FHLBs: safe as houses?

It was one of the many pronouncements made before the financial crisis that its speaker later had cause to regret. “Fannie Mae and Freddie Mac… are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.’’

That was Barney Frank, the ranking Democrat Representative on the Financial Services Committee, speaking in 2003 in opposition to tighter regulation of the two mortgage giants. Five years later, the government-sponsored enterprises (GSEs) had to be saved from bankruptcy by the US Treasury, and unceremoniously bundled into the conservatorship of the Federal Housing Finance Agency.

Today, some see similar levels of unjustified faith in policymakers’ and supervisors’ attitudes to the risk building up at another class of GSEs: US Federal Home Loan Banks.

FHLBs were chartered in the midst of the Great Depression to breathe life into the crippled residential mortgage market. Yet over time, they have evolved into very different beasts, quietly taking on a far more pivotal role in the US financial system. Today, the 11 FHLBs provide almost half a trillion dollars in cheap, readily available loans to dozens of US commercial banks – including giants such as JP Morgan and Wells Fargo – at terms that cannot be found elsewhere.

The banks are not subject to the same capital and liquidity constraints as the commercial lenders they do business with; nor, critics argue, do they have the diversified asset and liability profiles that could stave off insolvency in a credit crunch.

Of especial concern is the FHLBs’ growing reliance on government money market funds to buy up their liabilities. These investors generally buy short-term paper, while the FHLBs typically lend for the long-term. This dynamic is stretching out the maturity mismatch between the banks’ assets and liabilities: if they were ever to struggle to roll over their debt, or a large borrower were to default on a repayment, a chain reaction could ensue.

Significant disruption to the FHLB system would rob dealers of an increasingly vital funding source: at JP Morgan, FHLB loans accounted for a fifth of long-term funding as of the end of September 30, 2017, excluding deposits.

For smaller borrowers without access to a diverse range of willing lenders, the risks could be greater still: one analyst likens their funding to crack cocaine – both addictive and dangerous.

Banks in the FHLB system must put in capital, the same way banks have to put money into default funds for a clearing house, and both clearing houses and the FHLBs are too big to fail

Chris McHugh, London Institute of Banking & Finance

When considering also that the banks receiving the most funding from the FHLBs are their largest equity holders, it is easy to see how one or more FHLBs becoming distressed could rock the financial system.

“They strike me as similar to clearing houses,” says Chris McHugh, a lecturer at the London Institute of Banking & Finance. “Banks in the FHLB system must put in capital, the same way banks have to put money into default funds for a clearing house, and both clearing houses and the FHLBs are too big to fail.”

Understandably, FHLBs play down the systemic risk they pose. FHLB system chief executive officer, John Fisk, says he is “comfortable with the funding profile” of the banks under his charge. And it’s true, the FHLBs are extremely conservative lenders: as of September 30, each had rights to collateral with an estimated value greater than the related outstanding advances. In line with the FHLBs’ mission to serve as facilitators of the mortgage market, however, most of this collateral is residential mortgage debt. If the US housing market were to hit another downturn, this could leave them doubly exposed: their creditworthiness would come under pressure and, considering their business mix, the only way to boost earnings substantially would be to issue more advances – backed by more mortgages.

The chorus of those sounding warning noises is steadily growing: both the Federal Reserve and Office of Financial Research, a division of the US Treasury, have produced papers commenting on the FHLBs’ elevated status. The director of the Federal Housing Finance Agency, the FHLBs’ regulator – the same regulator overseeing Fannie and Freddie – spoke last May of the need to more closely monitor the banks’ funding profiles.

Policymakers would be well advised to listen.