What's the Point of the FHLBs?

Ah! Government sponsored enterprises! Last year saw Freddie (FRE) and Fannie (FNM) come to grief. But 2009 could be the year of the 12 Federal Home Loan Banks, wounded already by falling MBS values and the merger and resolution of several large shareholder/members and borrowers. Just what the financial system needs.

You’ll be forgiven if you’re not familiar with the details of this particular corner of the federal banking system. The Federal Home Loan Banks make up a $1.4-trillion (asset) lending cooperative originally chartered in the 1930s to facilitate mortgage lending. The banks’ shares don’t trade publicly; instead, shares are owned by 8,154 insured commercial banks, thrifts, credit unions, and insurance companies. But while the system may be semi-obscure, some of the industry’s largest institutions rely on it heavily for funding, often those banks and thrifts having the weakest deposit franchises.

In fact, both ownership and borrowing within the system are concentrated among just a few member banks. In 2008, for instance, ten members owned 34% of the system’s capital stock. Lending is even more concentrated. Some 75% of the FHLB’s $1 trillion in advances are outstanding to just 1.5% of its members, according to the FHLBs’ most recent financial report. The numbers aren’t publicly disclosed, but it’s likely that less than 5% of the system’s members borrow more than 90% of its advances. And that was before some of its largest members and borrowers, such as Washington Mutual, IndyMac, Wachovia, Countrywide, National City, and LaSalle, were acquired or placed in conservatorship. Going forward, concentrations will surely increase.

One long-standing accusation is that the FHLBs enable members’ aggressive lending, that they are the ones that provide the financial alcohol to the alcoholic lender that can’t stay off the sauce. IndyMac, for example, was probably the system’s largest single borrower when it was seized by regulators back in July. To resolve the company, the FDIC had to pay prepayment fees of $341 million to one FHLB and repaid $6.3 billion in advances, a substantial proportion of the total $8.5 billion to $9.4 billion estimated cost.

But now, the system’s problems are also home-grown. A week ago, Moody’s reported that the 12 system banks will see “substantial impairment” of their $77 billion portfolio of private-label residential MBS, commercial MBS, and home equity securities. Under Moody’s “worst case” scenario, only four of the banks would meet the minimum regulatory capital requirement of 4%. (There is no well-capitalized standard.) On January 9, the FHLB of Pittsburgh warned that other-than-temporary impairments could exceed its retained earnings. And a retained earnings deficiency is a problem that TARP funds can’t fix.

So far, the implications are not dire, at least for the FHLBs. The individual banks and system as a whole are highly rated by S&P and Moody’s, with long/short term ratings of AAA/A-1+ and Aaa/P-1, respectively. (The sole exception is the Chicago bank, rated AA/A-1+ by S&P.) But retained earnings are thin as a hatchet, at just $3.9 billion, or 7.2% of capital. Just a 5% investment mark would burn through the system’s consolidated retained earnings--hardly unlikely in this environment. Overall profitability is thinner still, at only 19 bps on average assets and 6.16% on equity in 2008 through September 30.

Those numbers provide a strong argument for consolidation from 12 banks to perhaps six, or just one FHLB. Even the Farm Credit System found means to consolidate into fewer banks.

Immediate implications are somewhat greater for the system’s 8,154 members, which collectively have invested $54 billion in its capital stock. The greater risk is that individual FHLBs will be unable to pay a dividend on members’ investment. (Dividends averaged 3.5% over the first three quarters of 2008.) Or members’ accountants may deem their clients’ FHLB investment impaired, spurring inopportune losses.

Which companies have the largest investments? Citibank (C) is largest with $4.7 billion in stock. JPMorgan Chase (JPM) owns $4.1 billion. Bank of America (BAC) owns just under $3 billion. After its Wachovia acquisition, Wells Fargo (WFC) owns $2.7 billion. Among the large banks, USBank (USB) comes in last with a paltry $846 million in stock.

Whether these risks become manifest, it is increasingly difficult to understand why they are acceptable, given that the vast preponderance of benefits go to the few and the large.

Comments

[James Wilson:]

What is the point of the FHLB ?

Just to make home ownership open to everyone. Do you forget your history when your color and your place in society determined where you could live. Even your job determines if you were allowed to by a home in certian neighbothoods.
This is not to mention the color of your skin.

Regulation are needed when laws are not followed. Just like Country Wide using a little know law allowed low interest loans subprimes to be used to keep people in homes so poor neighborhoods don't fall into chaos. But County Wide used the loans for Gated Communties and wealthy neoghbothoods.
County Wide knew people would not read the mortage really close and get a big suprize when the reset happened.

Jan 25 07:58 AM

[Acronym:]

James Wilson, I think I understand what you are getting at. Gary Townsend touches on it as well. How does the ability to buy debt empower the majority? There has to be some sort of dividend paid to the loanee for assuming the speculative risk of homeownership in the types of markets these loans are designed to "benefit".

Jan 25 09:08 AM

[Chkrazer:]

what the heck are you talking about ?

Jan 25 11:40 AM

[JohnL:]

"What is the point of the FHLB ?"

The money and credit of the U.S. taxpayer is channeled to certain homebuyers by subsidizing and guaranteeing their home mortgage. The point is to take money from some taxpayers and give it to others deemed more needy. It's called a wealth transfer -- just another form of socialism.

"Regulation are needed when laws are not followed."

No, the laws need to be enforced and the guilty need to be punished. More regulations are not needed. I would have a lot more faith in these government programs if the government proved capable of enforcing the laws already on the books.

Jan 25 01:57 PM