FHLBanks Focused on Wrong Business. Housing Mission Overlooked
Acting Federal Housing Finance Agency (FHFA) Director Edward DeMarco addressed the 2011 Federal Home Loan Bank (FHLBank) Directors Conference last week and picked up right where he left the group in 2010.
Last year DeMarco criticized the 12 Federal Home Loan Banks for focusing on investments that would allow them to pay out higher dividends to members rather than centering their investment strategies on optimizing core member benefits. "If a member considers dividends to be the principal benefit of FHLBank membership," he said at the time, "the member should ask itself why it has joined the System in the first place."
Speaking to the 2011 conference DeMarco likened the FHLB stock purchase membership requirement to obtaining a line of credit with a lender, which typically involves the payment of a commitment fee. In the case of FHLBank membership, that commitment fee is the earnings foregone by purchasing the stock rather than putting those funds to alternative use (like lending). In either case, the benefit is the ability to access liquidity, but in the case of FHLBank membership, members earn the additional benefit of dividends on the stock.
In a cooperative structure however, DeMarco said, there is inevitably a trade-off between the interest rates charged on advances and the dividends paid to stockholders. Ignoring bank investments, the only way to generate dividends for members would be to charge them rates on advances that exceed the cost of funds and the related expenses. "Whatever the trade-off, making advances is central to an FHLBank's business, but investments intended to arbitrage the FHLBanks' funding advantages are not." At the end of Q1 2011, system-wide investments constituted 38.7 percent of all FHLBank assets while advances at 52.4 percent, barely exceeded half. At six FHLBanks investments exceeded 40 percent of assets, and at four they exceeded advances. "This is not a sustainable operating condition for an FHLBank," DeMarco said.
As he looks back on history, DeMarco says he sees two lessons. First, the FHLBanks' various financial problems of the past 20 years have not come from their traditional advances business but from investments and mortgage purchase programs. Second, a large investment portfolio intended to generate added earnings is inconsistent with the system's purposes and is a misuse of its preferential access to capital markets.
As cooperatives, the FHLBanks differ from other companies in that the focus is not on the market value of its stock and current and future earnings prospects are an issue only so far as they affect the Bank's ability to repurchase its stock. These differences aside, each FHLBank must still be concerned about its franchise value which will fall unless it satisfies four minimum conditions. It must be able to maintain its operating costs and maintain adequate capital; be able to price advances competitively, and be able to do both without over-reliance on investments. The fourth condition is to operate in a fashion consistent with board-approved policies including providing advances on demand at competitive rates and being capable of repurchasing stock at par.
DeMarco said that advances, which should be the primary source of an FHLBank's income, have declined dramatically in recent years. System wide they peaked at over $1 trillion in September and October 2008 but have since declined by 55 percent to $445 billion. This is a level that hadn't previously been seen since 2000. For some Banks the decline is even greater. This is the result of weak loan demand, the expanded supply of other funding sources, and the failure of member banks and thrifts.
Other factors could affect the demand for advances in the years ahead. DeMarco cited recent FDIC-announced changes in deposit insurance pricing and market developments such as restrictions on FHLBank activities or the development of a covered bond market.
The advance volume is also related to the Banks' membership base. Consolidation of depository institutions has reduced the membership base and altered borrowing patterns and, while overall advance volume has decreased system wide, uneven consolidation of member banks has affected some FHLBanks more than others.
DeMarco said a basic long-run franchise value question to consider is "How can an FHLBank maximize the effectiveness and efficiency with which its members realize the benefits of System membership? As I have argued here and before, these benefits should be provided to members following a business model that predominantly focuses on advance lending, not investment returns."
DeMarco's speech also focused on other FHLBank issues, especially changes that are occurring in the overall financial system. In what sounded like a subtle warning, he noted that the FHLBanks need to demonstrate that they are meeting a housing finance mission. He noted that a recent set of Administration recommendations that mostly focused on the Government Sponsored Enterprises did suggested that a bank's membership be limited to a single FHLBank and that the FHLBank's activities be focused on small and medium sized institutions. DeMarco told Directors that the rule for voluntary merger of FHLBanks is moving forward but this does not mean that a small FHLBank cannot continue to exist as long as its directors understand what is necessary for a small bank to operate profitably. For example, he said, the board must understand how to price advances such that they generate the require yield, carefully controls costs, and may have to charge higher advance rates or offer more limited dividends to maintain value.
Financing of FHLBanks will also be changing. Under Dodd-Frank many derivatives contracts will be moving toward central clearing which may have an impact on both the cost of providing advances and on the franchise value issues. FHLBanks have a responsibility to develop executive compensation packages that conform to new standards and are appropriate and comparable to other financial institutions while recognizing that FHLBanks operate with government support and are less complex entities than commercial banks.