Some in the financial regulatory establishment have long viewed the Federal Home Loan Banks with skepticism and for good reason.
The Treasury Department and the 11 regional government-sponsored Federal Home Loan Banks (FHLBanks) both regularly issue U.S. debt obligations, driving up the cost of government debt. That increased cost is, ultimately, borne by all taxpayers. The FDIC cleans up the mess made by the FHLBanks after they lend to failing banks such as Silicon Valley Bank, Signature Bank, First Republic Bank and IndyMac Bank. Again, the cost is ultimately borne by the full faith and credit of the government, i.e., the taxpayers.
Now comes Federal Reserve Vice Chairman for Supervision Michael Barr warning that the FHLBanks’ lending to their member banks may be of concern. In response to a question from Sen. Catherine Cortez Masto (D-Nev.), Barr gave us a window into the Fed’s thinking about the FHLBanks when he observed, “a notable increase in utilization of FHLB advances may be considered a concern depending on the specific firm and circumstances.”
Say what you will about Silicon Valley Bank, Signature Bank and First Republic Bank, but all three were “notable” for the enormous spike in their FHLBank borrowings just before they failed. As for their specific circumstances, each was experiencing an extraordinary bank run, and each was rumored to be failing as it was borrowing large amounts from the FHLBanks.
It is said, however, that borrowing from the Fed’s discount window, not from the FHLBanks, carries a taint with it, despite the Fed’s effort of late to remove that stigma. That taint is used to explain why FHLBank borrowings have surged in recent weeks ($513 billion as of the end of April) while the Fed’s new lending facility, the Bank Term Funding Program, has lagged far behind in its appeal to bankers ($83 billion as of the end of April).
Barr is suggesting that the taint is misplaced — that it should more properly accompany bank borrowings from the FHLBanks than from the Fed. After all, recent experience has demonstrated that borrowing capaciously and suddenly from any of the FHLBanks is strongly correlated with the borrowing bank being in troubled condition.
But there is another explanation for why banks prefer to borrow from their FHLBanks. Unlike the Fed, the FHLBanks have no “skin in the game” when they lend to their members. When an FHLBank member bank fails, the offending FHLBank suffers no loss. Moreover, when a member fails, the offending FHLBank steps in front of all other creditors, including the Fed, to recover on its loan to that member. Witness First Republic Bank, which owed the FHLBank of San Francisco $28.1 billion at the time it was closed.
Because of their risk-free position, the FHLBanks do not truly underwrite loans. Rather, they take orders for loans. The only variable is the amount of collateral and the haircut on the loan, not the ability of the borrower to repay.
As a reminder, the FHLBanks lend taxpayer-supported funds, that is, funds that could not have been raised but for the implied guaranty of the taxpayers.
Contrast this approach to lending at the Fed’s discount window. The Fed, like all other creditors, takes a back seat to the FHLBanks when one of its borrowers defaults. It loses money. This gives it substantial skin in the game.
The FHLBanks have turned their obliviousness to credit risk into a talking point for their own benefit. They boast: “The FHLBanks have never incurred a loss on an advance in their more than eight decades of existence.”
Oh really? Tell that to Sen. Sherrod Brown (D-Ohio), chairman of the Senate Committee on Banking, Housing and Urban Affairs. Brown recently wrote to the FHLBanks’ regulator, the Federal Housing Finance Agency, stating, “The FHLBank System was created to provide liquidity to sound institutions to facilitate lending. It was not structured to be a lender of last resort — or of next-to-last resort — for struggling institutions.”
The FHLBanks have abandoned their role as a conduit for housing finance in favor of acting as the handmaidens of troubled banks. Imagine how differently matters might have unfolded if that had been publicly disclosed one year ago, when Silicon Valley Bank, Signature Bank and First Republic Bank began their binge borrowing from the FHLBanks. The marketplace, given such transparency, could have worked wonders, given time.
The essence of the FHLBanks’ business model is this: First, the FHLBanks borrow using the leverage of the taxpayers’ credit (almost $1.6 trillion of debt outstanding). Second, the FHLBanks generously distribute those funds to their member-owners. Third, the FHLBanks leave it to the FDIC to pay the damage the FHLBanks have caused by their profligate lending. When called to account, the FHLBanks note that they’re required to devote 10 percent of their income to affordable housing. But that’s less than 0.04 percent of their assets and does not stack up well against their exemption from taxes worth at least 25 percent of net income.
The due date for the much-anticipated report on the FHLBanks by their regulator, the FHFA, has slipped to later this year. It is easy to understand why. Every day, the FHLBanks demonstrate they are unfit to serve the mission originally charted for them by Congress. This places a heavy burden on their regulator to right the ship.
Cornelius Hurley was a director of the Federal Home Loan Bank of Boston for over 14 years and was assistant general counsel at the Federal Reserve Board. He teaches financial services law at Boston University School of Law.
Editor’s note: This piece was updated on May 25 at 2:20 p.m.