Will scrutiny of the Federal Home Loan Bank System lead to change?

January 3, 2023 12:19 PM

The Federal Home Loan Bank System came under intense scrutiny in 2022 with its regulator, the Federal Housing Finance Agency, launching its first major review in 90 years. The question going forward is whether a review of the Home Loan banks will result in any major changes to the 11 regional banks — whose offices stretch from San Francisco to New York — or if the status quo will remain preserved.

Most consumers know little, if anything, about the system. It was created in 1932 in the depths of the Great Depression when the Hoover administration was trying to stanch a wave of millions of home foreclosures. At the time, hundreds of savings and loan companies went bust, and the Home Loan banks were devised as a way to prop up the sagging housing market.

Now critics argue the system has strayed from its core mission. Former Federal Reserve Gov. Daniel Tarullo called the system "irrelevant" in housing finance — the very reason it exists. Though large banks and insurers are among the system's biggest users, community banks have come to depend heavily on the Home Loan banks for liquidity and balance sheet management.

Whether the regulatory review will identify major shortcomings of the system and work to change them remains unclear. But critics — including some former Washington insiders — continue to push for oversight, including for a deeper review and understanding of whether taxpayers are getting a return on their investment.

Against that backdrop, here are four areas that bankers are paying attention to regarding the Home Loan banks.

Sandra Thompson, director of the Federal Housing Finance Agency, has been urged by bank trade groups to adjust a tangible capital rule to prevent community banks from being shut out of obtaining Home Loan Bank advances.

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Some fear a liquidity squeeze ahead for small community banks

At least 100 community banks claim they could face a liquidity crisis in the future because of a rule that essentially prohibits banks with negative tangible capital from tapping the Federal Home Loan Bank system for low-cost funding. If the rule is not changed, banks with negative tangible capital would have to pay far more for deposits and funding would not be instantaneous.

Banks that report negative tangible capital are required to get a waiver in writing from their prudential regulator in order to access low-cost advances from the FHLB system. The FHFA's tangible capital rule restricts banks with negative tangible capital from tapping both new FHLB advances and from renewing existing advances beyond 30 days unless the bank's prudential regulator agrees to a waiver.

Community bankers have urged the FHFA to consider issuing an interim final rule to waive the requirements in the short-term of the tangible capital rule while the agency considers a more permanent fix. The FHFA's tangible capital rule dates back to 1994 — put in place after the last savings and loan crisis. Still, bankers argue that prudential regulators finalized Basel III capital rules in 2013 that changed the regulatory framework for how tangible capital is calculated resulting in FHFA's rule being out of sync with prudential regulators.

The American Bankers Association, Independent Community Bankers of America and nearly 75 state bank trade groups want FHFA Director Sandra Thompson to align the FHFA's rule with the Tier 1 capital rules used by prudential regulators. The FHFA has not yet indicated whether it will adopt those changes.

Nonbanks that fund majority of home loans excluded from FHLB system

A key bone of contention in the review of the Home Loan banks is why the system's membership excludes nonbank mortgage lenders that currently dominate the housing market.

Bob Broeksmit, president and CEO of the Mortgage Bankers Association, has called for independent mortgage bankers to be allowed into the FHLB system as members since nonbanks have supplanted banks in the past decade and now originate the vast majority of home loans.

"New classes of members would increase FHLB advances and earnings," Broeksmit said in September at a listening session hosted by the FHFA.

Bankers generally oppose allowing nonbanks into the system. Because Congress would have to approve any change to FHLB membership, many think this aspect of the debate is unlikely to lead to any change going forward.

Yet critics have argued that the Home Loan Bank system has become irrelevant in the housing markets. The secondary mortgage market is dominated by Fannie Mae and Freddie Mac, the two other, better-known government-sponsored enterprises. Some suggest the Home Loan banks are unnecessary due to the creation of the Federal Deposit Insurance Corp.

The Home Loan banks essentially operate as a "banker's bank," with its members pledging mortgages as collateral to obtain funding in the form of "advances," or loans with variable rates and terms. The Home Loan banks issue securities that come with a government guarantee, which has also become an issue since taxpayers are essentially subsidizing the system's bonds with an implicit government guarantee in the event of a default. Like Fannie Mae and Freddie Mac, they are government-sponsored enterprises regulated by the Federal Housing Finance Agency.

Taxpayer subsidy conflicts with return on investment, critics claim

Some critics have argued that the FHLB system is a form of corporate welfare because the largest users of the system are big banks and insurers with ample funding through the capital markets. Critics also claim the Home Loan Bank system has an inherent conflict between its public goals and private incentives.

Some critics have questioned whether the Home Loan banks are fulfilling their mission of supporting the housing markets when they largely provide large institutions, which have ready access to capital markets and cheap funding. Though community bankers claim they need the FHLB system for low-cost funding and balance sheet management, the top 10 banks accounted for 70% or more of advances last year at five of the 11 Home Loan banks, according to the FHFA's annual report to Congress.

Moreover, the top borrowers are not community or small banks, but rather giant, well-capitalized firms. New York insurance giant MetLife, with $760 billion of assets, was the largest user of FHLB advances in 2021, followed by the $59 billion-asset New York Community Bancorp in Hicksville, New York. Other top borrowers include JPMorgan Chase, with $3.8 trillion of assets; the New York pension giant TIAA, with $346 billion of assets; and Midland Financial, the holding company for the $32.1 billion-asset MidFirst Bank in Oklahoma City, Oklahoma. At least one former FHLB director, Cornelius Hurley, an adjunct professor at Boston University School of Law and a former independent director of the Federal Home Loan Bank of Boston, dropped a bombshell in November by estimating the system's members receive $5 billion a year in public subsidies in the form of a government guarantee on agency bonds. Hurley based the estimate on the Home Loan banks' current $1 trillion in outstanding debt with a 50-basis-point "benefit" attributed to the government guarantee. No one has yet disputed the $5 billion figure.

"The mission was never" for the Home Loan banks "to be a central bank for privately owned banks," Hurley has said. "It's nice to have a taxpayer-subsidized low-cost funding facility. But if we're going to have that, we need a substantial reward for our investment. Acting as a source of liquidity for private banks is a private benefit, it's not a public benefit."

Affordable housing goals considered inadequate, even negligible

The Home Loan banks are mandated to set aside 10% of their profits for affordable housing. Critics claim there is a mismatch between the banks' public subsidy — estimated at $5 billion for the explicit government guarantee on FHLB-issued bonds — and the roughly $200 million on average that the banks provided for affordable housing mostly in the form of grants and other programs to small nonprofits.

Many supporters of the system claim they desperately need the money for affordable housing, but that it does not have a big impact and many of the banks' requirements are onerous. Others think the system works well and should be left alone with the profits set aside for affordable housing increased to between 15% and 20%.

Multifamily housing projects use a patchwork of funding sources, notably low-income housing tax credits to cover 60% of the costs of a project. It typically costs roughly $400,000 per unit to build an affordable housing project with so-called gap financing from the Home Loan bank's accounting for roughly 2.5% of a project's cost. Grants typically provide eligible borrowers with $10,000 in down payment assistance, which critics consider to be negligible given the average price of a home is $350,000.

Some lawmakers also have called for the banks' affordable housing mandate to be raised. Last year Sen. Catherine Cortez Masto, D-Nev., introduced a bill that would have doubled the banks' investments in affordable housing to 20% of their net income, up from the current 10% mandate.

Still, politics is likely to play a major role in any changes to the FHLBs. The Home Loan banks have a core constituency in small community banks that have footprints all over the country and a powerful Congressional lobby. Meanwhile, state housing agencies and affordable housing advocates have ready allies in congressional Democrats. But without a crisis or notable bank failure, some think there is little impetus for Congress to reform the system in a dramatic way.