The Federal Housing Finance Board recently issued “FHLBank System at-100: Focusing on the Future.” The report offered ways the clarify the FHLBs’ mission, limit the use of FHLBs as lenders of last resort, and to enhance risk management. One key potential change would tighten membership requirements. The report also touches on but does not especially emphasize concentration risk, especially the tendency of a handful of large institutions to monopolize access to FHLB advances. It’s also questionable whether and to what extent the large institutions further the FHLBs’ avowed goal of promoting home mortgage lending.
The Federal Home Loan Bank Act of 1932 created the Federal Home Loan Bank system. The system was originally designed to serve a limited group of financial institutions (savings and loans and savings banks) primarily engaged in mortgage financing. In 1989, Congress extended FHLB eligibility to federally insured banks and credit unions. The change made sense, at least from a business standpoint. The thrift industry has been shrinking for most of the past 40 years and most of the largest thrifts have disappeared. The handful of large thrift charters that remain[1] make relatively few mortgage loans. Today, thrifts represent only 8.9% of FHLB member assets.
[1] Charles Schwab, SSB (($302 billion), USAA Federal Savings Bank (($109 billion), and Synchrony Bank ($105 billion) have 1-4 family residential loans equal to 8.65%, 1.89%, and 0.00% of total assets, respectively. However, Schwab does have a large mortgage securities portfolio.
Although the FHLB system has about 6,500 member institutions, a few large firms dominate the borrowing activity. Across the 11 FHLBs, the top five borrowers at each bank account for more than half of total advances, and roughly one-third of total assets.
*Not disclosed on 10-Q.
Advances to PNC alone totaled $36 billion, representing 47% of the FHLB-Pittsburgh’s total advances and 34% of total assets. The FHLB San Francisco extended $26.4 billion to JPMC, which represented 65% of total advances and 28% of total assets.
National banks must generally limit their extensions of credit to a single borrower to 15% of capital. This limit increases to 25% for loans secured by “readily marketable collateral.” However, it is unlikely that the mortgage loans that FHLBs accept as collateral would meet the “readily marketable” definition. In contrast, the Pittsburgh FHLB’s advances to PNC represent 637% of the FHLB’s capital. The San Francisco FHLB’s extensions to JPMC were 397% of capital.
The FHLBs have also extended advances to financially troubled members, including SVB, First Republic, and Signature. Advances increased as the condition of these banks deteriorated. Extensions to First Republic ballooned to $28.1 billion as of March 31, 2023, compared to only $3.7 billion a year earlier. SVB’s advances increased from zero as of March 2022 to $13.5 billion by the end of the year.
Outsized advances, even to healthy members, present considerable strategic and liquidity risks. Advances represent the FHLBs’ largest asset class and balances have fluctuated wildly, especially since 2008, as shown below:
There is also a crowding out effect. The FHFA report notes that “during the March 2023 bank failures, the FHLBank System’s role of providing low-cost liquidity came under stress, due to sizable advance demand from large members, some of which were significantly bigger than the FHLBanks themselves.” FHLBs fund advance activity through debt consolidated debt issuances and large debt issuances to fund advances to one or two members can distort the cost of similar advances throughout the system.
It’s not as though these borrowers have a great commitment to housing finance. Mortgage loans at PNC represent 9.52% of total assets. They account for 9.45% of total assets at JPMC. JPMC’s CEO Jamie Dimon wrote in the firm’s latest Annual Report that “it barely makes sense for banks to hold mortgages or mortgage-servicing rights.”
First Republic showed a greater commitment to mortgage finance, with 1-4 family mortgages representing 43.2% of assets as of March 31, 2023. However, First Republic’s median mortgage at origination was $790,000. FHLB advances in this case were less about expanding home ownership than making home financing cheaper for the already affluent. Should this be the goal of a government-sponsored enterprise?
FHLB membership does not extend to nonbank mortgage lenders. However, this group accounts for more mortgage originations than banks and thrifts. These firms usually follow an originate to distribute model, so do not normally originate for portfolio. That makes them less obvious candidates for FHLB advances. It may be hard to disentangle cause from effect. Nonbank lenders’ lack of access to either insured deposits or FHLB advances largely precludes portfolio lending. Potential credit concerns might present a bigger roadblock. While nonbank lenders are subject to many of the same consumer compliance regulations as banks, there is no safety and soundness oversight at the federal level. Some are subject to state licensing requirements that may include safety and soundness review, but requirements vary from state to state.
Of course, federal safety and soundness oversight did not prevent FHLBs from extending credit to soon-to-fail institutions. Credit decisions are not necessarily a binary yes/no proposition, however. FHLBs can and do adjust collateral requirements based on the borrower’s financial condition. FHLBs have a strong track record in mitigating their credit risk. No FHLB has ever suffered a credit loss on an advance. At the same time, some evidence suggests that the FHLBs’ status as secured creditors can increase losses to the FDIC.
While the lack of historical losses on advances should provide some comfort, the past is not necessarily prologue. The FHLBs’ own experience with private label CMOs provides a case in point. Losses on AA and AAA private label CMOs were practically nonexistent prior to the Global Financial Crisis. Some FHLBs loaded up on these securities, to their regret. Impairment charges at the Pittsburgh FHLB wiped out 2009 earnings. Impairment charges at the Seattle FHLB wiped out 2008 and 2009 earnings.
12 U.S.C. 1424 establishes requirements for FHLB membership, which includes holding residential mortgage loans equal to at least 10% of assets. This requirement is less stringent than it appears. While the statute specifies mortgage loans, the regulation (12 CFR 1263.1) defines “residential mortgage loans” to include pass-through securities. Adding mortgage securities puts PNC, JPMC, and some other large banks over the 10% threshold. In addition, banks only need to meet the 10% threshold initially, and not as an ongoing requirement.
The FHFA is considering several steps to move FHLBs closer to their original mission. One would make the 10% mortgage threshold an ongoing rather than a one-time requirement. The FHFA made a similar proposal back in 2014. That proposal failed to make it into the Final Rule following overwhelming opposition from the banking industry. The banks have been getting something for nothing and apparently like it that way. In other words, they get access to a relatively low cost and reliable funding from a government sponsored enterprise without needing to make a meaningful commitment to home financing.
The FHFA also plans to address the crowding out issue by limiting debt issuances “that unduly raise debt clearing costs or debt issuance activity.” The FHLBank System at 100 report is sketchy on the details, but the proposal appears to only address concentrations in a limited way. It might prevent one FHLB from crowding out another but does not address how large borrowers might crowd out others within an individual FHLB. The report does not indicate any intent to limit extensions of credit to individual members. Treating an FHLB like a national bank by limiting advances to a single member to 15% of capital is probably too restrictive for the risk involved. But how is extending credit equal to 400% or even 600% of capital consistent with either prudent risk management or the FHLBs’ mission?