FHLBanks Focused on Wrong Business. Housing Mission Overlooked

Acting FederalrnHousing Finance Agency (FHFA) Director Edward DeMarco addressed the 2011rnFederal Home Loan Bank (FHLBank) Directors Conference last week and pickedrnup right where he left the group in 2010.</p

Last year DeMarco criticized the 12 Federal Home Loan Banks forrnfocusing on investments that would allow them to pay out higher dividends to members ratherrnthan centering their investment strategies on optimizing core member benefits.  “If a member considers dividends to be thernprincipal benefit of FHLBank membership,” he said at the time, “the memberrnshould ask itself why it has joined the System in the first place.”</p

Speaking to the 2011 conference DeMarco likened the FHLB stock purchase membership requirement to obtaining a line of credit with a lender, which typicallyrninvolves the payment of a commitment fee. rnIn the case of FHLBank membership, that commitment fee is the earningsrnforegone by purchasing the stock rather than putting those funds to alternativernuse (like lending).  In either case, the benefit is the abilityrnto access liquidity, but in the case of FHLBank membership, members earn thernadditional benefit of dividends on the stock.</p

In a cooperativernstructure however, DeMarco said, there is inevitably a trade-off between therninterest rates charged on advances and the dividends paid to stockholders.rnIgnoring bank investments, the only way to generate dividends for members wouldrnbe to charge them rates on advances that exceed the cost of funds and thernrelated expenses.  “Whatever therntrade-off, making advances is central to an FHLBank’s business, but investmentsrnintended to arbitrage the FHLBanks’ funding advantages are not.”  At the end of Q1 2011, system-widerninvestments constituted 38.7 percent of all FHLBank assets while advances atrn52.4 percent, barely exceeded half.  Atrnsix FHLBanks investments exceeded 40 percent of assets, and at four theyrnexceeded advances.  “This is not arnsustainable operating condition for an FHLBank,” DeMarco said.</p

As he looks backrnon history, DeMarco says he sees two lessons. rnFirst, the FHLBanks’ various financial problems of the past 20 years havernnot come from their traditional advances business but from investments andrnmortgage purchase programs.  Second, arnlarge investment portfolio intended to generate added earnings is inconsistentrnwith the system’s purposes and is a misuse of its preferential access torncapital markets.</p

As cooperatives,rnthe FHLBanks differ from other companies in that the focus is not on the marketrnvalue of its stock and current and future earnings prospects are an issue onlyrnso far as they affect the Bank’s ability to repurchase its stock.  These differences aside, each FHLBank mustrnstill be concerned about its franchise value which will fall unless itrnsatisfies four minimum conditions.  Itrnmust be able to maintain its operating costs and maintain adequate capital; bernable to price advances competitively, and be able to do both without over-reliancernon investments.  The fourth condition isrnto operate in a fashion consistent with board-approved policies includingrnproviding advances on demand at competitive rates and being capable ofrnrepurchasing stock at par.</p

DeMarco said thatrnadvances, which should be the primary source of an FHLBank’s income, haverndeclined dramatically in recent years. rnSystem wide they peaked at over $1 trillion in September and Octoberrn2008 but have since declined by 55 percent to $445 billion.  This is a level that hadn’t previously beenrnseen since 2000.  For some Banks therndecline is even greater.  This is thernresult of weak loan demand, the expanded supply of other funding sources, andrnthe failure of member banks and thrifts. rn</p

Other factorsrncould affect the demand for advances in the years ahead. DeMarco cited recentrnFDIC-announced changes in deposit insurance pricing and market developmentsrnsuch as restrictions on FHLBank activities or the development of a covered bondrnmarket.</p

The advancernvolume is also related to the Banks’ membership base.  Consolidation of depository institutions hasrnreduced the membership base and altered borrowing patterns and, while overallrnadvance volume has decreased system wide, uneven consolidation of member banksrnhas affected some FHLBanks more than others.</p

DeMarco said arnbasic long-run franchise value question to consider is “How can an FHLBankrnmaximize the effectiveness and efficiency with which its members realize thernbenefits of System membership?  As I havernargued here and before, these benefits should be provided to members followingrna business model that predominantly focuses on advance lending, not investmentrnreturns.“</p

DeMarco’s speechrnalso focused on other FHLBank issues, especially changes that are occurring inrnthe overall financial system.  In whatrnsounded like a subtle warning, he noted that the FHLBanks need to demonstraternthat they are meeting a housing finance mission.  He noted that a recent set of Administrationrnrecommendations that mostly focused on the Government Sponsored Enterprises didrnsuggested that a bank’s membership be limited to a single FHLBank and that thernFHLBank’s activities be focused on small and medium sized institutions.  DeMarco told Directors that the rule forrnvoluntary merger of FHLBanks is moving forward but this does not mean that arnsmall FHLBank cannot continue to exist as long as its directors understand whatrnis necessary for a small bank to operate profitably.  For example, he said, the board mustrnunderstand how to price advances such that they generate the require yield,rncarefully controls costs, and may have to charge higher advance rates or offerrnmore limited dividends to maintain value.</p

Financing ofrnFHLBanks will also be changing.   Under Dodd-Frank many derivatives contracts willrnbe moving toward central clearing which may have an impact on both the cost ofrnproviding advances and on the franchise value issues.  FHLBanks have a responsibility to developrnexecutive compensation packages that conform to new standards and arernappropriate and comparable to other financial institutions while recognizingrnthat FHLBanks operate with government support and are less complex entitiesrnthan commercial banks.

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