Back in the darkest days of the Depression, New Dealers devised a clever way to prop up the devastated housing market: a network of government-sponsored banks that would lend funds to capital-starved savings and loans. Flush with cash from the new Federal Home Loan Bank system, thrifts could lend once again. During the following decades, housing ownership expanded exponentially.
But the once noble mission of the 63-year-old bank system is becoming an anachronism. To be sure, the 12 FHLBs have more than $100 billion in low-cost funding outstanding to thrifts as well as those banks that choose to become members by investing in the system. But these days, the dominant role by far in recycling mortgage money is played by the huge $1.5 trillion secondary market for home mortgages. Meanwhile, the FHLBs' once powerful regulatory authority over thrifts has been assumed by the Office of Thrift Supervision.
HELPING HAND. The FHLB system, though, is likely to escape extinction because of a more recent raison d'tre, little known beyond Capitol Hill, that has nothing to do with its original mandate: helping to clean up the 1980s savings and loan mess. Under 1989 legislation, the FHLBs, and indirectly, their members, pay $300 million annually for interest on S&L cleanup bonds, about 8% of the total interest tab.
But critics are increasingly worried about how the FHLBs are paying that bill, as well as dividends to members. The banks have been using complex financing techniques, including billions of dollars' worth of "structured notes," volatile debt securities whose yield is linked to such indexes as interest rates. Some of those notes ended up in bankrupt Orange County's portfolio. John K. Darr, director of finance for the FHLB system, says all investors were warned of their riskiness.
Another FHLB tactic to boost earnings: borrowing money cheaply via bonds and notes, thanks to an implicit government guarantee, and investing some proceeds in higher-yielding mortgage securities. That produces a hefty arbitrage profit. The FHLB system's investments swelled from $33.9 billion at the end of 1989 to $90.5 billion at the end of 1994's third quarter. While the banks have managed these investments well so far, some have been taking such steps as extending the maturity of their portfolios to produce higher earnings. But that has increased the exposure of their capital cushion to interest-rate moves.
The ballooning investment portfolio concerns some Clinton Administration officials. Says one: "If mismanaged, there is a risk to the taxpayer." Even some FHLB officials worry about the arrangement. "Our business is not to be in arbitrage," frets William G. Hamm, chief operating officer of the San Francisco Federal Home Loan Bank. "But that [interest-payment] obligation has made it our business."
Some critics see little use for the FHLBs altogether. In a 1993 report, the Congressional Budget Office noted that because of the secondary-mortgage market's growth, policymakers ought to consider whether the government should continue to offer subsidized liquidity, especially since most loans don't go to low-income homeowners. "We have to cut the subsidy bandwagon at some point," says banking consultant Bert Ely.
FHLB defenders say that for smaller institutions that hold on to their mortgages and for mortgages that don't meet the criteria for resale in the secondary market, the bank system is a life support. "It's awfully hard for a small institution to find viable low-cost sources of funds outside the Home Loan Bank system," says David F. Holland, CEO of Boston Federal Savings Bank, which has assets of $675 million.
LITTLE LEEWAY. And defenders dismiss worries about the system's soundness. Despite gyrations in interest rates last year, the banks' net income through the end of the third quarter rose 7.4%, to $739 million. FHLB of Boston President Michael A. Jessee contends that the system's regulator, the Federal Housing Finance Board, closely monitors investment policies. "There is just not a lot of leeway to take on excessive risk," Jessee says.
While the FHLB system is not on the GOP hit list, it is coming under scrutiny in Washington. Representative Richard H. Baker (R-La.), chairman of the House Banking subcommittee with oversight responsibility for the FHLB system, is expected to introduce legislation soon that would assure minimum capital levels. Capital levels shrank in the 1980s when Congress tapped the system's healthy balance sheets for a $3.2 billion contribution to the S&L cleanup. Deputy Treasury Secretary Frank N. Newman has said the Administration will draft its own reform proposal.
Neither of these measures is likely to call for abolition of the Federal Home Loan Bank system. And with its crucial role in quietly paying off one of Washington's most embarrassing blunders, the FHLB system won't have to do much to justify its existence. If the system gets into trouble, however, Washington may have second thoughts.
Do We Need The FHLB?
The FHLB system encourages lending to borrowers, particularly low-income homeowners, who don't fit the cookie-cutter mold required to sell mortgages in the secondary market. It also lends to member thrifts with liquidity problems. This allows them to put more money to work making mortgage loans.
The advent of the secondary market for mortgages and increasingly
efficient capital markets for even smaller financial institutions make the FHLB's lending activities increasingly redundant. And many loans by FHLB members go to wealthy homeowners, not low-income borrowers.