 and to 150 percent
in 2002.
Q.6. Was the Finance Board aware of the problems in the
manufactured housing portfolio at the New York Home Loan Bank
before Standard & Poor's raised the alarm? Are you concerned
about the potential for similar problems at other Banks?
A.6. During his regular monitoring of the FHLBank of New York
in the first quarter of 2003, our examiner-in-charge (EIC)
noted that the FHLBank had a concentration of securities backed
by manufactured housing loans. The EIC, who, as an FDIC
examiner had examined a large originator of manufactured
housing loans, recognized the potential risk posed by the New
York FHLBank's concentration of investment securities backed by
manufactured housing loans and home equity lines of credit.
Because of that concern, the EIC alerted the FHLBank in March
2003 that this portfolio would be a specific area of review at
the 2003 examination of the FHLBank. In particular, the EIC
notified the FHLBank that we would be reviewing the assumptions
of values, and potential for credit losses in manufactured
housing-backed securities.
Standard & Poor's reduced the outlook for the FHLBank of
New York to negative from stable in August 2003, well after the
EIC had first alerted the FHLBank of his concerns.
While we are monitoring the investment portfolios of all of
the FHLBanks, we are not concerned about the potential for
similar problems with respect to manufactured housing
securities at other FHLBanks. According to our quarterly call
report data, no other FHLBank has any significant holdings of
these securities.
Q.7. Earlier this year, Fannie Mae and Freddie Mac agreed to
provide MBS investors with additional information about their
mortgage backed securities, including such things as original
loan-to-value ratios, credit scores, property types, and
others. What disclosures are made to investors in the
certificates issued under the Shared Funding Program?
A.7. The three investors in the certificates of the initial
shared funding transaction are the FHLBanks of Des Moines,
Pittsburgh, and Chicago. Under Securities and Exchange
Commission (SEC) rules, they are qualified investors.
Under the Shared Funding Program, the underwriters of the
securities provide the disclosures to investors in the
certificates of the mortgage-backed securities in a
confidential Private Placement Memorandum and a Private
Placement Supplement (collectively, the ``Memorandum''). These
disclosures are governed by standards for private placement
securities as established by the SEC.
During an examination of an FHLBank, we reviewed that
Memorandum, which the FHLBank had received as an investor in
those securities. The Memorandum includes detailed information
on the mortgage pool. For example, information is provided on
credit score distribution, loan-to-value ratios, geographic
distribution of the mortgaged properties, loan purposes,
property types, and documentation types. In addition,
information is provided on the risks associated with investing
in these securities, for example, risk of loss. Without opining
as to the legal sufficiency of the Memorandum, our examiners
concluded that the Memorandum was comprehensive both as to the
characteristics of the underlying assets and the risks to an
investor.
Q.8. Dow Jones reported last month that total Federal Home Loan
Bank operating expenses for the second quarter of 2003 were
17.5 percent higher than operating expenses for the same period
last year (``FHLBanks Report Significant Boost in Operating
Expenses,'' August 15, 2003). Can you explain why operating
expenses have increased so dramatically?
A.8. The increase in operating expenses from the second quarter
of 2002 to the second quarter 2003 reflects the 13.3 percent
growth in System assets during this same period. Assuming that
operating expenses represent a constant proportion of assets,
this growth would account for more than three-quarters of the
increase in operating expenses noted in the question above.
During this period, however, the FHLBanks also began to
acquire significant holdings of mortgages under the Mortgage
Purchase and Mortgage Partnership Finance' programs,
with the value of combined program assets increasing by 135
percent between the second quarter of 2002 and the second
quarter of 2003. This growth pushed the value of such assets to
more than 11 percent of total System assets from 5.4 percent at
the beginning of the period. Because this represents a
relatively new line of business for FHLBanks and because the
risks posed by this business are more complex than those posed
by the Banks' traditional advance products, the Finance Board
expects that FHLBank operating expenses will increase at a
faster rate than aggregate assets until the appropriate risk-
management programs emerge.
A comparison between publicly available Fannie Mae and
Freddie Mac data underscores this expectation. While FHLBank
System annualized administrative operating expenses represent
5.7 basis points of combined assets, Fannie Mae (2002) and
Freddie Mac (2001 is the most recent data available) reported
administrative operating expenses of 13.7 basis points of
assets. Furthermore, both these institutions reported year-on-
year growth in operating expenses approaching 20 percent, a
result of expenses related to development of updated IT
infrastructures and salaries.
Past levels of FHLBank funding for risk management have not
been sufficient to manage their increasingly complex balance
sheets. FHLBank operating expenses can be expected to increase
at a faster rate than aggregate assets until enhanced risk-
management programs are in place. The Finance Board has been
recommending that the FHLBanks bolster their investments in
risk management infrastructures and their expenditures on
resources to create and maintain these investments. To measure
their success in doing so, Finance Board examinations and off-
site monitoring will look closely at whether FHLBank outlays
are sufficient for, and sufficiently directed toward, the
creation and maintenance of sound risk-management
infrastructures.
Q.9. Does the Finance Board collect information on the Home
Loan Banks' affordable lending and community development
activities? Is that information considered in your review of
the Banks' compliance with their mission?
A.9. The Finance Board collects information on the Banks'
affordable lending and community development activities for
four different mission-related activities of the FHLBanks:
The Affordable Housing Program (AHP);
The Community Investment Program (CIP);
Community Investment Cash Advances (CICA); and
Acquired Member Assets (AMA).
Congress established the AHP and CIP in 1989 as mission-
specific programs to assist in the financing of affordable
housing and community development projects for targeted income
levels. The AHP provides funding solely for affordable housing
for very low, and low- and moderate-income households. The CIP
is used for advances to members to fund both affordable housing
for targeted households and community development benefiting
low- and moderate-income households. All 12 FHLBanks are
required to provide funding through them. CICA is a regulatory
program, implemented in 1999, for financing community
development for which CIP is not well-suited and is targeted
according to household income, geographic areas, such as
brownfields or small business eligibility. FHLBank
participation in CICA programs is voluntary. The AMA program,
as adopted by the Finance Board in July 2000, allows an FHLBank
to acquire eligible whole residential mortgage loans, or
interests in such loans, from its members. The Finance Board
collects loan level data on all mortgages acquired by the
FHLBanks under the AMA program, including data on property
location and borrower characteristics.
These four programs--AHP, CIP, CICA and AMA--are important,
but not exclusive, components of the FHLBanks' overall
activities and operations designed to meet their public policy
mission. The AHP, CIP, and CICA programs are targeted programs
that complement the FHLBanks significantly larger advances
operations that support their financial institution members in
meeting the housing and community development needs of their
service areas.
The Finance Board uses the data collected for AHP, CIP, and
CICA to monitor and evaluate the activity levels of these
programs at individual FHLBanks and for the entire System; to
assess the FHLBanks' compliance with the statutory and
regulatory requirements of these programs; and to evaluate and
develop policies affecting the operation of these programs. The
Finance Board also uses the AHP data specifically to ensure
that all the FHLBanks contribute the full amount of the
required AHP contributions (ten percent of net earnings each
year) and that these amounts are distributed to eligible
projects. The Finance Board also uses CICA data to evaluate the
distribution of community development funding among the various
targeted purposes.
The Finance Board uses AMA data primarily for the
assessment of the safety and soundness of the FHLBanks mortgage
portfolios and to determine compliance with regulatory
requirements.
Since 1990, the FHLBanks have made more than $1.8 billion
available for affordable housing through the AHP; $27.9 billion
for affordable housing through the CIP; and $4.5 billion for
targeted community development projects through the CIP and
CICA.
During the past year, the Office of Supervision implemented
a horizontal review of all 12 FHLBanks' Affordable Housing
Programs. This review was comprised of a series of on-site
interviews with the FHLBanks' community investment staff,
senior managers, and directors, along with an examination of
the documents supporting the program. We are currently
analyzing the results of this review. Our analysis will result
in a report to be presented to the FHLBanks.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM SHELIA C. BAIR
Q.1. What is your assessment of the quality of the FHFB's
safety and soundness supervisory program as compared to the
major bank regulatory agencies? As compared to OFHEO? What do
you view as the primary weaknesses in the FHFB's safety and
soundness regulatory regime?
A.1. The FHFB does not publicly disclose as detailed
information about its safety and soundness supervisory program
as do the major bank regulators. Thus, comparisons are
difficult to make. A 1998 Report by the GAO \1\ identified
several deficiencies in the FHFB's examination program which
FHFB officials then attributed, at least in part, to a shortage
of qualified examination staff. At the time of that GAO report,
the FHFB had only 10 examiners. By late July 2002, the FHFB
still had only 10 examiners.\2\ The current FHFB has placed
greater emphasis on safety and soundness, and according to
recent public statements by Chairman John Korsmo, the number of
examiners has been increased to 17. The FHFB hopes to increase
that number to 24 by the end of this calendar year and 30 by
the end of the next fiscal year.\3\
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\1\ General Accounting Office. 1998. Federal Housing Finance Board:
Actions Needed to Improve Regulatory Oversight. September. (GAO/GGD-98-
203).
\2\ General Accounting Office. 2003. Financial Regulation: Review
of Selected Operations of the Federal Housing Finance Board. February.
(GAO-03-364).
\3\ Testimony of John Korsmo before the Subcommittee on Financial
Institutions, Senate Banking Committee (September 9, 2003).
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The number of examiners employed by the FHFB--though on the
rise--still pales in comparison to the large, experienced
examination staffs of the major bank regulatory agencies. For
instance, OCC will have 20 to 30 examiners assigned in
residence to each of its largest institutions, in addition to
special teams that may visit the institution as part of the
annual examination process. Similarly, the FDIC and OTS--while
not utilizing in-residence examiners--will assign teams of 20
to 30 examiners for extended periods to review their larger
institutions. For an institution the size of Washington Mutual,
for instance, the size of the team can go as high as 50
examiners. OFHEO also has significantly more examiners, a total
of 40, who conduct annual examinations and ongoing monitoring
of Fannie Mae and Freddie Mac.
The FHFB and OFHEO do not disclose detailed operating
budgets. Thus, it is difficult to compare the amount of
resources they devote to their supervisory programs. OFHEO's
2002 annual report to Congress indicated that it spent just 16
percent of its budget on examinations. However, because OFHEO
conducts capital adequacy reviews separately from the
examination process, that number may understate the resources
it commits to supervision. An additional 13 percent of the
Agency's budget is reportedly devoted to capital adequacy.
According to the 2003 GAO report $9.7 million of FHFB's $27
million budget was devoted to the Office of Supervision
(OS),\4\ or 36 percent. However, that figure may overstate the
amount actually spent on examinations because the OS is also
responsible for providing policy advice and analysis and
reporting on general economic, housing, finance, community
investment, and competitive environments for the FHLBanks.
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\4\ Ibid. pgs.10 and 28.
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In contrast, the Office ofthe Comptroller of the Currency
(OCC) spends 85 percent of its budget on its supervision
program, the bulk of which goes to salary and benefits for its
1,882 examiners. Similarly, the Office of Thrift Supervision
(OTS) spends 77 percent of its budget on its supervision
program, mostly supporting its 526 safety and soundness
exammers.
Both OFHEO and the FHFB lack formal training and
accreditation programs for their examiners. In contrast, all
the major bank regulators have training and accreditation
programs, and the overwhelming majority of their examiners are
either accredited or in training to become accredited.
It should be emphasized that the FHFB and OFHEO have a
number of experienced, knowledgeable examiners dedicated to
conducting rigorous oversight of institutions under their
authority. However, the size and the depth of experience of
these agencies' examination staffs do not compare favorably to
that of the bank regulators. Both agencies are no doubt impeded
in their ability to attract highly qualified staff given their
small size and narrow regulatory base, which in turn, limits
the opportunities for promotion and career advancement.
Q.2. How would the FHFB's recently withdrawn proposed AMA
rulemaking have affected safety and soundness oversight of the
FHLBanks? In your view, is the Chicago FHLBank's Shared Funding
Program consistent with the current AMA rule?
A.2. Chairman Korsmo's stated intent behind the recently
withdrawn AMA rulemaking was to ``to clarify and simplify the
current rule, while improving oversight.'' I have no doubt that
the Chairman and FHFB members believed the proposed changes
were consistent with safety and soundness. However, the impact
of many of the proposed changes would have been to ease
important safety and soundness restrictions currently in place
over the FHLBanks mortgage acquisition programs. The most
dangerous of the proposals was to eliminate the requirement
that acquired mortgage assets receive an investment grade
rating from an independent agency such as Moody's or Standard &
Poor's, instead allowing the FHLBanks to use their own
``estimated credit ratings.'' Another would have eased credit
enhancement requirements, and diluted restrictions on the types
of collateral that a member must post to secure its credit
obligations under AMA. The proposed changes would also have
allowed FHLBanks to purchase ``interests'' in whole loans, for
example, securitizations, in contrast to the current
requirement that they must purchase whole loans. Finally, the
proposed rulemaking would have opened the door to allowing
System members to act as conduits for participation in AMA by
nonmember finance companies and mortgage bankers.
It does not appear that Chicago's Shared Funding Program is
consistent with the current AMA rule, which, as mentioned
above, is restricted to purchases in ``whole loans.'' The FHFB
staff quietly approved the Shared Funding Program last
December, with no public discussion or input. Under the
program, Mortgage Partnership Finance (MPF) loans are sold to a
member of the Chicago FHLBank, which issues its own ``private
label'' securities backed by these loans. Two tranches of
securities are created, with the senior tier being sold to the
Chicago FHLBank or other FHLBanks, which may in turn, sell some
or all of the securities to System members. The member
securitizing the loans may sell the securities or
``certificates'' anywhere in the capital markets or hold them
in portfolio. Shared funding provides a vehicle for the Chicago
FHLBank to circumvent charter limitations on its own issuance
of MBS by partnering with one of its member institutions.
As previously mentioned, the FHFB' s current AMA rule
authorizes the FHLBanks to purchase from members only ``whole
loans'' based on the rationale that such purchases are the
``functional equivalent of an advance'' to such members.
However, Shared Funding Certificates are clearly ``interests''
in whole loans. Presumably, one of the reasons the FHFB sought
to extend the AMA to ``interests'' in whole loans was to
reconcile the current inconsistency between the Shared Funding
Program and FHFB regulatory requirements.
The FHFB has also exempted Shared Funding Certificates from
the limit FHLBanks otherwise must observe for investing in
mortgage-backed securities: Three times capital. The Treasury
Department has previously expressed the view that MBS
investments are a way for the FHLBanks to generate arbitrage
income, though they provide little public benefit. Similarly,
MBS acquired through the Shared Funding Program, while adding
interest rate and credit risk to the books of the FHLBanks,
would appear to add no new value.
These issues and others are discussed in more detail in a
comment letter Greg Baer and I filed on the proposed AMA
rulemaking, which is attached. Mr. Baer preceded me as the
Assistant Secretary for Financial Institutions in the Clinton
Administration.
Q.3. The Pittsburgh FHLBank suffered a very bad second quarter.
Based on its most recent financial reports, its annualized
return on assets is .02 percent. Its capital stands at $2.25
billion, or 4.2 percent of assets, barely above the regulatory
minimum. Its second quarter dividend was subsidized with $10
million from retained earnings. In your opinion, would a bank
regulator allow a bank to pay a dividend if the bank's core
operating results were so poor? What types of supervisory
action might be taken by a bank regulator when confronted with
a bank in this type of financial condition? Based on your
research, when will a bank regulator intervene based on a
bank's deteriorating capital position? Does the regulator wait
until the minimum requirement is breached before taking
supervisory steps?
A.3. Federally regulated banks and thrifts generally hold on
average at least 50 percent more capital than the regulatory
minimum. If they fall below a sufficient capital level, or if
there are other indicators of financial deterioration, Federal
examiners will carefully scrutinize their financial position,
request a capital restoration plan and direct corrective action
if there are indications of further financial deterioration.
Federal bank regulators try to identify early ``red flags'' of
financial troubles and institute corrective action long before
there is a threat that minimum capital will be breached.
Federal bank regulators look at several factors when
determining the appropriate supervisory action to take. In
determining a bank's financial condition, they perform an in
depth analysis of earnings to assess their quality, level, and
trends. They will seek to identify the source and cause of
earnings issues before making a determination of their severity
and the degree of supervisory concern
warranted. In determining the adequacy of a bank's capital,
bank regulators will evaluate the quality of the bank's assets,
interest rate sensitivity, and risk management practices.
Before a final determination concerning the bank's capital
level could be fully implemented, they would want to know the
bank's availability of other capital sources and if there were
any plans to use those sources. They would also evaluate the
possible adverse impacts of the bank not paying a dividend
before taking action to prohibit such payment.
If the Pittsburgh FHLBank had been regulated by one of the
Federal bank regulators, I believe it very likely that bank
examiners would have taken action to restrict or prohibit
dividend payments, and most certainly would not have permitted
a dividend payment that had to be subsidized with retained
earnings. (For example, Federal law 12 U.S.C. 56 and 60
restricts the payment of dividends by national banks; other
bank charter types are subject to similar restrictions.)
Rather, Federal bank examiners likely would have acted to
restrict asset growth, while protecting capital to cushion
against further losses, and taken action to address any
underlying unsafe and unsound practices that caused or
contributed to the bank's undercapitalized condition, including
restricting the bank's ability to enter into new contracts or
engaging in new business lines. This would be particularly true
if the earnings problems were associated with exponential
growth in a new, higher-risk activity and were expected to
persist, which is the case in Pittsburgh. The Pittsburgh
FHLBank grew MPF loans from about $2 billion at June 30, 2002
to over $9 billion at June 30, 2003 and is predicting
protracted constraints on earnings arising from losses
associated with prepayments on its mortgage portfolio. And of
course, the Pittsburgh Bank just announced that it is now
estimating a third quarter GAAP net loss of $6.5 million.