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FHLBs: Red Sea, Dead Sea or Both?

Posted by Larry Doyle on May 25, 2009 8:46 AM |

On April 2nd, in a post Putting Perfume on a Pig,  I compared Freddie Mac, Fannie Mae, and the Federal Home Loan Bank system to the Red Sea. Why? For the very simple reason that for the foreseeable future, these entities will accrue losses. How? Unlike commercial banks, Freddie, Fannie, and their 12 FHLBs have very little earnings power in this environment while faced with a steady stream of losses on their mortgage holdings given ongoing defaults and foreclosures.    

In retrospect, would it have been more appropriate to compare the FHLB system to the Dead Sea than the Red Sea? I think it may. As the Wall Street Journal highlights, Directors Are Faulted at Home Loan Banks:    

Financial troubles at some of the Federal Home Loan Banks are raising questions about how well directors of these institutions are supervising their executives.

A plunge in the value of mortgage securities bought by several of the regional home-loan banks has forced them to halt dividends and curtail funding for local housing projects. An annual report issued by the banks’ regulator this past week says some of them “paid insufficient attention” to credit risks and haven’t invested enough in information technology.

Unlike giant banks or government-backed mortgage companies Fannie Mae and Freddie Mac, the 12 regional home-loan banks draw little public scrutiny. (LD’s emphasis) Created by Congress in 1932 to support the housing market, they are cooperatives owned by more than 8,000 banks, thrifts, credit unions and insurers.

Why do these home loan banks draw such little public scrutiny? They are the wholesale entity (providing funds) to their retail network (banks, thrifts, credit unions, insurers) which deals with the public. With no interaction with the public, the media and market analysts have accorded them little coverage. Thus, I make the assertion that these banks truly are a combination of both the Red Sea (ongoing losses) and Dead Sea (no coverage). 

Charles Bowsher, the former chair of FHLB’s Office of Finance sent a warning shot loud and clear about the “hidden and embedded” losses in this system when he resigned his position as chair of the FHLB Office of Finance in late March. As Bloomberg reported on April 2nd:

Bowsher, who was comptroller general of the U.S. from 1981 to 1996, had a simple reason for resigning last week as chairman of the Federal Home Loan Bank System’s Office of Finance. He didn’t want to put his name on the banks’ combined financial statements, because he was uncomfortable vouching for them. Bowsher, 77, had held the post since April 2007.

With so many top executives complaining they can’t figure out what their companies’ assets are worth, the real wonder is that more corporate directors haven’t quit rather than certify financial reports they don’t understand.

The job Bowsher left is a crucial one. The Office of Finance issues and services all the debt for the 12 regional Federal Home Loan Banks. That’s a lot of debt — $1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. (LD’s emphasis) The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies.

Given the current financial straits of these FHLBs, there is truly very little the government or management can do short of hoping that defaults and foreclosures do not come in as the market is forecasting. Well, actually there is one thing the boards can do and they are doing it–trash management. As the WSJ offers,

In some cases, the directors of home-loan banks are cracking down. 

However, how are the boards constructed and who is really minding the store? The WSJ provides real insight on this point, and highlights:

the home-loan banks need more directors willing to ask tough questions of the executives. Most of the directors are representatives of small and midsize banks that rely on the home-loan banks for funding. Some other directors represent nonprofit groups that receive grants from the home-loan banks, which are required by law to devote 10% of their profits to housing projects benefiting poor people.

Make no mistake, the structure, systems, and mix of business within the FHLB system is a direct corollary of our two national wards, Freddie Mac and Fannie Mae. While board members may want to play defense or execute the backstroke, I view these signs as clearcut indications that the boards know where this situation is headed. Where’s that? Again, I defer to the WSJ:

If the home-loan banks ever stumble badly, U.S. taxpayers would be called on to “rescue yet another financial entity,” warns Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. These banks have about $1.26 trillion of debt outstanding, putting them among the world’s biggest borrowers. 

In my opinion, it is not a question of if, but when. Without a relaxation in the FASB’s mark-to-market, we would have probably already been there. The FHLB system in totality is the size of a third housing finance agency. There is little doubt in my mind that at some point they too will become official wards of the state. 


  • fiscalliberal

    Larry – an interesting approach might be to identify those financial interests which are not wards of the state.

    To be certain a lot of small banks would make up a large part of the list. One might argue that they are closest to what is the failure model in the sense that the regulator and FDIC will close them down.

    Congress is making new laws,but the big question is: what good are the new laws if we are not willing to enforce the existing laws of fraud which would have stopped a lot of this financial induced fiasco. This model of boards of directors being ineffective also has to be looked at.

    In the end, unless the system comes totally down, he hope of change is glim.

  • Fiscal….why will the smaller banks fail? Because they can not receive funding and liquidity from their wholesaler, the FHLBs. That is, if the calves fish are dying because their mother’s milk is not flowing, what does that tell us about the mother?

  • Larry –

    Excellent post – very interesting and very frightening. The resignation of the Office of Finance Chairman is interesting. I questioned if a similar motive was partially behind the recent suicide of the CFO of Freddie Mac – was he being forced to put his name on Freddie Mac’s financial statements and he was not at all comfortable doing that? Or did he see the coming explosion of Freddie Mac and he knew the consequences that would have to the housing market, our economy, and our financial system?

  • coe

    LD – you are doing everyone a service by tackling many of these issues, including the peculiarities of the FHLB system..I happen to be more sanguine than not in feeling that the cleansing and discipline is improving in this system – but I also feel that their leadership was quite ineffective and has caused the problems – how? three simple developments that all have gone wrong in recent years- first, their regulators allowed the banks to invest up to 300% of their capital in mortgage backed securities – wherein the legacy exposure is now adversely affected by the downturn; second, driven by the misguided vision of Alex Pollock, former head of the Chicago bank, the FHLBs went after the secondary market prize and competed with Freddie and Fannie in buying mortgages – the premise was that the originators would keep the “credit” risk, and the FHLBs would tackle the “interest rate” risk, given their capital markets expertise – reality was that the FHLBs had very limited “long duration” experience at all and badly bungled the hedging using derivatives in the asymmetrical accounting world we live in – and, to add insult to injury, had no effective exit strategy – thus gagging select balance sheets with more whole loan mortgage product as storm clouds were gathering; and third, they lent money to their members with way too much leeway related to collateral pricing and haircuts…throw a bunch of structured notes and advances into the stewpot and add the pressures caused in select districts by ongoing consolidation affecting their membership and stockholders, and it’s no wonder this seems to be a dirty little secret…I am optimistic, though, that the system’s purpose of being a wholesale lender of “last resort” is legitimate, and that they can and will outgrow their current balance sheet sensitivities (though never underestimate the ability of the administration to meddle and create a cure that is worse than the disease)…meanwhile, I’m not sure why I think of the old country song title, “Every time I get an itch, I wind up scratching you”! In this case, the “you” is us!!!

    • Sir,

      Wow. The light you are shining on the underbelly of the FHLB system is of great service to all of us. The intricacies of these wholesalers will, no doubt, escape the eye of the general media and market analysts.

      Thanks for bringing it to light here. Why do I think we may need the “large” popcorn and “big gulp” as we watch this show play out.

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