Federal Home Loan Bank System: An Overview of Changes and Current
Issues Affecting the System (13-APR-05, GAO-05-489T).
The FHLBank System (FHLBank System or System) is a
government-sponsored enterprise (GSE) that consists of 12 Federal
Home Loan Banks (FHLBanks) and is cooperatively owned by member
financial institutions, typically commercial banks and thrifts.
The primary mission of the FHLBank System is to promote housing
and community development generally by making loans, also known
as advances, to member financial institutions. To minimize the
potential for significant financial problems, the Federal Housing
Finance Board (FHFB) regulates the FHLBank System's safety and
soundness. Over time, a number of developments have affected the
System's safety and soundness and have created pressures on its
traditional cooperative structure. To assist the committee in
understanding the important issues surrounding the FHLBank System
and its regulation, this testimony provides information on the
development of the System; two legislative changes and FHFB
rulemaking that led to changes in membership, asset composition,
and capital structure; and important challenges and questions the
FHLBank System currently faces.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-489T
ACCNO: A21557
TITLE: Federal Home Loan Bank System: An Overview of Changes and
Current Issues Affecting the System
DATE: 04/13/2005
SUBJECT: Community development
Federal agency reorganization
Financial institutions
Government sponsored enterprises
Housing
Internal controls
Mortgage interest rates
Mortgage programs
Mortgage-backed securities
Performance measures
Risk management
Statutory law
Strategic planning
Commercial banks
Business planning
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GAO-05-489T
United States Government Accountability Office
GAO Testimony
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
For Release on Delivery
Expected at 10:00 a.m. EDT FEDERAL HOME LOAN
Wednesday, April 13, 2005
BANK SYSTEM
An Overview of Changes and Current Issues Affecting the System
Statement of Thomas J. McCool, Managing Director Financial Markets and
Community Investment
GAO-05-489T
[IMG]
April 13, 2005
FEDERAL HOME LOAN BANK SYSTEM
An Overview of Changes and Current Issues Affecting the System
What GAO Found
Established in 1932 to facilitate the extension of mortgage credit, the
FHLBank System has undergone significant statutory changes in the last 15
years. Between the 1930s and the 1980s, the System consisted primarily of
thrift members that accepted advances from the FHLBanks. However, during
the 1980s, hundreds of FHLBank member thrifts failed forcing Congress to
fundamentally reform the System through the Financial Institutions
Recovery, Reform, and Enforcement Act of 1989 (FIRREA). For example,
FIRREA permitted commercial banks to join the System. Although FIRREA is
credited with strengthening the thrift industry and the System, concerns
were raised during the 1990s about the System's capital structure. In
particular, commercial bank members could remove stock from their FHLBank
on 6-months notice, which raised concerns about the System's financial
stability. Among other provisions, the Gramm-Leach-Bilely Act (GLBA) of
1999 created a more permanent and risk-based capital structure for the
System.
Due to these statutes and FHFB rulemaking, the FHLBank System has evolved
substantially since 1990. For example, commercial banks now account for
more than 70 percent of all System members. The composition of FHLBank
System assets has also fluctuated considerably over the years. For
example, FHFB authorized the FHLBanks to purchase mortgages directly from
their members in the 1990s. The System's mortgage assets grew to about
$113 billion at yearend 2003 representing about 14 percent of total
assets. However, the rapid growth in System mortgage assets leveled off in
2004 as two FHLBanks experienced problems managing the interestrate risks
associated with holding mortgages on their books. As provided by GLBA,
System capital is now more permanent as members generally must invest
capital for a period of 5 years and the FHLBanks are subject to new
leverage and risk-based capital requirements.
The FHLBank System faces important challenges and questions going forward.
For example, FHFB has called the FHLBanks' risk-management practices into
question, particularly those related to mortgage purchase programs.
Further, proposals to permit the FHLBanks to issue mortgagebacked
securities (securitization) could help ensure the growth of the mortgage
purchase business and improve risk management, however these proposals
raise questions regarding the FHLBanks' capacity to manage the related
risks. Additionally, there is limited empirical information available
regarding the extent to which the System is fulfilling its housing and
community mission. Finally, questions have been raised regarding the
potential negative affects that large financial institutions may have on
the traditional cooperative structure of the FHLBank System and its
programs designed to benefit targeted groups.
United States Government Accountability Office
Dear Mr. Chairman and Members of the Committee:
I appreciate the opportunity to participate in today's hearing to provide
an overview on the Federal Home Loan Bank System's (FHLBank System or
System) operations, its federal oversight, and challenges that it faces.
As you know, the FHLBank System is a government-sponsored enterprise (GSE)
that consists of 12 Federal Home Loan Banks (FHLBanks) and is
cooperatively owned by member financial institutions, typically commercial
banks and thrifts (or savings and loans). The primary mission of the
FHLBank System is to promote housing and community development generally
by making loans, also known as advances, to member financial institutions.
These institutions are required to secure FHLBank advances with
high-quality collateral (such as single-family mortgages) and may use the
advances to fund mortgages. To raise the funds necessary to carry out its
activities, the FHLBank System issues debt in the capital markets at
favorable rates compared to commercial borrowers due to its GSE status.
According to the Federal Housing Finance Board (FHFB), as of December 31,
2004, the System had $855 billion in outstanding debt obligations.1
Because the FHLBank System is a GSE, the potential exists that the federal
government would be called on to provide financial assistance to the
System if it was unable to meet its financial obligations. To minimize the
potential that the FHLBank System would experience significant financial
problems, Congress established the FHFB as the System's safety and
soundness regulator in 1989. FHFB is also responsible for helping to
ensure that the FHLBanks fulfill their housing and community development
mission.
In recent years, the FHLBank System has undergone important changes and
questions have been raised regarding the adequacy of FHLBanks'
riskmanagement practices and the functioning of the System's cooperative
structure. For example, since 1997, the FHLBank System has moved beyond
the traditional advance business by establishing programs to purchase
mortgages directly from member financial institutions, an activity similar
to the mortgage purchase business of the two other housing GSEs: Fannie
Mae and Freddie Mac. Although such mortgage
1As of the date of this testimony, the FHLBanks 2004 annual combined
financial report was not yet available. For this testimony, we used
FHLBank System's Office of Finance data from 1990 through 2003 and
obtained the best available data for 2004 from FHFB.
purchase programs have the potential to increase profitability and better
serve member institutions, they also expose FHLBanks to interest-rate and
credit risk.2 FHFB recently identified interest-rate risk management
deficiencies at two FHLBanks and required them to take corrective
measures. The traditional cooperative structure of the FHLBank System has
also been challenged by sometimes sharp differences in business strategies
among the 12 FHLBanks. In particular, FHLBanks have disagreed over
proposals to permit securitization of mortgage assets.3 While
securitization may permit FHLBanks to expand their purchase of mortgage
assets, some FHLBanks also regard it as changing the business of the
System and increasing potential risks.
To assist the committee in understanding the important issues surrounding
the FHLBank System and its regulation, my testimony today is divided into
three parts. First, I will provide an overview on the development of the
FHLBank System and its supervision with a focus on how two statutes: the
Financial Institutions Recovery, Reform, and Enforcement Act of 1989
(FIRREA) and the Gramm-Leach-Bliley Act of 1999 (GLBA) made substantial
changes to the System's original structure and capital requirements.
Second, I will provide more detailed information as to how FIRREA and
GLBA, as well as FHFB rulemaking have changed the System's membership,
asset composition, and capital structure over the past 15 years. Third, I
will discuss important challenges and questions affecting the FHLBank
System.
In summary:
o Congress established the FHLBank System in 1932 to help rescue the
housing finance market, which had been decimated by the Great Depression.
Between the 1930s and the 1980s, each FHLBank made
2Interest-rate risk is the risk that relative and absolute changes in
interest rates may adversely affect an institution's financial condition.
Credit risk is the risk of nonperformance by counterparties to derivative
agreements and other obligations or the risk that an FHLBank member would
default on an advance. No FHLBank has reportedly ever suffered a credit
loss on an advance due, in part, to the System's collateral requirements.
Also, FHLBanks have a priority lien status on the assets of members who
experience financial problems and are placed into receivership.
3Securitization is the process of aggregating similar instruments, such as
loans or mortgages, into pools and selling investors securities that are
backed by cash flows from these loan pools. Proposals have been made to
permit FHLBanks to securitize mortgages that they purchase and issue
mortgage-backed securities to investors. Fannie Mae and Freddie Mac are
large issuers of mortgage-backed securities.
advances to thrifts in its district that were required to be members of
the System, and these activities were credited with helping to develop a
unified housing finance market. However, in response to the thrift crisis
of the 1980s, Congress enacted FIRREA which, among other provisions,
opened FHLBank System membership to commercial banks and other insured
depository institutions on a voluntary basis and permitted such members to
withdraw capital from the System with 6-months notice (whereas thrifts
were still required to become members and as mandatory members could not
withdraw their minimum required amount of capital). In 1999, due to
concerns that voluntary members' ability to withdraw capital increased
risks to the System, GLBA made System membership voluntary for all
institutions but required a more permanent capital structure with leverage
and risk-based capital requirements.
o Due to FIRREA, GLBA, and FHFB rulemaking, the FHLBank System has
evolved substantially since 1990. For example, commercial banks now
account for more than 70 percent of all the System members, whereas
thrifts accounted for nearly 100 percent of all members in 1990. The
composition of FHLBank System assets have also fluctuated considerably
over the years, although advances remain the largest asset. In the early
to mid 1990s, advances declined from about 70 percent of the System's
assets to about 50 percent as the FHLBanks increased investments in
mortgagebacked and other types of securities (investments increased from
about 27 percent of the System assets in 1990 to 43 percent in 1996).
System investment assets increased as FHLBanks sought higher returns than
those available from the traditional advance business. Between 1997 and
2003, FHLBank System mortgage holdings increased as a percentage of
assets, relative to advances and other investments. However, mortgage
holdings leveled off in 2004 as a result of the financial difficulties
some FHLBanks experienced with their mortgage purchase programs.
Consistent with GLBA, the FHLBank System has also largely implemented its
new capital structure.
o The FHLBank System is currently facing several important challenges
and questions regarding its risk-management practices, future business
strategies, mission accomplishment, and organizational structure. As I
described previously, FHFB has entered into written supervisory agreements
with two FHLBanks due to risk management deficiencies in their mortgage
purchase programs-including the Chicago bank which has been the engine of
growth for the System's mortgage purchases-and placed limits on future
purchases until identified deficiencies are corrected. Although
securitization has been proposed as a means to permit the FHLBank System
to continue expanding its mortgage purchase programs over the long-term,
the idea is highly controversial. Another
challenge facing the System is that there is limited empirical information
on the extent to which FHLBank advances and other services benefit housing
and community finance. Finally, concerns have been raised that large
financial institutions that may have subsidiaries with memberships in two
or more FHLBank districts could generate dangerous competition within the
System and negatively affect its community development efforts.
To prepare for this testimony, we reviewed several reports and testimonies
that we have completed on the FHLBank System and FHFB.4 We also obtained
FHLBank System financial data for 2004 from FHFB. Additionally, we
interviewed several FHLBank presidents as well as the FHFB Chairman, two
FHFB board members, and agency officials. We conducted our work in
Washington, D.C., between March and April 2005 in accordance with
generally accepted government auditing standards.
I would like to begin my testimony by briefly describing the development
of the FHLBank System, significant statutory changes to the System, and
its operations. Then, I will describe FHFB's structure and activities.
Overview of the
Federal Home Loan Bank System and Its Regulation
4See GAO, Federal Home Loan Bank System: Reforms Needed to Promote Its
Safety, Soundness, and Effectiveness, GAO/GGD-94-38 (Washington, D.C.:
Dec. 8, 1993); Capital Structure of the Federal Home Loan Bank System,
GAO/GGD-99-177R (Washington, D.C.: Aug. 31, 1999); Comparison of Financial
Institution Regulators' Enforcement and Prompt Corrective Action
Authorities, GAO-01-322R (Washington, D.C.: Jan. 31, 2001); Federal Home
Loan Bank System: Establishment of a New Capital Structure, GAO-01-873
(Washington, D.C.: Jul. 20, 2001); Financial Regulation: Review of
Selected Operations of the Federal Housing Finance Board, GAO-03-364
(Washington, D.C.: Feb. 28, 2003); and Federal Home Loan Bank System: Key
Loan Pricing Terms Can Differ Significantly,
GAO-03-973 (Washington, D.C.: Sep. 8, 2003).
The FHLBank System Was Established to Facilitate Housing Finance and Has
Undergone Significant Changes in Recent Decades
Congress passed the Federal Home Loan Bank Act (FHLBank Act) in 1932 and
established the FHLBank System to facilitate the extension of mortgage
credit and the housing finance market, which had been severely affected by
the Great Depression. The FHLBank Act required all federally chartered
thrifts to become members of the FHLBank located in their districts (see
fig. 1) and invest capital in the FHLBanks. The System acted as a central
credit facility that made advances to thrifts which, in turn, were
expected to make additional mortgage credit available to homebuyers and
thereby revive the housing finance market. The act also established
safeguards to help ensure the financial soundness of the FHLBanks. In
particular, thrifts had to pledge high-quality assets in excess of the
value of their advances as collateral. In addition, the act created the
Federal Home Loan Bank Board (Bank Board) to oversee the safety and
soundness regulation of the FHLBanks as well as the thrift industry.
However, between 1985 and 1989, the Bank Board delegated its oversight
responsibility of the thrift industry to each of the FHLBanks.
institutions to which they made advances) compromised the safety and
soundness oversight of the thrift industry. In response to these issues,
Congress enacted the FIRREA, which made substantial changes to the FHLBank
System's membership, regulation, and mission requirements as summarized
below:
o FIRREA opened FHLBank system membership to commercial banks and credit
unions that engaged in mortgage activities. These voluntary members were
required to invest capital in their FHLBank but could normally withdraw
such capital on 6-months notice. However, FIRREA still required thrifts to
be members of their FHLBank and did not allow them to withdraw their
capital contributions.
o FIRREA required the System to capitalize the Resolution Funding
Corporation (REFCORP) to help pay for the deposit insurance fund losses
resulting from thrift failures. Furthermore, the System had to pay up to
$300 million per year of annual earnings to contribute towards interest
payments on bonds issued by REFCORP to pay for thrift losses.
o FIRREA abolished the Bank Board and established FHFB to regulate the
12 FHLBanks. FIRREA also transferred the Bank Board's previous supervisory
and regulatory responsibilities for thrift institutions and their holding
companies to the newly created Office of Thrift Supervision.
o FIRREA also directed each FHLBank to establish or maintain two low-and
moderate-income housing programs-the Community Investment Program (CIP)
and the Affordable Housing Program (AHP). As part of CIP, each FHLBank
makes advances to finance the purchase or rehabilitation of housing for
eligible households and finance other projects benefiting residents of
low-and moderate-income neighborhoods. AHP requires each FHLBank to
subsidize the financing of eligible low- and moderate-income housing and
FIRREA sets priorities for use of these advances among eligible projects.
Although FIRREA is credited with helping to restore the financial
condition and supervision of the thrift industry during the 1990s, the
capital structure of the FHLBank System and the financial obligations that
the act imposed on the System and its members subsequently raised
concerns. In particular, the fact that voluntary members, such as
commercial banks, had the option of removing their capital from the System
with 6-months notice appeared to increase financial risks to the System.
Additionally, since the FHLBanks' earnings had been weakened by the
declining profitability of the thrift industry, the $300 million REFCORP
obligation posed a challenge. Consequently, FHLBanks looked for new
sources of revenue and increased investments in mortgage-backed securities
that offered potentially higher returns, but exposed them to increased
risks.
After years of attempting to resolve these issues, Congress passed the
Gramm-Leach-Bliley Act of 1999 (GLBA), which contained provisions that
o Eliminated the requirement that thrift institutions be members of the
FHLBank System and made membership voluntary for all members.
Additionally, GLBA established new capital requirements for FHLBank
members that were intended to make the System's capital more permanent. I
will describe the capital provisions of GLBA in more detail later in my
testimony;
o Revised the System's REFCORP obligations, moving from a fixed annual
payment of about $300 million to a specified percentage (20 percent) of
the System's annual earnings after AHP expenses. This change minimized the
financial obligation on the System during periods of relatively low
profitability but increased the total payment when profits increased; and
o Expanded the amounts and types of collateral that FHLBanks could
accept for advances from small members known as community financial
institutions (CFI).5 GLBA permitted CFIs to pledge small business and
agricultural loans as collateral for FHLBank advances.
The Structure and
Operations of the
FHLBank System
Each of the 12 FHLBanks has a board of directors of at least 14 persons,
with 8 elected by members and at least 6 appointed by FHFB. The FHFB
appointed directors are commonly referred to as public interest
directors.6 Additionally, each FHLBank board appoints a president who is
responsible for overseeing the institution's staff (see table 1). The
president and staff are responsible for such activities as the FHLBank's
asset and liability management, AHP and other community development
activities, and compliance with laws and regulations.
5CFIs are defined as Federal Deposit Insurance Corporation insured
institutions that have less than $500 million in total assets, adjusted
for inflation. In 2004, the CFI designation was $548 million. GLBA also
allowed FHLBank members to make greater use of other real estate related
collateral-such as commercial real estate loans and home equity loans-as
collateral for FHLBank advances.
6At least two of the public interest directors are designated as community
development directors because of their ties to the local community.
Table 1: Staff at Each FHLBank as of December 31, 2003
FHLBank Full-time Part-time Total
Boston 154 2 156
New York 204 4 208
Pittsburgh 192 5 197
Atlanta 278 0 278
Cincinnati 144 2 146
Indianapolis 127 7 134
Chicago 295 6 301
Des Moines 154 17 171
Dallas 135 0 135
Topeka 135 2 137
San Francisco 220 4 224
Seattle 148 3 151
Source: FHLBank System Office of Finance.
The FHLBank System raises funds in the capital markets through its Office
of Finance (OF), which has a board of directors consisting of three
individuals who serve 3-year terms. FHFB appoints the OF chair and selects
two FHLBank presidents to serve as the other OF board members. As I
discussed earlier, the FHLBank System can issue debt, generally referred
to as consolidated obligations, at a relatively low cost due to its GSE
status, which may allow members to fund mortgages at lower rates.
Consolidated obligations are the "joint and several" obligations of the
FHLBanks. That is, if an FHLBank defaults on its repayment obligations,
all the other FHLBanks may have to cover its obligations. Although the
federal government does not explicitly guarantee that it would provide
financial assistance to the FHLBank System in a financial emergency,
investors perceive an implied guarantee because of the ties between the
government and the System. For example, each FHLBank has a federal charter
and consolidated obligations are exempt from federal, state, and local
taxes. Moreover, the federal government did provide financial assistance
to other GSEs, such as Fannie Mae and the Farm Credit System, when they
experienced financial difficulties during the 1980s.
In addition to providing advances to its members, the FHLBank System
provides member institutions other benefits and services. For example,
FHLBanks generally pay dividends to their member financial institutions.
Other services FHLBanks may offer members include providing discounts on
advances for large transactions, funding the AHP and CIP programs to
help members finance affordable housing and community development
activities, and offering mortgage purchase programs as discussed next.
Although reportedly no FHLBank has ever suffered a credit loss on an
advance, the business activities of the FHLBanks have become increasingly
complex and potentially risky in recent years largely due to the
implementation of the mortgage purchase programs. All of the FHLBanks are
authorized to purchase mortgages from members through programs such as the
Mortgage Partnership Finance (MPF) program and the Mortgage Purchase
Program (MPP).7 Through these mortgage purchase programs, FHLBanks
purchase conventional or governmentguaranteed mortgages directly from
their members. The FHLBanks hold the mortgages on their books and bear the
interest-rate risks associated with them.8 To manage the interest-rate
risks, FHLBanks must employ sophisticated risk-management techniques
including the use of financial derivatives. Although such strategies are
appropriate for risk management, they require specialized expertise,
sophisticated information systems, and an understanding and application of
sometimes complex accounting rules. As I discuss later, some FHLBanks
recently have encountered financial problems in managing the interest rate
risks associated with their mortgage portfolios.
FHFB Regulates FHLBank System Safety and Soundness and Mission Achievement
FHFB is responsible for regulating the FHLBank System's safety and
soundness as well as its mission achievement. The agency has a fivemember
board, with the President of the United States appointing four board
members, subject to Senate approval. Each appointee serves a 7year term.
The fifth board member is the Secretary of the Department of Housing and
Urban Development, or the secretary's designee. The President also
designates one of the four appointed board members as the chair, subject
to Senate approval. FHFB is located in Washington, D.C. and
7In 1997, the FHLBank of Chicago received approval from FHFB to begin
operating a pilot program for MPF. In 1998, FHFB granted all 12 FHLBanks
the authority to establish similar mortgage purchase programs. Today, 9
FHLBanks offer MPF in conjunction with the Chicago FHLBank, and the
remaining 3 (Cincinnati, Indianapolis, and Seattle) offer their own
individual MPPs. However, the Seattle FHLBank recently announced its
intention to exit from its MPP.
8Interest-rate risk management has always been necessary to deal with
advances and holdings of investments in mortgage backed securities, but
the increasing purchases of mortgages from members through MPF and MPP has
increased the FHLBanks' need to manage the interest-rate risk associated
with holding mortgage assets.
has a staff of about 124 individuals, including 17 examiners in eight
cities where FHLBanks are located.
FHFB supervises the FHLBanks by conducting annual on-site examinations and
off-site monitoring to ensure that the Banks satisfy capitalization
requirements and maintain their ability to raise funds in the capital
markets. On-site examinations are focused on particular risk areas
(interest-rate risk, credit risk, and operational risk) and compliance
with mission requirements such as the AHP program.9 Examiners set the
scope for the examinations based on potential issues identified at
previous examinations, as well as through quarterly monitoring. Off-site
monitoring involves FHFB headquarters staff reviewing financial data on
the FHLBanks on a continual basis. FHFB also conducts systemwide reviews
of significant FHLBank operational, governance, and other practices and
uses advisory bulletins and regulatory interpretations to convey guidance
that addresses supervisory issues with systemwide implications.
Under the FHLBank Act, FHFB is authorized to promulgate and enforce such
regulations and orders that it deems necessary to carry out its
responsibilities. The following summarizes several of FHFB's key
authorities:
o FHFB has the authority to issue cease-and-desist orders and other
enforcement actions to address unsafe FHLBank practices. FHFB also has the
authority to remove FHLBank officials and prohibit actions by FHLBank
officers and directors.
o FHFB does not have specific statutory authority to establish a prompt
corrective action (PCA) mechanism as do other federal banking regulators
such as the Office of the Comptroller of the Currency and the Federal
Deposit Insurance Corporation. Under such PCA authorities, bank regulators
are required to take specific supervisory actions when bank capital levels
fall below specified levels and may take other actions when specified
unsafe and unsound actions occur. Although FHFB does not have PCA
authority, FHFB officials believe they have all the necessary authorities
to carry out their responsibilities; and
o FHFB has the statutory authority to liquidate or reorganize a
critically undercapitalized FHLBank "whenever [FHFB] finds that the
efficient and
9Operational risk is the risk of potential loss due to human error,
systems malfunctions, man-made or natural disasters, fraud, or
circumvention or failure of internal controls.
FHLBank System Membership, Asset Composition, and Capital Structure Have
Undergone Significant Changes in the Past 15 Years
economical accomplishment of the purposes of the [FHLB Act] will be aided
by such action."10
Until 1989, the FHLBank System consisted of the 12 FHLBanks, OF, and
thrifts, which were required to join. However, FIRREA and GLBA made
substantial changes to this traditional structure. In this section, I will
describe in more detail how FHLBank System membership, asset composition,
and capital structure have changed over the past 15 years after the
implementation of these statutes and FHFB regulations.
Commercial Banks Currently Account for the Majority of System Members and
Advances
Between 1990 and 2004, FHLBank System membership nearly tripled from 2,855
to 8,131 institutions (see fig. 2). As shown in the figure, the vast
majority of membership increase can be attributed to commercial banks;
whereas in the same period, thrift membership declined markedly. In 1990,
thrifts accounted for 98 percent of all the System members but only 16
percent in 2004. In contrast, commercial banks accounted for 2 percent of
all members in 1990 and 73 percent in 2004.11 A variety of factors may
account for the surge in commercial bank membership. First, FHLBanks
actively recruited commercial banks as members after FIRREA. Commercial
banks may also have been attracted by the fact that FHLBank advances
represent a stable and relatively low-cost source of funding.
Additionally, in an attempt to offset declining membership resulting from
the failure of many thrifts, FHLBanks modified their services and products
to attract new members. For example FHLBanks made changes in advance
pricing and terms in response to market pressures.
1012 U.S.C. S:1446.
11As of 1999 before GLBA made membership voluntary for all members,
commercial banks accounted for 72 percent of all System members.
Figure 2: Composition of FHLBank System Membership, 1990 and 2004, by
Member Institution Type
1990 (2,855 member institutions)
2004 (8,131 member institutions)
2% 1%
Thrifts
Commercial banks
Credit unions
Insurance companies
Source: GAO analysis of Federal Housing Finance Board data.
Not only do commercial banks represent a large percentage of FHLBank
System members, they also hold a large percentage of System capital and
advances.12 As shown in figure 3, commercial banks now account for almost
half of the System's capital and advances. However, member thrifts still
account for 43 percent of all system capital and 50 percent of all
advances. Although thrifts account for a relatively small percentage of
FHLBank members, they have remained significant customers of the FHLBank
System due to their focus on mortgage financing.
12FHLBank members are required to invest capital in their FHLBank as a
condition for membership. Members are generally also required to place
additional capital in their FHLBank on the basis of the size of their
advance business or mortgage purchases.
Figure 3: System Capital and Advances, by Member Institution Type, as of
December 31, 2004
Capital Advances
4% 4% 2%2%
FHLBank System assets, which consist of advances, investments, and
mortgages, increased from $165 billion in 1990 to $934 billion in 2004. As
shown in figure 4, the mix of the three asset types has fluctuated in this
time period although advances remained the largest category of assets.
However, I note that the System did not hold mortgage assets until 1997.
In 1990, advances represented about 70 percent of all the System's assets,
but declined to about 50 percent between 1991 and 1996. In contrast,
FHLBank System investments-such as holdings of mortgage-backed securities
(MBS) issued by Fannie Mae and Freddie Mac-increased from 27 percent of
all assets in 1990 to 43 percent in 1996. During that period, as I have
discussed, the number of thrifts declined, resulting in a loss of System
advance customers and concerns were raised that REFCORP obligations
imposed significant financial burdens on the FHLBanks. Investments in MBS
were viewed within the System as more profitable
Thrifts
Commercial banks
Credit unions
Insurance companies
Source: GAO analysis of Federal Housing Finance Board data.
Mix of System Asset Types Has Fluctuated Significantly from 1990 through
2004
than traditional advances and a potential means to comply with the REFCORP
obligations. Through rulemaking, FHFB facilitated the FHLBanks' ability to
invest in MBS. In 1991, FHFB increased the percentage of MBS that the
FHLBanks could hold as a percentage of their capital from 50 percent to
200 percent and, in 1993, FHFB raised the MBS to capital ratio to 300
percent. I note that investments as a percentage of all the System's
assets began to decline in 1995 while advances began to increase perhaps
due, in part, to the increase in commercial bank members joining the
System and taking advances.
Figure 4: Mix of System Assets between 1990 and 2004, by Advances,
Mortgages, and Investments
Percentage
80
70
60
50
40
30
20
10
0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
2004 Year
Advances
Investments
Mortgages Source: GAO analysis of Federal Housing Finance Board and Office
of Finance data.
Note: Data from 1990 to 2003 is from Office of Finance annual reports.
According to the Office of Finance, the FHLBank of Chicago restated its
2003 financial results, which resulted in changes to certain FHLBank
System financial information. As of the date of this testimony, the
restated report was not available, so we used the originally reported data
for 2003. Since the Office of Finance 2004 annual report was not available
at the time of this testimony, we used yearend 2004 data from FHFB.
However, FHFB and the Office of Finance calculate investments differently.
Therefore, we obtained 2004 data on investments from highlights of the
upcoming Office of Finance 2004 annual report.
As I have discussed, FHFB also authorized the FHLBanks to begin purchasing
mortgage assets through mortgage purchase programs in 1997. By 2003, such
mortgage assets grew to almost 14 percent of all the System's assets
(about $113 billion in total System mortgage assets at yearend 2003). The
growth in mortgages generally occurred relative to investments which
declined from 40 percent of all assets in 1997 to 23 percent in 2003.
However, in 2004, the System's mortgage assets leveled off, partly because
of difficulties identified at some FHLBanks in managing such assets. I
discuss this issue in the next section.
FHLBank System Has Implemented a New Capital Structure
As I discussed earlier, prior to 1999 voluntary FHLBank members, such as
commercial banks, could withdraw their capital on 6-months notice, which
raised questions about the stability of the FHLBanks' capital structure.
To address this concern, GLBA established that FHLBank membership was
voluntary but required that financial institutions that choose to become
members invest more permanent stock in their FHLBank. Under the new
capital structure, FHLBanks can issue class A stock, which can be redeemed
with 6-months notice, and class B stock, which can be redeemed with
5-years notice, or both. To help ensure that capital does not dissipate
due to redemption in times of stress, GLBA does not allow an FHLBank to
redeem or repurchase capital if following the redemption the FHLBank would
fail to satisfy any minimum capital requirement.
Under GLBA, the FHLBanks are also subject to both a leverage requirement
(minimum capital-to-assets ratio) and a risk-based capital calculation.
Under the leverage requirements, each FHLBank must comply with two minimum
capital ratios. First, permanent capital (equal to amounts paid in for
class B stock plus retained earnings) plus class A stock is to be at least
4 percent of assets. Second, class A stock plus 1.5 times permanent
capital is to be at least 5 percent of assets. The risk-based capital
standards account for credit risk, interest-rate risk, and operations
risk. For credit risk, a FHFB regulation specifies capital requirements
according to the mix of activities (advances, mortgages, etc.) in which
the individual FHLBank is engaging. For interest-rate risk, each of the
FHLBanks must have a FHFB-approved interest-rate risk model that provides
an estimate of the market value of the FHLBank's portfolio during periods
of market stress. The capital requirement for operations risk is generally
30 percent of the total capital charge for credit and interest-rate risk.
GLBA required each FHLBank to submit a capital plan to FHFB for review and
approval. FHFB approved all 12 FHLBank capital plans by 2002 and 11
of the 12 FHLBanks have implemented their capital plans. According to
FHFB, 10 of the 12 capital plans rely entirely on class B stock and two of
the capital plans include class A stock. As part of the capital plan
implementation process, FHFB has required the FHLBanks to submit plans for
modeling interest-rate risk and related procedures for managing these
risks.
Finally, I would like to discuss some important challenges and questions
affecting the FHLBank System. They include risk-management practices, the
securitization of mortgage assets, the extent to which the FHLBank System
is meeting its mission requirements, and the alleged impacts that large
financial institutions are having on the System's traditional cooperative
structure and AHP program.
FHLBank System Faces Important Challenges and Questions
FHFB Has Questioned FHLBanks' Risk-Management Practices
Over the past year, FHFB identified risk-management deficiencies at two
FHLBanks-Chicago and Seattle-primarily related to their management of the
interest-rate risks associated with mortgage purchases. FHFB identified
weaknesses at these FHLBanks in such areas as corporate governance,
financial recordkeeping, audit, and financial performance. Additionally,
FHFB entered into written enforcement agreements with both FHLBanks that
require improvements in accounting practices and internal controls. The
Chicago and Seattle FHLBanks were both required to submit 3-year business
and capital plans to FHFB and hire outside management consultants to
review the banks' management and their board's oversight of the banks. The
Chicago FHLBank has submitted its plan to FHFB, which accepted it. The
Seattle FHLBank received an extension and submitted its plan to FHFB on
April 5, 2005.
The financial problems identified at the Chicago and Seattle FHLBanks have
had significant effects on their operations and business practices. For
example, FHFB required the Chicago FHLBank to restate its financial
results for 2003 and placed limits on the growth of the institution's
mortgage purchases until its risk-management practices improve.
Previously, the Chicago FHLBank had been the primary engine of growth for
the mortgage purchase programs within the FHLBank System. The Seattle
FHLBank has decided to exit from the MPP program and thereby stop
purchasing mortgages from its members.
FHFB officials told us they continue to monitor risk management practices
within the FHLBank System, particularly the management of interest-rate
risks. FHFB officials said that their examinations continue to identify
deficiencies in these areas and that they are working with the FHLBanks to
correct them.
Proposals to Use Securitization to Expand FHLBanks' Mortgage Purchase
Programs Are Controversial
In recent years, proposals have been made to permit the FHLBanks to
securitize mortgage assets to provide for the continued growth of the
mortgage purchase programs. Without securitization, which would permit
FHLBanks to remove mortgage assets from their balance sheets, the System's
ability to increase its mortgage purchases may be constrained by capital
requirements. That is, since the FHLBanks must comply with capital
requirements for assets such as mortgages held on their balance sheets,
they would not be able to expand these programs without obtaining
additional capital from their members, which may prove difficult.
According to FHFB's chair, the agency should defer to Congress on the
question of whether FHLBanks should be permitted to securitize their
mortgage assets.
Securitization offers potential benefits to the FHLBank System but it
raises questions as well. One potential benefit of securitization is that
it would provide the FHLBanks with an additional tool to manage the
interest-rate risks associated with mortgage purchases. Authorizing the
FHLBanks to securitize mortgage assets has also been advocated as a means
to increase competition in the secondary mortgage market, which could
benefit lenders and homebuyers. However, questions exist on whether the
FHLBanks would be able to develop the necessary infrastructure, including
hiring staff with specialized expertise, to effectively manage
securitization programs. Some FHLBank System members have also commented
that securitization would further alter the System's traditional focus on
providing advances to member institutions, and therefore, be undesirable.
Limited Information Exists on the Extent to Which the FHLBank System Is
Meeting Its Mission
Although anecdotal information exists on the benefits of the FHLBank
System, limited quantitative analysis exists on the extent to which the
FHLBanks' activities benefit homebuyers, mortgage finance, and community
development. We recognize that conducting such research is challenging.
First, isolating the FHLBanks' effects on mortgage markets is a complex
and technical undertaking. Second, with the addition of mortgage purchase
programs, the financial activities of the FHLBanks have become more
sophisticated, thus complicating any analyses of benefits and costs.
Nevertheless, assessing the outcomes of the FHLBank System's activities is
important for Congress and others to determine
whether the risks associated with the System are offset by the potential
benefits.
I would now like to highlight information and data limitations that hamper
any assessment of mission achievement:
o We are not aware of any studies on the extent to which FHLBank
advances, mortgage purchase, and other activities directly benefit
homebuyers through lower mortgage costs. In contrast, several studies have
estimated the potential savings to homebuyers associated with the mortgage
purchase activities of Fannie Mae and Freddie Mac. Some of these studies
estimate a substantial savings to homebuyers while others conclude that
the savings are small and that Fannie Mae and Freddie Mac as well as their
shareholders are the primary beneficiaries. Although the studies' findings
may differ, they provide an empirical basis for discussing the costs and
benefits of Fannie Mae and Freddie Mac's activities.
o Similarly, there is minimal empirical evidence on the extent to which
the FHLBank System's advance business encourages lenders to expand their
mortgage business. We have identified one existing study on this subject:
a 2002 report by the Federal Reserve Bank of Cleveland.13 The study found
that there is a significant positive relationship between an FHLBank
member's use of advances and its mortgage finance activity. However, we
believe the report has certain methodological limitations and should be
interpreted with caution. For example, the report does not demonstrate
that members increased their mortgage assets as a result of joining the
System, it only shows that System members have relatively high mortgage
assets compared to non-System members (We are also aware that the FHLBank
Council recently released two reports on this subject but we have not had
time to analyze them in preparation for this testimony).
o There is limited information as to why the placement of small business
and agricultural collateral by small community financial institutions
(CFI) to secure FHLBank advances has been minimal. GLBA expanded the types
of collateral (including small business and agricultural collateral) that
CFIs could pledge to secure FHLBank advances in the view that doing so
would allow the System to better meet the needs of small institutions.
However, FHFB data indicates that such collateral represents less than 1
percent of all collateral pledged to secure System advances. On the one
hand, it may
13James B. Thompson, "Commercial Banks' Borrowing from the Federal Home
Loan Banks," Federal Reserve Bank of Cleveland, July 2002.
be the case that very few institutions are willing to pledge such
collateral to secure advances. However, the potential also exists that
FHLBanks have established such strict underwriting standards-for example
by applying significant haircuts to the collateral-that CFIs have been
discouraged from pledging it.14 We understand that FHFB is planning a
conference later this year to gather additional information on the use of
CFI collateral.
Questions Have Been Raised About the Impact of Large Holding Companies on
the FHLBank System
In recent years, questions have been raised about the potential impacts of
holding companies who may have mortgage subsidiaries that are members of
two or more FHLBank districts on the FHLBank System structure, which
traditionally involved each financial institution belonging to one
FHLBank. In a 2003 report, we noted that there are about 100 holding
companies that had subsidiaries who were members of two or more FHLBank
districts.15 Some observers have expressed concerns that such large
financial institutions could pressure the FHLBanks to compete with one
another on advance pricing terms-such as interest rates and collateral
requirements-and that this competition could impair the overall safety and
soundness of the FHLBanks. Our report noted significant differences in
advance term pricing among the 12 FHLBanks and that the opportunity
existed for holding companies to obtain advances from the FHLBank that
offered the most favorable advance terms. Some FHLBank officials also said
that holding companies seek to play one FHLBank off another creating
competition within the System. However, we also found that FHFB had not
identified any material safety and soundness issues related to FHLBanks'
advance-term pricing. I would reiterate a statement in our 2003 report
that FHFB has a continued responsibility to monitor the FHLBanks to help
ensure that any competition within the System does not result in unsafe
and unsound practices.
Concerns have also been raised that the activities of large financial
institutions such as holding companies are having negative affects on the
AHP program in certain FHLBank districts. Under FIRREA, FHLBanks
14Haircuts refer to the discounts that FHLBanks apply to collateral that
is used to secure advances. For example, if the FHLBank has a 40 percent
haircut for single-family mortgage loans, an FHLBank member could borrow
up to 60 percent of the value of the single-family mortgages loans that it
pledged as collateral.
15See GAO, "Federal Home Loan Bank System: Key Loan Pricing Terms Can
Differ Significantly," GAO-03-973 (Washington, D.C.: Sep. 8, 2003).
must contribute 10 percent of their previous year's earnings to subsidize
housing finance for targeted groups. In some cases, financial institutions
located in one FHLBank district have purchased banks or thrifts in other
FHLBank districts. As such financial institutions grow through out-of-area
acquisitions, they may be able to increase their business relations with
their local FHLBank thereby increasing its profitability. For example,
such financial institutions may take out additional advances or sell
additional mortgages to the FHLBank. With potentially increased profits
from doing business with a larger member, the FHLBank would have
additional funds to devote to the AHP program. In contrast, FHLBanks whose
members were acquired potentially lose net income and AHP funding dollars.
According to one FHLBank president, such acquisitions have hurt AHP
funding in his bank's district. However, according to FHFB officials,
recent research they conducted shows that mergers may have a short-term
impact on AHP funding, but these effects seem to balance out over time.
For example, financial institutions in a FHLBank district that lost
members through acquisitions may purchase financial institutions in other
FHLBank districts thereby recapturing AHP funds. FHFB officials also said
that they may develop a regulation to address any concerns associated with
mergers on AHP funding.
Mr. Chairman, this completes my prepared statement. I would be happy to
respond to any questions that you or other members of the committee may
have at this time.
For further information regarding this testimony, please contact me at
202512-8678 or [email protected] or William B. Shear, Director, at
202-5128678 or [email protected], or Wesley M. Phillips, Assistant Director,
at 202512-5660 or [email protected]. Individuals making contributions to
this testimony include Rachel DeMarcus, Austin Kelly, Jill M. Naamane,
Andy Pauline, Mitchell B. Rachlis, and Barbara Roesmann.
Staff Contacts and Acknowledgments
(250244)
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