JPMorgan Taps Taxpayer-Backed Banks for Bailout Rules

JPMorgan Chase & Co., the biggest U.S. bank, is using cheap funding from government-chartered institutions to meet new regulations designed to ensure it won’t need a taxpayer bailout in any future crisis.

The bank borrowed almost $20 billion in the first half of the year from Federal Home Loan Banks, according to filings, almost as much as it got from selling dollar-denominated bonds in 2013. New York-based JPMorgan, with $2.4 trillion of assets, obtained most of the loans from the Federal Home Loan Bank of Cincinnati, whose 740 members typically resemble the $139 million-asset Bank of McCreary County in Kentucky and $40 million-asset Rural Cooperatives Credit Union.

Set up during the Great Depression to help community lenders, FHLBs raise cash by selling bonds viewed by rating companies and investors as backed by the U.S. government. Lending by the Congressionally chartered banks is climbing at the fastest pace since the start of the financial crisis in 2007. The growth has little to do with most of the 7,600 banks, thrifts, credit unions and insurers that are members. Without JPMorgan, Bank of America Corp. and Citigroup Inc., the three largest borrowers, lending by the FHLBs would be shrinking.

“It’s astounding,” said Joshua Rosner, an analyst at research firm Graham Fisher & Co. and co-author of “Reckless Endangerment,” a 2011 book, which focused on the role in the housing crisis of government-sponsored Fannie Mae. “It doesn’t seem to be in keeping with the system’s mission.”

Top Ratings

FHLBs, cooperative institutions owned by their borrowers, were created in 1932 to provide savings-and-loan institutions with a way of tapping stable funding after a string of failures caused by runs on deposits. Their Washington-based trade group now says the aim “is to support residential mortgage lending and community growth in all areas of the country.”

In 1989, Congress allowed commercial banks to join the network, which comprises 12 regional FHLBs that raise money jointly in the bond market to fund lending to members and their investment portfolios. Because of the perception the government would step in to prevent a default, FHLBs can sell securities at yields similar to Treasuries and the bonds carry the top rating from Moody’s Investors Service and the second-best from Standard & Poor’s, the same as its U.S. ranking.

According to the FHLBs’ Reston, Virginia-based finance office, outstanding debt for the FHLBs grew to $700.6 billion at the end of August from $687.9 billion on Dec. 31, making it America’s second-largest borrower in financial markets after the Treasury Department.

Mortgage Collateral

FHLB loans to members secured by mortgages and other assets, known as advances, climbed $37.1 billion in the first six months of 2013 to $450.7 billion, the latest disclosures show, with loans to JPMorgan, Bank of America and Citigroup expanding $44.6 billion. Total loans climbed a further $19 billion last quarter, Mesirow Financial Inc. strategist Ryan Graf estimated, based on bond issuance.

JPMorgan, a member of four of the FHLBs, joined the Cincinnati branch last year, after gaining the ability to become a member with the 2004 acquisition of Bank One Corp., whose chief executive officer at the time was Jamie Dimon.

As head of JPMorgan, Dimon steered the lender through the housing crash, making it the only major U.S. bank to remain profitable throughout the period. He’s since pushed back against regulations designed to avoid bailouts for the industry and the perception that financial behemoths are too big to fail.

Federal Initiatives

While most banks, including JPMorgan, have repaid loans and investments provided by the government during the crisis, they continue to benefit from other federal initiatives, including the FHLBs and insurance on customer deposits of up to $250,000, a limit temporarily raised from $100,000 during the crisis before later being made permanent.

JPMorgan’s loans from the Cincinnati FHLB increased 64 percent to $42.7 billion in the first half of this year as its total FHLB borrowing climbed to $61.8 billion from $42 billion.

The bank stepped up its borrowing as it sought to use longer-term funding to add to its cash and similar investments to meet new liquidity rules called for by the international Basel III agreement, according to a person familiar with the company’s operations. The loans, which can cost less than similar-maturity unsecured debt, are backed by mortgage collateral, said the person, who asked not to be named because the details are private.

JPMorgan has issued $19.9 billion of senior dollar-denominated bonds this year, according to data compiled by Bloomberg.

Basel Rule

Justin Perras, a JPMorgan spokesman, declined to comment.

The Basel III rule was created to better prepare banks for market disruptions such as the upheaval that followed Lehman Brothers Holdings Inc.’s collapse in 2008. JPMorgan has exceeded the amount of liquid assets needed to meet the new rule since the second quarter, Treasurer Sandie O’Connor said at a recent CreditSights Inc. event, according to the research firm.

The bank isn’t alone among its peers in taking advantage of FHLB funding.

Bank of America, which is a member of five FHLBs, increased its advances by $19.4 billion to $33.8 billion during the first half, while Citigroup, which belongs to three, boosted the amount by $5.3 billion to $25.7 billion, disclosures show.

“We’re constantly borrowing across multiple alternatives to maintain flexibility and efficient funding,” Jerry Dubrowski, a spokesman for the Charlotte, North Carolina-based bank, said in a telephone interview.

Smith Barney

Citigroup’s growth, focused on short-term borrowing, was to prepare for a loss of deposits from Smith Barney customers, after it agreed to sell its stake in the brokerage to Morgan Stanley, according to a securities filing. Mark Costiglio, a spokesman for New York-based Citigroup, declined to comment.

Borrowing by the largest banks is vital to the system, because it creates a “deep and liquid” market for FHLB bonds, which are used to fund loans to all members, said John von Seggern, president of the Council of Federal Home Loan Banks, the system’s trade group.

“The small guys understand how important it is that the big guys belong to the system,” von Seggern said. “You don’t have the traders if you don’t have the volume. If you don’t have the traders you don’t have the market.”

At Cincinnati’s FHLB, demand for advances from members other than JPMorgan has been limited. The “anemic economic expansion” has depressed the amount of loans banks are making while they have inflated deposit levels, according to its disclosures.

Penultimate Lender

That’s been mirrored across the system for the past few years. FHLB loans fell to a 12-year low in 2011 at $403.3 billion, down from a year-end peak of $900.5 billion in 2008.

Advances had previously surged from $641.6 billion at the start of 2007 as members faced a funding squeeze when investors doubted their health. The FHLBs’ role in keeping banks afloat led New York Federal Reserve researchers to call the system the “Lender of Next-to-Last Resort” in a 2008 paper, ahead of the central bank itself.

FHLBs “can expand and contract, that’s what we do,” said FHLB Cincinnati CEO Andrew Howell. At the same time, having a range of member types -- such as big banks like JPMorgan along with small ones, or both deposit-taking lenders and insurers -- limits the challenges that would come from having more homogeneous borrowers that move in “lockstep,” he said.

Lending Cheaply

The perceived government backing and other strengths of FHLB bonds mean that they can lend cheaply to members. On Sept. 30, the Boston FHLB offered 4 1/2-year advances at 1.85 percent, according to its website. That day, JPMorgan’s $1.25 billion of senior unsecured bonds due in January 2018 yielded 2.16 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

FHLB advances, which require collateral exceeding the amount borrowed, have withstood numerous crises, with none ever suffering a loss on the loans, according to von Seggern. Taxpayers get added protection because members are required to buy more stock when taking out advances, making the system “self-capitalizing,” Howell said.

Several of the FHLBs, including those based in San Francisco, Boston and Pittsburgh, have experienced losses in their investment portfolios, according to disclosures. The Chicago and Seattle FHLBs faced formal enforcement actions over mismanagement of aspects of their balance sheets. JPMorgan, Bank of America and Citigroup are among lenders sued by FHLBs over disclosures on mortgage bonds sold before the crisis. The banks deny the claims.

The Federal Housing Finance Agency, which oversees the institutions, monitors large member activity at each “to ensure that the FHLB has the flexibility to maintain safe and sound operations should a large borrower choose not to renew its advances,” Denise Dunckel, a spokeswoman, said in an e-mail.

Redeeming Shares

JPMorgan’s share of the Cincinnati FHLB’s lending has grown to 66 percent, from 48 percent on Dec. 31. Howell, the CEO, said that the FHLB hasn’t added to its 200 employees and is able to match the maturity of its funding to that of its loans.

It also can force a member to redeem its shares as its borrowing is retired to avoid becoming over-capitalized, he said. Too much capital led the Seattle FHLB to take on too much risk in its investment portfolio, the American Banker newspaper reported in 2005.

Former Federal Deposit Insurance Corp. Chairman Bill Isaac, who’s now chairman of Cincinnati FHLB member Fifth Third Bancorp., said that as long as JPMorgan is using the money to fund real-estate loans, its use of the system would match the FHLBs’ intended mission.

Government Backstop

At the same time, Isaac said, the existence of a system with a perceived government backstop is “something that we’ve got to look at and debate” after the financial crisis.

That’s not really happening, according to von Seggern of the FHLB trade group and Howell of the Cincinnati FHLB, who said he last month visited policy makers in Washington.

Lawmakers are instead considering how the FHLBs might play a bigger role in the future amid a reform or elimination of mortgage-finance companies Fannie Mae and Freddie Mac, they said. Until 2008, Fannie Mae and Freddie Mac operated as private companies, while benefiting from a similar implied government guarantee. That year, investors’ perceptions were confirmed when the U.S. took over the firms.

Bipartisan legislation introduced this year in the Senate that would replace Fannie Mae and Freddie Mac with a U.S. agency that sells catastrophic-loss insurance on mortgage securities envisions the FHLBs offering small lenders a way to tap the program.

“What I hear is, ‘This system works, and has done well over the cycles,’” Howell said. While the FHLBs’ size and government charters could be seen as creating the risk of another taxpayer-funded bailout, it’s “something the system has been well-positioned to keep from happening.”

Insurer Borrowing

While the FHLBs’ net lending would be shrinking without JPMorgan, Bank of America and Citigroup, many other individual members, particularly insurers, are also borrowing more, according to e-mails and interviews with officials and spokesmen from the New York, Cincinnati, Indianapolis, San Francisco and Atlanta branches.

One reason banks of all sizes are increasing their FHLB borrowing is to obtain longer-term funding that better matches the duration of their assets to protect against a rise of deposit costs from record lows, according to officials at the Federal Home Loan Banks of San Francisco and New York.

That’s one way in which the financial system is made safer by the FHLBs, said Alfred DelliBovi, president of the Federal Home Loan Bank of New York.

“Regulators frankly would like to see matched books in most cases, and advances are a good way to match the maturities of asset and liabilities,” he said.

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