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S. HRG. 108–834

OVERSIGHT OF

THE FEDERAL HOME LOAN BANK SYSTEM

HEARING

BEFORE THE

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

THE OPERATIONS OF THE FEDERAL HOME LOAN BANK SYSTEM, FOCUSING ON THE RESPONSIBILITY THAT CONGRESS HAS PLACED

WITH THE FEDERAL HOME LOAN BANKS TO ENHANCE THE LIQUIDITY OF FINANCIAL INSTITUTIONS, PARTICULARLY AS THE FEDERAL

HOME LOAN BANK MEMBERS MEET SUCH COMMUNITY NEEDS AS

PROMOTING HOMEOWNERSHIP

SEPTEMBER 9, 2003

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

SARAH A. KLINE, Democratic Counsel

JONATHAN MILLER, Democratic Professional Staff

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

ROBERT F. BENNETT, Utah, Chairman

TIM JOHNSON, South Dakota, Ranking Member

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

WAYNE ALLARD, Colorado

RICK SANTORUM, Pennsylvania

CHUCK HAGEL, Nebraska

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

CHRISTOPHER J. DODD, Connecticut

JACK REED, Rhode Island

EVAN BAYH, Indiana

DEBBIE STABENOW, Michigan

MICHAEL NIELSEN, Staff Director

NAOMI CAMPER, Democratic Legislative Assistant

(II)

CONTENTS

TUESDAY, SEPTEMBER 9, 2003

Page

Opening statement of Senator Bennett ................................................................. 1

Senator Johnson ............................................................................................... 3

Senator Corzine ................................................................................................ 10

Senator Hagel ................................................................................................... 12

Senator Reed ..................................................................................................... 14

Senator Bunning ............................................................................................... 16

Prepared statement ................................................................................... 46

Senator Allard ................................................................................................... 17

Prepared statement ................................................................................... 46

Senator Miller ................................................................................................... 20

Senator Sarbanes .............................................................................................. 34

WITNESSES

Wanye A. Abernathy, Assistant Secretary for Financial Institution, U.S. Department of the Treasury .................................................................................... 4

Prepared statement .......................................................................................... 46

John T. Korsmo, Chairman, Federal Housing Finance Board ............................. 6

Prepared statement .......................................................................................... 50

Response to written questions of Senator Sarbanes and Senator Carper ... 77

Norman B. Rice, President and Chief Executive Officer, Federal Home Loan

Bank of Seattle ..................................................................................................... 21

Prepared statement .......................................................................................... 56

Michael Middleton, Vice President, Federal Home Loan Bank of Atlanta,

Chairman and Chief Executive Officer, Community Bank of Tri-County,

Waldorf, MD ......................................................................................................... 24

Prepared statement .......................................................................................... 60

Shelia C. Bair, Dean’s Professor of Financial Regulatory Policy, Isenberg

School of Management, University of Massachusetts ....................................... 27

Prepared statement .......................................................................................... 64

Response to written questions of Senator Sarbanes ...................................... 100

Terry Smith, President, Federal Home Loan Bank of Dallas .............................. 30

Prepared statement .......................................................................................... 67

David W. Hemingway, Director, Federal Home Loan Bank of Seattle, Executive Vice President, Zions First National Bank, Salt Lake City, UT .............. 32

Prepared statement .......................................................................................... 75

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter to John W. Snow, Secretary, U.S. Department of the Treasury from

George J. Parseghian, Chief Executive Officer and President, Freddie Mac

dated July 14, 2003 .............................................................................................. 116

‘‘Is the Federal Home Loan Bank System Forsaking its Roots?’’ by Shelia

C. Bair, dated June 2003 ..................................................................................... 117

(III)

(1)

OVERSIGHT OF

THE FEDERAL HOME LOAN BANK SYSTEM

TUESDAY, SEPTEMBER 9, 2003

U.S. SENATE, SUBCOMMITTEE ON FINANCIAL INSTITUTIONS, COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Subcommittee met at 2:05 p.m., in room SD–538, Dirksen

Senate Office Building, Senator Robert F. Bennett (Chairman of

the Subcommittee) presiding.

OPENING STATEMENT OF SENATOR ROBERT F. BENNETT

Senator BENNETT. The hearing will come to order. We appreciate

the witnesses’ being here and look forward to hearing their testimony, and making this a worthwhile hearing.

One of the fundamental roles of Congress and this Subcommittee

is to provide periodic oversight, and that is why we are here today.

We have no specific legislation before us. But it has been a considerable amount of time since Congress or the Banking Committee

has held an oversight hearing on the Home Loan Bank System,

and we recognize that periodic oversight helps keep houses in

order.

President Eisenhower, when he was a general, used to say that

areas that are not periodically inspected tend to deteriorate. Those

of us who have been in the military know what periodic inspections

are like, and we do not want to make this hearing quite like that.

This is not to say that this particular house is not in order or

that it has tended to deteriorate. But we have not looked at any

part of the Home Loan Bank System since Gramm-Leach-Bliley

where we made adjustments to the membership rules, collateral

options for advances, and the capital requirements of the System.

Since Gramm-Leach-Bliley, our banking and finance system has

continued to evolve to meet the demands of an important and ever

changing marketplace.

We have had consolidations that have brought efficiencies and

synergies that have undoubtedly played a major part in the sustained success we have been experiencing in the housing and housing financing market. I believe the Home Loan Banks, along with

the other housing GSE’s, have played a vital role in funding this

growth.

My own State of Utah is a net borrower. Utah’s future housing

growth and economic vitality depends upon the capital that can

come partly from Home Loan Banks and others that can access

Wall Street and bring investment to my State. The role of the

2

Home Loan Banks and other housing GSE’s play in communities

across the Nation is, in my opinion, invaluable.

We are currently experiencing what I hope, and still believe, is

just a hiccup in our housing GSE system, but given the importance

of the housing finance system and the billions of dollars that move

daily through the GSE’s from investors all around the world and

then into our communities, even this little hiccup requires Congress to act to ensure that safety and soundness and the confidence

of the markets in the GSE system is maintained and, we would

hope, be even strengthened.

This is a good time for Congress to take a look at the entire system, and while this Subcommittee does not have jurisdiction over

all of the GSE’s, we do have the responsibility for the Federal

Home Loan Banks, and that is why we are concentrating there

today.

Since Gramm-Leach-Bliley, several issues have emerged in the

Home Loan Bank System that Congress has not reviewed, and

these issues relate directly to safety and soundness and the mission

of the System. So we will begin to create a record on these issues

here this afternoon.

The issues are: one, whether or not the Home Loan Banks should

register with the SEC; two, whether or not a member institution

of the System should be permitted to be a member of more than

one regional Home Loan Bank; three, at what level should the

Home Loan Banks be permitted to participate in the secondary

mortgage market; and, four, whether or not we should have a single regulator for all of the housing GSE’s. And all of these issues

are closely related to the safety and soundness and the mission of

the System.

I understand, to put it somewhat mildly, that these issue remain

unagreed upon, both inside and outside the System, and I believe

that all would agree that each of them could have a major impact

on housing finance, homeownership costs, and, therefore, the economy, particularly the economy at this point where housing has led

the recovery. That usually is not the case. Housing is usually the

last thing to recover. But in this very unusual recession and recover, housing has been one of the strongest parts. That is another

reason why we need to pay attention.

In bringing up the final question of whether Congress should create a single regulator for all of the GSE’s, I want to make sure that

I acknowledge the efforts of Chairman Korsmo. Mr. Chairman, you

have put forth tremendous effort to strengthen the regulation of

each institution individually as well as the System as a whole

through a more thorough examination regime, and I congratulate

you for that.

Mr. KORSMO. Thank you, sir.

Senator BENNETT. Regardless of the quality of regulation, there

are those who believe that all the housing GSE’s should operate

under a coordinated regulator with appropriate authority, believing

that separate can never be equal, at least in perception of the markets. I will continue to reserve judgment on that, but we are going

to hear from Treasury Secretary Snow tomorrow before the House.

I expect he will address that issue, and we will look at his testimony with great interest.

3

Secretary Abernathy, we welcome you back to the Committee,

where you served so ably for such a long period of time. I suspect

you will feel the same way and reserve judgment until after your

boss has spoken. But if you want to surprise us——

[Laughter.]

—we would be happy to have you surprise us.

Senator Johnson, I appreciate very much your attendance, not

only at this hearing but your diligence in this issue in the past, and

we would be delighted to hear from you.

STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. Thank you, Chairman Bennett, and welcome

to Secretary Abernathy and Mr. Korsmo. I thank you, Mr. Chairman, for holding this afternoon’s hearing on oversight of the Federal Home Loan Bank System. I cannot think of a more timely

hearing given recent attention on Government Sponsored Enterprises and debate over the nature and scope of their regulatory

agency.

Today is a good opportunity to take stock of the role, mission,

and regulation of the Home Loan Banking System. I apologize in

advance if my schedule will not allow me to stay for the entire

hearing. As usual, I have competing and overlapping obligations,

and I know that we are in good hands under your leadership.

The Federal Home Loan Banks play a critical role in our Nation’s housing finance and community lending system. Since the

Home Loan Banks were created in 1932 with the mission of helping to make homeownership more affordable, the positive impact

and the mission of the Bank has grown significantly.

In my State of South Dakota, the Home Loan Banking System

has provided critical funding for community lending needs. Until a

recent flight to safety of financial assets, our small community

banks faced serious funding issues, related in part to the continued

erosion in the value of deposit insurance. The Home Loan Banks

provided advanced services to counteract those funding shortfall,

ensuring that South Dakota consumers had access to loans that

they needed to keep our rural areas economically viable.

I should also note that since 1990, South Dakota has received

$8.6 million from the Federal Home Loan Bank of Des Moines’ affordable housing program. This investment has assisted 66 affordable housing projects throughout our State.

Mr. Chairman, today’s hearing is also well-timed because it is

not in response to a crisis. The Committee has important responsibility to conduct regular oversight, and this is especially important

with respect to the Federal Home Loan Banking System because

of the central role that it plays in today’s financial marketplace.

Few would dispute that the Banks play a different role than they

did back in the 1930’s. Some do, however, dispute whether these

new activities fall within the proper mission of the Banks. That is

a legitimate question. I am pleased we will have a chance to hear

from a variety of witnesses today.

In addition, we should also consider whether the Federal Housing Finance Board has the tools it needs to regulate what have become increasingly complex and sophisticated financial institutions.

At least one witness has advocated that the Home Loan Banks

4

share a regulator with the other housing GSE’s. This hearing could

not be better timed to hear both sides of that debate as we move

toward consideration of possible changes in the regulation of

Fannie Mae and Freddie Mac.

Finally, some of us here have had the chance to hear from SEC

Chairman Donaldson this morning about the implementation of

Sarbanes-Oxley. I hope that the witnesses will describe for the

Subcommittee their experience with any corporate governance reforms and their position on disclosure proposals currently under

discussion.

Chairman Bennett, thank you for holding today’s hearing, and I

look forward to hearing from these excellent witnesses.

Senator BENNETT. Thank you very much.

Secretary Abernathy, we will start with you.

STATEMENT OF WAYNE A. ABERNATHY

ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS

U.S. DEPARTMENT OF THE TREASURY

Mr. ABERNATHY. Thank you, Mr. Chairman, Senator Johnson,

Members of the Subcommittee. Thank you for this opportunity to

testify this afternoon on the Federal Home Loan Bank System. I

would like to focus on three topics this afternoon: First, the need

for the Federal Home Loans Banks to register with the Securities

and Exchange Commission under the terms of the Securities Exchange Act of 1934; second, I would like to talk about multidistrict

membership; and, third, Treasury’s current review of the Federal

Home Loan Bank System.

The observance of good, fundamental practices of corporate governance is a high priority for this Administration. For more than

a year, the Administration has been urging that all GSE’s comply

with the same corporate disclosure requirements of the Securities

Exchange Act of 1934. We are pleased that Fannie Mae has complied with this request. Freddie Mac has also agreed, though we

are disappointed to learn that Freddie Mac may not be registering

until sometime in 2004. The sooner they register, the better.

The Administration has continued to urge that the Federal Home

Loan Banks also move forward with voluntary registration. Some

have argued that the unique characteristics of the Banks lessen the

need for registration under the 1934 Act. All of these facts are important and must be, and I believe can be, taken into account.

However, the differences do not change the fundamental fact that

the Home Loan Banks are significant participants in our capital

markets. Investors should have the same information regarding the

condition of the Home Loan Banks as they have for other significant participants in the capital markets.

At the end of June, the Federal Home Loan Banks had outstanding consolidated obligations of $713 billion. The individual

Banks are each large financial institutions. As of year-end 2002,

the largest Bank, the Bank of San Francisco, had $135 billion in

total assets. The smallest, the Bank of Topeka, had $33 billion in

total assets, while the average was $58 billion in total assets. Even

the smallest would rank among the top 40 commercial banks in the

United States.

5

Investors would benefit from the added oversight of the SEC,

both in terms of reviewing financial disclosures and through uniform enforcement of current standards. And investors would have

a basis for making comparable evaluations of the variety of institutions that are competing for their investment dollars. Our system

of securities regulation should offer investors nothing short of that

standard.

The continued operation of the Banks outside of the SEC-administered corporate disclosure regime is inconsistent with our objectives of a sound and resilient financial system. We understand that

the Banks have some remaining concerns with how certain aspects

of their business operation would be treated. I would remind all

concerned that the Federal Home Loan Banks are not the only corporate institutions in America that have unique characteristics.

Given the flexibilities that the SEC has to address individual circumstances, we are confident that the Banks’ concerns can be

worked out.

We appreciate the discussions that several of the Banks have

had with the SEC earlier this year, and we look forward to these

discussions being renewed in the immediate future, within a context of acceptance of the public interest that would be served by the

Federal Home Loan Banks registering under the 1934 Act.

We understand that the Board of Directors of the Bank of Cincinnati recently announced that the Bank will be taking the next

step in the process. In a recent letter to Secretary Snow, HUD Secretary Martinez, and Chairman Korsmo, the Board of Directors of

the Federal Home Loan Bank of San Francisco expressed their goal

‘‘to enable the Federal Home Loan Banks to become role models for

corporate transparency.’’ That is our goal as well, to which registration under the Securities Exchange Act of 1934 is essential.

Let me just talk about multidistrict membership, in context.

While there continues to be debate over a number of Home Loan

Bank activities, one current issue, the question of multidistrict

membership, raises particular concern. The appropriate forum for

the resolution of this issue must be kept in mind. As the Treasury

Department has written in a comment letter to the Finance Board,

regardless of whether allowing multidistrict membership is wise, a

plain reading of the statute finds little room to conclude that the

Finance Board has the legal authority to approve it. It provides,

and I quote from the statute,

An institution eligible to become a member under this section may become a

member only of, or secure advances from, the Federal Home Loan Bank of the district in which is located the institution’s principal place of business, or of the Bank

of a district adjoining such district, if demanded by convenience and then only with

the approval of the Board.

I have played with that language many times trying to make

sure how does that ‘‘or’’ work, and I have thought of it in terms

of my children at home. I can say to my son, ‘‘You may have your

army toys in your room or you may have it in the playroom.’’ To

my mind, that is one room. If I wanted to say it could be either

one of those two and both of them, I would say, ‘‘You can have your

toys in your room and the playroom.’’ But if I use an ‘‘or,’’ it brings

into my mind there is only one place where those are going to be

6

located. The statute provides for an ‘‘or,’’ and it seems pretty clear

to us.

Now, to say this is not to render a policy point of view. There

are compelling arguments on both sides of the question. Clearly,

our financial system has changed dramatically since 1932. In the

intervening years, however, Congress has revised the governing

statutes on several occasions. But they have never changed that

particular requirement. It is to the Congress that these arguments

should be offered and where any change in the statute will have

to be made.

The third point I would like to raise. Earlier this year, I requested the Office of Financial Institutions Policy at Treasury to

conduct an in-house review of the Federal Home Loan Bank System, with particular but not exclusive, consideration of the effect

of the changes enacted as part of the Gramm-Leach-Bliley Act of

1999. As I announced at that time, the review would consider the

following points: how these changes have affected the ability of the

Federal Home Loan Banks to meet their statutory mission; implications for the financial strength of the Banks individually and the

System in general; how the business operations of the Banks contribute to accomplishing their statutory mission; issues regarding

governance structure and management, including executive compensation; effect of new capital structures on operations; and other

issues regarding the strength of the System and the structure of

Federal oversight.

We are now about 4 months into that process, nearing completion of our first phase. Again, I would like to emphasize that Treasury’s review of the Federal Home Loan Bank System is part of

what we normally do at Treasury, and what I envision for our current review is a more specific look at how the changes made to the

Federal Home Loan Bank System as part of the GLBA have been

implemented. Treasury is not primarily a regulatory agency. We

see as part of our important function, however, providing executive

branch oversight of the activities of the independent financial regulators, and this study is part of meeting that obligation and responsibility.

The Federal Home Loan Bank System presents policymakers

with issues that deserve continued attention. We must continue to

evaluate the System to ensure that it is achieving the objectives set

forth by Congress, meeting the needs of our communities that

might not be otherwise met.

Thank you again for providing me this opportunity to present our

views before you today and to discuss these important issues, and

I would be glad to answer any questions.

Senator BENNETT. Thank you very much for your testimony.

Chairman Korsmo, we appreciate your being here and look forward to hearing from you.

STATEMENT OF JOHN T. KORSMO

CHAIRMAN, FEDERAL HOUSING FINANCE BOARD

Mr. KORSMO. Thank you, Chairman Bennett, Ranking Member

Johnson, and distinguished Members of the Subcommittee, I appreciate the opportunity to speak with you today about the Federal

Housing Finance Board and the Federal Home Loan Bank System.

7

I have a brief opening statement, but I have also brought prepared

testimony with more thorough discussion of several key topics affecting the Federal Home Loan Banks I have been asked to address.

Senator BENNETT. Without objection, your testimony shall appear

in the record.

Mr. KORSMO. Thank you, Mr. Chairman.

Many important issues are facing the Nation’s Government

Sponsored Enterprises, including, certainly, the Federal Home

Loan Banks. In the interest of time, I highlight the aggressive

steps we have taken at the Federal Housing Finance Board, the

System’s regulator, first, to strengthen the agency’s oversight capabilities and, second, to improve financial disclosures by the Federal

Home Loan Banks through voluntary registration with the Securities and Exchange Commission.

These initiatives will benefit not just the Federal Home Loan

Banks and their more than 8,000 member institutions, but also the

investors who purchase their debt, and ultimately the homebuying

public and the taxpayers.

Soon after President Bush named me Chairman in December

2001, I determined that the Finance Board lacked many of the necessary resources to effectively oversee the Federal Home Loan

Banks for safety and soundness and achievement of their housing

finance mission. Just one example demonstrates this point. At the

time, the Finance Board had only eight bank examiners on staff to

review and supervise 12 financial institutions with, at the time,

more than $700 billion in assets, more than $30 billion in capital,

and some $650 billion in outstanding debt. Yet, at the same time,

the agency had eight people in its Office of Public Affairs. The relative allocation of resources simply did not meet the agency’s statutory mandates.

I immediately addressed these problems beginning with the recruitment of new leadership for the agency’s Office of Supervision.

After a national search, the Finance Board hired a new Director

and a new Deputy Director of Supervision, who, between them,

have 40 years of Federal bank regulatory experience.

Mr. Chairman, I appreciate your comments about the improvements we have made in our supervisory and examination function.

I should say that while often much is made of the times that my

Finance Board colleagues and I do not agree, on this issue, as on

most issues, my colleagues deserve equal credit for our initiatives

in this area. My fellow Finance Board members and I acting together increased the resources available for supervision, expanding

our examination staff to 17 full-time examiners. Our goal is to have

24 in place by the end of this calendar year and 30 by the end of

the next budget year.

We are now conducting more thorough examinations, focusing on

the Banks’ risk assessment processes, internal control systems, and

systems of corporate governance. And we are communicating the

results of those examinations more effectively to the Banks. Now

our examinations recognize that banking, even AAA-rated, GSE

banking, is a business of managing risks, and the responsibility of

bank supervisors is to ensure that the institutions they regulate

8

understand those risks and that they monitor and control them

through prudent practices.

On the subject of enhanced financial disclosures, last summer I

formed a working group with the Finance Board and the Federal

Home Loan Banks to review the issues associated with voluntary

registration of the Banks with the Securities and Exchange Commission.

Earlier this year, I concluded that voluntary registration is indeed the best approach to enhancing public disclosure of the governance and finances of these important institutions. I reached this

conclusion based on two premises.

First, the Banks’ long-term access to global capital markets will

be enhanced by providing investors in consolidated obligations with

maximum reliable transparency into the finances and governance

of each of the 12 Banks. Markets function best, especially in times

of stress, when needed information is readily available and reliable.

Second, as public trusts, these 12 GSE’s have a duty to contribute both to the smooth functioning of capital and mortgage finance markets and to public confidence that the benefits of GSE

status are used wisely.

The Federal Home Loan Banks and the staff of the SEC have

held numerous meetings to address the process for voluntary registration. In fact, another meeting was held only yesterday. It is

now time, I believe, to bring this process to a positive conclusion.

I note that this summer the boards of the Federal Home Loan

Bank of San Francisco and the Federal Home Loan Bank of Atlanta, as Secretary Abernathy mentioned, resolved that if SEC registration was the determined course of action, then the Federal

Housing Finance Board should adopt a regulation requiring it.

In response to those requests, tomorrow at our regularly scheduled meeting the Federal Housing Finance Board will consider a

proposed regulation requiring the Banks to register a class of their

securities with the SEC.

The proposed rule provides for a lengthy, 120-day comment period, during which, I hope, the Banks will each meet with the SEC

to work out the necessary details to effectuate registration and

begin meeting the periodic financial reporting requirements of the

1934 Act.

Mr. Chairman, distinguished Members of the Subcommittee, I focused on these two areas of safety and soundness oversight and improved financial disclosures because of their importance to the

strength and resiliency of the Federal Home Loan Banks. Certainly

we are dealing with many other issues at the Finance Board, which

are addressed in my written testimony, and I welcome the opportunity to discuss any and all of them with you.

Thank you again for your time this afternoon. I look forward to

addressing your questions.

Senator BENNETT. Thank you very much.

The Federal Home Loan Bank System has traditionally focused

on providing advances to their members. In the last couple of

years, Home Loan Banks have initiated a program of directly acquiring loans from their members. At what level should the Home

Loan Banks participate in the secondary market in this way, in

9

your opinion? And should securitization be considered as an option

for the Banks?

Do either one of you want to go first on that question?

Mr. ABERNATHY. I am happy to proceed, Mr. Chairman. Let me

deal with the securitization issue first, if I may.

Senator BENNETT. Certainly.

Mr. ABERNATHY. I think it is important to understand the nature

of the Federal Home Loan Bank System as a cooperative system.

It is different than a lot of other systems. They were put together

as a cooperative system. The Banks are owned by their members.

They are governed by their members. The Banks have this joint

and several liability responsibility to shore up and assist each of

the other members.

I think that is important to keep in mind when you are looking

at the question of securitization. These institutions were created to

serve their membership, and in our view, anything that would suggest that they should be securitizing something for sale outside of

that membership is something that is outside of the concept of the

Federal Home Loan Bank System as it is presently constituted.

On the other hand, I think with regard to some of the innovative

programs that have been established that are currently in operation, those are all kept within the System. They provide an important source of liquidity to the member banks, and by that I mean

the member banks of the Federal Home Loan Bank System, the

ones that are members of each of the Home Loan Banks. And as

far as we can see, they are providing an important service both

with regard to the individual banks and the people who are most

impacted, the people who take out the mortgages and buy and sell

their homes based upon that financing.

Mr. KORSMO. Mr. Chairman, do you want me to respond?

Senator BENNETT. Yes.

Mr. KORSMO. Secretary Abernathy has outlined the concerns in

the larger context very well. I think it is appropriate to mention

that right now Federal Housing Finance Board regulations do not

permit Federal Home Loan Banks to issue or guarantee mortgagebacked securities. There has been no request from any Bank or

from any Bank’s Board of Directors to seek such approval.

I think if the question does come before us, obviously we will

have to look at the whole question of legal authority and the safety

and soundness basis for making a judgment. I do not know if there

is anything more to say about that at this point, but that goes to

the point of your question.

Senator BENNETT. I want to go back to the first part of my question. At what level should the Banks participate in the secondary

market in this way? Because, again, traditionally, as you pointed

out, Secretary Abernathy, the Banks exist to serve their members.

Now they have gone in the direction of acquiring loans from the

members as opposed to making advances to the members. And is

there a financial level for this activity that would raise any concern

on your part, or do you assume that that would be fine and this

is where we go?

Mr. ABERNATHY. Well, I think perhaps the most flexible definition of how far they should go would be how far their capital and

resources can appropriately finance the risk that would be involved

10

with purchasing the mortgages from their entities. But so far, the

requirements for purchasing the mortgages from their member

banks has been that the mortgages must be just as good as if they

were being held for collateral, in which case it is difficult to say

that they are taking on much more of a risk than they would by

holding these merely as collateral.

I think that is an important requirement, that the quality of the

loans they purchase be of a high level so that they can manage that

risk appropriately.

Senator BENNETT. Looking ahead to the debate as to whether or

not they should be allowed to compete directly with Fannie Mae

and Freddie Mac, is that the same level of safety that is required

for Fannie and Freddie?

Mr. KORSMO. In fact, sir, I would argue it is higher. The riskbased capital standards under which the Federal Home Loan

Banks act are actually higher. I think Secretary Abernathy is right

in portraying this particular aspect of the Banks’ function, which

is indeed providing more direct liquidity for mortgage lending. Advances, of course, are fungible, and to some extent, while they have

to be collateralized with approved collateral that meets the standards of our regulations, the reality is that while advances remain

by far the most significant aspect of Federal Home Loan Bank portfolios, the growth of acquired member asset programs truly reflect

a member need.

Senator BENNETT. Okay. Quickly, because my time has expired,

but I want to follow up before we have lost the thought. Assuming

that you are correct that the standard for a Home Loan Bank is

higher than the standard for the other GSE’s, does that mean if

you get into direct competition that in the Home Loan Bank System they would like to lower the standard to that that exists with

Fannie and Freddie?

Mr. ABERNATHY. I think there is direct competition. I think everybody recognized that when they made their most recent filing

with the SEC. They listed who their competitors were, and they indicated they are the Federal Home Loan Banks. But they are a

competition at a certain level. It is a competition for those higher

quality——

Senator BENNETT. Yes. At a certain level do we see——

Mr. ABERNATHY. In a different form, I should mention.

Senator BENNETT. Would we see a lowering of the standard that

you have just described? Do you think that is going to happen?

Mr. KORSMO. I would certainly hope not. That would not be the

view of this regulator, anyway, to permit it, and right now the statute would not.

Mr. ABERNATHY. I think there is a certain value in making sure

that the mortgages purchased are very similar to the collateral requirements.

Senator BENNETT. Okay. Thank you.

Senator Johnson has left, so, Senator Corzine, you came in next

on the minority side. We will turn to you.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman, for holding this important and timely hearing.

11

I guess I have to ask the following question: What is the basis

to say that the standards of the Home Loan Bank are superior to

the ones for other GSE’s? Is it a risk-based model? Does it take into

account the prepayment exposures and convects the exposures that

are so difficult to manage in all financial institutions, in my perspective? And, second, what type of off-balance-sheet exposures, if

any, letters of credit or other forms, exist in the Home Loan Bank

System? And how can we be certain that those are factored into the

risk-based models?

Mr. KORSMO. Certainly, sir, I am not exactly sure where to start

on that question, but certainly we could assure you that the oversight that we provide and the constraints that the regulatory environment that we have created or the Finance Board has created

are extremely strict. These are very conservative institutions. They

are driven by a very conservative model and driven by, as I mentioned, a very conservative regulatory structure.

Senator CORZINE. Was the Treasury prepared to make that——

Mr. ABERNATHY. I do not know that I would have phrased it the

same way as Chairman Korsmo with regard to the Federal Home

Loan Banks having a higher quality of portfolio. Fannie and

Freddie were created particularly to establish secondary markets,

and their mandate is broader. They are required to go into more

markets than the Federal Home Loan Banks are. Because the Federal Home Loan Banks are required to have a very high level of

collateral for the advances they give, and their program was designed to match that standard with regard to the loans they purchase, they are only targeting a certain segment of the home mortgage market.

Fannie and Freddie were required to address a much broader

range, in fact, with a particular emphasis on middle to lower income. And so because of that you would expect that they would be

taking on what might be considered riskier mortgages, but they

also have hedging and other types of strategies to manage that

risk. And so as institutions, I would not like to have on the record

the concept that Fannie and Freddie are riskier institutions than

the Federal Home Loan Banks. They are required to have a broader portfolio, I think is the point I would make.

Mr. KORSMO. I would certainly agree with that, but I would mention that the leverage requirements of our risk-based capital regulation are higher in the sense that we have a 4-percent leverage

requirement versus the 2.5 that applies, I believe, to Fannie and

Freddie. I really am not terribly familiar with the Fannie and

Freddie model, frankly.

Senator CORZINE. They have a minimum of 2.5, and then they

have a risk-based standard.

Mr. KORSMO. Right, exactly.

Senator CORZINE. As an add-on.

Mr. KORSMO. You also asked about off-balance-sheet items. Our

regulations require that derivatives be used only for hedging. Federal Home Loan Banks cannot use them for investment purposes.

Eighty-two percent of the derivative use makes a perfect match

with advances in consolidated obligations. So, again, I think the

short answer is that the regulatory environment that we have created is very strict, and I think there is no question about that these

12

institutions operate in a very high plane in terms of safety and

soundness, which, after all, is our primary mission as the Federal

Housing Finance Board.

Senator CORZINE. As an individual that has looked at risk-based

models off and on, it is hard to know, except through practical experience through time and different stresses, whether those models

are as effective as one might always imagine in circumstances. I

am not challenging whether it is or not, but I think it is very hard

to say whether one model is better than another given the complexity of so many of the financial instruments. It really is a test

of those that oversee, from my perspective, anyway, the building of

those models, that they have the capacity to make a judgment

about whether they are fully impacting all the issues.

Thank you, Mr. Chairman.

Senator BENNETT. Thank you.

Senator Hagel.

COMMENTS OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you.

Gentlemen, welcome. We appreciate your appearance today. As

each of you may be aware, some of my colleagues on this Committee and I introduced legislation before the August break that

would reform oversight for two of the other GSE’s, Fannie and

Freddie. And my question to each of you is: Do you think we should

explore including the Finance Board in that legislation as well?

Secretary Abernathy?

Mr. ABERNATHY. Well, if I could, Senator, Secretary Snow is

going to speak directly to that point tomorrow, and I certainly do

not want to front-run him, presenting any views. But I will say

this: We looked carefully at your legislation as we were evaluating

those issues, and so we have taken very much into account your

legislation and the reasoning behind it. And I believe that has been

an excellent contribution to the debate.

But with regard to whether or not we should include them, I

would like to save that for Secretary Snow’s statement tomorrow,

if I may.

Senator HAGEL. Do you know if the Secretary will address that

issue tomorrow in the House?

Mr. ABERNATHY. That is in the whole panoply of things that he

is presenting. That is right. We are looking at the GSE’s in their

totality, the housing GSE’s, all of them together.

Senator HAGEL. So you do not want to venture any speculation

on whether we should take the Finance Board and include that?

Mr. ABERNATHY. I will be happy to after Secretary Snow does.

[Laughter.]

I will let him make the news.

Senator HAGEL. He is Gramm-trained, you can tell, cannot you,

Mr. Chairman?

[Laughter.]

Mr. Korsmo.

Mr. KORSMO. At the risk of being the second duck in this shooting gallery, for a different reason, obviously I think the primary

role of any regulator is to ensure the safety and soundness of those

institutions it regulates. I think to the extent that we create as

13

strong as possible regulatory oversight, not just for the 12 GSE’s

that I oversee but for all 14, I think that is important. Given the

fact that I am the Chair of a five-person Board who is reluctant

to take a position that has not been adopted by that Board, I guess

I would also be reluctant to speculate as to where the best site is

for that oversight function to take place. I think it is an important

debate. Let me leave it at that. I look forward as well, needless to

say, to hearing the Secretary’s comments tomorrow.

Senator HAGEL. Spoken like a true Chairman. Thank you.

Well, obviously, we will be talking to Secretary Snow and you,

Mr. Secretary, about this, as well as the Federal Home Loan Bank

officials, and we would welcome at the appropriate time your input,

which I am sure we will receive.

Mr. Chairman, you have developed a very impressive array of additions and completions since you have been Chairman on the Finance Board—objectives, responsibilities—and I think it had

redounded, as the Chairman noted and others here today, to more

confidence in your organization’s oversight, safety, soundness, and

credibility. Any additional changes, thoughts, practices, activities,

or actions that you are anticipating that you can tell this Committee about to further enhance the effectiveness of the Finance

Board?

Mr. KORSMO. Yes, sir. Thank you for asking that question. Obviously, I would hate to make it sound like all it takes is more dollars. We have the luxury as an independent financial regulator

that is a nonappropriated agency and can, in essence, adopt its own

budget and pass the cost of that budget on to those we regulate.

We are in the process really of a 2-year program to enhance and

improve our oversight capacity. It is not something that can change

overnight. The difficulty of adding to a staff, frankly, has been an

important lesson to us. We had budgeted for this fiscal year to increase our number of examiners, for example, to 24. The reality is

we have been unable to hire that many top-quality people and integrate them into our system fast enough.

That having been said, we are continuing that process. We are

going to add in this year’s budget accountants, some financial analysts who will be assigned specific responsibilities with each of the

Banks. I would be remiss if I did not touch quickly on our initiatives in the area of board governance. Board governance has in the

last year or so become a watch word, and it has been a focus for

the Finance Board as well. We have recently conducted a systemwide audit of board governance at each of the 12 Federal Home

Loan Banks. We have an ongoing process to review board governance. We are scheduling a hearing tentatively for October 15, next

month, where we will hear from the Banks and from other interested parties about recommended changes, both statutory that we

could recommend and regulatory that we could implement that

would improve the job that our boards of directors do.

All of those come together, I think, to create a picture. We are

not where we want to be, but we are headed in the right direction.

Senator HAGEL. Thank you.

Mr. Chairman, thank you.

Senator BENNETT. Thank you.

Senator Reed.

14

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman, and, gentlemen, thank you for being here today.

Both of you have alluded to, at least in your testimony, the

multidistrict membership banks issue. Mr. Secretary, do you have

a position on that issue?

Mr. ABERNATHY. In our view, the question begins with is there

authority for the Federal Housing Finance Board to make a determination. In our view, the statute does not leave that issue to the

Finance Board to decide. It has really left that issue with Congress.

The statute seems pretty clear that a bank has perhaps an either/

or choice, but it is still one district.

Senator REED. Would you urge that Congress give the Board that

authority?

Mr. ABERNATHY. We have not addressed the question of whether

it is wise to do that or not, and I think at some point we need to

do that. And, in fact, if Congress wants to take that issue on, we

would be glad to take a look at it and perhaps come back with recommendations.

Senator REED. Thank you.

Chairman Korsmo, do you have a position?

Mr. KORSMO. Let me just say that, first of all, no action by the

Finance Board in this area is planned, and while I appreciate Secretary Abernathy’s plain reading of the statute, sometimes a plain

reading is not enough. As a regulator, I think I would be remiss

in suggesting that the Federal Home Loan Bank Act does not provide broad authority to the Federal Housing Finance Board to take

any action to the extent that it goes to meeting the primary mission, that is, ensuring the safety and soundness of the Banks.

Unfortunately, sometimes when all one does is recite that circumstance and talk about how the financial services industry has

changed and the membership in the Bank System has changed, it

has taken for support for a particular policy position. I want to

make clear here, because I think there may be some question based

on comments others have made about my position, I am neither an

advocate of nor an opponent of multidistrict membership. The

Chairman alluded earlier to there are many unagreed-upon issues

in this system. This is certainly one of them. I think you will find

disagreement even among the boards—on boards of directors of individual banks as how to best deal with the changing circumstances in the housing finance industry.

It is an issue that, as I say, at this point we have no plans to

take action on.

Senator REED. I think we can mark you down as scrupulously

noncommittal.

Mr. KORSMO. Thank you. Yes, sir.

Senator REED. Chairman Korsmo, I am concerned about the

process that the Finance Board has followed to make some important decisions, specifically the shared funding program operated by

the Chicago Home Loan Bank Board. As I understand it, the staff

approved under Section 955.2, and this would be for the purchase

of interest in whole loans. But as I understand the Section, it only

authorizes purchase of whole loans, not interest, or certain types

of State and local housing finance agency bonds. Is that correct?

15

Mr. KORSMO. No, sir. I think a broader reading of the regulation,

again, particularly as it exists on the books now, is that the Banks

have authority to purchase mortgage assets both in the form of

whole loans and——

Senator REED. Interest loans.

Mr. KORSMO. Thank you. I am losing my train of thought here.

Interest in loans as well.

Senator REED. Can I just work my way through here? Because

my notes indicate that the only reference to interest in whole loans

was in the preamble of the regulation.

Mr. KORSMO. That is correct, sir.

Senator REED. Which was a response to a comment made.

Mr. KORSMO. That is correct, sir, but our general counsel and Office of Supervision’s reading of that was that the regulation did indeed provide the authority for banks to apply for new business activity—excuse me, permission to engage in this activity.

I think that it would be good to understand the process, however.

Senator REED. May I make one other point?

Mr. KORSMO. Yes, sir.

Senator REED. Apparently, in July of this year, the Finance

Board put this issue out for comment. Is that correct?

Mr. KORSMO. Yes, we put out a draft of a revised AMA reg, yes,

sir, for comment.

Senator REED. So why would you ask for comment after the approval of the program, which you say——

Mr. KORSMO. The comment was not on this particular item, although broadly speaking, of course, commenters on this particular

proposal, the revision of the entire AMA reg, certainly could have

commented on this particular provision. But it was the provision as

a whole that was being put forward for comment.

Let me just mention that at our meeting tomorrow, because of

the confusion that has developed over what exactly our proposal

was and what it entailed, when it was unanimously adopted by the

Board on June 18 at our regular meeting, we have—in consultation

with my colleagues—all agreed that we will withdraw the proposed

regulation, revise it to perhaps clarify what our intentions were in

the regard not just of the item that you have mentioned, but some

other areas that have been misunderstood as to intention, and reissue—assuming Finance Board adoption of a reissued proposed

draft—that for comment.

Senator REED. Well, thank you, Mr. Chairman. I think this

raises a very specific issue, but a more general issue of the process

of approving and interpretation of your own regulations and public

comments on proposed changes. We hope you would act on those

general issues.

Mr. KORSMO. Yes, sir, I recognize your concern in this area, and

we will take it into consideration.

Senator BENNETT. Thank you very much.

If Secretary Abernathy is right and the law is clear, the law is

clear. So, I think you better, if you are going to argue with that,

have the firm legal position rather than a general statement that,

well, we have the right to do whatever is best for the System. Just

an editorial comment as I listen to this back and forth.

16

COMMENTS OF SENATOR JIM BUNNING

Senator BUNNING. Mr. Chairman, I would like to put in opening

remarks.

Senator BENNETT. Without objection, it will appear in the record.

Senator BUNNING. Secretary Abernathy, does the Treasury believe that all GSE’s, including the TVA, should register with the

SEC?

Mr. ABERNATHY. I would have to say, Senator, when we made

the statement with regard to all GSE’s, it was a general blanket

statement. We did not limit it. With regard to the TVA itself, that

is not one type of entity that I have been looking very closely at

with regard to——

Senator BUNNING. To GSE, though?

Mr. ABERNATHY. Senator, our view is that entities that are putting significant capital into the markets should be providing the

full set of disclosures that other capital participants are required

to follow.

Senator BUNNING. Would $30 billion be a——

Mr. ABERNATHY. That is significant to me.

Senator BUNNING. It is significant, okay. I just want to make

sure that is the Treasury’s position, then; that all GSE’s should——

Mr. ABERNATHY. That is our position, yes.

Senator BUNNING. Thank you very much.

Do you believe all—this is for either—housing GSE’s should have

the same regulator?

Secretary Abernathy.

Mr. ABERNATHY. If I could take a pass on that, Senator, and the

reason why is tomorrow Secretary Snow is going to be addressing

that very issue, and I would prefer to let him address it first.

Senator BUNNING. And obviously you will take the same pass.

Mr. KORSMO. As a sitting regulator, I will take the same pass,

please.

Senator BUNNING. I just had a very good meeting with the Federal Home Loan Bank Board of Cincinnati. They have agreed to

voluntarily register alternative of their securities with the SEC.

Some of the other banks I just was surprised that in your statement you said San Francisco seems to be now more cooperative in

registering.

Mr. ABERNATHY. They certainly seem to be laying the predicate

for doing so, but they have not yet made that same commitment

that the Cincinnati Bank has. And I certainly would like to praise

the Cincinnati Board for making that determination.

Senator BUNNING. Does that trouble you, though, that just 1 out

of 12 would come forward and voluntarily register?

Mr. ABERNATHY. I remain troubled until we have all of them registered, frankly, because we do not have the information about

those entities that we need to have otherwise.

Mr. KORSMO. Senator, in fairness to some of the other Banks,

there has been a varying degree of participation. In fact, all 12 of

the Banks have been actively engaged in the process of discussing

this issue. There was a meeting yesterday, I believe, of the committee representing 10 Banks, but representing specifically the

New York, the San Francisco, and the Pittsburgh bank with SEC

17

officials. I know the Chicago Bank is also going through the process

of preparing some draft documents for the SEC to look at.

While certainly the Cincinnati Bank deserves being singled out

for particular praise in their willingness to move ahead in this

project, I would be reluctant to characterize the involvement of any

of the Banks as being dilatory. They have all, to one degree or another, have recognized their responsibility to provide enhanced disclosures to the marketplace. At this point, we are debating what

form that is going to take.

Senator BUNNING. Well, you both realize that registration with

the SEC was the red flag for Freddie. When they were trying to

get prepared to register with the SEC is when the big red flag went

up for them. I hope that is not the case in any Federal Home Loan

Bank Board or any area of the country, but to register with the

SEC you have to undergo certain registration scrutinies, and I

want to make sure, if somebody is reluctant because of that, you

should know that as the chief regulator.

Mr. KORSMO. That is correct, sir, and my sincere hope is that the

reluctance is based on principle and not on any reluctance that

some action or practice would be revealed which would embarrass

the Banks. I can assure you that the job we are doing as the safety

and soundness overseer and supervisor is sufficient to assure that

that is not the case.

Senator BUNNING. Last, but not least, I disagree with your definition of ‘‘or.’’

[Laughter.]

I have more than one child, and I would make comparisons

equally as distinguishing as you did in either/or or and/or, and I

would be with the Chairman on that regulation. Thank God I am

not a lawyer. I do not get confused with the facts, you know.

[Laughter.]

But I believe ‘‘or’’ means exactly what it says. Thank you.

Senator BENNETT. Senator Allard.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, thank you. I have a statement

I would like to have put in the record.

Senator BENNETT. Without objection, it will be placed in the

record.

Senator ALLARD. I have a question for Mr. Abernathy. In your

testimony, you noted that investors in GSE securities should have

access to the same corporate disclosures as they have for other

companies who publicly offer their securities for investment. In

your opinion, how do the current disclosures compare?

Mr. ABERNATHY. The most significant thing that I think that we

obtain by having the Federal Home Loan Banks register with the

SEC, even if they did not disclose an additional piece of information that they are currently not disclosing is the timing, by registering with the SEC, that the timing of disclosures will be the

same to provide comparability for investors, the standards for disclosure and the standards for review of those disclosures will become the same, and it is a high standard, and those who are doing

those particular reviews will be the same.

18

The penalties for false filings would become the same, and it is

that high standard that I think has elicited the point that Senator

Bunning mentioned. Before Freddie Mac agreed, and they did

agree to register the SEC, they were, for a time, saying there

would be nothing new that would be disclosed if we agreed to this

regime. Then, they agreed to it and discovered maybe it does mean

a higher standard. Maybe it does mean that what we are required

to comply with is more meaningful. We think that would probably

be similar with regard to the Federal Home Loan Banks, not that

there is anything hidden, but that it provides a more rigorous

standard of comparability, particularly.

Senator ALLARD. Chairman Korsmo, you mentioned in your testimony, the Federal Housing Finance Board is a nonappropriated

agency and enacts its own budget and assesses the Banks for the

cost of its operation. How important is this authority in your ability

to carry out your mission?

Mr. KORSMO. It is extremely important. I think I am still too

early in my tenure, frankly, and not having served in a situation

where that was not the case, it is hard for me to make a comparison. But I think the fact that we can structure a budget responsibly that provides us the resources we believe we need to carry out

our responsibilities is significant. Again, given the fact I have never

operated under a different system makes it difficult for me to compare, but I will say that it certainly makes our job easier.

Senator ALLARD. Now, that I have given you both softball questions, I would like to hear the pros and cons from each one of you

about this proposal to have a consolidated approach to regulation.

One regulator for all financial institutions. I would like to hear

your pros, and I would like to hear your cons.

Mr. ABERNATHY. Well, if I could take a pass, Senator. Secretary

Snow is, I understand this is an important issue, and I am uncomfortable and have not been able to lay it out for you like I would

like to lay the issues before you, but at the risk that if I presented

the pros and cons, I am not very good at hiding where I think the

weight of the good opinion rests. Rather than laying out the pros

and cons and disclosing where I think we are, I will leave that for

Secretary Snow, if I might.

Senator ALLARD. Well, then, let me put it this way—you both

have the same response about the mission of safety and soundness;

would you talk a little about that?

Mr. ABERNATHY. I think the mission of safety and soundness

needs to be understood in a large context, and that is not just with

regard to the safety and soundness of an institution itself, but also

with regard to the markets in which it operates, and that is an important responsibility for the regulators. That is the way our bank

regulators operate, and I think that is the way our GSE regulators

should operate.

They are looking at the safety and soundness, not just of the institutions, but of the financial system that those institutions are

participants in. That is obviously the most important function the

regulator has.

Senator ALLARD. I think the farm loans or the home loan, at

Farmer Mac, as well as the Fannie Mae and Freddie Mac have all

had in the past, at some time or another, some problems with bad

19

debt. Do you think it is the appropriate role of Government to come

in and bail them out when they have debt problems like that or

is it that you do not have any choice? Are we absolutely required

to?

Mr. ABERNATHY. I do not think that we are required to. I think

that we have tried to make it very clear, and——

Senator ALLARD. Well, let me put it this way. Does the ‘‘too big

to fail’’ principle come in line, and we simply have to bail them out

in order to sustain the economy?

Mr. ABERNATHY. Yes. I think, on many occasions, we have tried

to emphasize the fact that there is no Federal guarantee standing

behind any of the obligations of the Government Sponsored Enterprises. And those who invest in their debt or in their stocks, where

they are publicly traded stocks, they have to evaluate just what is

the risk involved with those securities and should not take into account thoughts that there is some Federal guarantee.

Now, what would happen if one of those institutions was on the

point of failure? Frankly, we have good regulators, hopefully, to

prevent that from happening, to make sure that there is adequate

levels of capital maintained by each of these institutions and that

the——

Senator ALLARD. How do we make sure that happens?

Mr. ABERNATHY. The best way to do that, I think, is by a system

of ongoing, on-site examination. We have a lot of enthusiasm for

the steps that Chairman Korsmo has brought to pass on the Federal Housing Finance Board to beef up that examination pool.

Senator ALLARD. Does that mean bringing all of the regulators

into one, uniform approach?

[Laughter.]

Mr. ABERNATHY. Well, I will let Secretary Snow give his views

on that, if I may.

Senator ALLARD. Mr. Korsmo, would you respond to that.

Mr. KORSMO. Obviously, Secretary Abernathy has a larger responsibility, and my context is to focus on the Federal Home Loan

Bank System, and I have ducked the question as effectively, as

Secretary Bunning will tell you, perhaps not as effectively, but I

have made the effort.

Let me say one thing, however, I think there is a——

Senator BENNETT. At least as often.

Mr. KORSMO. At least as often. Thank you, Mr. Chairman.

[Laughter.]

Let me say one thing, in terms of a pro and con, I think the argument in favor of a single regulator will be how will the larger market look at the particular Government Sponsored Enterprise who

is not subject to the same regulatory oversight in terms of site, as

opposed to quality that is not included in that process.

The flip side of that, of course, is the familiarity that a particular

regulator can develop with the policies, practices, and institutions

over which that regulator has responsibility is certainly easier if it

is focused on a particular entity. I think there is some concern, and

I do not mean to speculate on this part, but I think there is some

concern among the Federal Home Loan Banks what would happen

to us if we were buried, if you will, with Fannie Mae and Freddie

Mac.

20

And I think that is perhaps a legitimate concern, but I too will

wait for Secretary Snow’s view tomorrow.

Senator ALLARD. Mr. Chairman, I was going to yield some time

for my colleague, the Senator from Kentucky, but I see my time

has expired.

Senator BENNETT. Senator Miller has joined us, so we will go to

Senator Miller and then come back to Senator Bunning.

COMMENTS OF SENATOR ZELL MILLER

Senator MILLER. I do not think I want to just get here and start

to speak. Let me listen for a while, Mr. Chairman.

Senator BENNETT. Okay.

Senator BUNNING. I just have one question, Mr. Chairman.

Senator BENNETT. Sure. Senator Bunning.

Senator BUNNING. Secretary Abernathy, you made the statement

about oversight and watching closely those entities, GSE’s particularly. I am going to bring the TVA back to you. They are unregulated by anyone. No one, except these three commissioners, has

anything to say about TVA. They sell up to $30 billion worth of

debt. It is AAA because everybody else thinks that it is backed by

the full faith and credit of the U.S. Government.

FERC, who oversees almost every other entity in electric generation, has not one thing to say about the TVA. I suggest that the

Treasury makes very sure that if you are going to include people

in oversight and regulation that you look at a GSE called the TVA,

which is unregulated and governed by three people.

Senator ALLARD. That is a powerful argument, Senator. Thank

you. We will look at it.

Senator BENNETT. Thank you, both.

Secretary Abernathy, you made note in your comments that

Freddie Mac has so far failed to register, in spite of the fact that

they promised.

Senator ALLARD. And I will say, if I could, Mr. Chairman, we

have no doubt about Freddie Mac’s willingness and intention to

comply. We are eager to see it happen as soon as possible, but we

have no doubts that they will comply.

Senator BENNETT. Very good.

Thank you, both. We appreciate your testimony here today, and

we appreciate your service to the Nation in the various positions

that you hold.

Mr. ABERNATHY. Thank you, Mr. Chairman.

Senator BENNETT. We will look forward, with great interest, to

Secretary Snow’s answers to the questions you have so artfully

dodged here today.

[Laughter.]

Mr. ABERNATHY. Thank you, Mr. Chairman.

Mr. KORSMO. Thank you, Mr. Chairman.

Senator BENNETT. We now move to our second panel.

We are going to hear from them in this order, regardless of

where their name tags go. We will hear first from Norman B. Rice,

who is the President and CEO of the Federal Home Loan Bank of

Seattle; Mike Middleton, the President and CEO of the Community

Bank of Tri-County, Waldorf, Maryland. Senator Sarbanes had

hoped to be here, Mr. Middleton, to introduce you to the ComVerDate 11-MAY-2000 18:52 Jun 03, 2005 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 21384.TXT SBANK4 PsN: SBANK4
21

mittee, and he may yet appear. If he does, we will take appropriate

notice of that.

Sheila Bair, who is the Dean’s Professor of Financial Regulatory

Policy at the Isenberg School of Management at the University of

Massachusetts. Sheila is well known to this Committee and its

Members and staff; Terry Smith, President of the Federal Home

Loan Bank of Dallas; and David Hemingway, Executive Vice President of Zions First National Bank in Salt Lake City, Utah.

I must exercise the hometown prerogative of introducing Mr.

Hemingway to the Committee. He has been a witness before the

Committee before on other issues and is very knowledgeable. I do

recall a conversation with one of my colleagues in the House about

an issue where Zions Bank was involved, and the House Member

said to me, ‘‘Now, let us see, was that Roger Zion that owns that

bank?’’

And I said, ‘‘No, it was Brigham Young that started that bank.’’

[Laughter.]

And Zion has a reference to something other than a family. With

that, we welcome you all, and, Mr. Rice, we will start with you.

STATEMENT OF NORMAN B. RICE

PRESIDENT AND CHIEF EXECUTIVE OFFICER

FEDERAL HOME LOAN BANK OF SEATTLE

Mr. RICE. Good afternoon, Mr. Chairman and Members of the

Subcommittee. I am Norman B. Rice, President and Chief Executive Officer of the Federal Home Loan Bank of Seattle, and I would

like to thank Chairman Bennett and the Subcommittee for the opportunity to provide my perspective on the critical role the Federal

Home Loan Banks play in building strong communities and

healthy economies across America.

The 12 Federal Home Loan Banks have a long history of service

and accountability to the more than 8,000 financial institutions we

serve, to the millions of individuals and families we help realize the

American Dream of homeownership, and to the regulators and

Congress who oversee our system.

It is not the history of our Banks that I want to talk about this

afternoon. Where we have been and what we have accomplished as

a Bank System is significant and well documented. My focus is on

the relevance of the Bank System today—and in the future—and

the essential role we play on behalf of our financial institution

members, and the economic health of our country.

I will start with what I consider to be the most important element of the Federal Home Loan Banks. We are a cooperative. Our

members own the Bank System, and we are accountable to them.

These are the Banks, credit unions, thrifts, and other institutions

that give our communities critically needed access to credit. These

are the risk-takers whose leadership and resources build stronger

towns, cities and, to a very real extent, a stronger Nation.

They are able to do that as part of a cooperative that provides

each member, small and large, the same access to a stable, lowcost, and reliable source of wholesale funding. No other housing

GSE or financial institution can replicate our System’s unique partnerships of bank, member, and community.

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As I sit here before you today, the Federal Home Loan Banks

and the housing GSE’s are facing significant challenges and

changes regarding their business practices, regulatory structure,

and mission-based programs and activities. In the weeks and

months ahead, as this Subcommittee and other Members of Congress debate the future of the Federal Home Loan Banks and the

housing GSE’s, I would like to offer some questions and principles

for you to consider in your discussion, as well as clear evidence of

the powerful impact our bank system has on the economic health

of our country.

Over the course of any week, I am asked by a number of people

what the Federal Home Loan Bank of Seattle is and what it does.

And my short answer is this: We help ensure that Americans have

homes and a stable local economy. That is a good quick response

for anyone unfamiliar with the Home Loan Banks, but for the purpose of our discussion today, I would like to offer a more comprehensive—and slightly different—way to look at the value and

the benefits provided by the Bank System.

Imagine, if you will, our country with the 12 Home Loan Banks

and then consider the following: The Bank System extends nearly

a half-trillion dollars in advances, what we call loans, to our member financial institutions annually, strengthening those local economies, and homeownership. Imagine those dollars gone. Since 1991, the Federal Home Loan Banks have awarded $1.6

billion in Affordable Housing Programs grants, helping to create

360,000 low-income housing units across the country. Imagine

those homes gone. Since 1990, the Bank System has provided nearly $36 billion in

reduced-rate, long-term loans for low-income housing and economic

development. Imagine those dollars, and homes, and businesses

gone.

Now, imagine the collective impact on our national economy. I

would urge you to ask yourselves how would your local banks compete if they did not have access to the capital markets? Where

would your constituents go to get loans to buy homes and run their

businesses? Now, go one step further. If the housing GSE’s did not

exist today, what would you put in their place? I believe you would

come back to something that looked a lot like the Federal Home

Loan Bank System as it is, and here is why.

The Bank System is funded entirely through private capital. The

cooperative is built by private owners who have put more than $36

billion of their own money at risk to capitalize the system. The

Bank System is cooperatively owned to support, rather than compete, with the private marketplace. Our stock is not publicly traded, and we do not have third-party investors pulling out value. The

Bank System is organized by region, ensuring that each Bank is

connected and responsive to local markets.

The Bank System pays its fair share of taxes. The Home Loan

Banks carry a special tax burden that cannot be sheltered and is

equivalent to a Federal corporate tax rate. The Bank System has

been required, since 1989, to pay off the REFCORP debt and provide 10 percent of its net income in support of low-income housing.

This is the single largest private source of housing subsidy in the

United States.

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The Bank System is a critical source of liquidity through all

parts of the economic cycle. So this country’s network of community

banks relies on our capacity to access the capital markets on their

behalf.

The Bank System has the capacity to innovate and keep pace

with an evolving financial services industry. This is why we offer

mortgage purchase programs. Our members have told us they can

better serve homebuyers and local markets if there is more competition in the secondary mortgage market. It is no accident that

our program volume has accelerated from zero to almost $100 billion.

As you can see, it is not a difficult task to illustrate the benefits

provided by the Home Loan Banks. Today, as one of the 12 Presidents within the System, I stand committed to work with you to

further the mission and the vision of our Bank System and meet

the evolving needs and issues facing our housing GSE’s.

On the matter of consolidation of GSE regulators, whether or not

Congress determines that a single regulator is the appropriate direction or not, all three housing GSE’s must have strong, consistent

regulatory oversight to ensure both safety and soundness and mission achievement. There can be no debate on this point.

And that means it is time to straighten out the wide variety of

requirements and oversight regarding the housing GSE’s. For example, why did two housing GSE’s have lower capital requirements

than the 12 Home Loan Banks which carry less credit risk? Why

is there inconsistent mission oversight, with the Home Loan Banks

delivering cash grants, while the other housing GSE’s hit a different set of affordable housing goals?

What public policy goal is advanced when roadblocks are put in

front of our Bank System, when we respond to our members’ stated

desire to have greater competition in the secondary mortgage market, and when, in fact, those roadblocks actually hinder our ability

to drive more funding to our member financial institutions and

their communities? I have heard it called ‘‘mission creep,’’ but from

my point of view, it is more like ‘‘mission leap.’’ When our mortgage

purchase programs are allowed to grow, they allow us to take significant steps toward fulfilling our mission and not walking away

from it.

I want to be clear today that I believe the onus for strengthening

our system lies not only with Congress and regulators, but also

with the Home Loan Banks themselves. We need to continue to

step up and accept the risk in our System and our industry and

embrace the fact that more intense public oversight is inevitable.

We welcome that public oversight because, if done smartly, it will

strengthen our Bank System, ultimately, and the economy of this

country.

In closing, I would like to leave you with five principles that I

believe should inform your discussions and decisions in the months

to come:

One, private capital is the most effective cushion to guard the

public against the risks inherent in our enterprises. As a cooperative, the Home Loan Banks are capitalized by their customers who

monitor risk-taking in a way that third-party shareholders cannot.

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Two, insist on competition among housing GSE’s, rather than

competition with the private financial services industry.

Three, demand that more of the value created by the housing

GSE’s be delivered to the housing finance system and consumers,

rather than private investors.

Four, demand consistent strong and smart regulatory oversight

for all housing GSE’s and recognize the critical differences between

the Bank System and publicly traded housing GSE’s.

And last, but not least, demand an intense focus on our mission,

hold us accountable, and keep in mind what America would look

like if the Federal Home Loan Banks did not exist.

That concludes my remarks, and I thank you, again, for allowing

me to testify today, and I will be happy to answer questions at the

appropriate time.

Senator BENNETT. Thank you very much. We appreciate that.

Mr. Middleton.

STATEMENT OF MICHAEL MIDDLETON

VICE-CHAIRMAN, FEDERAL HOME LOAN BANK OF ATLANTA

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

COMMUNITY BANK OF TRI-COUNTY, WALDORF, MARYLAND

Mr. MIDDLETON. Good afternoon, Chairman Bennett, Senator

Bunning, Senator Miller and, hopefully soon, Senator Sarbanes.

[Laughter.]

Thank you for the opportunity to discuss something that——

Senator BENNETT. You are among friends, even if he is not here.

[Laughter.]

Mr. MIDDLETON. He is a good friend.

Thank you for the opportunity to discuss something that is very

important to my business and my community, which is the Federal

Home Loan Bank System. I am Michael Middleton, Chairman and

CEO of the Community Bank of Tri-County, which is a $300-million community bank located in Waldorf, Maryland.

I serve as Maryland’s elected Director to the Federal Home Loan

Bank of Atlanta’s Board, and I am honored to serve as Vice Chairman on that Board. I am also a Member of the Board of the Council of the Federal Home Loan Banks.

I am testifying today on behalf of the Federal Home Loan Bank

of Atlanta. Mr. Chairman, while I have covered details in my written testimony, I would just like to highlight some of the more important issues.

As a member and a long-time user of the Federal Home Loan

Bank advances, as well as other products, as well as a Director to

the Atlanta Bank, I have gained a broad perspective on the system,

and I hope it will be of use to the Subcommittee.

The Community Bank of Tri-County serves southern Maryland.

Our customer base draws from a broad economic range. We tailor

our services and our products to meet the needs of our communities, while competing with larger regional and national financial

institutions.

At my bank, we take our CRA responsibilities very seriously.

Many community banks, are faced with the challenges of meeting

their CRA requirements. And the Federal Home Loan Banks provide us with the tools and the skills to meet those challenges.

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The Federal Home Loan Bank System helps level the competitive

playing field in many, many ways. As GSE’s, the 12 Federal Home

Loan Banks were created to stabilize and improve the availability

of funds to support homeownership. Today, capitalized by the cooperative stock of its member owners, the Banks still fulfill that mission. The Banks and their members are the largest source of residential and community development credit in the United States.

Through the work of many on this Committee, including Senators Hagel, Johnson, and Bayh, to modernize the Federal Home

Loan Bank System in the Gramm-Leach-Bliley Act, it helped direct

and expand the reach of the Banks and their members by providing

critical residential community development credit to rural and

urban communities.

I believe it is important to note that the Federal Home Loan

Bank is the only institution in the United States that fulfills this

mission. The Banks are a stable, low-cost, reliable source of shortand long-term funding. For the many small and medium-sized community banks, the Federal Home Loan Banks are essential because

direct borrowing from the capital markets is not a

viable option for us.

The Bank System enables us to remain independent and to continue to be an economic engine in our communities. That, of course,

translates into jobs.

The Federal Home Loan Banks developed their programs in

response to their members. For example, in response to member

demand, the Atlanta Bank now offers both the MPP and the MPF

Acquired Member Assets Program. The Bank’s members that use

these programs are pleased that they have yet another financial

tool in delivering competitive credit products.

Like the advance programs, the AMA programs, again, help level

the competitive playing field for community banks. At my bank,

Community Bank of Tri-County, we rely on Atlanta’s programs to

deliver financial service to our communities. Like many other

areas, our communities need more affordable housing, improved

medical school, and volunteer and rescue support facilities. The

Federal Home Loan Bank is often an invisible, but vital, partner

fulfilling these needs.

Community Bank has partnered with nonprofit CDC’s in using

the Federal Home Loan Bank programs to create layered funding

that supports affordable housing and infrastructure development.

We do this with programs, like the AHP, or the Atlanta Bank’s

EDGE program. These, and similar Federal Home Loan Bank programs, make affordable housing and community development

projects economically feasible in communities such as mine.

A good example of this is the Yardley Hills project in Calvert

County, Maryland. I am sure Senator Sarbanes is familiar with

that section of Maryland. That project, as an example, used $2.7

million in complex, layered funding through our partnership with

the Atlanta Bank’s AHP.

In another project, we used the EDGE program to provide the

Jarboe Family Head Start Center in St. Mary’s County with permanent funding, when other traditional banking sources of larger

regional banks became unavailable.

26

The Federal Home Loan Banks also helped their members provide other needed forms of community development credit. Community Financial Institutions, CFI’s, may now pledge, as collateral for

advances, small business, small farm, and small agribusiness

loans. This may allow smaller institutions, particularly in rural

areas, to better serve the community development credit needs of

their neighborhoods and their farmers.

I strongly believe that the Federal Home Loan Bank System is

able to provide these important benefits because of its dynamic

membership of both large and small institutions and its regional,

decentralized, and cooperative structure. I can say, unequivocally,

that without the Federal Home Loan Banks and the programs they

provide, it would be far more difficult for my bank, and the thousands of other community banks, to remain independent, competitive, and capable of extending important housing and community

development credits.

I have given you examples of why the Federal Home Loan Bank

System is so vital for community banks like mine, but I am also

a Member of the Board of Directors of the Federal Home Loan

Bank in Atlanta, and that imposes additional important responsibilities.

The Atlanta Bank and its Board support the Administration’s position that housing GSE’s should provide complete and transparent

financial disclosures that constitute the best of class. That is why

we, along with other Federal Home Loan Banks, have been working with all relevant parties to resolve the specific issues presented

by the Federal Home Loan Bank statutory mission, cooperative

structure, and joint several liability.

In fact, the Atlanta Bank will file its annual financial reports for

2003 in SEC 10–K format.

Senator BENNETT. Could you summarize?

Mr. MIDDLETON. Thank you.

I will tell you what. This is the summary.

Senator BENNETT. All right.

Mr. MIDDLETON. I am sorry if I have taken too much time of the

Committee.

As a director, I want the Atlanta Bank to meet the highest

standards of disclosure. At the same time, and this is an important

distinction, as a director, I have an obligation to the member owners of the FHLB to be certain that the disclosures are administered

in a manner that would not impair the mission or the operation of

the Bank or increase its cost of funds.

Again, as a director, if I vote to voluntarily register the Atlanta

Bank’s equity with the SEC, not only do I assume additional personal, civil, and criminal liabilities for the relevant statutes, but I

also assume a liability to our members for my decision to voluntary

register.

Thus, it is most compelling that the critical issues have been satisfactorily resolved and sustainable written agreements reached.

Reasonably known issues, critical accounting issues, must be resolved in a way that all Federal Home Loan Banks and their members can rely on going forward without the threat of quarter-toquarter, year-to-year reconsideration with each SEC filing.

And there I will abbreviate my text. Thank you, Senator.

27

Senator BENNETT. Thank you very much.

Mr. MIDDLETON. It has been a great opportunity.

Senator BENNETT. Yes. We will be happy to put the entire statement in the record.

Mr. MIDDLETON. Thank you.

Senator BENNETT. Ms. Bair, again, welcome to the Committee,

where you are well-known and spent a good portion of your career

working on both sides of the aisle.

STATEMENT OF SHEILA C. BAIR

DEAN’S PROFESSOR OF FINANCIAL REGULATORY POLICY

ISENBERG SCHOOL OF MANAGEMENT

UNIVERSITY OF MASSACHUSETTS

Ms. BAIR. Thank you, Mr. Chairman. It is good to be back. Senator Bunning and Miller, thank you for being here.

It is a pleasure to appear before you today to assist you in your

oversight of the Federal Home Loan Bank System. It is in the spirit of System supporter that I come to you this morning to raise two

issues that I believe warrant your attention: Multidistrict membership and expansion of the System’s mortgage acquisition programs.

These issue are important because their resolution will help determine the future of the System and its long-term stability. They

are examined in detail in a paper I recently completed that was

funded by a grant to the School of Management from the Fannie

Mae Corporation, which I would like to submit for the record.

Senator BENNETT. Without objection, it will be put in the record.

Ms. BAIR. Thank you.

Ms. BAIR. Thank you. The conclusions reached in the paper are

my own and do not reflect the views of the research sponsor.

After summarizing my paper, I will make some general observations about the FHLB systems regulatory structure in relation to

efforts underway to improve safety and soundness regulation of

Fannie Mae and Freddie Mac.

Recent industry consolidations have prompted some to call for allowing members to belong to more than one district Federal Home

Loan Bank.

My primary objection to multidistrict membership is that Congress, not the FHFB, should decide whether such a fundamental

change should be made to the System’s historic regional and cooperative nature. I am also concerned that multidistrict membership

could have a destabilizing influence on the System. Multidistrict

membership would allow large institutions to ‘‘shop’’ their advance

activity among multiple FHLBanks, but because all of the

FHLBanks raise funds in the same way, their ability to compete,

based on price, will be limited. As a consequence, they will likely

compete on collateral and credit standards. Allowing one member

to have multiple relationships with FHLBanks would also increase

operational risk, since the System lacks safeguards to obviate the

multiple pledging of collateral or the prospect of competing blanket

liens. Moreover, allowing multiple memberships could increase

large borrow activity in the System as a whole, thus, exacerbating

large borrower concentrations. Nearly 24 percent of all advance activity is already concentrated in the System’s 10 top borrowers.

28

Multidistrict membership would, by definition, help only institutions large enough to take advantage of it, and fundamentally alter

the basic concept of the System—a cooperative of regional banks

existing to serve the funding needs of institutions headquartered in

their districts. Moreover, given the seismic consolidation activity

that occurred in the 1980’s, which the System weathered quite

well, it is difficult to see why current consolidation activity should

provide the impetus for such a dramatic restructuring.

The System’s mortgage acquisition programs also primarily benefits the System’s largest members. Begun in 1997 as a small pilot

capped at $750 million, these programs have grown exponentially.

The System now holds $90 billion worth of mortgages in portfolio,

representing over 10 percent of its assets.

There is nothing in the System’s legislative history or authorizing statute that grants authority for direct mortgage purchases,

and the other two major housing GSE’s—Fannie Mae and Freddie

Mac—were established and chartered by Congress expressly for

that purpose. Congress, not the individual FHLBanks or the

FHFB, should decide whether it wants the System to be a major

player in the secondary mortgage market, and if so, the terms and

limitations that should apply.

The risk associated with mortgage acquisition are distinctly different from those associated with the System’s traditional role of

making fully collateralized advances. Advances have prepayment

penalties and call features that allow the FHLBanks to effectively

manage their interest rate risks. Different, more complex, tools are

needed for the interest rate/prepayment risk presented by mortgages held in portfolio. Operational risk is also significant. There

is a serious question as to whether the System has sufficient numbers of qualified staff or infrastructure needed to manage even the

day-to-day risk associated with secondary mortgage market participation. Regarding credit risk, the mortgage acquisition program’s

proponents boast that the originators, not the FHLBanks, retain

the credit risk. In truth, the originators provide credit enhancements that are only as good as the FHLBanks require them to be

based on their own interpretation of historical default data, which

again is outside the traditional mission and expertise. It is telling

that a recent FHFB proposed rulemaking, now withdrawn, would

have eliminated one of the program’s most important tools in managing credit risk; the requirement that pools of purchased mortgage

assets, achieve an investment grade rating from an independent

rating agency.

No adequate public policy basis has been advanced for the System’s foray into this new, riskier line of business. Though promotional materials for the programs claim that they are designed

to help smaller institutions, available data suggests that they are

being run overwhelmingly for the benefit of large originators. According to trade journal reports, the top five mortgage originators

sold $42.7 billion in mortgages to the FHLBanks in 2002. Assuming the accuracy of this report, these five institutions would account for almost all of the $45.7 billion in FHLBank mortgage acquisitions in 2002.

Questions about the capability of the System to manage new

risks associated with multidistrict membership and mortgage acVerDate 11-MAY-2000 18:52 Jun 03, 2005 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 21384.TXT SBANK4 PsN: SBANK4
29

quisition programs are heightened by longstanding weaknesses in

the FHFB examination process, identified by the GAO in 1998 and

again in 2002. Though the FHFB has taken a number of steps to

address these weaknesses, including increasing the number of examiners and putting greater focus on major risk and the quality of

controls at FHLBanks, the GAO found, in a report released last

February, that it is still too soon to evaluate the effectiveness of

these measures. We heard from Chairman Korsmo earlier that they

are now up to 17 examiners, with plans to increase that total to

24 by 2004, and I believe he said 30 by the end of 2005. However,

according to its fiscal year 2003 budget, only $9.7 million of its $27

million budget was allocated for the Office of Supervision. By way

of comparison, Treasury’s two bank regulatory bureaus, the Office

of the Comptroller of the Currency and the Office of Thrift Supervision, were typically assigned teams of 20 to 30 examiners to each

of its large institutions, and will spend 70 to 80 percent of their

budgets in direct support of supervision.

More fundamentally, the structure of the FHFB suffers from

many of the same defects now being scrutinized at the Office of

Federal Housing Enterprise Oversight. It is a small, low-profile

agency that simply cannot attract and retain the quality of staff

that it needs. It exists outside the financial regulatory mainstream

and, thus does not benefit from the routine, day-to-day interaction

that occurs among the major bank regulatory agencies. It is responsible for only 12 banks, plus the Office of Finance, and narrow constituent base that creates the perception of ‘‘captive regulator.’’

Other major financial regulators have a much broader regulatory

base, and their actions are generally reflective of the views and interests of diverse and competing constituencies. When a regulator’s

jurisdiction is confined to a small group of closely aligned institutions, the pressure and input it receives can become narrowly focused and one-sided. It becomes difficult for that regulator to stay

objective and ‘‘above the fray.’’

Should a new agency be created at the Treasury Department for

oversight of Fannie Mae and Freddie Mac, I believe it would be a

stronger agency if it also included oversight of the FHLB System.

The new regulator would have a bigger, better view of the housing

finance market and would be in a better position to evaluate the

advantages and dangers of the major housing GSE’s competing directly with each other in the same lines of business. From the

standpoint of systemic risk and taxpayer exposure, it is just as important to the Government for the FHLB System to have quality

safety and soundness oversight, as it is for Fannie and Freddie. At

year-end 2002, the System had $668 billion in outstanding debt,

compared to Fannie’s $884 billion and Freddie’s $644 billion. It enjoys the same implied Government guarantee, with an even more

generous line of credit from the U.S. Treasury.

The competitive impact on FHLB funding costs should also be

weighed in the balance when considering whether to merge the

FHFB into the new agency. The creation of a credible, high-quality

GSE regulator within the Treasury will likely receive a positive reaction in the capital markets, which could reduce Fannie and

Freddie’s funding costs. If the FHLB System is left out, that could

widen spreads between FHLBank securities and those issued by

30

the enterprises. Wider spreads would in turn mean the higher cost

of funds for the FHLBanks, which would adversely impact the price

of advances and ultimately raise costs for homeowners.

Strong momentum is building with the creation of a credible,

high-quality regulator within the Treasury Department to replace

OFHEO. Now would be a propitious time for the Congress to consider whether oversight of the FHLB System should also be placed

under this new regulator. To be sure, there are important policy

determinations that Congress needs to make regarding the FHLB

System’s mission and future, and it is important not to impede the

momentum behind the transfer of OFHEO’s safety and soundness

functions. However, concurrent action could assure quality regulation of all three major housing GSE’s and prevent a widening of

spreads which could further weaken the System.

Thank you, Mr. Chairman.

Senator BENNETT. Thank you very much.

Mr. Smith, we appreciate your being here.

STATEMENT OF TERRY SMITH

PRESIDENT, FEDERAL HOME LOAN BANK OF DALLAS

Mr. SMITH. Mr. Chairman, Senator Sarbanes, Senator Bunning,

I appreciate the opportunity to speak to you today about the Federal Home Loan Banks. My name is Terry Smith. I am the President of the Home Loan Bank of Dallas. I am pleased to provide an

update on the Bank’s activities and our progress implementing the

Home Loan Bank provisions of Gramm-Leach-Bliley. My written

statement includes an overview of a range of issues related to those

banks, and since my colleagues are addressing some of those same

issues, I will limit my oral remarks and ask that the remainder of

my statement be accepted for the record.

Senator BENNETT. It shall be printed in the record.

Mr. SMITH. Thank you.

I would like to stress four points related to the Federal Home

Loan Banks.

First, the Banks are a valuable resource for more than 8,000

member financial institutions, representing 78 percent of all FDICinsured depository institutions. Those members, primarily community banks and thrifts, use the Banks’ advances and housing

programs to meet the mortgage and community lending needs of

their local markets and use our affordable housing programs to

make housing more affordable for thousands of low-income families

in those communities. This is our primary purpose, and we are

proud of our accomplishments.

Second, the Banks continue to be financially strong and conservatively managed cooperative institutions. The Banks are well capitalized, maintaining capital asset ratios between 4 and 5 percent.

The Banks’ advances are fully collateralized, allowing the Banks to

maintain their enviable record of never having suffered a credit

loss on a member advance in their 71-year history.

The Banks also manage interest rate risk very conservatively,

using derivatives in a very precise and prudent way to minimize

the difference between the maturities of their assets and liabilities.

These risk management practices enable each of the Banks individually to maintain a AAA rating and for the Banks collectively to

31

enjoy the same high ratings on their consolidated obligations, the

debt of the 12 banks issued jointly.

Third, the Banks’ cooperative corporate structure reinforces our

conservative approach to risk management and eliminates many of

the incentives that a publicly traded company might have to increase its risk profile in hopes of achieving higher returns for its

shareholders. There is no stock compensation for management, directors, or employees of the Banks.

Only members may purchase a Bank’s capital stock, which they

do in order to obtain access to the Bank’s products, and not primarily as a stand-alone investment. The price of a Bank’s capital

stock does not fluctuate, but can only be purchased or repurchased

at its par value.

Members expect stability, reliability and consistency of dividends, and credit product pricing, rather than a high yield. And

our boards of directors are structured to ensure that outcome.

No members of management serve on the board of directors. A

majority of each bank’s directors are elected representatives of

member institutions, primarily from community financial institutions, who have a vested interest in the Bank’s long-term viability

and stability. The remaining directors are public interest directors

appointed by the Finance board.

Fourth, the Banks are subject to rigorous safety and soundness

oversight and regulation. Finance Board regulations govern every

facet of the Bank’s operations, from advances pricing to eligible collateral, to risk management, to capital plans, to directors’ responsibilities, and so on.

The Finance Board also collects and monitors financial and risk

management data from the Banks each month, performing ongoing

reviews of various aspects of the Bank’s operations and conducts

annual on-site examinations of all 12 Home Loan Banks.

When Congress enacted the Gramm-Leach-Bliley Act in 1999, it

included several provisions related to the Banks’ operations. The

new law provided for universal voluntary membership and equal

access to the Banks for all types of financial institutions. It established a framework for more permanent capital structure that includes total leverage- and risk-based capital requirements for the

Bank for the first time.

It also expanded the types of collateral the community banks can

pledge to secure advances which has allowed those institutions to

take greater advantage of their access to the Banks and to meet

the credit needs of their communities.

These changes have, and will continue to have, a positive impact

on the Banks’ ongoing ability to fulfill their statutory role and to

do so safely and soundly.

I would be happy to answer questions of the Committee at the

appropriate time.

Senator BENNETT. Thank you.

Mr. Hemingway.

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STATEMENT OF DAVID W. HEMINGWAY

DIRECTOR, FEDERAL HOME LOAN BANK OF SEATTLE

EXECUTIVE VICE PRESIDENT

ZIONS FIRST NATIONAL BANK, SALT LAKE CITY, UTAH

Mr. HEMINGWAY. Thank you. Good afternoon, Chairman Bennett

and Senator Sarbanes.

My name is David Hemingway, and I am Executive Vice President of Zions First National Bank, based in Salt Lake City, Utah.

I am also a Member of the Board of Directors of the Federal Home

Loan Bank of Seattle.

I would like to thank Chairman Bennett and the Subcommittee

for the opportunity to speak this afternoon on behalf of the Federal

Home Loan Bank System.

First, I would like to discuss why Zions Bank and other regional

and community financial institutions across our country use the

Home Loan Banks and then address the issue of corporate governance and the responsibility within the Bank System.

In 1932, the Bank System was created to provide liquidity to the

savings and loan industry. At that point in history, there was no

secondary market for mortgages, and the S&L’s needed a way to

borrow against the mortgages in their portfolio, so the Federal

Home Loan Bank System was created, providing low-cost advances

to meet the needs of community financial institutions and their

customers.

This need for liquidity in our Nation’s network of community

banks is as real today as it was in 1932, and the only housing GSE

that can meet this need is the Federal Home Loan Bank System.

Let me briefly explain how this works.

Banks accept deposits, as you all know, and then make loans

with a portion of those deposits. The deposits not invested in loans

are invested in securities, such as U.S. Treasury notes.

There is no rule that says, in the real world, that deposits will

always be greater than the loans outstanding in a financial institution. These fluctuate from day-to-day. There is also no rule that

says depositors cannot withdraw their funds at will simply by writing checks.

So, in the case of Zions First National Bank having the balance

in Zions’ checking account at the Federal Reserve Bank of San

Francisco, where banks have their checking accounts in the Federal Reserve System, having that balance increase or decrease by

$200 to $300 million in a day is not unusual. And a bank is trying

to manage its checking account the same way as you might be

managing your own checking account, and a fluctuation of a couple

of hundred million dollars is something to be noticed. Zions has a $1-billion liquidity line from the Federal Home Loan

Bank of Seattle. Now, this line of credit from the Federal Home

Loan Bank overdraft protection is secured with mortgages, first

mortgages, in Zions First National Bank’s loan portfolio of about

$1.2 billion. When Zions’ depositors withdraw $300 million in a

day, and I assure you this does happen on a regular basis, we call

up the Federal Home Loan Bank of Seattle and borrow $300 million overnight to replace those deposits until they can be replenished in the normal course of business. Now, no other GSE or

financial partner can provide or does provide this type of service.

33

Another area where the Bank System is unique is in providing

liquidity in the form of low-cost and long-term loans to regional

and community banks that do not have access, and I think the important part here, is do not have access to the capital markets

which most community banks do not have access or even smaller

regional banks.

Developers of low-income housing projects need long-term fixedrate loans. The only source of long-term low-cost liabilities for a

community bank is the Bank System advance. I have often said

that the Home Loan Banks are the savior of our regional and community banks. The System, with its GSE status, AAA rating, cooperative equity structure, and low overhead is the best, and in many

cases, the only source of low-cost long-term liquidity for regional

and community banks.

I would respectfully and forcefully request that no changes be

made to the basic structure of the Bank System which was created

to address a very real problem of liquidity for our country’s financial institutions, a problem that the Federal Home Loan Banks continue to solve every day.

I will now address the issue of corporate governance and the responsibility within the Bank System.

As both a community banker, for the better part of three decades, and as an elected board member of the Seattle Bank, the

issue of board governance is of paramount importance to the financial institutions and communities we serve, and to me, personally.

As a director, I have been elected by the bankers of Utah to

watch over their investment in the Seattle Bank. While I am not

alone in that role—I share it with 17 other directors, and the management team of the company—I consider it my job to ensure that

the financial management of this $47-billion bank is effective over

the long-term, including proper stewardship of our shareholders’

capital. That is a staggering responsibility when you consider that

the funding provided within the Seattle Bank district fuels housing

finance, affordable housing initiatives, and economic development

in communities from Pago Pago to Walla Walla, Washington, to

Blanding, Utah.

When I was elected to serve as a director, I understood the critical importance of my role and what I needed to bring to the Board;

namely, my personal integrity and accountability, my financial

services and community banking experience.

We are all aware that a quantum shift has occurred in how

American corporations, large and small, privately held or publicly

traded, must be run. We share with our regulator the Federal

Housing Finance Board, the Treasury, and Congress, the sense of

urgency that is so pervasive today regarding the need for increased

accountability, and we have worked hard over the last several

years to significantly strengthen the leadership and oversight of

our Banks.

Over the course of the last year, the Seattle Bank board has created, adopted, and publicly disclosed a set of core principles and

guidelines relating to board governance. In addition, we have realigned our board committee structure to more effectively oversee

all facets of the Bank’s operations, upgraded education and training for all directors, and created a website that provides directors

34

with faster access to a wide range of information critical to their

board roles.

Our regulator, the Federal Housing Finance Board, is also diligent in overseeing and supporting sound corporate governance

practices across the Bank System. The Finance Board just recently

completed a horizontal review designed to assist the Agency in directing and developing its supervisory and regulatory initiatives.

The Finance Board interviewed management and board members

and reviewed a wide range of bank documents with respect to the

board policies, practices, and decisions.

Key questions asked by the Finance board include:

Does your board audit committee provide sufficient oversight of

internal and external auditing functions?

Is the audit function independent, reporting only to the board,

and is it supported appropriately by directors?

Does the board ensure that material risks are accurately and

consistently assessed by management and reported to the board, in

compliance with regulation and prudent practices?

I am pleased to say that Seattle Bank has ‘‘yes’’ answers to each

of these questions, but that is today. The board’s job is to ensure

that we have ‘‘yes’’ answers tomorrow, the next day and next year.

As one of 216 bank directors of the various different Banks, I am

proud to be a director of the Federal Home Loan Bank System, and

I would not have it any other way.

Mr. Chairman, that concludes my testimony. Thank you.

Senator BENNETT. Thank you very much.

Senator Sarbanes, we welcome you. We, by proxy, introduced Mr.

Middleton to the Committee, but I understand you wanted to welcome him, and we are happy to hear from you.

COMMENTS OF SENATOR PAUL S. SARBANES

Senator SARBANES. Mr. Chairman, I am sure it has certainly

been done adequately by you, but I just wanted to take a moment

to say that Mike Middleton is a very distinguished business leader

in our State and also a distinguished leader in the community. He,

in fact, is the Chairman of the Charles County Economic Development Commission’s Board of Directors, and I want to just mention

one thing.

He has taken, as a volunteer, an active role in teaching ethical

decisionmaking to high school students in Charles County, and we

very much appreciate that commitment on his part. Of course, he

has been a very successful head of the Community Bank of TriCounty in Waldorf, Vice Chairman of the Board of the Federal

Home Loan Bank of Atlanta, and we are very pleased he was able

to come and be with us today.

Senator BENNETT. He did you proud with his testimony.

Senator SARBANES. Thank you.

Senator BENNETT. While you have the microphone, do you want

to either make an opening statement or ask questions? Go ahead.

Senator SARBANES. I will defer to you.

Senator BENNETT. Thank you.

I thank you all. This has been a very informative expression of

how the Home Loan Bank System works.

35

May I go back to the issues that I outlined in my opening statement and see if any of you have any particularly burning opinion

that you want to express on these? The first one, whether or not

the Home Loan Bank should register with the SEC, we heard that

discussed by the first panel, and some of you have mentioned it in

passing, but if you have any additional comment that you need to

make there, we would appreciate that.

Whether or not a member institution of the System should be

permitted to be a member of more than one regional Home Loan

Bank, Ms. Bair has made that very clear, as far as her position.

If some of the others want to argue with her or support her, whatever, we would look at that.

At what level should the Home Loan Banks be permitted to participate in the secondary mortgage market? And, again, you have

discussed that, but if you want to be more sharply focused on that

question.

And then, finally, whether or not we should have a single regulator for all of the housing GSE’s. I do not want to recover the

question of what kind of a regulator that should be. Some of you

have outlined your feelings about a regulator, but just the overall

question of whether or not Congress should move in the direction

of trying to create a single regulator. Those are the four issues that

were driving us behind the calling of the hearing, and along with

the general comments that you have made, which I stress, again,

have been very educational and very helpful, if someone has a very

specific, pointed comment they want to make on any one of those

four, now is the time.

Mr. RICE. I would make one quick comment, as it relates to the

Mortgage Purchase Program, Mr. Chairman. At the Seattle Bank

last year, our Mortgage Purchase Program created about $1.75 million in profit that went directly for our Affordable Housing Programs. And at this point in time, about 42 percent of our mortgage

purchase loans are for low- and moderate-income individuals. And

just in 2 years, we have made extraordinary gains in making sure

that the return from the mortgage purchase program goes back to

the members and goes back to affordable housing.

That is one point. And the second point is that our members are

desirous of having choice; choice to sell their mortgages, and I

think choice is fundamental in their decisionmaking, rather than

being limited.

We created a program, in direct response to our members’ needs,

and we are now organizing and setting ourselves up to run it in

a safe and sound manner, to come up with some level or cap I

think is difficult. I believe the biggest issue is to make sure we

have a regulator who can oversee and make sure that we are managing the program in a safe and sound manner.

Mr. MIDDLETON. May I?

Senator BENNETT. Mr. Middleton, yes.

Mr. MIDDLETON. As a $300-million community bank, for us to

lend in more residential lending is just part of the business plan.

I can tell you we have been doing this for five decades, and we

have been selling to the housing GSE for the last two decades.

They have had a zero-loss experience.

Senator BENNETT. Which GSE have you utilized?

36

Mr. MIDDLETON. Freddie Mac.

Senator BENNETT. I see.

Mr. MIDDLETON. However, due to our volume, we get charged a

fairly significant guarantor fee. With the MPP, our credit loss experience is reflected in the pricing, and it will allow us to make a

business decision to continue this product line in our community

because it becomes more profitable for us. So this is a very important service to a community bank.

Senator BENNETT. So you are saying that if you had the opportunity to have a larger secondary mortgage market than exists currently with your choice of Freddie Mac, specifically, if you could do

it through a Home Loan Bank, you would either be able to make

more money or charge less to your customer or both?

Mr. MIDDLETON. That is correct, sir.

Senator BENNETT. I see. Any other comment?

Ms. Bair, yes, go ahead.

Ms. BAIR. Just a couple of things. First and foremost, my objection to the Mortgage Acquisition Program is that it has not been

authorized by Congress. And I think a lot of people were looking

the other way when it started as a small program. A lot of people

were assuming that because of the capital structure of the Federal

Home Loan Bank System, it could not really grow to sizeable levels. It is, in fact, growing exponentially, primarily the Chicago program. I think Seattle has maybe progressed in a little more responsible fashion.

I also think one of the reasons Chicago has been able to grow so

exponentially under the existing capital structure is the shared

funding program. And to Senator Reed’s question earlier, I think

there is a real process issue about the way that shared funding

came about. The regulations only refer to purchase of whole loans.

Under shared funding, basically, a member of the Chicago Federal Home Loan Bank securitizes the pool of mortgages, creates

two tranches, sells the senior tranche back to the Chicago Bank,

so it is not a direct securitization. A member is used to securitize,

but then the interest and the mortgages are sold back to Chicago

Bank. It can then sell those throughout members of the System. In

this way, it has been able to get a lot of assets off of its balance

sheet and get around the capital problems it would otherwise have.

There is really no public comment. It is questionable whether the

regulations currently allow them to be purchasing interests in

whole loans, as opposed to the whole loan itself, to Senator Reed’s

comment.

I believe there are just some process issues and some significant

policy issues that need to be dealt with that really are not. These

programs are really growing quite rapidly, and I am just concerned

that there is not anybody really in charge taking a close look to

make sure it is not undermining safety and soundness. It is just

not the System. This thing keeps going. You talk about the high

credit quality of the loans.

If this is coming out of the Fannie and Freddie business I assume it is, you know, what type of destabilizing effect would this

have on the overall market? Nobody is really looking at that. And

I think, again, a single regulator, with all three major housing

37

GSE’s, could get a better handle about whether this is a good thing

or a bad thing, in terms of the overall housing market.

I would also add that I think, to the extent there is a good justification for the System being in this business, it is for the community banks, and I wish I saw, in the numbers that I am reading,

more marketing and delivery of services to the smaller banks, as

opposed to the large originators.

Thank you.

Senator BENNETT. Anyone else?

Mr. Hemingway.

Mr. HEMINGWAY. Yes, Senator. I was going to change and talk

about a different subject.

Senator BENNETT. Please, go ahead.

Mr. HEMINGWAY. SEC registration.

Senator BENNETT. Right.

Mr. HEMINGWAY. I would like to speak from my experience as a

banker on this area, but also, as you may remember, I am also a

member of the board of directors of Farmer Mac. I have some experience in the area of being involved with a GSE, where Zions is a

large shareholder, for an entity that is regulated by the SEC. One

of the issues that needs to be taken into consideration is the mission of the SEC is quite different than the mission of a safety and

soundness regulator, whether it be the Comptroller of the Currency

or the Federal Housing Finance Board or, in the case of Farmer

Mac, the FCA.

The mission of the SEC is to protect investors, and particularly

small investors in public securities. The mission of a safety and

soundness regulator is to make sure that the financial institutions

that they regulate are safe and sound. So they approach problems

differently, and I will give you an example, which raises some of

the concerns here.

The example is take loan loss reserves. Anybody that has been

in banking very long knows that the regulators love to see large

loan loss reserves. They would like to see them as large as possible

because that gives protection to the Bank and to the FDIC, ultimately, and the U.S. Government if there are losses in the loan

portfolio.

But the SEC takes an exact opposite position. They believe that

the loan loss reserves in the various different financial institutions

are too large, and they view the large loan loss reserves being a

way for financial institutions to manage their earnings. They believe that transparency would require smaller loan reserves. And,

of course, they have the accountants, with GAAP, who come out to

enforce their views.

You get a board of directors and a management that are being

told exactly the opposite from their two regulators, if they, in fact,

have two regulators. Their safety and soundness regulator telling

them that we believe we would like to see some higher reserves so

that you will be safer and sounder or, at the same time, the SEC

is saying, no, you have too much in reserves and, in fact, we believe

that you are approaching the point of managing earnings, which is

not good for the public markets.

This is not fiction. This is real. It is happening today. One of the

concerns I have is how we deal with two regulators, and we deal

38

with it in banking all the time, but it is a problem when you get

two regulators with different views, and both of them having the

power to regulate a single financial institution.

One of the concerns, not to drag it on, but the safety and soundness regulators, which I have already mentioned the names, have

the power to remove an executive or remove a member of the board

of directors. The SEC has the power to send you to jail. And so,

at the end of the day, the boards tend to be more responsive to the

SEC because of the more power and the threat of criminal activity

if, in fact, you do not follow their rules.

Senator BENNETT. I assume, when you go to jail, you are also removed from the board.

[Laughter.]

Mr. HEMINGWAY. Well, you know of an incidence in Utah where

that was not the case, but that is usually the case.

[Laughter.]

Senator BENNETT. Well, let us go back to Senator Bunning’s comment, then, when he raised the suggestion that it was potential

registration with the SEC that caused Freddie Mac to get in the

situation where they restated their earnings. Do you accept that as

a cause-and-effect relationship?

Mr. HEMINGWAY. I think there is another issue there, is they

changed accountants. You will probably recall that Arthur Andersen was the accountant for Freddie Mac, and I am personally not

aware which of those instances caused this to come to light; was

it the new accounting firm or was it registering with the SEC, a

combination of both or neither. I do not know, personally.

Senator BENNETT. Before I turn it over to Senator Sarbanes, does

anybody have a comment on the conflicting stresses created by the

two types of regulators that Mr. Hemingway has raised?

Mr. MIDDLETON. Senator, I support that. My company is an SECregistered bank as well, but we registered with the SEC because

it was in the best interest of our business plan, and I worry about

the mission of the FHLB we have a statutory mission plan, if you

will, by Congress.

Senator BENNETT. Did you have an option not to register with

the SEC?

Mr. MIDDLETON. Yes, sir, but because of the number of shareholders, we registered. We could have restricted the number of

stakeholders had we want to do so.

Senator BENNETT. I see.

Mr. MIDDLETON. That is a choice, and that is why it is a voluntary registration. I just worry, as a deep user of the Federal

Home Loan Bank, is that the difficulties that have to be worked

through can be worked through, and a disclosure, in SEC format

is easy to obtain, and everybody has recognized that this is always

good for a GSE, but we do need to have sustainable, written agreements that say, here is how we are going to interpret issues such

as joint and several obligations. This is how we are going to interpret issues such as REFCORP. This is what happens if the mission

requires specific action—how do we serve the mission if it conflicts

with the SEC’s decisions.

So there are very difficult things to work through, and I can assure you—I am on the Audit Committee and I chair the Finance

39

Committee of the Atlanta Bank—we have spent a lot of hours and

a lot of resources making sure that we do this thing in an appropriate manner because, at the end of the day, corporate law prevails. The prudent business judgment decision provision of the duty

of care prevails. So, when we vote for this, we must know that

these critical issues are resolved so that we will not hurt and do

no harm to the System.

Senator BENNETT. Okay.

Mr. MIDDLETON. Does that help you?

Senator BENNETT. That is helpful. Ms. Bair, do you want the last

word on this?

Ms. BAIR. If I could just add, my sense is that the prospect of

SEC registration was added impetus to the Freddie Mac board to

get their house in order, so to speak.

I would also say I worked with the SEC for many years as the

head of Government Relations for the New York Stock Exchange.

It is a disclosure-based regulatory regime. It is not a safety and

soundness regulatory regime vis-a ́-vis publicly traded companies.

So, even though there have been conflicts between the bank regulators on the loss reserves, that has been not a safety and soundness issue for the SEC so much as it has been a managed earnings

issue, a disclosure issue.

It is also ironic, you bringing it up, because I have heard another

concern may be that the low-level retained earnings in the System,

which goes counter to where you might think the conflict was with

the SEC in the loss reserves.

But my sense is they are not a safety and soundness regulator.

They are a disclosure-based regime, and that is the approach they

take.

Senator BENNETT. I see.

Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

I would like each of the panelists very succinctly, if they could,

to state what they think is the proper regulatory structure for the

Home Loan Banks.

Senator BENNETT. Mr. Rice, let us start with you and go on

down.

Mr. RICE. The proper regulatory structure is——

Senator BENNETT. Here, the buck always starts in the middle of

the table.

[Laughter.]

Mr. RICE. You are right.

The proper regulatory structure is the structure, as it exists in

the Finance Board now. If it is to move, I would hope that you

would preserve the structure that is there, which has mission and

safety and soundness tied together, the notion of respect for the cooperative, which makes it different than the other housing GSE’s,

and to make sure that the return on the investments that are

made in the system go to their members, rather than to shareholders. So, I see that structure as being a very solid structure.

Mr. MIDDLETON. Let us go to the users of the System, not the

community banks, but the purchasers of the consolidated obligations. What do those users need? They need a very strong indeVerDate 11-MAY-2000 18:52 Jun 03, 2005 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 21384.TXT SBANK4 PsN: SBANK4
40

pendent regulator of a GSE, and that establishes credibility that

their investment is safe and sound.

Ms. BAIR. I would hope that there is, as I said in my written testimony and oral statement, I believe that the broader the constituent base of the regulator, the stronger or the better position

a regulator is in to be independent and not captive of a particular

point of view. I think it will be a stronger regulator if the Federal

Home Loan Bank System, and perhaps all other GSE’s, are included in this new regulatory entity that it looks like we are on

track to create.

I would hope that this new regulator, it is not worth doing, unless the quality and credibility of the regulatory regime is significantly enhanced. I would hope we would be designing a system

that would parallel the supervisory quality and professionalism

that you get with OCC and OGS, including accreditation standards

for examiners, you know, the overwhelming bulk of the budget

going to safety and soundness oversight, not mission promotion or

housing promotion.

I think those are the things that the market needs to be sure

that these things that we have created that do perform, all three,

perform extremely significant and important roles in the housing

market are run in a safe and sound manner.

Senator SARBANES. What are the roles that they perform in a

housing market?

Ms. BAIR. The traditional role has somewhat been debated because they are getting into each other’s line of business right now.

But the traditional role has been for Fannie and Freddie to purchase and either hold, in portfolio or securitized mortgages, mortgages that come within the conforming limits set by HUD.

The Federal Home Loan Bank System’s job has been to provide

advances, loans to its members. Its focus is on the institutions, as

opposed to direct purchase of loans, which are collateralized by

mortgage assets provided by the members.

They are two distinctly different, somewhat competing roles, and

since that, you can go to two different places for your funding. You

can sell your mortgage to Fannie and Freddie or you can get an

advance from the Federal Home Loan Bank System, but now we

have a situation——

Senator SARBANES. I understand that the majority of the loans

held by the Bank System are jumbo loans, beyond the conforming

limits; is that correct?

Ms. BAIR. For collateral?

Mr. RICE. No, they are not.

Mr. HEMINGWAY. They do not buy jumbo loans.

Senator SARBANES. Are you telling me the Home——

Ms. BAIR. I think by regulation——

Senator SARBANES. —the Home Loan Bank system holds only

conforming loans?

Mr. RICE. Yes, that is correct.

Mr. HEMINGWAY. The Mortgage Purchase Program will not buy

jumbo mortgages.

I believe you are talking about the Mortgage Purchase

Program——

Ms. BAIR. No, he is talking about——

41

Senator SARBANES. I am talking about the collateral for securing

advances.

Mr. HEMINGWAY. Oh, excuse me.

Senator SARBANES. What is the answer to that?

Mr. HEMINGWAY. Whatever the bank pledges. I mean, jumbo

mortgages qualify as collateral, as do conforming mortgages. It is

whatever the Bank happens to have available to pledge. But in the

Mortgage Purchase Program, you cannot, a bank cannot sell, a

member cannot sell jumbo mortgages to the Home Loan Bank, only

conforming mortgages.

Senator SARBANES. What about a regulator?

Mr. SMITH. I would just like to echo what we heard. I think the

key point is a strong, credible, and independent regulator for the

Home Loan Bank System.

Mr. HEMINGWAY. I would agree, a strong independent regulator.

I would just add to it, in my banking back——

Senator SARBANES. Those of you who are saying that, is it your

view that you now have such a regulator?

Mr. SMITH. Yes.

Mr. MIDDLETON. Yes.

Senator SARBANES. Ms. Bair is no.

[Laughter.]

Mr. MIDDLETON. Does it vary by the volume of the affirmation?

[Laughter.]

Senator SARBANES. What is your——

Mr. MIDDLETON. It is my understanding that the credit markets

are very efficient, and they recognize that we have a very strong,

safe, and sound——

Senator SARBANES. What is your view, expressed by some, that

the exposure to risk that the Home Loan Bank System is engaged

in is increasing and that poses a potentially significant public policy question?

Mr. RICE. I believe——

Senator SARBANES. Do you think there is nothing to that?

Mr. RICE. Oh, no, on the contrary. I believe that as we progress

in this program, we are adding the resources, we are changing our

models, to take into account this new business activity, and we will

add the necessary resources to maintain a safe and sound operation.

There are a different analytics that go with it, and we are recognizing what those are and investing in the people that are necessary.

Senator SARBANES. When we say ‘‘we,’’ who do you——

Mr. RICE. Our bank, I am sorry.

Senator SARBANES. Your particular bank.

Mr. RICE. My particular bank. I cannot speak for all of the others, but I think almost every bank that is looking at MPP are making those decisions.

Senator SARBANES. The fact that you just said you cannot speak

for the others leads me to my next question. I am moving quickly

here because we have limited time.

One observer described a system with joint and several liability

with different capital structure as akin to 12 people with their

shoelaces all tied together, but running at different speeds, and

42

concluded that one of them is bound to fall on his face. And, of

course, this leads to a number of concerns about the problem of

moral hazard, with respect to the Home Loan Bank System.

In a system where the Banks are doing highly collateralized advances, the issue raised by joint and several liability is muted.

That is at a lower order of concern, I think, because of the highly

collateralized advances that you are operating with.

But now the System is expanding into new areas. Proposals to

restructure the System to allow multidistrict membership have

emerged. I must say, in both instances, I, it is my own position,

that the board cannot do this without coming back to Congress for

a statutory change.

Senator BENNETT. If you had been here, Secretary Abernathy

would have taken the same position.

Senator SARBANES. Yes. If banks are put into a position of competing with each other for members, for example, as they would be

under multidistrict membership, or for business with each other’s

members, as in the Shared Funding Program, what danger do you

see in the possibility that Banks would engage in a race to the bottom, relaxing collateral, capital standards, and others in order to

attract or retain members?

The GAO said, ‘‘Under the joint and several structure, the potential for moral hazard exists; that is, Federal Home Loan Banks

may have incentives to take financial risk, knowing that their

losses would be covered by other Federal Home Loan Banks or ultimately by the Federal Government.’’

What is your view of that?

Mr. RICE. That is a big question. I will take them in pieces.

Number one, I really do believe that the way in which we are

managing mortgage purchases, and the way in which the Finance

Board reviews it, and through the examination of safety and soundness, I do not see that risk growing. And I think that the oversight

that we have from our Board, and the way in which we direct profitability and the like, are well served in this process.

Senator SARBANES. When you say ‘‘by our board,’’ you mean the

Seattle Board?

Mr. RICE. Our board of directors of the Seattle Bank. But at the

end of the day, all Banks are examined. All Banks’ capital plans

have to be approved by the Finance Board. There is oversight over

all of the Banks, and I think that that oversight is the protection

that you get in managing these programs.

The second issue that you have on multidistrict, I believe that

the degree of consolidation that has gone on in the System necessitates some direction about modernization and accepting what is

there. Whether that is the Congress’ job or not, I think that if Congress chooses to move in that area, then I think it can resolve that

issue, but we are not moving for multidistrict. The chairman of the

Finance board is not entertaining any notion, and I do not think

there will be a proposal before the Finance board to do so.

I forgot the last one, but I will defer to my colleagues.

Senator SARBANES. Mr. Middleton, do you want to address any

of that?

Mr. MIDDLETON. May I just address components of it, Senator?

[Laughter.]

43

With respect to the multidistrict, the Atlanta Bank raises a concern that we think it might introduce unhealthy competition, but

I think, in light of the reality of what is going on in the financial

markets, perhaps it should be looked at by somebody in authority.

So whatever mode that you choose is fine.

The purchase of member assets, I can assure you that at the Atlanta Bank we just completed an exhaustive strategic plan that we

have to do by regulation. And one of the directives that the board

gave to management and ensured that we are properly allocating

the budgeted resources that are sufficient to assure competent

staffing in place prior to any significant growth or expansion of a

new business product line. We would do in that measure normal

banking circles, because we all have a day job at our banks.

I can assure you that we devoted a tremendous amount of resources and discussion to the endeavor. We are not going to eliminate risk. Our job is to manage risk. We want to manage risk in

the most prudent manner possible. So that is at the forefront of our

directorate at the Atlanta Bank.

Senator SARBANES. Let me throw another factor into the mix as

we proceed along. As I understand it, the bulk of Federal Home

Loan Bank advances go to a small number of very large members.

The System has over 8,000 members, but the largest 1 percent of

its members account for 50 percent of the advances. In some Federal Home Loan Banks, the concentration is even higher. In San

Francisco Bank, 80 percent of the advances go to only five institutions.

I guess that raises the question, you know, what is the purpose

of the System and why should the Home Loan Banks be devoting

or providing low-cost funding to such large institutions which have

direct access to the capital markets themselves? Should we graduate them from the Federal Home Loan Bank System at some

point?

I mean, what is the purpose of this? I mean, from the point of

view of the institution, it is a good deal, but what is the public purpose of it? And why are we, in effect, running perhaps a significant

public risk in order to do this?

Sheila, why do we not go to you here.

Ms. BAIR. Well, I am asking the same question, Senator. I do not

understand. I believe Congress’s most recent pronouncement on the

System, in Gramm-Leach-Bliley, clearly put an emphasis on community-based smaller institutions. I do not begrudge the ability of

a large institution to use the System. They do, they always have,

and they should continue in the traditional line of business of advances.

But to take on these new controversial business lines and new

risk, for a service that is being more predominantly used for large

mortgage originators, it does not, you know, they have a lot of sophistication on their own to manage interest rate risk associated

with mortgage portfolios. Why do they need the Federal Home

Loan Bank System to be stepping up to the plate and providing

this service? I do not understand it either.

I think that it is telling that even those large originators are

starting to get a little worried, I think, because the regulatory

structure that was set up assumed a system that would continue

44

its traditional line of business of fully collateralized advances,

which is a very low-risk business. The lines that they are getting

into now are not low-risk businesses. And if this is the direction

the System is going to take, then they need dramatically enhanced

regulatory scrutiny, which is I think why world savings are calling

for concurrent action on the Federal Home Loan Bank System as

it appears Congress moves toward the creation of a new enhanced

regulator at Treasury for Fannie and Freddie.

Do not forget, a lot of these large and small institutions hold a

lot of system capital stock. And if the System gets in trouble, that

stock is going to be in trouble, too, which could have systemic implications for the banking system.

Senator SARBANES. I might note, in that regard, we just received

a letter from Washington Mutual:

The housing GSE’s should have a strong regulatory oversight structure that ensures both the safe and sound operation of the GSE’s and the fulfillment of their

housing missions. The best way to assure this goal would be for Fannie Mae,

Freddie Mac, and the Federal Home Loan Banks to be regulated by an independent

agency within the U.S. Treasury Department.

The Agency should have a single director and should be funded through user fees,

like the other bank regulatory agencies under Treasury, with appropriate recognition of the unique nature of the Federal Home Loan Banks as cooperatives, compared to the other housing GSE’s, which are publicly traded companies.

Mr. Chairman, I presume this letter is in the record, but, if not,

I would like to put it in the record.

Senator BENNETT. It shall appear in the record.

[The letter follows:]

Mr. SMITH. Back to, in terms of the large institutions, the first

point here is to effect the housing market for consumers, and all

consumers do not use small institutions to get their mortgages.

Many consumers use large institutions. To the extent we are able

to effect the cost of funds at those larger institutions, it then flows

through to the same consumer base.

The second thing, when you look at our concentrations, our member base mirrors the industry. If you look at the percentage of asset

distribution in the banking industry and compare it to the Home

Loan Banks, we mirror that. We are a little highly weighted to the

community institutions, the very small ones, but essentially we

mirror the industry, and the industry is highly concentrated in its

asset holdings. So, as a result, those are the institutions that typically are going to borrow more money.

And then, finally, in terms of our business model, the larger institutions provide us with scale, and that scale flows through to the

small institutions. One thing you have to remember from my testimony is our boards are primarily controlled by elected directors

from community and financial institutions.

If there was a concern that the larger institutions were being

treated in any way better or advantageously relative to those institutions, I think our boards would be more than happy to tell us to

knock it off.

Senator SARBANES. Did you want to add anything, Mr. Hemingway?

Mr. HEMINGWAY. No.

Senator SARBANES. I am not pressing you to do so, but I have one

other question I want to ask, Mr. Chairman.

45

Senator BENNETT. Sure.

Senator SARBANES. You have been very generous with the time.

Senator BENNETT. Well, this has been a worthwhile exchange.

Senator SARBANES. Thank you.

Some time ago the Atlanta Bank issued a notice that it would

not accept as collateral any loans that included single-premium

credit insurance. As far as I know, no other bank has yet followed

suit, nor have other banks taken any of the other steps, such as

reducing prepayment penalties that one or more of the other housing GSE’s have taken, let alone some of the moves with respect to

best practices that lenders of their own volition or perhaps because

of prompting have also taken.

Isn’t this an area where the Home Loan Banks can make a real

contribution to the reduction of predatory lending?

Mr. RICE. Yes.

Senator SARBANES. Mr. Smith.

Mr. SMITH. Yes.

Senator SARBANES. Mr. Hemingway.

Mr. HEMINGWAY. It sounds like a good idea to me.

Senator SARBANES. Yes, well, why do you not at least do what

the Atlanta Bank——

Mr. HEMINGWAY. I suspect it will be on the next agenda, Senator.

[Laughter.]

Ms. BAIR. Let the record show we all agree on that one.

[Laughter.]

Senator SARBANES. Thank you very much.

Senator BENNETT. Thank you, Senator.

And, again, thanks to the panel. This has been most informative.

We appreciate your patience and your persistence in responding to

the questioning of the Subcommittee.

The hearing is adjourned.

[Whereupon, at 4:28 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional materials supplied follow:]

46

PREPARED STATEMENT OF SENATOR JIM BUNNING

Mr. Chairman, I would like to thank you for holding this important hearing and

I would like to thank all of our witnesses for testifying today.

The Federal Home Loan Bank System has brought the American Dream of homeownership to millions in this country. The Cincinnati Federal Home Loan Bank,

which represents the Commonwealth of Kentucky, has helped many in my State

achieve that same dream. But with the troubles recently experienced by Freddie

Mac and given the changing world of the Federal Home Loan Banks, it is very timely that you are holding this hearing here today.

There are many issues facing the Home Loan Banks, multidistrict membership,

mortgage acquisition programs, SEC registration, and regulatory structure are all

questions that are before the banks today. In the past, Members of this Committee

have brought up questions about the salaries of the Home Loan Bank presidents.

I intend to bring up some of these issues in the question and answer period.

And I thank the Chairman for bringing in these witnesses. I think we have just

about everyone connected to the Federal Home Loan Banks covered today.

I look forward to all of your testimony and to talking about some of these issues

during the question and answer period.

Thank you, Mr. Chairman.

—————

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

I want to thank Chairman Bennett for holding this hearing to discuss the Federal

Home Loan Bank System and the integral role it plays in providing liquidity to the

U.S. housing markets. The Federal Home Loan Banks provide the largest private

source of residential mortgage and community development credit in the United

States. The Congress, the Federal Housing Finance Board, and the Banks themselves have the important task of assessing and updating the Federal Home Loan

Bank System in order to make the changes necessary to ensure its continued success in fulfilling and executing its mission.

As Chairman of the Housing and Transportation Subcommittee, I have particular

interest in and appreciation for the crucial role that the Federal Home Loan Bank

System plays in promoting affordable housing in our country. The Banks’ Affordable

Housing Program (AHP) is the largest privately funded grant program for housing

in the country, and key in financing affordable housing efforts through each of the

Banks. In 2002, the Federal Home Loan Banks contributed $199 million toward lowincome housing through the AHP program. The Community Investment Program

(CIP) is also instrumental in funding community and economic development projects

throughout the country.

The unique aspect of the Federal Home Loan Bank System that contributes to its

success, is the ability of each Bank to develop its own programs in response to the

needs of its membership. I am particularly appreciative of the Rural First Time

Housing Program (RFHP), the Community Housing Program (CHP), the Rural

Technical Assistance Program (RTAP) and the Community Development Program

(CDP). These specific programs of the Federal Home Loan Bank of Topeka help aid

homeownership and community development in Colorado. The Topeka Bank plays

a vital role in providing liquidity to the independent community banks in Colorado

so that they can, in turn, address the affordable housing andeconomic development

needs of Colorado communities.

I would like to thank each witness for appearing before the Subcommittee today

to address the Federal Home Loan Bank System and its role in the U.S. economy.

I look forward to your testimonies.

—————

PREARED STATEMENT OF WAYNE A. ABERNATHY

ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS

U.S. DEPARTMENT OF THE TREASURY

SEPTEMBER 9, 2003

Thank you, Chairman Bennett, Ranking Member Johnson, and Members of the

Subcommittee for this opportunity to testify today on the Federal Home Loan Bank

(FHLBank) System. The Department of the Treasury is keenly interested in the operations of the Federal Home Loan Bank System because of the important responsibility that the Congress has placed with the Federal Home Loan Banks to enhance

47

the liquidity of financial institutions, particularly as the Federal Home Loan Bank

members meet such important community needs as promoting homeownership.

The housing finance market in the United States is the broadest, deepest, and

most successful housing finance market in the world. That market is supported by

a complex financial services infrastructure, which includes depository institutions,

mortgage brokers, mortgage bankers, mortgage insurers, and a variety of other capital market intermediaries. Prominent among capital market intermediaries that

make up that infrastructure are the housing government sponsored enterprises

(GSE’s)—Fannie Mae, Freddie Mac, and the FHLBank System.

The FHLBank System has had a long history of supporting housing finance in

America. Congress created the FHLBank System in 1932 in response to a Depression-era liquidity crisis in housing finance. The FHLBank Act directs the FHLBanks

to make loans—called advances—to eligible members. Advances traditionally served

the role of providing thrifts access to reliable long-term funding for mortgage lending and as a source of liquidity to help thrifts finance deposit outflows without calling or selling their mortgages. Over time, Congress has expanded the System’s

membership base beyond thrifts, but the primary function of advances has remained

relatively constant. Today, financial markets and our Nation’s housing finance system bear little resemblance to the one that existed when the FHLBank System was

created.

It is in that light that I would like to focus on three topics this morning: The need

for the FHLBanks to voluntarily register with the Securities and Exchange Commission (SEC) under the terms of the Securities Exchange Act of 1934; the FHLBank

Act and the activities of the FHLBank System; and Treasury’s current detailed review of the FHLBank System.

Voluntary Registration with the SEC under the 1934 Act

The observance of good, fundamental practices of corporate governance is a high

priority of this Administration. Foremost among such practices is regular, comparable, quality disclosure of corporate financial conditions. A key part of that commitment is improving the quality of corporate disclosure requirements by the GSE’s,

which is why for more than a year the Administration has been urging all GSE’s

to comply with the same corporate disclosure requirements of the Securities Exchange Act of 1934, as interpreted and applied by the SEC. Investors in GSE securities should have access to the same corporate disclosures as they have for other

companies who publicly offer their securities for investment.

We are pleased that Fannie Mae has complied with this request to voluntarily

register and made its first disclosures under the 1934 Act in the first quarter of

2003. Freddie Mac has also agreed to register with the SEC, though we are disappointed to learn that Freddie Mac may not be registering until sometime in 2004.

The sooner that they register with the SEC the better for them and their investors,

though we fully concur with their intention that such registration and the financial

disclosures that this step entails fully meet the high standards that are required.

The Administration has continued to urge the FHLBanks to move forward with

voluntary registration with the SEC under the 1934 Act. Some have argued that the

structure of the FHLBank System and the unique characteristics of the FHLBanks

in comparison to Fannie Mae and Freddie Mac lessen the need for registration

under the 1934 Act. Certainly there are differences: When the FHLBank System

was created in 1932, it was created with geographically limited regional banks.

Each regional Home Loan Bank is cooperatively owned by its members, and its capital stock is not publicly traded. The 12 FHLBanks raise funds in the capital markets by issuing consolidated obligations for which they are jointly and severally liable. All of these facts are important and must be—and I believe can be—taken into

account.

However, the differences between the FHLBanks and the other GSE’s do not

change the fundamental fact that the FHLBanks are significant participants in our

capital markets by any measure, and that investors should have the same information regarding the condition of the Home Loan Banks as they have for other significant capital market participants. The facts make this case dramatically:

At the end of June, the FHLBanks had outstanding consolidated obligations

of $712 billion, of which bonds with original maturity of 1 year or longer

constituted $556 billion of the total.

The individual FHLBanks are each large financial institutions. As of yearend 2002, the largest Home Loan Bank (the FHLBank of San Francisco)

had $135 billion in total assets, the smallest (the FHLBank of Topeka) had

$33 billion in total assets, while the average among the 12 banks was $58

billion in total assets. Even the smallest Federal Home Loan Bank would

rank among the top 40 commercial banks in the United States.

48

1 12 U.S.C. § 1424(b).

Federal Home Loan Bank registration under the Securities Exchange Act of 1934

is an important step in increasing the transparency of the FHLBanks’ financial information to investors. The recent problems of Freddie Mac and a credit rating

agency’s revision of its outlook for one of the Federal Home Loan Banks from stable

to negative illustrate the need for investors to have a more accurate picture of the

GSE’s’ financial operations. Following Federal Home Loan Bank registration under

the 1934 Act, investors would have access to the FHLBanks’ financial information

through the same forms and methods as those that apply to other companies that

sell publicly traded securities. Investors would benefit from the added oversight of

the SEC, both in terms of reviewing the Federal Home Loan Banks’ financial disclosures and through the uniform enforcement of current standards. And investors

would have the basis for making comparable evaluations of the financial conditions

of the variety of institutions competing for their investment dollars. Our system of

securities regulation should offer investors nothing short of that standard.

The continued operation of the FHLBanks outside of the SEC-administered corporate disclosure regime is inconsistent with our objective of a sound and resilient

financial system. We understand that the FHLBanks have some remaining concerns

with how certain aspects of their business operation would be treated if they registered under the 1934 Act. I would remind them and all concerned that the Federal

Home Loan Banks are not the only corporate institutions in America that have

unique characteristics. It was specifically in order to deal with the variety of

corporations in the Nation—while still preserving a high standard of comparable

disclosures—that the SEC was given its exemptive authority under the securities

statutes. Given the flexibilities that the SEC has to address the individual circumstances of the various registrants under the 1934 Act, we are confident that the

Federal Home Loan Banks’ concerns can be worked out with the SEC.

We appreciate the discussions that several of the Banks have had with the SEC

earlier in the year, and we look forward to those discussions being renewed in the

immediate future, within a context of acceptance of the public interest that would

be served by the Federal Home Loan Banks registering under the terms of the Securities Exchange Act of 1934. We understand that the Board of Directors of the Federal Home Loan Bank of Cincinnati recently announced the Bank will be taking the

next step in the process of voluntary registration with the SEC. In a recent letter

to Secretary Snow, Housing and Urban Development Secretary Martinez, and Federal Housing Finance Board Chairman Korsmo, the Board of Directors of the Federal Home Loan Bank of San Francisco expressed their goal ‘‘to enable the Federal

Home Loan Banks to become role models for corporate transparency.’’ That is our

goal as well, to which Federal Home Loan Bank registration under the Securities

Exchange Act of 1934 is essential.

Multidistrict Membership, In Context

In chartering each of the housing GSE’s, Congress described the markets to be

served by these GSE’s, the financial activities these GSE’s should undertake, and

created a regulatory structure to oversee the GSE’s and their activities. While there

have been and continue to be debates over a number of Home Loan Bank activities

and how these activities fit within the statutory confines of the Federal Home Loan

Bank Act, one current issue—the question of multidistrict membership—raises particular concern. The Federal Housing Finance Board (Finance Board) has received

a number of petitions requesting that Federal Home Loan Bank members be permitted to join more than one Federal Home Loan Bank. The Finance Board has analyzed this issue, obtained outside legal counsel on its authority to authorize multidistrict membership, and solicited views from interested parties.

All of that is well and good and appropriate. A lively discussion of policies and

programs is healthy. But the appropriate forum for the resolution of these issues

must be kept in mind. As the Treasury Department has written in a comment letter

to the Finance Board, regardless of whether allowing multidistrict membership is

wise, a plain reading of the statute finds little room to conclude that the Finance

Board has the legal authority to approve it. It provides:

An institution eligible to become a member under this Section may become

a member only of, or secure advances from, the Federal Home Loan Bank

of the district in which is located the institution’s principal place of business, or of the bank of a district adjoining such district, if demanded by convenience and then only with the approval of the Board.1

49

2 Id. (citing Hearings on S. 2959 concerning creation of the FHLBank System), 72nd Cong., 1st

Sess (1932), at 199.

This view is reinforced by the comments of Assistant Legislative Counsel Mr.

John O’Brien (a principal drafter of the Federal Home Loan Bank Act) in response

to questions regarding the Federal Home Loan Act at a Senate hearing in 1932.

[I]t was not the desire, say, for members in South Carolina to borrow of a

New York bank, because it would mean too great a concentration at the

New York bank. If the New York bank happened to do better than a South

Carolina bank, all members would go there. There is the opportunity in the

bill for a member whose principal place of business is in one district to belong to a bank in the adjoining district, but outside of that there is no provision. It is impossible under the terms of the bill for a company doing business in New York to belong to a South Carolina bank.2

To say this is not to render a policy point of view. There are compelling arguments on both sides of the question with regard to the advisability of multidistrict

membership. Clearly our financial system has changed dramatically since the System was established in 1932 and the predecessor to the current regulator created

the 12 banks, and determined their locations and boundaries. In the intervening

years, however, Congress has revised the governing statutes on several occasions.

It is to the Congress that these arguments should be offered and where any change

in the statute will have to be made.

To some, multidistrict membership represents a natural progression in the modernization of the FHLBank System. We would only add our view that if multidistrict

membership is considered, it should be done within the general context of evaluating the Federal Home Loan Bank System’s charter.

Treasury’s Review of the FHLBank System

Perhaps the time for such a review is near. Earlier this year, I requested the

Office of Financial Institutions Policy at the Treasury Department to conduct an inhouse review of the Federal Home Loan Bank System, with particular—but not exclusive—consideration of the effect of the changes enacted as part of the GrammLeach-Bliley Act of 1999 (GLBA). As I announced at that time, the review would

consider:

• how these changes have affected the ability of the Federal Home Loan Banks to

meet their statutory mission;

• implications for the financial strength of the Banks individually and the System

in general;

• how the business operations of the Banks contribute to accomplishing their statutory mission;

• issues regarding governance structure and management, including executive compensation;

• effect of new capital structures on operations; and

• other issues regarding the strength of the System and the structure of Federal

oversight.

We are now about 4 months into that process, nearing completion of the first

phase. In the first phase, the staff conducted a general review of the literature, discussions, debates, and developments to put a sharper focus to the questions to be

examined. Now they are preparing to go into greater detail. The initial step in the

second phase will be to discuss specific topics with the Finance Board.

Some of the issues we will be looking at in greater detail include:

Capital Structure

GLBA significantly changed the capital structure of the Federal Home Loan

Banks and provided greater flexibility in the development of capital plans. What are

the similarities and differences among the various capital plans? How have the riskbased capital requirements been implemented? How will new capital plans impact

the Banks’ investment portfolios?

Membership

GLBA eliminated mandatory membership requirements for Federal savings associations and permitted broader access to FHLBank membership for community financial institutions (insured depository institutions with less than $500 million in

total assets). What has been the impact of these changes in membership participation? Have those changes affected governance of the Home Loan Banks?

50

Advances and Collateral

The GLBA provided community financial institutions with a broader range of eligible collateral for FHLBank advances. The Finance Board reports that as of June

30, 2003, expanded collateral from community financial institutions represents approximately $10.6 billion of the $486 billion in outstanding advances. How has this

provision been implemented by the FHLBanks and what factors impact community

financial institutions use of the broader range of eligible collateral?

In addition to evaluating these specific legislative changes, over the last decade

the activities of the Federal Home Loan Banks have evolved in many ways. Some

specific activities that we will be focusing on include:

Balance Sheet Developments

How have key activities (advances, investments, and mortgage purchases) of the

System and the individual Home Loan Banks evolved over the last decade, and

what does this imply for the future of the System?

Advance Usage

What are the characteristics of FHLBank advance users? What types of advances

are most commonly used by System members? What impact is it having on the activities of the members and their ability to serve their customers?

Again, I would like to emphasize that Treasury’s review of the Federal Home

Loan Bank System is part of what we normally do at Treasury, and what I envision

for our current review is a more specific look at how the changes made to the

FHLBank System as part of GLBA have been implemented. Treasury is not primarily a regulatory agency. We see as part of our important function, however, providing executive branch oversight of the activities of the independent financial regulators, and this study is part of meeting that responsibility.

And before I leave this subject, with regard to regulatory oversight of the

FHLBank System, I would like to commend Finance Board Chairman Korsmo for

the increased emphasis he has placed on safety and soundness oversight, in particular the emphasis he has placed on the supervision and examination function. In

recent years, many observers have pointed to weaknesses in the Finance Board’s supervision of the Federal Home Loan Banks. Chairman Korsmo has given major

focus to strengthening the examination process, doubling examination staff on the

way to tripling it. I have no doubt that even further increases will be made as necessary.

As another related aside, I would like to raise a point about a legislative proposal

regarding the membership of privately insured credit unions in Federal Home Loan

Banks. As part of that proposal, private insurers of credit union deposits would be

required to submit annual audit reports to the National Credit Union Administration (NCUA). In addition, upon the NCUA’s request, the appropriate State supervisory agency would be required to provide the NCUA with examination reports of

private deposit insurers. We are concerned that the provisions related to the NCUA

could give the false impression that the NCUA has oversight authority over the private deposit insurers of credit unions and that the Federal Government somehow

stands behind the private insurers. Not only would that be a terribly false impression potentially harmful to depositors, but it would also remove some of the market

discipline that is so essential to the successful functioning of any private insurance

program.

Conclusion

The Federal Home Loan Bank System presents policymakers with issues that deserve continued attention. The System has historically played an important role in

our Nation’s housing finance markets. We must continue to evaluate the System to

ensure that it is achieving the objectives set forth by Congress, meeting the needs

of our communities that might not otherwise be met.

Thank you again for providing me with the opportunity to discuss these important

issues with the Subcommittee today.

—————

PREPARED STATEMENT OF JOHN T. KORSMO

CHAIRMAN, FEDERAL HOUSING FINANCE BOARD

SEPTEMBER 9, 2003

Thank you, Chairman Bennett, Ranking Member Johnson, and distinguished

Members of the Subcommittee on Financial Institutions. I appreciate the opporVerDate 11-MAY-2000 18:52 Jun 03, 2005 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6621 21384.TXT SBANK4 PsN: SBANK4
51

tunity to speak with you today about the Federal Housing Finance Board (Finance

Board) and the Federal Home Loan Bank System.

Many important issues are facing the Nation’s Government Sponsored Enterprises

(GSE’s), including, certainly, the Federal Home Loan Banks (Banks). I highlight

today the aggressive steps we have taken at the Federal Housing Finance Board,

the System’s regulator, first, to strengthen the Agency’s oversight capabilities; and

second, to improve financial disclosures by the Federal Home Loan Banks through

voluntary registration with the Securities and Exchange Commission (SEC).

These initiatives will benefit not just the Federal Home Loan Banks and their

member institutions, but also the investors that purchase the Banks’ debt, the taxpayers, and ultimately, the homebuying public who are served by the housing finance mission of the Banks.

As requested in Chairman Bennett’s invitation to this oversight hearing, I will

also address the issues of multidistrict memberships in Federal Home Loan Banks

and the Banks’ various Acquired Member Asset programs (AMA).

Allow me to begin by providing a brief overview of both the Federal Housing Finance Board and the entities we regulate, the 12 Federal Home Loan Banks and

the Office of Finance.

The Federal Housing Finance Board is an independent agency in the executive

branch of the U.S. Government, with a five-member Board of Directors, four appointed by the President and one ex-officio member, the Secretary of Housing and

Urban Development. Created to take over certain duties of the Federal Home Loan

Bank Board by the Financial Institutions Reform, Recovery, and Enforcement Act

of 1989 (FIRREA), the Finance Board’s primary duty is to ensure that the 12 Federal Home Loan Banks and the Office of Finance operate in a financially safe and

sound manner.

In addition, the Finance Board ensures that the Federal Home Loan Banks carry

out their housing finance and community lending mission and remain adequately

capitalized and able to raise funds in the capital markets. The Federal Home Loan

Bank Act requires the Finance Board to examine and report on the condition of each

Federal Home Loan Bank at least annually. Finally, the Finance Board is a nonappropriated agency that enacts its own budget; it assesses the Banks for the costs

of its operation.

The 12 Federal Home Loan Banks and their joint office, the Office of Finance,

serve the public by promoting the availability of housing finance, including community lending credit, through 8,000-plus member institutions. The 12 Banks provide

a readily available, low-cost source of funds to members and a secondary market facility for home mortgages originated or acquired by their members. The Banks are

cooperatives; only members may own the stock of each Federal Home Loan Bank,

and the members receive dividends on their investment. Insured banks, thrifts, and

credit unions and insurance companies engaged in housing finance can apply for

membership.

The Federal Home Loan Banks play a unique role in housing finance. They make

loans, called advances, to their members and eligible housing associates (principally

State housing finance agencies) on the security of mortgages and other collateral

pledged by those members and housing associates. Advances generally support

mortgage originations, provide term funding for portfolio lending, and may be used

to provide funds to any member ‘‘community financial institution’’ (an FDIC-insured

institution with assets of $538 million or less) for loans to small business, small

farms, and small agribusiness. Because portfolio lenders may originate loans they

are unwilling or unable to sell in the secondary mortgage market, Federal Home

Loan Bank advances serve as a funding source for a variety of mortgages. This flexibility allows these advances to support important housing markets, including those

focused on low- and moderate-income households.

Federal Home Loan Bank advances can provide funding to smaller lenders that

lack diverse funding sources. Smaller community lenders often do not have access

to funding alternatives available to larger financial entities, including repurchase

agreements, commercial paper, and brokered deposits. The Federal Home Loan

Banks give these lenders access to competitively priced wholesale funding.

The Federal Home Loan Banks principally fund themselves by issuing consolidated obligations, which are the primary obligation of a sponsoring Bank or Banks,

backed by a joint-and-several liability guarantee of all Banks. Consolidated obligations outstanding at June 30, 2003, totaled $712.4 billion. This includes bonds

(original maturity of 1 year or longer) of $556.2 billion and discount notes (original

maturity of less than 1 year) of $156.2 billion.

Finally, a few more key figures: Total assets of the Federal Home Loan Banks

stood at $812 billion as of June 30, 2003. Advances totaled $506.3 billion, which is

52

7.6 percent greater than 1 year ago. Viewed collectively, the Federal Home Loan

Banks represent the third largest domestic banking organization.

Institutions of this size and importance to the Nation’s housing market and economy in general clearly require a robust and capable regulator, and since President

Bush named me Chairman in December 2001, I have sought to establish the Finance Board as just that.

Improvements in Safety and Soundness Oversight

Soon after I became Chairman, my Finance Board colleagues and I determined

that the Finance Board lacked the necessary resources to effectively carry out its

primary responsibility, that of overseeing the Federal Home Loan Banks and the

Office of Finance for safety and soundness. Just one example demonstrates this

point: The Finance Board had only eight bank examiners on staff to review and supervise a dozen financial institutions with, at the time, more than $700 billion in

assets, more than $30 billion in capital, and some $650 billion in outstanding debt.

Yet, the Agency also had an Office of Public Affairs with the same number of staff,

eight. The relative allocation of resources simply did not meet the Agency’s statutory

mandates.

In addition to being understaffed, the examination function was also insufficiently

focused on the Banks’ risk assessment processes and the Banks’ internal control systems. Such shortcomings had been identified in a 1998 General Accounting Office

(GAO) report of the Finance Board’s examination program, but had not by that time

been addressed and corrected.

I immediately set out to respond to these problems, beginning with the recruitment of new leadership for the Agency’s Office of Supervision. After a national

search, the Finance Board hired a new director and a new deputy director of supervision, who between them have 40 years of regulatory experience with the Office

of the Comptroller of the Currency and the Federal Deposit Insurance Corporation

(FDIC).

My Finance Board colleagues and I increased the resources available for supervision, expanding the Agency’s examination staff to 17 full-time bank examiners.

Our goal is to have 24 in place by the end of this calendar year, and 30 by the end

of the next budget year.

The Finance Board is now conducting more thorough, risk-focused examinations,

and communicating the results of those examinations more effectively to the Banks.

Examinations now recognize that banking—including AAA-rated, GSE banking—

is a business of managing risks, and the responsibility of bank supervisors is to ensure that the institutions they regulate understand those risks and monitor and

control them through prudent risk management practices.

To enhance analysis and oversight in the risk management area, we have established two risk units—a Risk Modeling Division and a Risk Monitoring Division.

The Risk Modeling Division is responsible for the development of our asset/liability

modeling and for monitoring the Bank’s internal interest rate risk models. The Risk

Monitoring Division pulls together all our data and the Banks’ own financial reporting into a risk-monitoring framework.

We have hired an Associate Director for Examinations who oversees all our safety

and soundness examiners. She has more than 15 years of bank regulatory experience with the FDIC. We also have hired a Senior Advisor to the Director of Supervision to provide support to the Risk Modeling and Risk Monitoring Divisions. That

Senior Advisor possesses some 30 years of bank supervision, capital markets, and

capital regulation experience with the Board of Governors of the Federal Reserve

System and the Office of Thrift Supervision.

While on-site examinations remain the primary tool of supervisors, the Agency

now complements exams with off-site monitoring and regular communication with

the Banks. Our new ‘‘Bank Analyst Program’’ charges a member of our Office of Supervision with following an individual Bank and reviewing monthly and quarterly

financial reports for trends and changes, while also keeping abreast of issues in the

financial and housing industries to determine their effect on each Bank.

Our Office of General Counsel has also assigned attorneys who serve as points

of contact for the examiners on particular Bank issues.

In short, the Finance Board’s safety-and-soundness oversight of the Federal Home

Loan Banks has improved dramatically. We have more work ahead of us, to be sure,

but the Finance Board is a much stronger and more capable regulatory agency than

it was as recently as 12 months ago.

The 1998 GAO report also found that Finance Board examinations neglected the

critical area of board governance at the Federal Home Loan Banks. To address this

shortcoming, and as another element of our safety and soundness supervision, the

Finance Board has undertaken a thorough assessment of corporate governance at

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each of the Banks. This effort included the first-ever horizontal review—that is, a

systemwide supervisory review of a single issue at each of the 12 Banks—which addressed the Banks’ effectiveness relative to eight indicators of effective board governance.

Those indicators are:

• Engaged Board of Directors;

• Skilled Senior Management;

• Thorough Strategic Planning;

• Sound Risk Management;

• Robust Internal Control;

• Effective Audit Program;

• Strong Ethical Culture;

• Timely, Accurate, and Complete Communications.

The Finance Board’s final report on this review includes a variety of general recommendations for improving corporate governance. The Agency also provided specific, confidential feedback to each of the 12 Banks.

The next step with respect to bank governance is a public hearing, tentatively

scheduled for October 15. The Finance Board will solicit from the Banks, their member institutions, experts, and interested members of the public any ideas for reform

in this important area. Input generated may be used in the design of proposals

aimed at making the Federal Home Loan Banks role models in corporate governance.

Earlier this year, the Finance Board undertook a second systemwide horizontal

review—that of the Federal Home Loan Banks’ implementation of the statutorily

mandated Affordable Housing Program (AHP). The AHP is a highly successful program that warrants a separate discussion and some background.

The Affordable Housing Program (AHP)

The Federal Home Loan Bank Act requires each Bank to establish and fund an

Affordable Housing Program. Under the AHP, each Bank must annually contribute

the greater of 10 percent of its net earnings for the previous year, or such prorated

sums as may be required to ensure that the aggregate contribution of the Banks

is at least $100 million. Actual contributions to the program were $199 million for

2002, and the contributions have exceeded $100 million each year since 1994.

AHP subsidies must be used to fund the purchase, construction, or rehabilitation

of:

• Owner-occupied housing for very low-income, or low- or moderate-income (no

greater than 80 percent of area median income) households; or

• Rental housing in which at least 20 percent of the units will be occupied by and

affordable for very low-income (no greater than 50 percent of area median income)

households.

In 2002, the Finance Board adopted a regulation enabling Banks to allocate annually the greater of $4.5 million or 35 percent of each Bank’s AHP contribution to

homeownership set-asides. Part of this increased funding authority helps Banks

combine AHP subsidies with HUD initiatives benefiting minority, immigrant, and

other first-time homebuyer families.

Since the inception of the AHP in 1990, the Federal Home Loan Banks have contributed $1.7 billion to the program, funding 236,596 rental units and 122,126

owner-occupied units. In 2002, the Banks committed $286 million to AHP projects.

The Finance Board appropriately devolved operation of the AHP to the individual

Banks in the late 1990’s, a valuable development because the Banks are best

equipped to assess local affordable housing needs and build partnerships with local

community groups and housing agencies.

Correspondingly, the Finance Board’s oversight responsibility has grown with respect to the AHP to ensure proper and effective program operation. As such, we are

following up the horizontal review with a new practice of examining each Bank’s

AHP once a year. These exams are performed by examiners and analysts whose specialized training has specifically equipped them for this task.

We are also preparing regulatory language intended to enhance the effectiveness

of the AHP by permitting Banks more latitude in establishing the criteria to score

applications. The goal is for Banks to be more responsive to local housing conditions.

We also plan to streamline the application process to permit projects to proceed

more quickly and with lower administrative costs.

AHP is truly one of the Federal Home Loan Banks’ great success stories, and with

rigorous oversight at the Federal Housing Finance Board, I am confident it will be

even more successful in the years ahead.

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Enhanced Disclosures

The other key initiative I wish to discuss today is enhancing the quarterly and

annual corporate disclosures of the Federal Home Loan Banks.

In July 2002, the administration called on all Government Sponsored Enterprises

to comply with the corporate disclosure requirements of the Securities Exchange Act

of 1934, as interpreted and enforced by the SEC.

Fannie Mae and Freddie Mac, the other two housing-related GSE’s, answered this

call. Fannie Mae has already filed its first disclosures under the new SEC regime.

As Chairman of the Federal Housing Finance Board, I too am determined to hold

the Federal Home Loan Banks to the highest standard of disclosure. Accordingly,

I formed a working group from the Finance Board and the Federal Home Loan

Banks to review the implications of acceding to the Administration’s request.

Early this year, I concluded that voluntary registration with the SEC was indeed

the best approach to providing enhanced public disclosure of the operations and finances of the Federal Home Loan Banks. I reached this conclusion based on two

premises.

First, the Banks’ long-term access to global capital markets will be enhanced by

providing investors in consolidated obligations with maximum reliable transparency

into the finances and governance of each of the 12 Banks. Markets function best,

especially in times of stress, when needed information is readily available and reliable.

Second, as public trusts, these 12 GSE’s have a duty to contribute both to the

smooth functioning of capital and mortgage finance markets and to public confidence that the benefits of GSE status are used wisely.

At my urging, Federal Home Loan Banks and the staff of the SEC have held numerous meetings to address the process for voluntary registration, including methods for resolving several key disclosure and accounting questions.

The Board of Directors of the Federal Home Loan Bank of Cincinnati actively embraced the disclosure initiative as in the best interest of its members, voting in February to pursue voluntary registration. Last month, the Cincinnati board resolved

to ‘‘actively engage, effective immediately, in the process of voluntary registration

with the SEC of its member-held stock.’’

This summer, too, the boards of the Federal Home Loan Bank of San Francisco

and the Federal Home Loan Bank of Atlanta resolved that if SEC registration was

the determined course of action, it is their request that the Finance Board adopt

a regulation requiring it.

In response to those requests, at its regularly scheduled meeting tomorrow the Finance Board will consider a proposed regulation requiring each Bank to register a

class of securities with the SEC under Section 12(g) of the Securities Exchange Act

of 1934.

The proposed rule provides for a lengthy, 120-day comment period, during which,

I hope, the Banks will each meet with the SEC to work out the necessary details

to effectuate registration and begin meeting the periodic financial reporting requirements of the 1934 Act.

The focus of the enhanced disclosure effort from the start has been to ensure that

the Federal Home Loan Banks play their part, as Government Sponsored Enterprises, in contributing to the smooth functioning of the capital and mortgage finance

markets. In the end, consistent and full disclosures of these institutions’ finances

and corporate governance also serve the public, who stand behind their charters as

Government Sponsored Enterprises.

Acquired Member Assets (AMA)

I have been asked to address two other issues in my testimony today. The first

of these concerns regulations governing the Acquired Member Assets programs, or

AMA, of the Federal Home Loan Banks.

The 12 Federal Home Loan Banks are authorized to purchase single-family mortgages that do not exceed the conforming loan limit applicable to Fannie Mae and

Freddie Mac, currently $322,700. The authority granted under the current rule (12

CFR Part 955) is an expansion and refinement of previous authority that had been

granted to the Banks by a Finance Board resolution in 1996. That authority was

challenged in 1997, a challenge rejected by a U.S. District Court in 1998. The U.S.

Court of Appeals for the Fifth Circuit upheld the District Court’s ruling in 2000,

affirming the Finance Board’s authority in this area.

There are currently two AMA programs—Mortgage Partnership Finance (MPF)

and Mortgage Purchase Program (MPP). MPF is the older and larger program.

Under the current AMA programs, a Bank may purchase mortgage assets from a

member institution. The programs, like advances, provide member institutions liquidity for mortgage lending. In AMA programs, the member manages and bears

55

a material portion of the credit risk. Since the programs’ inception in 1996, the

Banks have purchased more than 600,000 loans. Approximately 75 percent of those

loans were purchased under MPF and 25 percent under MPP. More than 95 percent

of the total loan acquisition has occurred since 2000, the current AMA regulation

having become effective on July 17, 2000.

On July 1 of this year, the Finance Board unanimously adopted and published

for comment a proposed revision to the current AMA regulation. The Finance

Board’s intent is clearly stated in the preamble to the regulation, that is, to make

the regulation more ‘‘effective and efficient in regulating the Banks’ mortgage purchase programs.’’ In the rule, the Finance Board also seeks to clarify and simplify

the language of the current rule. The proposed regulation does not expand or alter

the fundamental structure of the AMA programs.

The proposed regulatory changes also maintain or strengthen many appropriate

safety and soundness provisions of the current rule, again reflecting the Finance

Board’s continued emphasis on improving its safety and soundness oversight of the

Federal Home Loan Banks.

Safety and soundness provisions maintained or strengthened under the proposed

rule include requirements that:

• All AMA must be at least investment grade when acquired by the Bank.

• The Bank must have in place a process and methodology to determine the required credit enhancement prior to acquisition of any asset and throughout the

life of the asset on the Bank’s books.

• The Bank must take remedial action by requiring the member to provide additional credit enhancement or hold additional capital if the estimated credit rating

of the asset declines to below the rating required at time of acquisition.

• Insurers must be rated AA or better to provide a portion of the credit enhancement to the member institution selling assets to the Bank.

• Banks without risk-based capital structures in place must hold retained earnings

for losses as support for the credit risk associated with any AMA estimated to be

rated below AA.

In addition, the proposed regulation incorporates Finance Board criteria previously set forth in the preamble of the July 2000 final AMA rule outlining the circumstances under which Banks are permitted to acquire from members highly rated

interests in pools of mortgages as an alternative to acquiring whole loans. Among

the criteria is a requirement that all loans backing such interests must themselves

be eligible for purchase by the Bank as AMA. As with any new AMA product, a

Bank is only allowed to acquire such interests after its proposed program has been

reviewed and approved under the Finance Board’s New Business Activity regulation.

The proposal further seeks comment on whether the Finance Board should take

measures to prevent a Bank from acquiring loans or assets backed by loans, through

its AMA program, where the loans have features or were made under circumstances

that may be considered predatory or abusive. The proposal also asks for comment

on whether and how to limit Banks’ authority to acquire such loans or assets backed

by such loans.

The text of the proposed regulation maintains the current prohibition on purchases directly from affiliates of member institutions. In response to numerous

requests from members using affiliates and subsidiaries for mortgage origination activities, the preamble does invite comment on changing current policy to allow affiliates owned and controlled by members to directly sell assets to Federal Home Loan

Banks.

The importance of revising Finance Board regulations to better reflect the Agency’s supervision approach argues for a constructive exchange among the interested

public, Federal Home Loan Banks, and the Finance Board. It appears, however, that

some may have misunderstood the intention of this proposed regulation.

As a result, in agreement with my fellow Directors, I will ask the Finance Board

to vote at its regular Board meeting tomorrow to withdraw the present rulemaking.

The proposed text will be revised and clarified to more clearly enunciate the principles I listed above, and the resulting proposed regulation will be voted on in a subsequent meeting. If approved by the Finance Board, the revised proposed regulation

will be published for a 90-day comment period.

Multidistrict Membership

When I became Chairman of the Finance Board in December 2001, the multidistrict membership debate was already over a year old, having been prompted by regulatory requests filed in 2000 and 2001 by four Federal Home Loan Banks that had

lost large members to mergers with institutions headquartered in other Federal

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Home Loan Bank districts. A Solicitation for Comments on the issue was pending

and remained open until March 2002.

When Congress created the 12 Federal Home Loan Banks 71 years ago, it anticipated that each member thrift institution would operate where its collateral was located, and at that time, that meant in its home State alone. The financial world,

of course, has fundamentally changed since 1932, as has the membership base of

the Federal Home Loan Banks now that membership is voluntary for all and open

to commercial banks and credit unions, as well as thrifts and insurance companies.

With the advent of interstate banking and national holding companies, the Federal Home Loan Banks are operating in a different competitive environment than

existed through most of their history. For Bank member institutions organized

under certain holding company structures, multidistrict membership already exists.

One hundred three holding companies, doing business in more than one Federal

Home Loan Bank district through separately chartered subsidiaries, currently account for 451 distinct Bank memberships. Institutions that operate in multiple regions through a single charter, however, are precluded by Finance Board regulations

from establishing similar operating arrangements with more than one Federal

Home Loan Bank.

Let me make clear that, while it is my view that the Federal Home Loan Bank

Act both empowers and obligates the Finance Board to continue regulating the

terms of Bank membership to the extent necessary to ensure safe and sound operation of Banks, access by Banks to capital markets, and achievement of the Banks’

housing finance mission, I am neither an advocate nor an opponent of expanding

multidistrict membership in the Federal Home Loan Bank System.

When I became Chairman, I asked the four Banks seeking regulatory approval

for multidistrict membership to withdraw their requests to permit a thorough, comprehensive review of the changed financial services industry and mortgage market

circumstances that give rise to the multidistrict issue. That review has occurred

without producing any compelling reason for the Finance Board to address the question of expanded multidistrict membership on its own initiative.

My commitment to those Banks that withdrew their pending regulatory requests,

however, was that, when the review was complete, any Bank seeking authority to

admit as a full member an institution doing business in that Bank’s district but

maintaining a charter and membership in another Federal Home Loan Bank district

would be afforded an opportunity to make its case to the Finance Board and present

its recommended solutions to the various operational challenges its proposal would

raise. In June, in fulfillment of my commitment to those Banks, I requested the Office of Supervision and the Office of General Counsel to draft a proposed regulation

establishing a process by which the Finance Board could receive, review, and accept

or reject such applications, should any Bank choose to make one. No Bank, however,

has made any request to the Finance Board to proceed on multidistrict membership,

the draft proposal was never completed, and no further Finance Board action establishing a procedure is planned.

Conclusion

Chairman Bennett, distinguished Members of the Subcommittee, I close by returning to the very reason the Federal Housing Finance Board exists: to ensure that

Federal Home Loan Banks operate in a financially safe and sound manner, carry

out their housing-finance mission, and remain adequately capitalized and able to

raise funds in the capital markets.

Since 2002, the Finance Board has dramatically improved its ability to perform

these statutorily mandated responsibilities. The Agency’s supervision function is

stronger, more thorough, and more effective. Taken in conjunction with the initiative to enhance the financial disclosures filed by the Federal Home Loan Banks, I

believe the Finance Board is capably representing the interests of the public and

taxpayers who stand behind the Federal Home Loan Banks and who benefit from

the successful performance of the Federal Home Loan Banks’ important role in

housing finance.

—————

PREPARED STATEMENT OF NORMAN B. RICE

PRESIDENT AND CHIEF EXECUTIVE OFFICER, FEDERAL HOME LOAN BANK OF SEATTLE

SEPTEMBER 9, 2003

Good afternoon Chairman, Ranking Member Johnson, and Members of the Subcommittee. I am Norman B. Rice, President and Chief Executive Officer of the Federal Home Loan Bank of Seattle.

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I would like to thank Chairman Bennett and the Subcommittee for the opportunity to provide my perspective on the unique and vital role the Federal Home

Loan Banks play in building strong communities and healthy economies across

America.

The 12 Federal Home Loan Banks have a long history of service and accountability to the more than 8,000 financial institutions we serve, to the millions of individuals and families we help realize the American Dream of homeownership, and

to the regulators and Congress who oversee our system.

But it is not the history of our banks that I want to talk with you about this afternoon. Where we have been and what we have accomplished as a Bank System is

significant and well documented. But my focus is on the relevance of the Bank System today—and in the future—and the critically important role we play on behalf

of our financial institution members, and the economic health of our country.

I will start with what I consider to be the most important element of the Federal

Home Loan Banks—we are a cooperative. Our members own the Bank System, and

we are accountable to them.

We are truly unique in that sense. By constructing the Home Loan Banks as a

cooperative, Congress ensured that all value and benefits from the System are

passed directly back to the member financial institutions that are the lifeblood of

small business, agriculture, and neighborhood revitalization in this country.

These are the banks, credit unions, thrifts, and other institutions that give communities critically needed access to credit; these are the risk-takers whose leadership and resources build stronger towns, cities, and, to a very real extent, a stronger

Nation.

You can do that in a cooperative that provides each one of its members—small

and large—the same access to a stable, low-cost, and reliable source of wholesale

funding. In turn, you cannot do what we do in a publicly traded company where

your primary focus is building investor value for tens of thousands of individual

stockholders.

It works much differently in the Federal Home Loan Bank System. We have a

business relationship with each of our members—they are both our owners and our

customers. We know them by name. We understand their individual market needs

and the needs of their communities. They are represented on our boards and provide

the leadership of our 12 banks.

No other housing GSE or financial institution can replicate this partnership of

bank, member, and community.

At the Seattle Bank, we like to use the term ‘‘rock solid’’ to characterize our organization and the business relationship we have with our members. It conveys a

sense of accountability and commitment to our cooperative, and the unwavering belief that a member’s investment is being managed for the long-term, not just quarter

to quarter. That is how our member financial institutions see us—as a safe, sound

partner they can use to more effectively manage their balance sheets—in good economic times and bad—for the purpose of better serving their local customers and

communities.

Within the cooperative structure of the Bank System, it is also important to understand the profile of our membership. The overwhelming majority of our member

financial institutions are smaller, community-based companies. Our typical member

has about $110 million in assets, almost half of our members are located in rural

areas, and most are independently owned.

We also serve the Nation’s largest lenders. Our Congressionally mandated mission

is to make bank credit available for our local communities. Given the realities of

the financial services industry, which has consolidated enormously, it would simply

be impossible to fulfill our mission unless we also supported the largest lenders who

now account for a vast amount of lending activity. For example, the top three U.S.

lenders now account for 37 percent of all home mortgage originations. The top 30

originators account for 60 percent of all loan originations.

As you can see, the Bank System cooperative is a place where financial institutions of all sizes share mutual interests and share mutually in the benefits of their

joint enterprise.

As I sit before you today, the Federal Home Loan Banks and the housing GSE’s

are facing significant challenges and changes regarding their business practices,

regulatory structure and mission-based programs and activities.

There is much to discuss and determine in the coming months, and potentially

much at stake for financial institutions, businesses, homebuyers, and the American

economy.

As this Subcommittee and other Members of Congress consider the future of the

Federal Home Loan Banks and the housing GSE’s, you will no doubt be inundated

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with recommendations and solutions from many people representing many of the

constituencies that have come before you today.

As a former public policymaker, I remember that process all too well. But in place

of recommendations and solutions, I would like to offer you two things today: Some

baseline questions and principles to consider in your discussions in the weeks and

months ahead, and clear evidence of the powerful impact the Bank System has on

our country’s financial services industry, our communities, and our economy.

First, two questions that I believe appropriately frame the issues now before Congress regarding our Bank System and housing GSE’s.

• What are the benefits and risks that the housing GSE’s present to taxpayers? • How are the risks best managed?

Over the course of any week in my job, I am asked by a number of people what

the Federal Home Loan Bank of Seattle is, and what it does. For those not involved

in the banking and financial services industry, our system is, for the most part, unknown. So, I am always pleased to provide some quick education, and pleased because of the answer I am able to give: We help ensure that Americans have homes

and healthy local economies.

How do we do that? By connecting financial institutions of all sizes to the capital

markets. This provides our member banks with a stable source of lower-cost funds

that they use in their own communities to support homebuyers, businesses, and

farmers.

But perhaps an even better way to illustrate the benefits of the Bank System is

to imagine our country without the 12 Home Loan Banks. Consider the following:

• In 2002, the Bank System extended nearly a half trillion dollars in advances

(what we call loans) to our member financial institutions, strengthening local

economies, and increasing homeownership. Imagine those dollars gone.

• Since 1991, the Federal Home Loan Banks have awarded $1.6 billion in Affordable Housing Program grants, helping to create 360,000 low-income housing units

across the country. Each of our 12 Banks annually provides 10 percent of their

net income for affordable housing. Last year, that totaled about $200 million.

Imagine those dollars gone.

• In 2002, the Bank System provided nearly $9 billion in reduced-rate, long-term

Community Investment Program (CIP) advances, used by our member financial

institutions to finance commercial and economic development initiatives that benefit low- to moderate-income families and neighborhoods. Since CIP began in

1990, our Banks have issued nearly $36 billion in reduced-rate loans. Imagine

those dollars gone.

Now imagine the collective impact on our national economy, not to mention individual business owners, homebuyers, and farmers.

Ask yourselves who would provide the bank credit to support your local economies? How would your local bank compete if they did not have access, through their

regional Home Loan Bank, to the capital markets? Where would these institutions

turn, in good times and bad, to meet loan demand despite the outflow of consumer

deposits from the banking system? Where would your constituents go to get loans

to buy homes and run their businesses?

Now go one step further: If the housing GSE’s did not exist today, what would

Congress put in their place? I believe you would come back to something that looked

a lot like the Federal Home Loan Bank System.

Here’s why:

• The Bank System is funded entirely through private capital. The cooperative is

built by private owners who have put more than $36 billion of their own money

at risk to capitalize the Bank System.

• The Bank System is cooperatively owned to support—rather than compete with—

the private marketplace. Our stock is not publicly traded. We are not driven by

an imperative for double-digit growth to meet expectations of the stock market.

We do not have third-party investors pulling value out. Every dollar of value created by the Bank System is poured back into the housing finance system, ultimately benefiting your constituents, the consumers of bank credit. Those are bank

owners, business owners, farmers, homebuyers, nonprofit housing corporations,

neighborhood social service organizations, municipalities, and many, many others.

• The Bank System has the capacity to innovate and keep pace with an evolving financial services industry. This is why the Bank System offers mortgage purchase

programs. Our members have told us they can better serve homebuyers and local

markets if there is more competition in the secondary mortgage markets. It is no

accident that our System’s program volume has accelerated from zero to almost

$100 billion. Without question, there is a private-market demand for competition,

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and we believe that competition is healthy—it is good public policy. And it is

equally important to remember that when programs such as these boost earnings

and profitability in our banks, that provides more funding for affordable housing

and economic development in our communities. At the Seattle Bank last year

alone, our Mortgage Purchase Program generated $1.75 million in additional AHP

subsidies. My point here is, you cannot disconnect profitability and mission with

the Bank System.

• The Bank System is organized by region, ensuring that each bank is connected

and responsive to local markets. Twelve Home Loan Banks were created to focus

on local markets, to know their local member financial institutions and create

products and services that meet their customers’ needs and the affordable housing

and economic development needs of their communities.

• The Bank System pays its fair share of taxes. The Home Loan Banks carry a special tax burden that cannot be sheltered and is equivalent to a Federal corporate

tax rate. The Bank System has been required, since 1989, to pay off the

REFCORP debt and provide 10 percent of its net income in support of low-income

housing. This is the single-largest private source of housing subsidy in the United

States.

• The Bank System is a reliable source of liquidity through all parts of the economic

cycle. This is the primary reason why financial institutions join the Bank System.

They rely on our capacity to access the capital markets on their behalf. That is

why, even in a down economy, demand for advances across all of our banks has

reached nearly a half trillion dollars.

As you can see, it is not a difficult task for me to list the benefits provided by

the Bank System. Over the last 70 years, the 12 Home Loan Banks have consistently proven their relevance to our members and their communities.

The harder question—especially in today’s environment—is whether or not the

risks are being managed appropriately. While it is one thing to say our advance and

mortgage purchase programs drive profitability and support mission-based programs

and activities—which they do—it is quite another to ensure that the risks inherent

in those programs are being managed appropriately.

My colleagues testifying on this panel today will address other key issues regarding the Bank System, including risks associated with financial management, governance, and regulatory oversight.

Just as I have noted some attributes and principles that should underlie a modern

housing GSE, I would like to also articulate some basic principles as you consider

GSE oversight going forward.

First of all, it would be disingenuous of me or anyone else to state that the Home

Loans Banks and other housing GSE’s are far bigger and more complex, and therefore should be held to different risk standards. Clearly, the bar has been raised

across the financial services industry in this regard.

While history proves that we have done a great job for a long time—not a single

credit loss against advances since the inception of the Bank System in 1932—I also

understand this is 2003, not 1932, and much more must be done. Your constituents

and ours are demanding the highest levels of accountability, and we must deliver

on that.

On the matter of consolidation of the GSE regulators: Whether or not Congress

determines that a single GSE regulator is the appropriate direction or not, all three

housing GSE’s must have strong regulatory oversight to ensure both safety and

soundness and mission achievement. There can be no debate on that point.

The fact is that the three housing GSE’s must manage many of the same risks,

and we share a common mission—to support homeownership by providing the funding and the tools the Nation’s housing lenders need to be successful. That means

it is time to straighten out the hodgepodge of inconsistent requirements and oversight of the housing GSE’s.

For example, why do two housing GSE’s have lower capital requirements than the

Home Loan Banks that demonstrably carry less credit risk? Why is there inconsistent mission oversight—with the Home Loan Banks delivering cash grants, while

the other housing GSE’s hit a different set of affordable housing goals?

What public policy goal is advanced when roadblocks are put in front of our Bank

System when we respond to our members’ stated desire to have greater competition

in the secondary mortgage market? And when, in fact, those roadblocks actually

hinder our ability to drive more funding to our member financial institutions and

their communities? I have heard it called ‘‘mission creep.’’ From my point of view,

it is more like ‘‘mission leap’’—it allows us to take more significant steps toward

fulfilling our mission, not walking away from it.

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While it is often frustrating to me that the Bank System’s mission and impact

is understood by so few, I think it is apparent that this Nation and your constituencies—our financial institutions and local communities—would struggle mightily if

we failed to do our job.

Today, as one of 12 presidents within the Federal Home Loan Bank System, I

stand committed to work with you to find better ways to serve the ever-changing

needs of the financial services industry and our communities.

I want to be clear that I believe the onus for strengthening our system lies not

only with Congress and regulators, but with the Home Loan Banks themselves. We

must further step up and accept the risks in our system and industry, and accept

that more intense public oversight is inevitable. We welcome that public oversight

because, if done smartly, it will strengthen our Bank System and, ultimately, the

economy of this country.

In closing, I would like to leave you with some principles that I believe should

inform your discussions and decisions in the months to come:

• Private capital is the most effective cushion to guard the public against the risks

inherent in our enterprises. As cooperatives, the Home Loan Banks are capitalized by their customers, who are risk-averse, and who monitor risk-taking in a

way that third-party shareholders cannot.

• Insist on competition among housing GSE’s rather than competition with the private financial services industry.

• Demand that more of the value created by the housing GSE’s be delivered to the

housing finance system and consumers rather than private investors.

• Demand consistent, strong and smart regulatory oversight for all housing GSE’s—

and recognize the critical differences between the Bank System and publicly traded housing GSE’s.

• Demand an intense focus on our mission, hold us accountable, and keep in mind

what America would look like if the Home Loan Banks did not exist.

Mr. Chairman, this concludes my written remarks. Thank you, again, for allowing

me the opportunity to speak with you today. I would be happy to answer any questions you or other Members of the Subcommittee may have.

—————

PREPARED STATEMENT OF MICHAEL MIDDLETON

VICE-CHAIRMAN, FEDERAL HOME LOAN BANK ATLANTA

CHAIRMAN AND CEO, COMMUNITY BANK OF TRI-COUNTY, WALDORF, MD

SEPTEMBER 9, 2003

Good afternoon Chairman Bennett, Senator Johnson, and Members of the Subcommittee. Thank you for the opportunity to appear before you today to discuss

something that is very important to my business and to my community—the Federal Home Loan Bank System. I am Michael Middleton, Chairman and CEO of

Community Bank of Tri-County, in Waldorf, Maryland. I serve as Maryland’s elected Director on the Federal Home Loan Bank of Atlanta’s Board of Directors and am

honored to serve as the Vice-Chairman of that Board. I am also a Member of the

Board of the Council of Federal Home Loan Banks.

I am pleased to testify today on behalf of the Atlanta Bank. I am Chairman and

CEO of a bank that is a member and long-time user of Federal Home Loan Bank

advances, as well as other products, particularly in the community investment area.

I believe this experience, together with my 5 years of service on the board of the

Federal Home Loan Bank of Atlanta, gives me a broad perspective on the Federal

Home Loan Bank System that I hope can provide helpful insight to the Subcommittee.

Community Bank of Tri-County has over $300 million in assets and is a true community bank serving southern Maryland. Our customer base draws from a broad

economic range and includes rural, agricultural, small business owners, and the

families employed by high tech companies that support three naval facilities. We try

to tailor our services and products to meet the needs of our communities while competing with large regional and national financial institutions.

At my bank, we take our Community Reinvestment Act responsibilities very seriously. Moderate to smaller-sized community banks are increasingly challenged in

meeting their CRA requirements. The FHLBank’s programs, explained in greater

detail below, provide us with the tools and skills to fulfill this statutory and community responsibility. The FHLBank System helps level the competitive playing field

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in many ways, enabling Community Bank to continue to be part of the economic

foundation of southern Maryland.

Background

As you may be aware, the 12 Federal Home Loan Banks are Government Sponsored Enterprises that were created and organized under the authority of the Federal Home Loan Bank Act of 1932. Congress created the Federal Home Loan Banks

to stabilize and improve the availability of funds to support homeownership. Although initially capitalized with Government funds, member banks, like mine, have

contributed all the Federal Home Loan Banks’ capital for over 50 years. The Federal

Home Loan Banks have provided over 70 years of innovation and service to the U.S.

housing market, and currently have over 8,000 member institutions.

The Federal Home Loan Banks and their members (federally insured savings associations, commercial banks, credit unions, and some insurance companies) are the

largest source of residential mortgage and community development credit in the

United States. Federal Home Loan Banks increase the lending power of local financial institutions. Thanks in large part to the work of Senators Hagel, Johnson, and

Bayh to include Federal Home Loan Bank modernization in the Gramm-Leach-Bliley Act, the Federal Home Loan Banks help community financial institutions provide critical small business, community development, rural and agricultural loans,

as well as residential mortgages. I believe it is important to note, Senators, that the

Federal Home Loan Bank System is the only institution in the United States that

fulfills this mission.

The Federal Home Loan Banks are very different from the other housing GSE’s.

They are unique in that they are cooperatives that are jointly and severally liable

for the consolidated debt issued through the Office of Finance as their agent. As cooperatives, only member institutions own the capital of each Federal Home Loan

Bank. There is no publicly traded stock and no established marketplace for the Federal Home Loan Banks’ capital. Further, there is no market pressure on the price

of the capital stock; it is always bought and sold at par. While the Federal Home

Loan Banks are not the only cooperatives, nor are they the only institutions that

operate with joint-and-several liability, no other housing GSE or private sector financial institution plays the same economic role or operates under the same overall

structure as the Federal Home Loan Banks.

It is the task of the Federal Home Loan Banks to maintain a balance between

their public policy mission and their obligation to provide adequate returns on the

capital supplied by their members. They do this by providing a stable, low-cost, and

reliable source of short- and long-term funding. For many Federal Home Loan Bank

members that are small- or medium-sized community banks, direct borrowing in the

capital markets is not a viable option. With the disintermediation of our deposits

to Wall Street during the 1990’s, a gap in funding during the last economic expansion proved the value of the FHLBanks in assisting us in meeting the credit needs

of our local market. By providing a necessary source of wholesale funding to help

members manage liquidity, loan demand, and interest rate risk, the Federal Home

Loan Banks enable us to remain independent and continue as an economic engine

in our community. Between 1994 and 1999, approximately 30 percent of all wholesale funding used by banks came from the Federal Home Loan Bank System.

As regional institutions, each Federal Home Loan Bank develops its programs in

response to the needs of its membership. For example, in response to member demand, the Federal Home Loan Bank of Atlanta provides its members a competitive

alternative to the traditional residential secondary mortgage market through two

acquired member asset (AMA) programs, Mortgage Partnership Finance,® and

Mortgage Purchase Program. These AMA programs provide medium- and smallersized institutions with another financial tool in delivering competitive credit products. Like the advance programs, the AMA programs help level the competitive

playing field.

Reflecting the Federal Home Loan Banks’ cooperative nature, the financial strategies of the Federal Home Loan Banks are designed to enable them to expand and

contract in response to their members’ credit needs.

Federal Home Loan Bank Programs—How They Meet Their Mission Locally

My bank relies on the Federal Home Loan Bank of Atlanta and its programs to

deliver financial services to our communities. Like much of the country, our area

needs more affordable housing. The price of housing continues to rise and demands

for land limit the availability of workforce housing throughout our local market. Our

major population centers are growing, resulting in greater need for improved medical, school, and volunteer fire/rescue support facilities. The Federal Home Loan

Banks are often an invisible, but vital, partner in fulfilling these needs. We use the

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FHLBank to provide the critical first layer of support upon which many layers of

private and public support are built to bring about new affordable housing and/or

community growth.

Community Bank has partnered with a number of nonprofit Community Development Corporations to support affordable housing and infrastructure development

projects through programs offered by the Federal Home Loan Bank of Atlanta.

These include the Affordable Housing Program (AHP) and the Economic Development and Growth Enhancement (EDGE) Program. By using AHP, EDGE, and other

similar programs, community banks like mine can make affordable housing and

community development projects economically feasible.

A good example of this is the Yardley Hills project in Calvert County, Maryland. That project utilized over $2.7 million in complex layered funding made available

by participation in the Federal Home Loan Bank of Atlanta’s Affordable Housing

Program. In another project, we used the EDGE loan program to provide the Jarboe

Family Head Start Center in St. Mary’s County, Maryland with permanent funding

when other traditional banking sources of large regional banks became unavailable.

Federal Home Loan Bank Community Investment Programs have allowed us to

partner with the USDA to provide single-family homeownership to very low-income

families with structured funding and first time homebuyer funds.

Finally, for one of our community’s volunteer fire/rescue needs, we obtained a $2,000,000 Economic Development Program advance to provide permanent financing

for a new firehouse located in a low-income community in La Plata, Maryland.

Senators, these projects and hundreds of others like them would not have been

economically feasible without the programs of the Federal Home Loan Bank. They

enable community banks to meet those credit needs that often would go unmet by

larger nonlocal banks. It is also important to point out that the Federal Home Loan

Banks provide the training and technical assistance that teach smaller institutions

to use these programs—training that would otherwise be too expensive for or unavailable to community banks.

The examples I have given with respect to my bank describe in part the distinctive role played by the Federal Home Loan Banks in housing finance. They make

loans, called advances, to their members on the security of mortgages and other eligible collateral. Federal Home Loan Bank advances directly support our housing

markets, including those focused on low- and moderate-income households, as well

as all aspects of community development critical to the creation of jobs.

Federal Home Loan Banks also help their members provide other needed forms

of community development credit. Since the passage of the Gramm-Leach-Bliley Act,

Federal Home Loan Banks may now allow ‘‘community financial institutions’’ to

pledge as collateral for advances small business, small farm, and small agribusiness

loans. Expanding the types of eligible collateral that smaller financial institutions

may pledge serves a number of purposes. Many smaller institutions, particularly in

rural areas, have faced funding needs but have not had sufficient residential mortgage collateral to secure FHLBank advances. Expanding the eligible forms of collateral for these institutions will help them meet these funding needs. With the help

of the Federal Home Loan Banks, small local financial institutions may now better

serve the community development credit needs of their areas.

As I indicated earlier in my testimony, the Federal Home Loan Banks also help

members meet their Community Reinvestment Act (CRA) responsibilities. They do

this through programs such as the Affordable Housing Program (AHP), the Community Investment Program (CIP), EDGE, and others. These programs give members

access to subsidized and other low-cost funding for affordable housing and community development projects that benefit low- and moderate-income neighborhoods.

By supporting their member institutions, the Federal Home Loan Banks also

strengthen their communities. Each Federal Home Loan Bank is required, by law,

to allocate 10 percent of its net income to affordable housing programs. The funds

provided under this program are grants and loans. Last year, the Federal Home

Loan Banks contributed $199 million to the AHP. Since the program’s beginning in

1990, the Federal Home Loan Banks have set aside approximately $1.7 billion in

AHP subsidies, helping to create 360,000 units for low-income families. The Federal

Home Loan Banks collectively are the largest source in the Nation of private funding for affordable housing.

The Federal Home Loan Banks also have established a number of other housing

and economic development initiatives for their members. These programs are funded

voluntarily by the Federal Home Loan Banks separate from AHP. The Federal

Home Loan Bank of Atlanta has established a predevelopment fund that offers recoverable grants to help finance predevelopment expenses associated with affordable

housing and economic development projects. The Atlanta Bank also offers a training

and technical assistance initiative for community development corporations serving

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the neighborhoods surrounding Historically Black Colleges and Universities, as well

as a subsidized loan program called EDGE, mentioned earlier in this testimony, to

finance targeted community economic development projects. In addition, FHLBank

Atlanta also offers both an at-cost advance program to help members finance loans

for economic development activity, and a fund to provide matching equity investments for members investing in New Market Tax Credits.

In addition to examples cited earlier involving my bank, EDGE loans have helped

finance a childcare center serving low-income families in Tuscaloosa, Alabama.

Training and technical assistance supported by the Federal Home Loan Bank of Atlanta in North Carolina enabled Elizabeth City State University, a Historically

Black University, to obtain financing through the Bank’s Affordable Housing Program for the rehabilitation of owner-occupied units damaged by Hurricane Floyd.

Other Federal Home Loan Banks have customized programs as well—programs like

assistance to potential minority-homebuyers; first-time low-income homebuyer programs; various predevelopment and affordable housing capacity initiatives; flood

relief assistance programs; and rural technical assistance programs to help communities address unmet affordable housing needs by establishing rural housing partnerships.

I strongly believe that the Federal Home Loan Bank System is able to provide

the important benefits it does because of its dynamic membership of large and small

institutions and its regional, decentralized, cooperative structure. And, I can say

unequivocally that without the Federal Home Loan Banks and the programs they

provide, it would be far more difficult for my bank, and the thousands of other community banks to remain independent, competitive, and capable of extending important housing and community development credit.

FHLBank and Director Responsibility

I have discussed the role of the Federal Home Loan Banks in meeting their mission of providing competitive funding to their member financial institutions to increase the availability of funds for residential and community development lending.

I have given you examples of why the Federal Home Loan Bank System is so vital

for community banks like mine. As I stated earlier, I am also an elected Member

of the Board of Directors of the Federal Home Loan Bank of Atlanta, and that role

imposes additional important responsibilities.

As a director, I know that the Federal Home Loan Banks have obligations in addition to the mission of being a creative funding source for the extension of residential

and community development credit. The Federal Home Loan Banks, although being

exempt from Federal, State, and local taxation, are required to make payments to

the Resolution Funding Corporation (REFCORP) and the Affordable Housing program (AHP). Those mandatory contributions are equivalent to a 26.5 percent effective income tax rate.

The Federal Home Loan Bank of Atlanta and its board of directors support the

Administration’s position that the housing GSE’s should provide complete and

transparent financial disclosures that constitute ‘‘best of class.’’ That is why we,

along with the other FHLBanks, have been working on these issues with all relevant parties to resolve the specific issues presented by the FHLBanks’ statutory

mission, cooperative structure, and joint and several liability.

As a director, I want the Atlanta Bank to meet the highest standards of disclosure. At the same time, as a director, I have an obligation to all the other member/

owners to be certain that such disclosures are not administered in a manner that

could impair the mission, operations, or increase the cost of funds of the Bank. If,

as a director, I agree to voluntarily register the Bank’s equity with the SEC, not

only do I assume additional personal civil and criminal liabilities under the relevant

statutes, but I also assume liability for my decision to voluntarily register. In conducting my fiduciary duty as a corporate director consistent with the Business Judgment Rule, I must believe that all critical issues have been satisfactorily resolved

and sustainable agreements reached before I, as a director representing the shareholders of the Bank, am permitted to agree to such action.

Just one example of the outstanding issues is how joint and several liability will

be handled. The Federal Home Loan Banks have always been jointly and severally

liable for each other’s debt. Under SEC registration, it is possible that each Federal

Home Loan Bank could have to create an additional on balance sheet liability reflecting the ‘‘fair value’’ of such liability for the combined debt of all the FHLBanks.

Critical accounting issues like this and others must be effectively resolved in a manner that all the Federal Home Loan Banks can rely on going forward without the

threat of quarter-to-quarter or year-to-year reconsideration upon each SEC filing.

Contrary to popular misconceptions, the Federal Home Loan Banks are privately

capitalized by their members and do not receive any taxpayer assistance to operate.

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The Federal Home Loan Bank System debt is not guaranteed by the Federal Government, and does not constitute an obligation of the United States. The Federal

Home Loan Banks have operated since 1932 to help bring needed credit to the members and communities they serve. And they have done so in a safe and sound manner. The Federal Home Loan Banks are required by statute to obtain sufficient collateral on advances to protect against losses, and to accept only certain collateral

on their advances. Consequently, no Federal Home Loan Bank has ever experienced

a credit loss on an advance. At the end of 2002, for example, the Federal Home Loan

Banks had rights to collateral, either loans or securities, on a member-by-member

basis, with an estimated fair market value in excess of outstanding advances.

The resources and services provided by the Federal Home Loan Banks to their

member institutions play a key role in the continued success of our Nation’s housing

market. They play a key role in serving the financial needs of our local communities. Without the Federal Home Loan Banks, it would be far more difficult for our

Nation to achieve these objectives.

Thank you for the opportunity to appear before you this afternoon. I would be

pleased to answer any questions that you may have.

—————

PREPARED STATEMENT OF SHEILA C. BAIR

DEAN’S PROFESSOR OF FINANCIAL REGULATORY POLICY

ISENBERG SCHOOL OF MANAGEMENT, UNIVERSITY OF MASSACHUSETTS

SEPTEMBER 9, 2003

Chairman Bennett, Senator Johnson, Members of the Subcommittee, it is a pleasure to appear before you today to assist you in your oversight of the Federal Home

Loan Bank System. A strong housing market is among the Nation’s top economic

priorities, and the Federal Home Loan Bank System is an indispensable component

of that market. When the Hoover Administration developed the blueprint for the

System in the throes of the Great Depression, it was based on the premise that this

cooperative was needed to assure a constant flow of funding when deposits proved

inadequate due to national or regional economic conditions. Seventy years later,

with over $500 billion in FHLB advances outstanding, the underlying premise for

the System remains valid. The Federal Home Loan Banks play a vital role in mortgage finance and deserve to be continued and strengthened.

Challenges Confronting the System

It is in the spirit of System supporter that I come to you this morning to raise

three issues that I believe warrant your attention: Multidistrict membership, expansion of the System’s mortgage acquisition programs, and lack of SEC registration

of FHLB securities. These issues are important because their resolution will help

determine the future of the system and its long-term stability. They were examined

in detail in a paper I recently completed that was funded by a grant to the School

of Management from the Fannie Mae Corporation, which I would like to submit for

the record. The conclusions reached in the paper are my own, and do not reflect the

views of the research sponsor. After discussing my paper, I will make some general

observations about the FHLB System’s regulatory structure in relation to efforts underway to improve safety and soundness regulation of Fannie Mae and Freddie Mac.

Multidistrict Membership

Recent industry consolidations have prompted some to call for allowing members

to belong to more than one district FHLBank. Throughout the System’s history, no

single institution has ever been a member of more than one district bank and the

System’s authorizing statute leaves little doubt that this is what Congress intended.

The Federal Housing Finance Board’s (FHFB) efforts to allow multidistrict membership by regulation have been highly controversial, supported by only 5 of the System’s 12 district banks. Four of the FHLBanks are strongly opposed, with the remaining three undecided and expressing serious reservations.

My primary objection to multidistrict membership is that Congress—not the

FHFB—should decide whether such a fundamental change should be made to the

System’s historic regional and cooperative structure. I am also concerned that multidistrict membership could have a destabilizing influence on the System. Multidistrict membership would allow large institutions to ‘‘shop’’ their advance activity

among multiple FHLBanks, but because all the FHLBanks raise funds in the same

way, their ability to compete based on price will be limited. As a consequence, they

will likely compete on collateral and credit standards. In addition to diminution of

credit quality, allowing one member to have multiple relationships with FHLBanks

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1 Congress placed specific limitations on Fannie Mae and Freddie Mac regarding capital, safety and soundness, and mission requirements. However, since Congress never authorized the

FHLB System to enter the secondary mortgage market, it did not specify the limitations that

should apply. 2 Inside the GSE’s (April 2, 2003), at p.6; 2002 FHLBank System Annual Report at p.22.

would increase operational risk since the System lacks safeguards to obviate the

multiple pledging of collateral or the prospect of competing blanket liens. Moreover,

allowing multiple memberships could increase large borrower activity in the System

as a whole, thus exacerbating large borrower concentrations. Nearly 24 percent of

all advance activity is already concentrated in the System’s 10 top borrowers.

Multidistrict membership would, by definition, help only institutions large enough

to take advantage of it, and fundamentally alter the basic concept of the System—

a cooperative of regional banks existing to serve the funding needs of institutions

headquartered in their districts. Moreover, given the seismic consolidation activity

that occurred in the 1980’s—which the System weathered quite well—it is difficult

to see why current consolidation activity should provide the impetus for such a dramatic restructuring. Under a holding company structure, separately chartered subsidiaries have been able to hold memberships in different banks—the same arrangement commercial banks have with the Federal Reserve Banks—which maintains

consistency with the Federal Home Loan Bank Act and the regional character of the

System.

The Mortgage Acquisition Programs

The second issue I examined—expansion of the System’s mortgage acquisition programs—also primarily benefits the System’s largest members. Begun in 1997 as a

small pilot capped at $750 million, these programs have grown exponentially. The

System now holds $90 billion worth of mortgages in portfolio, representing over 10

percent of its assets. One FHLBank now has half its assets invested in mortgages

and only one-third of its assets in advances, the business activity that Congress assigned it.

There is nothing in the System’s legislative history or authorizing statute that

grants authority for direct mortgage purchases, and the other two major housing

GSE’s, that is, Fannie Mae and Freddie Mac were established and chartered by

Congress expressly for that purpose. Congress, not the individual FHLBanks or the

FHFB, should decide whether it wants the System to be a major player in the secondary mortgage market, and if so, the terms and limitations that should apply.1

The risks associated with mortgage acquisition are distinctly different from those

associated with the System’s traditional role of making fully collateralized advances.

Advances have prepayment penalties and call features that allow the FHLBanks to

effectively manage their interest rate risks. Different, more complex tools are needed for the interest rate/prepayment risk presented by mortgages held in portfolio.

Operational risk is also significant—there is a serious question as to whether the

System has sufficient numbers of qualified staff or infrastructure needed to manage

even the day-to-day risk associated with secondary mortgage market participation.

The staffs of each FHLBank and the Office of Finance are relatively small, and they

are trained in the traditional business of advances, not mortgage acquisition and

portfolio management. Regarding credit risk, the mortgage acquisition programs’

proponents boast that the originators—not the FHLBanks—retain the credit risk.

In truth, the originators provide credit enhancements that are only as good as the

FHLBanks require them to be based on their own interpretation of historical default

data, which again, is outside their traditional mission and expertise. It is also telling that a recent FHFB proposed rulemaking—now withdrawn—would have eliminated one of these programs most important tools in managing credit risk—the

requirement that pools of purchased mortgage assets achieve an investment grade

rating from an independent ratings agency.

No adequate public policy basis has been advanced for the System’s foray into this

new, riskier line of business. Though promotional materials for the programs claim

that they are designed to help smaller institutions, available data suggests that they

are being run overwhelmingly for the benefit of large originators. According to trade

journal reports, the top five mortgage originators sold $42.7 billion in mortgages to

the FHLBanks in 2002.2 Assuming the accuracy of this report, these five institutions would account for almost all of the $45.7 billion dollars in FHLBank mortgage

acquisitions in 2002. If Congress wishes to authorize yet another GSE entry into

the secondary mortgage market, it should assure itself there is a valid public policy

basis to do so. Meeting legitimate market needs of smaller, community-based institutions might be one justification. Enriching large mortgage originators is not.

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SEC Registration

In my paper, I also concluded that voluntary SEC registration would be in the

best interests of the System and its debtholders. I will not belabor the arguments,

because Assistant Secretary Abernathy has already eloquently stated them in his

testimony. Suffice it to say, voluntary SEC registration would enhance the image

of the System and demonstrate that the FHLBanks are committed to a policy of full

disclosure.

Thoughts on Regulatory Structure

Questions about the capability of the System to manage new risks associated with

multidistrict membership and mortgage acquisition programs are heightened by

longstanding weaknesses in the FHFB examination process, identified by the Government Accounting Office (GAO) in 1998 and again in 2002. Though the FHFB has

taken a number of steps to address these weaknesses, including increasing the number of examiners and putting greater focus on major risks and the quality of controls

at FHLBanks, the GAO found in a report released last February that it is still too

soon to evaluate the effectiveness of these measures. As of February 2003, the

FHFB had only 14 examiners, with plans to increase the total number of examiners

to 24 by the end of 2004. According to its fiscal year 2003 budget, only $9.7 million

of its $27 million budget was allocated for the Office of Supervision. By way of comparison, Treasury’s two bank regulatory bureaus—the Office of the Comptroller of

the Currency (OCC) and the Office of Thrift Supervision (OTS) will typically assign

teams of 20–30 examiners to each of its largest institutions, and will spend 70–80

percent of their budgets in direct support of supervision.

More fundamentally, the structure of the FHFB suffers from many of the same

defects now being scrutinized at the Office of Federal Housing Enterprise Oversight.

It is a small, low-profile agency that simply cannot attract and retain the quality

of staff that it needs. It exists outside the financial regulatory mainstream, and thus

does not benefit from the, routine day-to-day interaction that occurs among the

major bank regulatory agencies. It is responsible for only 12 Banks, plus the Office

of Finance—a narrow constituent base that creates the perception of ‘‘captive regulator.’’ Other major financial regulators have a much broader regulatory base, and

their actions are generally reflective of the views and interests of diverse and competing constituencies. For instance, bank regulators are constantly mediating differences between large and small banks, those with different business lines, geographic concentrations, or customer bases. This in turn enhances the credibility and

quality of regulatory decisionmaking. When a regulator’s jurisdiction is confined to

a small group of closely aligned institutions, the pressure and input it receives can

become narrowly focused and one-sided. It becomes difficult for the regulator to stay

objective and ‘‘above the fray.’’

Should a new agency be created at the Treasury Department for oversight of

Fannie Mae and Freddie Mac, I believe it would be a stronger agency if it also included oversight of the FHLB System. The new regulator would have a bigger, better view of the housing finance market and would be in a better position to evaluate

the advantages—and dangers—of the major housing GSE’s competing directly with

each other in the same lines of business. From the standpoint of systemic risk and

taxpayer exposure, it is just as important to the Government for the FHLB System

to have quality safety and soundness oversight as it is for Fannie and Freddie. At

year-end 2002, the System had $668 billion in outstanding debt, compared to

Fannie’s $884 billion and Freddie’s $644 billion. It enjoys the same implied government guarantee, with an even more generous line of credit from the U.S. Treasury.

Though unlikely, a widespread failure in the System could have staggering ramifications for U.S. taxpayers and the housing market.

Some have argued that the FHLBanks would be overwhelmed by the other two

politically powerful GSE’s if their oversight were to be housed in the same agency.

I do not believe it. With their longstanding community bank ties, and extensive

grass roots, I have no doubt the FHLBanks can hold their own. I have also heard

it argued that the Treasury Department would be hostile to the System, which I

can say from first hand experience is not the case. On the contrary, I believe the

Treasury respects the role of the System in the housing finance market and would

not do anything to disrupt it.

The competitive impact on FHLB funding costs should also be weighed in the balance when considering whether to merge the FHFB into the new agency. The creation of a credible, high quality GSE regulator within the Treasury will likely

receive a positive reaction in the capital markets, which could reduce Fannie and

Freddie’s funding costs. If the FHLB System is left out, that could widen spreads

between FHLBank securities and those issued by the Enterprises. Wider spreads

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would in turn mean a higher cost of funds for the FHLBanks, which would adversely impact the price of advances and other FHLBank services.

Conclusion

Strong momentum is building for the creation of a credible, high quality regulator

within the Treasury Department to replace OFHEO. Now would be a propitious

time for the Congress to consider whether oversight of the FHLB System should

also be placed under this new regulator. To be sure there are important policy determinations that Congress needs to make regarding the FHLB System’s mission and

future, and it is important not to impede the momentum behind the transfer of

OFHEO’s safety and soundness functions. However, concurrent action could assure

quality regulation of all three major housing GSE’s, and prevent a widening of

spreads, which could further weaken the System.

Thank you Mr. Chairman. I will now be happy to answer any questions you may

have.

—————

PREPARED STATEMENT OF TERRY SMITH

PRESIDENT AND CEO, FEDERAL HOME LOAN BANK OF DALLAS

SEPTEMBER 9, 2003

Mr. Chairman, Ranking Member Johnson, and Members of the Subcommittee, I

appreciate the opportunity to speak to you today about the Federal Home Loan

Banks. My name is Terry Smith, and I am President and CEO of the Federal Home

Loan Bank of Dallas. I am also the current Chairman of the Bank Presidents Conference of the Federal Home Loan Banks (FHLBanks). Along with my colleagues,

I am pleased to provide an update on the FHLBanks’ activities and our progress

implementing the FHLBank provisions of the Gramm-Leach-Bliley Act (GLB Act).

Overview of the FHLBanks

The FHLBanks were created in 1932 to support America’s housing finance system. It was largely the FHLBanks’ ability to raise long-term debt in the capital

markets and pass that funding along to their member financial institutions that encouraged the development of the 30-year fixed-rate mortgage that is the predominant financing tool in the U.S. mortgage finance system today.

The FHLBanks continue to play a vital role in the Nation’s housing finance and

community lending system. Our member institutions, primarily community banks

and thrifts, use the FHLBanks’ advances program to meet the mortgage and community lending needs of their local markets, and use our Affordable Housing Programs to make housing more affordable for thousands of low-income families in

those communities. These are our primary purposes, and we are proud of our accomplishments in carrying them out.

The FHLBank System, as it is sometimes called, is comprised of 12 individual

FHLBanks, their 8,080 member institutions, and the Office of Finance which issues

debt on behalf of the FHLBanks. Each FHLBank is a separate and distinct corporate entity with its own stockholder/member institutions and its own board of directors. While the FHLBanks issue debt collectively and are jointly and severally

liable for the repayment of those debt obligations, there is no single controlling corporate entity with responsibility for or authority over the FHLBanks. The 12

FHLBanks operate independently under the authority granted by Congress through

the Federal Home Loan Bank Act (Bank Act), as amended, and in accordance with

the regulations established by and under the regulatory oversight of the Federal

Housing Finance Board (Finance Board).

The FHLBanks are cooperative institutions that operate within districts originally

established by the Federal Home Loan Bank Board, the predecessor to the Finance

Board. Each FHLBank’s capital stock is owned only by its member institutions, and

only a FHLBank’s members (plus certain nonmember housing associates such as

state housing authorities) may conduct business with an individual FHLBank.

FHLBank members must meet certain statutory eligibility criteria. Each member

must purchase the FHLBank’s capital stock in order to become a member, and must

maintain capital stock holdings sufficient to support its business activity with the

FHLBank, either in accordance with the statutory formula or, for FHLBanks that

have already implemented the capital plans required by the GLB Act, in accordance

with the individual FHLBank’s capital plan.

A FHLBank’s capital stock cannot be issued to or held individually by members

of a FHLBank’s board of directors, its management, its employees or the public, and

is not publicly traded. There is no market for FHLBank capital stock other than

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among FHLBank members. The price of a FHLBank’s capital stock cannot fluctuate,

and all FHLBank capital stock must be purchased, repurchased, or transferred only

at its par value. There are no stock options or other forms of stock-based compensation for FHLBank management, directors, or employees.

Prior to the passage of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989, the FHLBanks’ membership was generally limited to

thrift institutions (building and loan associations, savings and loan associations,

savings banks, homestead associations, etc.) and a handful of insurance companies.

FIRREA expanded eligibility for membership to include commercial banks and credit unions with a demonstrated commitment to housing finance. The GLB Act further

refined FHLBank membership rules by making federally chartered thrifts voluntary

members for the first time and eliminating the remaining statutory differences in

the terms of access between thrift institutions and commercial banks and credit

unions.

The combination of the FIRREA and GLB Act statutory changes, along with

changes in the mortgage lending market, have caused FHLBank membership to expand exponentially in the last decade. As of June 30, 2003, the 12 FHLBanks had

a total of 8,080 member institutions, which included 6,037 commercial banks, 1,273

thrift institutions, 693 credit unions, and 77 insurance companies.

As an indication of the role the FHLBanks play in today’s financial system, the

FHLBanks’ 7,310 commercial bank and thrift institution members represent approximately 79 percent of all FDIC-insured institutions in the country. Reflecting

the structure of the depository institutions industry, approximately 6,519 (or 89 percent) of those FDIC-insured members are Community Financial Institutions (CFI’s),

as defined by the GLB Act. (CFI’s are FDIC-insured institutions with average total

assets for the 3 years ended December 31, 2002 of $538 million or less.) Altogether,

approximately 7,493 member institutions (93 percent of all members) as of June 30,

2003 were community lenders with total assets less than $1.0 billion.

As noted previously, every member institution has made a voluntary decision to

belong to a FHLBank. Among other things, that means that the FHLBanks must

offer, and continue to provide, a membership value proposition that members perceive as adding value to their institutions. The value the FHLBanks provide our

members is a blend of the modest dividends we pay on members’ capital stock investment, the value of access to stand-by liquidity from the FHLBanks, availability

of short- and long-term funds at attractive rates, and access to other products that

make a community lending institution better able to profitably serve the credit

needs of its community.

The FHLBanks’ primary product offerings include traditional advances (fully secured loans to member institutions) and the more recently introduced Acquired

Member Asset (AMA) programs. Advances represent the core of the FHLBanks’

business, providing a source of funds members can use to support mortgage lending

and, for CFI’s, other community banking assets. The AMA programs, through which

the FHLBanks acquire mortgage loans originated by member institutions under

risk-sharing rules and other parameters established by Finance Board regulations,

provide a secondary market alternative for those loans. In addition, the FHLBanks

offer favorably priced advances for members’ special community lending activities

under their Community Investment Cash Advances (CICA) programs, and competitive grant programs that provide funds for housing for low-income families under

Affordable Housing Programs (AHP) established following FIRREA.

Implementation of Gramm-Leach-Bliley Legislative Changes

Since the enactment of the GLB Act in November 1999, a principal focus of the

FHLBanks has been the implementation of the FHLBank provisions contained in

Title VI of that Act. The modifications to the Bank Act made by the GLB Act represented the culmination of many years of effort to reform the FHLBanks, particularly the membership rules and capital structure. The main purposes of the

FHLBank provisions were to establish a system of universal voluntary membership,

provide for a more permanent capital structure to accommodate voluntary membership, equalize the terms of access to the FHLBanks for all types of institutions eligible for membership, and to expand the types of collateral that community banks can

pledge to secure advances. I am pleased to report that the FHLBanks are in the

last stages of implementing those changes and fulfilling that purpose.

Before FIRREA, the membership of the FHLBanks was comprised almost entirely

of thrifts that were required to be members by terms of their charter or deposit insurance. FIRREA authorized commercial banks to become voluntary members, but

most thrifts continued as mandatory members. In addition, the terms of access to

the FHLBanks for newly eligible institutions, including capital stock purchase requirements, differed from the requirements for thrift institutions. It quickly became

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evident that this disparate treatment was inconsistent with the cooperative structure of the FHLBanks and was not needed to ensure that thrift institution members

had adequate access to the FHLBanks. As a result, the FHLBanks and their members urged Congress to amend the Bank Act to provide for universal voluntary

membership and equal terms of access.

The System of total voluntary membership has been successfully implemented. All

members now have the same rights to access FHLBank products and services. In

particular, the higher capital stock purchase requirements for advances to commercial banks and credit unions based on their different asset mix have been eliminated, which has enabled community bank members better access to advances and,

in turn, to better serve the credit needs of their customers. And, although FHLBank

membership is now voluntary for all, only a handful of institutions whose business

model did not benefit from FHLBank membership have taken the opportunity to

withdraw from membership.

Community banks historically have had a somewhat different customer base than

thrift institutions, often spreading their lending activity among the various types of

loans needed in the community, such as mortgage, small business, and small farm

loans. In recognition of this fact and in order to allow the FHLBanks to better serve

their members’ needs, the GLB Act authorized the FHLBanks to make advances to

CFI’s secured by small business and small farm loan collateral. The FHLBanks have

successfully and responsibly implemented this new authority, acting prudently as

secured lenders to assign appropriate lending values to the new collateral and maintain their record of never having suffered a credit loss on an advance to a member.

As a result, the new collateral authority has enabled community bank members to

better serve their communities.

In order to implement universal voluntary membership, while at the same time

providing for capital with more permanence, the GLB Act outlined a new capital

structure for the FHLBanks. The major differences include authorization to issue

two classes of capital stock—Class A stock redeemable with 6 months notice and

Class B stock redeemable with 5 years notice—and implementation of new leverage,

risk-based and total capital requirements. This new framework adds permanence to

the FHLBanks’ capital structure by requiring them to maintain sufficient Class B

stock plus retained earnings to meet the new risk-based capital requirements.

The GLB Act created a series of statutory deadlines for adoption of new capital

regulations by the Finance Board and adoption and implementation of new capital

plans by the individual FHLBanks. All of the relevant deadlines have been met and

the FHLBanks are well on their way to implementing their new capital plans. In

fact, six FHLBanks have already implemented their new capital plans, I believe another FHLBank will implement its plan later this year, and the remaining five

FHLBanks will implement their plans by mid-2005. Each FHLBank has developed

its capital plan in consultation with its members and in accordance with the Finance Board’s regulations. The plans have been well received thus far, with only

a very few members exercising their right to withdraw from membership before implementation.

In general, the provisions of the GLB Act have been very positive for the

FHLBanks and their members. These changes have had, and will continue to have,

a positive impact on the Banks’ ongoing ability to fulfill their statutory role, and

to do so safely and soundly.

Federal Home Loan Banks Financial Profile

Reflecting the expansion of their membership base, the overall growth in the

banking industry, and increased usage of FHLBank advances and AMA programs,

the 12 FHLBanks have grown considerably in the last decade. As of June 30, 2003,

the FHLBanks had combined total assets of $809 billion. The FHLBanks’ balance

sheets were supported by nearly $38 billion of capital, of which more than $36 billion represented capital stock contributed by member institutions. The FHLBanks’

aggregate capital-to-assets ratio was 4.7 percent at June 30, with capital ratios for

individual FHLBanks ranging from 4.2 to 5.6 percent.

Of the FHLBanks’ total assets, $596 billion (74 percent) represented direct funding of member assets through advances and AMA. The FHLBanks’ aggregate

advances were $506 billion at June 30, representing 63 percent of their combined

balance sheets, and AMA were $90 billion, accounting for about 11 percent of the

FHLBanks’ aggregate assets. The remaining $209 billion (26 percent) of the

FHLBanks’ balance sheets were comprised primarily of various highly rated investments that the FHLBanks hold to maintain a ready supply of liquidity to satisfy

member demand for advances and AMA, and to supplement earnings to keep advances rates low and maintain adequate returns on members’ capital stock investment. Approximately $78 billion of the FHLBanks’ investments were in short-term

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instruments such as Federal funds sold or commercial paper used by the FHLBanks

to warehouse liquidity to meet members’ credit needs and the FHLBanks’ other dayto-day obligations.

The FHLBanks also maintain longer-term investment portfolios that provide a

source of standby liquidity and supplement earnings so the FHLBanks can provide

advances and other credit products at attractive rates. At June 30, 2003, the

FHLBanks’ longer-term investment portfolio represented about 16 percent of their

total assets and included $23 billion in securities issued by the U.S. Government

or U.S. agencies, approximately $6 billion of securities issued by state or local housing agencies to support their housing finance activities, and approximately $98 billion of mortgage-backed securities. The FHLBanks’ mortgage-backed securities have

been purchased in accordance with Finance Board guidelines not to exceed three

times an individual FHLBank’s total capital. These securities are all issued by the

U.S. Government or U.S. agencies, or rated triple-A when they are purchased by the

FHLBanks.

After weathering the storm of the thrift crisis of the late 1980’s and its aftermath,

the FHLBanks have been consistently profitable throughout the past decade. Although actual earnings and rates of return have fallen with the decline in interest

rates over the last 3 years, this reduction in earnings is a natural and expected result of the way the FHLBanks are structured and how they operate. Because the

FHLBanks are wholesale institutions investing primarily in fully secured advances,

high credit quality mortgage loans or highly rated investment securities, they operate on very narrow interest spreads between their cost of funds and the yields on

their assets. It is typical for a FHLBank to have a net interest spread (the difference

between the cost of its liabilities and the yield on its assets) of about 20 basis points

(0.20 percent). By way of comparison, a commercial bank might have an interest

spread closer to 400 basis points (4.0 percent). Given the FHLBanks’ small interest

spreads, a much greater proportion of the FHLBanks’ earnings are derived from the

investment of capital than is the case for commercial banks.

Before paying dividends to members, the FHLBanks’ earnings from these and

other sources must cover the FHLBanks’ operating expenses and assessments.

These assessments include the expenses of the Finance Board and the FHLBanks’

obligations to contribute 20 percent of their earnings toward the payment of interest

on REFCORP bonds issued in the early 1990’s to help finance the cost of resolving

the thrift institution crisis, and an additional 10 percent to fund their own regional

AHP.

As interest rates have fallen (particularly short-term interest rates such as the

Federal funds rate which is now at 1.0 percent), the return on a FHLBank’s investment of its capital has necessarily fallen as well. If a FHLBank could completely

insulate itself from interest rate risk by perfectly match funding all of its assets and

maintaining a constant interest spread as interest rates fall, it would expect its rate

of return on invested capital to fall about 75 basis points (0.75 percent) for every

100 basis point (1.0 percent) reduction in interest rates.

Because of this dynamic, the FHLBanks’ earnings and rates of return generally

rise and fall with the level of interest rates, and our dividend rates follow suit. In

the case of the Dallas Bank, we paid dividends at an average rate of 6.36 percent

in 2000 when the average Federal funds rate was about 6.25 percent, while we expect to pay dividends at an annual rate of 2.0 percent in the third quarter of this

year, with the Federal funds rate at 1.0 percent.

Our experience indicates that this result fits very well with our members’ investment expectations. Members do not invest in FHLBank capital stock with the expectation of earning equity investment returns. Rather, members’ investment in

FHLBank capital stock represents a very low-risk asset with explicit returns in the

form of dividend payments that fluctuate with market interest rates, and overall

benefits that include the value of access to FHLBank funding. The FHLBanks do

not attempt and are not expected to produce rates of return comparable to other

equity investments.

Corporate Governance of the FHLBanks: The Role of the Board

of Directors

Congress established a unique ownership and governance structure for the

FHLBanks, which has served the FHLBanks well in the past and continues to do

so. The most critical feature of this structure is that the FHLBanks are wholly

owned by their members/customers. In addition, the boards of directors of the

FHLBanks are truly independent of management. No member of management may

serve as a director of a FHLBank, and management is precluded by regulation from

recruiting directors or participating in the election of directors.

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The Bank Act provides that a majority of each FHLBank’s directors be elected by

its member institutions from among officers and directors of those institutions.

Members vote for directors representing member institutions from their States. The

FHLBanks’ members currently elect approximately 57 percent of the FHLBanks’ directors in this way, with the remaining directors being appointed by the Finance

Board.

Not only are members assured of the ability to elect the majority of their

FHLBank’s directors, but the Bank Act also provides that no member may cast a

number of votes greater than the average number of shares all the members in its

specific state are required to hold. This prevents large members holding relatively

large amounts of a FHLBank’s capital stock from dominating director elections and,

in practice, means that the majority of each FHLBank’s elected directors generally

represent the small institutions that make up the great majority of all members.

The statutory framework that controls the composition of the FHLBanks’ boards

of directors ensures that each FHLBank’s board of directors will have a balance of

interests represented. With no members of management on the board of directors,

directors are in a position to independently oversee management actions. The members that contribute capital and benefit from the FHLBank’s products and services

are assured a majority of the directors. The director election voting preferences for

small members ensure that larger members cannot dominate the board of directors

and that a FHLBank’s policies will not be detrimental to small members. Finally,

the large contingent of appointed directors ensures that the FHLBanks will appropriately consider their public policy obligations.

Finance Board regulations require that the FHLBanks’ boards of directors not

only fulfill the typical corporate director duties of care and loyalty, but that they

also carry out specific responsibilities. These duties include, but are not limited to,

the responsibility to select and oversee management, the responsibility to ensure the

establishment and maintenance of an adequate internal control system, the responsibility to adopt a risk management policy, a strategic business plan, and a member

products policy that details the Bank’s credit and pricing policies, and the responsibility to approve the FHLBank’s annual operating budget and quarterly dividends.

In carrying out their responsibilities, the boards of directors typically establish

and act through committees. Finance Board regulations require each FHLBank’s

board of directors to have an audit committee with very specific regulatory responsibilities, including direct oversight of the FHLBank’s internal and external audit

functions. The boards of directors also typically establish other committees to facilitate their oversight of management. Committees vary from FHLBank to FHLBank,

but typically include risk management, human resources, and housing oversight

functions. The various elements of the FHLBanks’ corporate governance structure

combine to provide boards of directors that are active, knowledgeable, and engaged,

and that are fully aware of their responsibilities and take them seriously.

Regulatory Oversight of the FHLBanks

The combination of this governance structure and the regulatory oversight provided by the Finance Board make the FHLBanks among the most intensively

audited entities in the country. As noted above, each FHLBank has its own independent internal auditor, who actively and regularly audits all FHLBank operations

and reports directly to the board of directors. In addition, each FHLBank’s financial

statements are reviewed by an outside accounting firm (currently

PricewaterhouseCoopers). Finally, the Finance Board’s ‘‘primary duty’’ under the

Bank Act is ‘‘to ensure that the Federal Home Loan Banks operate in a financially

safe and sound manner.’’

The Finance Board is not limited by funding constraints in carrying out its declared focus of ensuring the FHLBanks’ safety and soundness because its funding

is provided by assessments on the FHLBanks that are not subject to review or challenge by the FHLBanks. The Finance Board not only has regulatory authority over

the FHLBanks that extends beyond that which is typically afforded a safety and

soundness regulator—the GLB Act extended to the Finance Board the regulatory

enforcement powers of both the Federal banking regulatory agencies and the Office

of Federal Housing Enterprise Oversight (OFHEO) and—but also has wide-ranging

authority over many aspects of FHLBanks’ operations.

Finance Board regulations govern every facet of the FHLBanks’ operations, from

advances pricing to eligible collateral to risk management to capital plans to directors’ responsibilities to new business activities. The Finance Board also collects and

monitors financial and risk management data from the FHLBanks each month, performs ongoing reviews of all aspects of the FHLBanks’ operations and conducts annual on-site examinations of all 12 FHLBanks. While the FHLBanks do not always

enjoy being subjected to regulatory scrutiny, all believe that it is essential that the

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FHLBanks have a strong, independent regulator with the resources to ensure the

FHLBanks’ safety and soundness.

Risk Management of the FHLBanks

As 12 independent institutions, all the FHLBanks are responsible for their own

risk management activities. Each FHLBank has its own risk profile and approaches

management of its risks in a slightly different way. However, there are a number

of factors that are held in common across the FHLBanks that enable each FHLBank

individually, as well as the Consolidated Obligations (CO’s) issued by the 12

FHLBanks collectively in the capital markets, to be rated triple-A.

The cooperative structure of the FHLBanks eliminates many of the incentives a

publicly traded company might have to raise its risk profile, and in fact discourages

FHLBanks from taking excessive risk. Just as FHLBank members do not expect equity investment returns on their capital stock investment in a FHLBank, they also

do not expect equity investment risk in that investment. Members purchase

FHLBank capital stock in order to obtain access to FHLBank funding products, and

must maintain capital stock investments in the FHLBank as long as they maintain

advances outstanding. That is, members provide the capital that supports their

advances transactions with the FHLBanks. In that environment, members expect

stability, reliability, and consistency of returns and credit product pricing. These

member expectations are reflected in the oversight provided by each FHLBank’s

board of directors, a majority of which is comprised of directors representing and

elected by member institutions.

In large part due to the incentives created by the FHLBanks’ cooperative structure, risk aversion and conservative risk management practices are ingrained in the

corporate culture. That same conservative approach to risk management is also reflected in both the legal restrictions and the Finance Board’s regulatory regime. For

instance, the Bank Act and the Finance Board’s implementing regulations clearly

describe and mandate the various limitations on the types of collateral the

FHLBanks may accept to secure advances. Regulations limit the types, amounts,

and required credit ratings on both short and long term investments the FHLBanks

make with surplus funds. Finance Board regulations include separate additional restrictions on the aggregate amount, ratings, and characteristics of mortgage-backed

securities the FHLBanks may purchase and hold.

In addition, Finance Board regulations require that each FHLBank maintain a

Risk Management Policy, reviewed at least annually and readopted at least every

3 years by its board of directors, which identifies specific risk management practices

and limits for the individual FHLBank. These practices and limits are monitored

by the FHLBanks’ internal audit departments, which report their findings directly

to the FHLBanks’ boards of directors. The Finance Board also monitors FHLBank

compliance with these and other regulatory requirements through monthly call reports, constant off-site monitoring, and annual on-site examinations. The FHLBanks

are also subject to very conservative capital requirements imposed by statute in the

GLB Act and by Finance Board regulations implementing those statutory requirements. These requirements specify that FHLBanks must have total capital equal to

at least 4.0 percent of their total assets, and must have sufficient permanent capital

(as defined by the GLB Act) to meet a risk-based capital regime established by Finance Board regulation.

The FHLBanks minimize credit risk by ensuring that advances are fully secured,

that their investments are limited to issuers or securities that are highly rated at

the time the investments are made, and that their AMA have appropriate risk-sharing features. No FHLBank has ever suffered a credit loss on an advance to a member in the FHLBanks’ 71 year history. As of June 30, 98 percent of the FHLBanks’

investment securities have long-term ratings of triple-A or the corresponding highest short-term ratings. In addition, due in large part to the risk sharing structure

of the AMA programs, the FHLBanks’ loss experience on AMA assets has been very

favorable.

Since each FHLBank’s primary activity is to serve as a financial intermediary, the

FHLBanks are also subject to market (or interest rate) risk. To the extent the individual maturities of a FHLBank’s assets are not exactly matched by the individual

maturities of its liabilities, the FHLBank’s future earnings stream is subject to fluctuation due to changes in the relationship between yields on its assets and the cost

of its liabilities. Complicating the picture is the fact that the FHLBanks hold assets

(such as mortgage loans and securities) or have issued liabilities (such as callable

debt) that can be repaid prior to their stated maturities. Further complicating the

issue is the fact that the FHLBanks’ narrow interest spreads do not provide a large

margin of error.

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To manage these risks, each FHLBank uses sophisticated financial models to continually assess the magnitude of the risk to the FHLBank’s estimated market value

or earnings from various changes in interest rates. This information is reported to

the FHLBank’s board of directors on a regular basis and to the Finance Board as

often as monthly, and is summarized in the FHLBanks’ combined financial statements.

Reflecting the FHLBanks’ conservative approach to interest rate risk management, the 12 FHLBanks’ ‘‘duration gaps,’’ or (generally) the difference between the

estimated average maturity of a FHLBank’s assets and the estimated average maturity of its liabilities, ranged from negative 1.4 months to positive 1.6 months as of

June 30, 2003. A duration gap of 1.6 months generally means that the weighted average expected maturity of a FHLBank’s assets is 1.6 months longer than the

weighted average expected maturity of its liabilities.

The FHLBanks use interest rate derivatives extensively to maintain their conservative interest rate risk profile. While much has been written about the potential

risks that can be created by the improper use of derivatives, the manner in which

the FHLBanks use derivatives is a key component of their risk management activities. A couple of facts are germane to an understanding of the FHLBanks’ use of

derivatives.

First, Finance Board regulations prohibit the use of derivatives for speculative

purposes. That means that every derivative instrument entered into by a FHLBank

is designed to hedge (that is, reduce) an identified risk. Second, a majority of the

FHLBanks’ interest rate derivative transactions are structured to exactly offset another specific transaction. For instance, a FHLBank may use an interest rate swap

to convert the interest payments on a particular fixed rate advance to a floating

rate, so that the net payment stream will float in a manner that matches the debt

the FHLBank has issued to fund the advance. Similarly, much of the debt the

FHLBanks issue is long term, fixed rate, and often callable. The FHLBanks typically convert a large portion of this fixed rate debt to floating rates by executing

exactly offsetting interest rate swaps simultaneously with the issuance of the debt.

Approximately 82 percent of the FHLBanks’ outstanding derivatives as of June 30,

2003 represented these two types of transactions.

While the use of interest rate derivatives is critical to managing the FHLBanks’

interest rate risk, derivatives can cause problems if not managed appropriately. The

FHLBanks mitigate these risks in several ways. The appropriateness of the

FHLBanks’ derivatives activities for risk management purposes are validated internally by the use of internal valuation models, by internal audits that often employ

external experts to validate a FHLBank’s valuation model and hedging practices, by

external audits of the FHLBank’s derivative valuations, and through the Finance

Board’s annual on-site examination process.

The use of derivatives can also increase credit and operational risks that must

be managed carefully. For instance, derivatives pose credit risk created by the potential for default by derivative counterparties. The FHLBanks mitigate this risk by

engaging in derivatives transactions only with highly rated counterparties, and

maintaining bilateral collateral agreements with each counterparty that require

that the net fair value of derivatives positions be calculated periodically and collateral exchanged to the extent that the FHLBank is exposed to risk of default beyond

some small threshold.

It should be noted that the magnitude of the potential counterparty credit risk

of a derivatives portfolio has little to do with the aggregate notional amount of the

derivatives. The potential credit risk is represented by the net fair value of the portfolio of derivatives between a FHLBank and a particular counterparty. For instance,

the aggregate notional amount of the FHLBanks’ interest rate derivatives as of

June 30, 2003, was $694 billion. However, the net fair value of those derivatives

represented a fair value loss to the FHLBanks (not including offsetting fair value

gains on hedged instruments) of $16 billion.

Each FHLBank’s credit exposure created by its derivatives portfolio is determined

by netting the current fair value of the derivatives by counterparty, as provided in

the FHLBanks’ bilateral collateral agreements. After taking that step, the

FHLBanks’ total aggregate counterparty credit exposure was $2.2 billion before taking into consideration collateral held to offset that exposure. After taking collateral

into consideration, the FHLBanks’ aggregate net exposure was $435 million, about

one-third of the FHLBanks’ aggregate retained earnings. Of the FHLBanks’ aggregate net exposure, $125 million of the exposure was to triple-A rated counterparties,

$228 million to double-A rated counterparties, and $82 million to single-A rated

counterparties.

One of the primary operational risks related to derivatives is the risk of inaccurate accounting for those instruments, particularly since the implementation of

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Statement of Financial Accounting Standard 133, Accounting for Derivatives and

Certain Hedging Transactions (SFAS 133) in 2001. That statement requires generally that derivatives be carried on the balance sheet at fair value, prescribes the

appropriate income recognition for changes in fair value of derivatives, and specifies

criteria that must be met in order for hedged instruments to qualify for hedge accounting.

The FHLBanks have gone to great lengths to apply SFAS 133 appropriately and

ensure that all derivatives accounting complies with generally accepted accounting

practices (GAAP). Prior to implementation of the accounting standard, the

FHLBanks’ controllers formed an inter-FHLBank task force, which included representatives from the FHLBanks’ external audit firm, to catalogue the various types

of derivatives transactions on the books of the FHLBanks, identify the appropriate

accounting treatment for each, and develop an accounting guide used across the 12

FHLBanks to ensure consistency. This task force has remained in place since the

implementation of the standard to ensure ongoing accounting consistency and compliance with GAAP. In addition, the FHLBanks’ external audit firm reviews each

FHLBanks’ derivatives accounting as part of its quarterly reviews and annual audits of their financial statements.

FHLBank Financial Reporting and Disclosure

There has been much discussion recently about the appropriate forum for the

FHLBanks’ financial reporting and disclosure. We believe that it is most important

to focus carefully on the precise nature of the issue under consideration. All 12

FHLBanks are fundamentally committed to provide complete and state of the art

disclosure consistent with the unique characteristics of the FHLBanks as established by Congress.

Under the FHLBanks’ current financial reporting and disclosure regime, the

FHLBanks’ combined financial statements are required by Finance Board regulation

to comply with most Securities and Exchange Commission (SEC) reporting requirements, except those specifically excluded by the regulation. The individual

FHLBanks’ financial statements are required to be consistent in form and content

with the combined financial statements. Both the FHLBanks’ combined statements

and their individual financial statements comply with GAAP as certified by the

FHLBanks’ external auditor. In addition, all 12 FHLBanks are evaluating ways to

enhance their financial reporting and disclosure in accordance with evolving best

practices. As part of that consideration, for instance, it is my understanding that

all 12 FHLBanks are currently preparing to voluntarily comply with the requirement for attestation of internal controls as set forth in Section 404 of the SarbanesOxley Act, and evaluating the applicability of other aspects of that legislation.

The matter under discussion is not disclosure, but rather the request by the

Chairman of the Finance Board and others within the Administration that the

FHLBanks voluntarily register with the SEC. The FHLBanks take these requests

very seriously and have devoted a great deal of time and resources to considering

the appropriate application of SEC standards—designed for publicly traded companies—to cooperatives whose capital stock is not traded, has a fixed value and is only

held by member financial institutions. In order for our boards of directors to carry

out their legal fiduciary duty, they must carefully consider the potential effects of

voluntary registration on the FHLBanks, their members and the fulfillment of the

FHLBanks’ mission.

We are involved in ongoing discussions with SEC staff on how voluntary registration of the FHLBanks would be implemented. While some key threshold issues appear to have been resolved in a workable way, other important issues remain to be

resolved, as does the form of the agreement between the FHLBanks and the SEC

that would memorialize the resolution of those issues.

Conclusion

Over its long history, the Federal Home Loan Banks have played a vitally important role in supporting their member financial institutions’ ability to meet the housing finance and credit needs of their local communities. The FHLBanks remain

economically strong today and continue to serve a vital function for their financial

institution members and the communities they serve.

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PREPARED STATEMENT OF DAVID W. HEMINGWAY

DIRECTOR, FEDERAL HOME LOAN BANK OF SEATTLE

EXECUTIVE VICE PRESIDENT, ZIONS FIRST NATIONAL BANK

SEPTEMBER 9, 2003

Good afternoon Chairman Bennett, Ranking Member Johnson, and Members of

the Subcommittee. I am David Hemingway, Executive Vice President of Zions First

National Bank, based in Salt Lake City, Utah, and a Member of the Board of Directors of the Federal Home Loan Bank of Seattle.

I would like to thank Chairman Bennett and the Subcommittee for the opportunity to speak this morning on behalf of the Federal Home Loan Banks and

address the critically important issue of corporate governance and responsibility

within the Bank System.

As both a community banker for the better part of three decades, and an elected

member of the board of directors of the Federal Home Loan Bank of Seattle, the

issue—and practical application—of board governance is of paramount importance

to the financial institutions and communities we serve every day, and to me, personally. Simply put, I am accountable for the safety and soundness of the Seattle Bank.

While I am not alone in that role—I share it with 17 other directors and the management team of the company—I consider it my job to ensure that the financial

management of this $47 billion bank is effective over the long-term, including proper stewardship of our shareholders’ capital.

That is a staggering responsibility when you consider that the funding provided

within the Seattle Bank district fuels housing finance, affordable housing initiatives

and economic development in communities from Pago Pago to Walla Walla, Washington. Our nearly 400 member institutions rely on the Federal Home Loan Bank

of Seattle to be their partner in helping their communities and local economies not

only survive, but thrive.

Across the Federal Home Loan Bank System, we partner with nearly 8,000 community financial institutions in extending affordable credit to communities in every

region of the United States. The Federal Home Loan Banks hold nearly $800 billion

in assets, provide nearly a half trillion dollars in advances annually, issue about

$200 million in affordable housing grants yearly, and hold nearly $100 billion in

mortgage assets.

So when elected to serve as a director of the Federal Home Loan Bank of Seattle,

I understood the critical importance of my role and what I needed to bring to the

board—namely, my personal integrity and accountability, and my financial services

and community banking expertise.

Over the last several years, we have witnessed corporate failures of historic proportions—financial disasters brought on by a combination of inept business practices, poor leadership and financial oversight, and fraudulent and unethical behavior. We are all well aware that a quantum shift has occurred in how American corporations—large and small, privately held or publicly traded—will be run. Must be

run.

The term used most these days is ‘‘corporate governance.’’ It is now in our business vernacular; it makes headlines in The Wall Street Journal; it comes out of the

mouths of network anchors on a frequent basis. But I believe there is another way

to state it, and it goes something like this: Those who get to exercise the power

must be accountable to those who are affected by it.

We share with our regulator, the Federal Housing Finance Board, the Treasury,

and Congress the sense of urgency that is so pervasive today regarding the need

for increased accountability and responsibility. And we have worked hard over the

last several years to significantly strengthen the leadership and oversight of our

banks.

While we fully understand that corporate governance is a process; a discipline

that can—and must be—constantly improved, I am personally and professionally encouraged by the intensity of our efforts and the progress being made.

Over the course of the last year, the Seattle Bank board has created, adopted, and

publicly disclosed a set of Core Principles and Guidelines relating to board governance, realigned our board committee structure to more effectively oversee all facets

of the bank’s operations, upgraded our education and training program for directors,

and established a website that provides directors with faster access to a wider range

of information critical to their board roles.

Our Core Principles and Guidelines provide us with a corporate governance roadmap, if you will, keeping us focused on:

• Assuring that policies, risk assessments, internal controls and decisions are effective in managing risk and are administered fairly.

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• Operating in an independent and active manner.

• Setting the strategic direction of the bank and managing progress against goals.

• Determining if management is capable and if the business is being properly managed.

• Evaluating our own board effectiveness.

Our regulator, the Federal Housing Finance Board, is also diligent in overseeing

and supporting sound corporate governance practices across the Bank System. The

Finance Board just recently completed a horizontal review designed to assist the

Agency in directing and developing its supervisory and regulatory initiatives. The

comprehensive review provided all 12 banks with a valuable resource for identifying

practices that contribute to effective governance programs. The Finance Board interviewed management and board members, and reviewed a wide range of bank documents with respect to board policies, practices, and decisions.

I offer these comments to underscore the ongoing value of having boards and bank

management teams focused on enhancing corporate governance standards, and a

regulator performing its supervisory duty in a way that provides additional information and resources that further enhance the safety and soundness of the Bank System. As we all know, it is one thing to say your house is in order and quite another

to prove it. As a director—and a member and owner of the Seattle Bank—it is my

job to prove it.

Does your board audit committee provide effective oversight of the internal and

external audit functions? Is the audit function independent, reporting only to the

board, and is it supported appropriately by directors? Does the board ensure that

material risks are accurately and consistently assessed by management and reported to the board in compliance with regulation and prudent business practice?

Are all directors working responsibly in carrying out their duties? Are board and

management actively involved in strategic planning?

I am pleased to say the Seattle Bank has ‘‘yes’’ answers to these questions posed

by the Finance Board in its recent horizontal review. But that is today. Our job is

to ensure that we have ‘‘yes’’ answers tomorrow, the next day, and the day after

that. Which is a much tougher proposition. But that is our job.

We are fortunate within the Federal Home Loan Bank System when it comes to

corporate governance and responsibility. We were never starting from scratch. We

have had the advantage of enhancing practices and standards that have, for more

than 70 years, protected the Bank System against even a single member credit loss.

But I would emphasize again that we are fully aware that a new era has dawned

in American business—one that looks on corporate governance as an ongoing, rigorous discipline that demands, at all times, review and accountability.

As one of 216 directors of the Bank System cooperative, I wouldn’t have it any

other way.

Mr. Chairman, this concludes my written testimony. Thank you, again, for allowing me the opportunity to speak with you today. I would be happy to answer any

questions you or other Members of the Subcommittee may have.

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES

AND SENATOR CARPER FROM JOHN T. KORSMO

Q.1.a. I would just like to ask several questions regarding your examination and supervision of the Federal Home Loan Banks. What

has been your total budget for the last 5 years? Of that amount,

what percentage has been spent on safety and soundness supervision? Of the amount spent on safety and soundness, please specify what percentage is spent on: Examination personnel; Examiner

travel; Examiner training; and Systems support? For each of the

last 5 years, what has been the total number of examiners? What

is the average examiner’s pay? The range of examiner’s pay?

A.1.a. The following tables provide answers to the questions listed

above.

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80

81

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Q.1.b. For each examiner currently employed by the FHFB, specify

education level, years of examination experience, and whether or

not they are accredited.

A.1.b. The examination staff, including the Deputy Director of the

Office of Supervision, averages more than 17 years of professional

experience in banking, mortgage finance, and bank examinations.

All examiners are commissioned examiners or have a professional

accreditation, and many have both.

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Q.1.c. How many safety and soundness examinations have you conducted in the last 12 months? How many examiners were assigned

to each examination? How often do you conduct safety and soundness examinations of each bank? How many on-site examinations

did you conduct during the last 12 months? How often do you conduct on-site examinations of each bank? What was the length of

time spent on each on-site examination? How many examination

staff conducted each on-site examination?

A.1.c. The Finance Board has a statutory requirement to examine

each FHLBank at least annually as set forth in Section 1440 of the

Federal Home Loan Bank Act. Accordingly, the Finance Board conducts annual on-site examinations of each FHLBank and the Office

of Finance.

The Finance Board’s Office of Supervision has a comprehensive

program to supervise, monitor, and examine the FHLBanks. Each

FHLBank is assigned an examiner-in-charge who oversees the implementation of a supervisory strategy and monitors that

FHLBank on a regular basis. In addition to examination staff, accountants, financial analysts, and economists monitor trends that

have the potential to affect all FHLBanks. Further, an analyst designated for each FHLBank analyzes the FHLBank’s quarterly and

annual financial results and monitors developments at the

FHLBank. The Office of Supervision also has a risk modeling division that is charged with evaluating and validating the FHLBanks’

risk modeling results and assumptions. Finally, the Office of Supervision has a risk monitoring division that, among other duties, is

charged with monitoring the quality of data submitted by each of

the FHLBanks.

Finance Board supervision of the FHLBanks is predicated on the

principle that banking is a business of managing risks. Indeed,

FHLBanks must continually manage risks in selling debt, underwriting advances, evaluating collateral, acquiring mortgages and

mortgage backed securities, setting dividend and retained earnings

policies, managing liquidity positions, swapping cashflows, and

using derivatives to hedge market risks. Decisions in each of those

areas are made separately by each FHLBank pursuant to the

policy direction and risk limits established by the FHLBank’s

Board of Directors.

It has not always been this way. Until the passage of the

Gramm-Leach-Bliley Act (GLBA) in 1999, the Finance Board was

actively involved in a number of key operating decisions for the

FHLBanks—such as setting dividend payouts and preparing the

FHLBanks’ combined quarterly and annual financial statements.

Finance Board examinations were little more than checklists designed to assess the FHLBanks’ compliance with Finance Board

regulations.

Today, day-to-day operating decisions are properly the responsibility of the individual FHLBank, pursuant to the policy direction

established by its Board of Directors. Our examiners do not substitute their judgment, on individual business decisions, for the decisions made by the FHLBank’s management or board. However,

our examiners review the framework within which those decisions

are made. In particular, our examiners evaluate the risk management policies and controls established by the FHLBank’s Board of

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Directors and assess the adequacy and effectiveness of the

FHLBank’s policies and practices in identifying, measuring, monitoring, and controlling risks.

FHLBank examinations are typically conducted over an 8-week

period, with the on-site portion of the examination lasting 4 weeks.

During the period prior to the on-site portion of the examination,

Finance Board examiners spend several weeks conducting preliminary analyses and reviews of FHLBank records, and defining the

scope of the on-site portion of the examination. During the on-site

portion of an FHLBank examination, a team typically consisting of

6 to 10 staff members from the Finance Board travel to the

FHLBank to conduct the examination.

In the period following the on-site portion of the examination, Office of Supervision staff prepares and presents examination findings to the FHLBank’s Board of Directors. The FHLBank’s Board

of Directors is responsible for reporting back to the Finance Board

its actions taken in response to the findings in the examination report. Finance Board staff conduct quarterly follow up reviews to

monitor the progress of the FHLBank in addressing the findings of

the report of examination.

Over the past year, both the number of examination staff on-site

and the length of examinations have generally increased. Our efforts to hire well-qualified examiners are beginning to realize results, as measured by the number of examiners we are able to devote to each examination, and by the quality of the examinations.

Examination statistics over the year are as follows:

• The length of an FHLBank examination is typically 8 weeks, including 4 weeks on-site. As warranted, the on-site period is extended. In one 2003 examination, for example, the on-site portion

lasted 6 weeks. • During 2003, the number of staff on-site at the FHLBanks during an examination normally ranged from 6 to 10. The Office of

Supervision devotes more staff to an examination as conditions

warrant.

• During 2002, all 12 FHLBanks and the Office of Finance were

examined.

• During 2003, all 12 FHLBanks and the Office of Finance will be

examined. To date, 10 FHLBanks have been examined during

2003.

• During 2003, we installed a ‘‘resident examiner’’ (an examiner

operating full-time on-site) for 6 weeks prior to the scheduled examination for one FHLBank.

• During 2003, the Finance Board also conducted System-wide (or

‘‘horizontal’’) reviews of the effectiveness of board governance and

of the operations of the Affordable Housing Program (AHP) at

the 12 FHLBanks.

Q.1.d. Without revealing the names of individual institutions, how

many examinations identified ‘‘problem’’ areas? What were these

problem areas?

A.1.d. All FHLBank examinations in 2002 and 2003 identified matters that required the attention of the management and Board of

the FHLBank. Not all of these matters would necessarily be ‘‘problems.’’ There were instances, however, where the seriousness of the

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examination ‘‘findings’’ resulted in the Finance Board seeking specific action by an FHLBank’s Board of Directors.

There are eight ‘‘findings’’ categories defined in the endnotes of

each safety and soundness report of examination. They are identified in such a way as to convey the seriousness or nature of the

‘‘finding.’’

All examinations conducted in 2002 and 2003 identified matters

that resulted in ‘‘recommendations’’ from the Finance Board to the

FHLBank. ‘‘Recommendations’’ represent the mildest ‘‘findings’’ included in a report of examination. Most examinations also resulted

in ‘‘findings’’ that included ‘‘weaknesses,’’ ‘‘exceptions,’’ ‘‘resolved

violations,’’ and ‘‘violations.’’ In six FHLBanks, the examination

‘‘findings’’ or related supervisory activities resulted in the Finance

Board seeking specific corrective or preventative action by the

FHLBank’s Board of Directors. In those cases, the FHLBank was

required to address deficiencies in:

• Risk assessment and controls programs;

• Board and management oversight;

• Affordable Housing Program oversight;

• Risk modeling;

• Credit analysis;

• Strategic planning; or

• Documentation of hedging activities.

Q.1.e. Over the past 5 years, how many enforcement actions has

the FHFB taken against the FHLBanks? Please list each action.

A.1.e. Prior to the passage of the Gramm-Leach-Bliley Act in 1999

(GLBA), the Finance Board’s statutory enforcement authorities

were limited to suspension and removal powers over any director,

officer, employee, or agent of any FHLBank or joint office, for example, the Office of Finance. GLBA gave to the Finance Board enforcement powers similar, but not identical, to those of the banking

agencies. In particular, the Finance Board was granted statutory

cease and desist authority.

As is typical of any banking regulator/supervisor, the Board enforces regulations and the safe and sound conduct of its regulated

entities in three ways. In the majority of cases we detail statutory

or regulatory violations and operating deficiencies in an examination report or, if the violation or deficiency is noted through our offsite monitoring of the FHLBank, by formal notification to the

FHLBank. Our examination reports are sent to each board member

of the FHLBank, and presented in detail at a meeting of the full

board of directors shortly after the completion of the on-site examination. Where appropriate, we require the FHLBank to take remedial actions. We check the sufficiency of those actions by requiring

a response from the FHLBank and by following up during the onsite portion of the next examination of the FHLBank. In virtually

every case where such operating deficiencies or violations have

been cited, the FHLBank board and management have corrected

the deficiencies or violations in the normal course of business.

If an unsafe or unsound condition or practice that threatens the

safety of an FHLBank were to be noted, the Office of Supervision

would take a formal enforcement action to correct and/or reverse

the condition or practice. Over the past 5 years, there have been

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numerous occasions when our examiners or analysts have noted operating deficiencies at the FHLBanks. Less frequently, they have

noted situations where the FHLBanks have violated statutes or

regulations. There have not been occasions where our examiners

have cited violations or deficiencies that have risen to a level that

would threaten the safe and sound operation of an FHLBank. Consequently, no formal enforcement actions have needed to be taken

against any FHLBanks.

Between those situations where normal course-of-business operating deficiencies and/or violations have been cited, and where unsafe or unsound conditions or practices have been noted, we employ

‘‘preemptive’’ supervisory strategies. Specifically, we strongly encourage an FHLBank’s Board of Directors to exercise its fiduciary

responsibilities by taking action to assure the safe and sound operation of the FHLBank. Where we believe it necessary, we communicate to the board of directors our view that it needs to intercede

more actively. That exercise of responsibility and authority by an

FHLBank’s board normally takes the form of a board resolution

and follow-up action plan, together with regular reporting by management to the board or to an appropriate committee thereof. It is

also customary for us to receive, as part of our supervisory activities, copies of those resolutions and copies of status reports regarding progress. In addition, we offer comments on the sufficiency of

those actions plans and/or progress reports.

Over the past 5 years, and particularly over the past 12 months,

we have worked with the boards of directors of the FHLBanks to

improve their operations or to correct ongoing deficiencies. In most

cases, particularly in the past 12 months, our efforts have been

aimed at enlisting the boards of directors to improve the risk management practices of their institutions. A brief description of those

actions is provided below. In several cases, our actions took the

form of notifying an FHLBank’s board that the implementation of

its approved capital plan should not move forward until noted and

cited deficiencies had been corrected.

• In one case, the Board of Directors of an FHLBank postponed the

scheduled conversion to its new capital structure until the examination-cited deficiencies in the FHLBank’s planning and risk

management practices were addressed to our satisfaction.

• In response to our supervisory concerns, an FHLBank’s Board of

Directors postponed conversion to its new capital structure until

the FHLBank had enhanced its risk assessment and risk management practices.

• At our behest, an FHLBank postponed its capital conversion and

suspended dividends in light of operating losses and risk management deficiencies.

• Based on discussions with the Office of Supervision, the Board

of Directors of an FHLBank agreed to analyze and revise its retained earnings and dividend policies before declaring or paying

dividends.

• Based on examination-cited deficiencies in risk assessment and

risk management practices, two FHLBanks’ boards of directors

have limited growth and committed to maintaining their capital

positions until those deficiencies have been corrected. One of

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3 If a mortgage with a coupon rate that matches the current market rate sells for $100, then

a mortgage with a coupon rate above the current market rate will sell for more than $100, since

it offers higher cashflows. The amount in excess of $100 is the ‘‘premium’’ associated with that

mortgage.

those FHLBanks has also committed to suspend requests for new

business activities. • Based on examination-cited deficiencies in the administration of

its Affordable Housing Program, the Board of Directors of an

FHLBank contracted for an independent third-party review of its

program.

Again, these actions, while not specifically characterized as formal enforcement actions, are examples of recent instances where

the Finance Board has used its available supervisory tools to promote the safe and sound operation of the FHLBanks. As is normal

for any bank regulator, the actions taken by boards of directors as

a result of discussions with us are part of a supervisory effort

aimed at preventing, rather than reacting to, unsafe and unsound

conditions.

Q.2.a. The Pittsburgh FHLBank suffered a very bad second quarter. Based on its most-recent financial reports, its annualized return on assets is 0.02 percent. Its capital stands at $2.25 billion,

or 4.2 percent of assets, barely above the regulatory minimum. Its

second-quarter dividend was subsidized with $10 million from retained earnings. How do you explain the Pittsburgh FHLBank’s

poor performance?

A.2.a. After reporting net income of $15.3 million for the first quar- ter of the year, Pittsburgh’s net income fell to $2.4 million for the

second quarter. Three principal factors depressed the FHLBank of

Pittsburgh’s earnings in the second quarter.

First, low market rates adversely affected the Pittsburgh

FHLBank’s net income. To the extent that an FHLBank invests

member capital primarily in short- or intermediate-term instruments, the rate of return on these investments, and thus the return on its equity, will move in tandem with short-term interest

rates.

Second, as assets prepaid faster than debt was retired, compressed interest margins reduced net income. The Pittsburgh

FHLBank experienced higher than expected prepayment on mortgages and securities backed by mortgages in the second quarter.

The Pittsburgh FHLBank was using previously issued long-term

debt to support its operations. That debt, issued principally in 1994

and 2000, carries relatively high interest rates, ranging from approximately 4.0 to 6.3 percent, reflecting market rates at the time

of issuance. In the lower interest-rate environment during the second quarter, margins were compressed and earnings declined. Margins will continue to be squeezed until that debt is retired or asset

yields rise. The Pittsburgh FHLBank has reported that the higher

cost debt will begin to roll off in July 2004.

Third, during the second quarter, the recognition of substantial

premium amortization expenses associated with the prepayment of

mortgage loans significantly reduced the Pittsburgh FHLBank’s net

income.3

There are three components to mortgage premium amortization.

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4Statement of Financial Accounting Standards No. 91, Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (SFAS 91), governs

the accounting for mortgage premiums and discounts. 5 As employed by the FHLBanks, a floor is an interest-rate exchange agreement where the

FHLBank pays a fixed fee up front and the counterparty pays the FHLBank the difference between 3-month LIBOR and some specified interest rate if 3-month LIBOR falls below that specified rate. Thus, the FHLBank buying a floor expects the gains from the floor to offset premium

amortization when interest rates fall.

• When a loan is purchased at a premium (normally due to an interest rate on the loan that is above the current market level),

accounting rules require the holder to amortize the premium over

the loan’s expected life. This represents regular amortization of

the premium. • When a loan is prepaid, any unamortized premium associated

with that particular loan must be written off immediately because that that loan is no longer on the institution’s books and

the mortgage’s cashflow ceases. • The amortization of the premium associated with loans remaining in portfolio must be adjusted to reflect current prepayment

speeds. When interest rates fall and prepayment rates rise, amortization rates increase. This is normally referred to as ‘‘catchup’’ amortization.4

The Pittsburgh FHLBank currently limits its exposure to accelerated premium amortization by using interest-rate floors.5 The

Pittsburgh FHLBank has reported to the Finance Board that it is

reevaluating the most effective hedge vehicles available and is limiting growth in its net premium exposure.

Q.2.b. Why did FHFB supervisors allow the Bank to pay a subsidized dividend given its poor performance?

A.2.b. Prior to the passage of GLBA, the Finance Board approved

dividends paid by the FHLBanks. GLBA devolved the responsibility to set dividends to the FHLBank boards of directors. One

focus of the Finance Board’s supervision of the FHLBanks has been

to ensure that the FHLBanks’ boards of directors exercise this authority appropriately and in compliance with Finance Board regulations.

Finance Board regulations prohibit an FHLBank from paying a

dividend if it would result in the FHLBank failing to meet any of

its capital requirements (See 12 CFR § 931.4). The FHLBank of

Pittsburgh met all of its capital requirements after the payment of

the second-quarter dividend. However, we have communicated our

concerns to the Pittsburgh FHLBank about their paying a dividend

in excess of their quarterly net income.

In August 2003, the Office of Supervision issued Advisory Bulletin 03–08 instructing each FHLBank to adopt a retained earnings

policy that specifically assesses the adequacy of retained earnings

in light of alternative future financial and economic scenarios, and

prioritizes retained earnings over dividends. On October 8, 2003,

the Finance Board, during an open board meeting, took the position that an FHLBank should not use retained earnings to pay a

dividend to its members unless and until that FHLBank meets the

standards set in Advisory Bulletin 03–08.

We monitor dividends and retained earnings in our supervisory

program. The Finance Board has expressed to the FHLBanks its

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6The call report is the principal way an FHLBank reports financial information to the Finance Board. There are both monthly and quarterly reporting requirements. Balance sheet, investments, income statement, advances, leverage, derivatives, capital compliance, and credit

concentration information is required monthly.

concern about the relatively low levels of retained earnings at a

number of the FHLBanks. Advisory Bulletin 03–08, mentioned

above, requires:

• Each FHLBank to assess the adequacy of its retained earnings

in an analytically rigorous fashion using a variety of truly stressful scenarios;

• The Board of Directors of each FHLBank to review the analysis

of retained earnings of that FHLBank, and

• Each FHLBank to establish a formal retained earnings policy.

We will review those analyses and retained earnings policies during our 2004 examinations.

Q.2.c. What will happen if bank regulators mark down the Pittsburgh Bank stock?

A.2.c. A write-down of the Pittsburgh FHLBank’s capital would

occur only if the capital stock were impaired and this impairment

were viewed as other than temporary. The Pittsburgh FHLBank’s

stock is not impaired. Members can purchase and redeem stock in

the FHLBank of Pittsburgh at par.

Q.2.d. Please describe the supervisory steps you will take when an

FHLBank’s capital falls below required levels. At what point do you

take supervisory action? Do you wait until the minimum capital requirement is violated?

A.2.d. As a practical matter, because of their portfolio composition,

FHLBanks should not fall out of compliance with the minimum

capital requirements. An FHLBank that approaches its regulatory

capital minimum should be able to sell assets (or not roll over

short-term asset positions) to remain in capital compliance.

In addition, Finance Board regulations prohibit the payment of

any dividend by any FHLBank if the payment would result in that

FHLBank failing to meet any of its minimum capital requirements

(See 12 CFR § 931.4). Finance Board regulations also prohibit any

FHLBank from redeeming or repurchasing any capital stock if the

FHLBank would fail to meet any minimum capital requirement

after the redemption (See 12 CFR § 931.7(c)). Furthermore, an

FHLBank may not redeem or repurchase any capital stock without

the prior written approval of the Finance Board if the Finance

Board or the Board of Directors of the FHLBank has determined

that the FHLBank has incurred or is likely to incur losses that result in or are likely to result in charges against the capital stock

of the FHLBank (capital impairment) (See 12 CFR § 931.8(a)).

The Finance Board also has in place a comprehensive regulatory

structure to facilitate prompt supervisory action before any

FHLBank would violate the minimum capital requirements. First,

the FHLBanks must submit monthly, as well as more extensive

quarterly, call reports to the Finance Board.6 Second, the Finance

Board has designated an examiner-in-charge (EIC) for each

FHLBank. The EIC assignment is for a multiyear period to provide

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7Those appointed to EIC positions are senior bank examiners, all of whom had extensive experience at other financial institution regulatory agencies before joining the Finance Board.

continuity of supervision of each FHLBank.7 EIC’s have formal contact with their designated FHLBank no less frequently than quarterly, and more frequently if conditions warrant. Third, the Finance Board has designated 12 financial analysts, each to serve as

the principal analyst for one FHLBank. The analysts can alert the

EIC, senior management, or the Board of Directors of the Finance

Board about deteriorating trends at any FHLBank.

If, despite these regulatory and supervisory protections, an

FHLBank’s capital were to fall below required levels, the Finance

Board would take formal enforcement actions with provisions to address the capital deficiency.

Q.3.a. Looking at System financial statements for the second quarter of this year, several FHLBanks had losses attributable to ‘‘derivatives and hedging operations.’’ For example, Boston and Pittsburgh each had $14 million in losses, Atlanta had $72 million, and

Chicago and Topeka each had $23 million. Of these Banks, several

had reduced net income from the prior quarter—for example, Boston went from $22 million in the first quarter of 2003 to $19 million, Pittsburgh from $15 million to $3 million, and Topeka from

$17 million to $11 million. Atlanta had a slight dip and Chicago

had a slight increase in income. My understanding is that the average Return on Assets for the FHLBank System is generally around

1 percent, but for the last quarter it was only 0.2 percent, with one

Bank earning only 0.02 percent. Are derivative losses responsible

for the overall drop in earnings?

A.3.a. Net realized and unrealized losses on derivatives and hedging activities were approximately $138 million in the second quarter of 2003, $111 million higher than in the first quarter of 2003.

Because those losses flow through the income statement, they affect the level of reported net income. Those losses, therefore, contributed to the overall drop in reported FHLBank earnings in the

second quarter. However, two points warrant elaboration. First, the

drop in overall earnings to approximately 0.2 percent of assets was

not as steep as the question suggests. The return on average assets

for the FHLBanks ranged from 0.25 percent to 0.47 percent for the

1988–2002 period. It is not ‘‘generally around 1 percent.’’ Second,

in isolation, the realized and unrealized gain or loss on derivatives

and hedging activities offers an incomplete picture of an institution’s hedging activities.

When a financial institution reports a ‘‘loss’’ on derivatives and

hedging activities, the loss often arises because accounting rules

prohibit the recognition in income of simultaneous gains on the balance sheet items being hedged. For example, losses or gains on derivatives used to hedge the risks associated with held-to-maturity

securities flow through the income statement. Under generally accepted accounting practices (GAAP), however, fluctuations in the

value of the held-to-maturity assets being hedged with those derivatives are not recognized in income unless the fluctuation in

value is deemed to reflect ‘‘other than temporary’’ impairment. In

other words, an institution’s GAAP income may be affected by the

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asymmetry of accounting rules that require the marking to market

of the derivative, but not the held-to-maturity assets being hedged.

In the case of ‘‘securities held at fair value,’’ changes in their

market value appear on the income statement as an ‘‘unrecognized

gain or loss on securities held at fair value.’’ To the extent derivatives are used to hedge against changes in the market value of

securities held at fair value, the income-statement categories ‘‘unrealized gain or loss on securities held at fair value’’ and realized

or unrealized ‘‘gains or losses on derivatives and hedging activities’’

tend to move in opposite directions.

Consequently, a given change in interest rates will tend to generate gains on one set of instrument and losses on the other. To

gauge the overall effect, one must consider the net effect of the

change in value of the derivatives and of the securities held at fair

value. The following table provides that information for the

FHLBanks during the second quarter and the first half of 2003.

For the second quarter of 2003, the combined effect of gains/

losses on derivatives and the unrealized gain/loss on securities held

at fair value was to contribute $16 million to income before

REFCORP and AHP assessments of $613 million. For the first half

of 2003, the combined effect of gains/losses on derivatives and the

unrealized gain/loss on securities held at fair value was to decrease

income before REFCORP and AHP assessments by $31 million resulting in a total of $1.2 billion. In each case, the net effect was

less than 3 percent of income before assessments for REFCORP

and AHP.

Thus, in isolation, the gain or loss on derivatives and hedging activities offer an incomplete picture of the effectiveness of an institution’s hedging strategies. As bank supervisors, we are principally

concerned with whether an FHLBank has a well conceived, properly documented, and prudently implemented hedging program

that is designed to limit or reduce risk and that is subject to rigorous internal controls and oversight.

Q.3.b. How can we be sure that the Home Loan Banks are using

derivatives to hedge risk instead of to speculate?

A.3.b. At June 30, 2003, the FHLBanks had notional derivatives

of $693.8 billion. The total net exposure at fair value was $2.2 billion.

A focus of our supervisory policy, on-site examinations, and offsite monitoring is to review FHLBank derivatives activities for

compliance with our rule prohibiting their use for speculative purposes. The following factors mitigate against the speculative use of

derivatives by the FHLBanks.

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• Finance Board rules specifically require that all derivative transactions must either qualify as hedging instruments pursuant to

generally accepted accounting principles in the United States

(GAAP) or the FHLBank must demonstrate the nonspeculative

use (See 12 CFR § 956.6). • All derivative contracts with a single counterparty must be governed by a single master agreement to facilitate the netting of

obligations, such as International Swaps and Derivatives Association (ISDA) agreements. • Finance Board rules require that all derivative contracts be

marked to market and subsequent collateral adjustments occur

no less frequently than monthly. • The Finance Board receives information on the derivatives of the

FHLBanks through monthly and quarterly sections of the call report. • A critical element of the on-site examination of each FHLBank

is a review of the policies and procedures dealing with derivatives, as well as a review of the internal controls, documentation,

accounting, board of director oversight, and segregation of duties

dealing with derivatives transactions. • Each year as part of its annual audit, each FHLBank undergoes

a review of the accounting for its derivative instruments by the

FHLBank’s independent external auditor.

Appropriate risk limits at the individual FHLBanks are a critical

factor in controlling the use of derivatives for speculative purposes.

Some of these limits are regulatory, for example, limits on duration

of equity contained in the Finance Board’s Financial Management

Policy. Other limits are properly adopted and monitored by the

FHLBank itself, subject to asset-liability committee and board of

director approval. Duration of equity and value at risk, as well as

other measures, such as market-value sensitivity to a variety of

risk measures, are effective ways to assess the extent to which derivatives hedge risk exposure. The Finance Board regularly reviews

compliance with both regulatory and internal risk limits as part of

annual, on-site examinations.

The Finance Board examiners also assess whether the

FHLBanks have appropriate policies, procedures, and controls in

place regarding their use of derivatives at the instrument level.

Key elements of such policies, procedures, and controls include a

process for developing and approving hedging strategies and controls over implementation of those strategies. We expect those controls to include risk limits, identification of individuals within the

FHLBank approved to conduct a trade, requirements for documenting hedge transactions, including risk analytics showing the

specific risk exposure(s) reduced by the trade, and procedures to be

followed if ever risk limits are violated.

The aforementioned steps limit the likelihood of unauthorized

use of derivatives by any FHLBank. Nevertheless, a number of Finance Board initiatives should provide additional transparency and

enhance oversight of FHLBank derivative activity. For example,

the Finance Board has requested proposals for purposes of acquiring an Enterprise Risk Management system to enhance further our

supervision of the FHLBanks. This sophisticated computerized

asset-liability management software should enable the Finance

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8 ‘‘Aggregate unpaid loan principal’’ means the aggregate unpaid principal of a subscriber’s or

member’s home mortgage loans, home-purchase contracts and similar obligations. (See 12 CFR

§ 925.1).

Board to generate a ‘‘second opinion’’ of risk exposure calculations

generated by the FHLBanks, to compare risk exposures of the

FHLBanks using a common set of methodologies and assumptions,

and to measure additional risk exposures as the need arises. In the

coming months, the Finance Board also expects to issue further

guidance regarding market-risk management information that will

be reported to the Finance Board for supervisory and monitoring

purposes, providing additional information on the risk implications

of derivative investments in a whole-portfolio context.

Q.4. It is my understanding that the Chicago and Pittsburgh

FHLBanks impose a zero percent capital charge against mortgages

acquired under their mortgage acquisition programs. However,

they are required to maintain a minimum 4 percent total capital

against assets. Given the fact that the Chicago FHLBank holds

over $39 billion in mortgage assets, and only $25 billion in advances, can you please explain how the Chicago FHLBank is meeting its minimum capital requirements? Similarly, Pittsburgh holds

$9.8 billion, nearly 20 percent, of its assets in mortgages. How does

it meet its minimum capital requirements?

A.4. Prior to the passage of the Gramm-Leach-Bliley Act of 1999

(GLBA), member stock purchase requirements were uniform across

the FHLBanks. Each member had to purchase subscription stock

in its FHLBank that was at least as great as the larger of either

(1) $500; (2) 1 percent of the member’s aggregate unpaid loan principal; 8 or (3) 5 percent of the member’s aggregate amount of outstanding advances.

With the passage of GLBA and its requirement that the

FHLBanks convert to a risk-based, permanent capital structure,

the FHLBanks were granted authority, subject to Finance Board

approval, to develop their own stock purchase requirements for

their members. Irrespective of how stock purchases requirements

are defined, the FHLBanks are required to maintain a minimum

of 4 percent total capital against assets.

The Finance Board approved all of the FHLBanks’ new capital

plans in 2002. To date, 6 of the 12 FHLBanks have implemented

their revised capital plans (Seattle, Indianapolis, Pittsburgh, Cincinnati, Dallas, and Des Moines). The remaining 6 FHLBanks are

expected to implement their new capital plans by the end of 2005.

Under the new capital plans, the FHLBanks impose on their

members stock purchase requirements that are dependent on either the member’s size, for example, measured by total assets,

mortgage assets, or borrowing capacity, or on the level of business

activity that member has with the FHLBank. In fact, all

FHLBanks use member-based stock purchase requirements; all

also use activity-based requirements for at least one or more activities. In cases where the FHLBanks impose a zero percent stock

purchase requirement for a given activity, capital to support the assets acquired by the FHLBank because of that activity must come

either from the membership stock purchase requirement, or other

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9The Home Loan Bank Act allows members to voluntarily acquire ‘‘excess stock,’’ for example,

stock that is not required to be purchased by membership requirements or activity-based requirements.

outstanding stock, such as stock dividends or member voluntary

stock purchases.9

All capital stock held by members, regardless of how it is obtained, is subject to the same waiting period once it notifies the

FHLBank of its desire to redeem stock:

• 6 months after a member has given notice of its intention to redeem stock under the pre-GLBA capital plans, and for Class A

stock under the GLBA capital plans;

• 5 years after a member has given notice of its intention to redeem stock for Class B stock issued under the GLBA capital

plans.

Stock supporting a member activity may not be redeemed until

that activity has been completed. Further, no FHLBank may

redeem capital stock if doing so would result in that FHLBank’s

failure to meet minimum capital standards. Thus, it makes little

difference whether the FHLBank is using membership, activitybased, or voluntary stock to meet its capital requirement supporting its assets, since the degree of permanence is not related to

how the stock is acquired.

As the accompanying table indicates, the FHLBank of Chicago

had total capital stock of $3.3 billion as of December 31, 2002. Of

this amount, capital stock requirements assessed on the members

of the FHLBank accounted for 45.2 percent of total capital, while

voluntary stock holdings accounted for 49.1 percent. Retained earnings were 5.8 percent of the FHLBank’s total capital.

The table similarly illustrates how the FHLBank of Pittsburgh

capitalized its operations. As of December 31, 2002, total capital

stock was $1.9 billion. Of this, 91.1 percent came from stock requirements assessed on members, 5.4 percent came from voluntary

stock holdings, and 3.5 percent came from retained earnings.

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Q.5. As I understand it, one result of treating Shared Funding interests as ‘‘acquired member assets’’ under the AMA rule is that

such assets are not subject to the FHFB’s requirement that MBS

investments not exceed 300 percent of capital. Please indicate to

what extent the Chicago FHLBank’s investments in Shared Funding interests, combined with its other MBS investments, exceed

this [three times capital] cap?

A.5. The Chicago FHLBank has not exceeded the three times capital limit on MBS investments.

As of August 31, 2003, the FHLBank of Chicago had $4.2 billion

in mortgage-backed securities, $682 million in Shared Funding assets, and capital of $4.3 billion. As such, the total of mortgage

backed securities and Shared Funding assets was approximately

112 percent of capital.

As a general matter, the FHLBank of Chicago has not substantially increased its investment in mortgage-backed securities over

the last few years even though capital has increased substantially.

The quarterly average of mortgage-backed securities reached its

highest dollar amount in the fourth quarter of 2002 at $4.8 billion

when average capital was $3.3 billion. The ratio of mortgagebacked securities to capital, based on annual averages from 2000

to 2002, fell from 271 percent in 2000, to 206 percent in 2001 and

to 150 percent in 2002.

Q.6. Was the Finance Board aware of the problems in the manufactured housing portfolio at the New York Home Loan Bank before

Standard & Poor’s raised the alarm? Are you concerned about the

potential for similar problems at other Banks?

A.6. During his regular monitoring of the FHLBank of New York

in the first quarter of 2003, our examiner-in-charge (EIC) noted

that the FHLBank had a concentration of securities backed by

manufactured housing loans. The EIC, who, as an FDIC examiner

had examined a large originator of manufactured housing loans,

recognized the potential risk posed by the New York FHLBank’s

concentration of investment securities backed by manufactured

housing loans and home equity lines of credit. Because of that concern, the EIC alerted the FHLBank in March 2003 that this portfolio would be a specific area of review at the 2003 examination of

the FHLBank. In particular, the EIC notified the FHLBank that

we would be reviewing the assumptions of values, and potential for

credit losses in manufactured housing-backed securities.

Standard & Poor’s reduced the outlook for the FHLBank of New

York to negative from stable in August 2003, well after the EIC

had first alerted the FHLBank of his concerns.

While we are monitoring the investment portfolios of all of the

FHLBanks, we are not concerned about the potential for similar

problems with respect to manufactured housing securities at other

FHLBanks. According to our quarterly call report data, no other

FHLBank has any significant holdings of these securities.

Q.7. Earlier this year, Fannie Mae and Freddie Mac agreed to

provide MBS investors with additional information about their

mortgage backed securities, including such things as original loanto-value ratios, credit scores, property types, and others. What disVerDate 11-MAY-2000 18:52 Jun 03, 2005 Jkt 000000 PO 00000 Frm 00101 Fmt 6633 Sfmt 6601 21384.TXT SBANK4 PsN: SBANK4
98

closures are made to investors in the certificates issued under the

Shared Funding Program?

A.7. The three investors in the certificates of the initial shared

funding transaction are the FHLBanks of Des Moines, Pittsburgh,

and Chicago. Under Securities and Exchange Commission (SEC)

rules, they are qualified investors.

Under the Shared Funding Program, the underwriters of the securities provide the disclosures to investors in the certificates of the

mortgage-backed securities in a confidential Private Placement

Memorandum and a Private Placement Supplement (collectively,

the ‘‘Memorandum’’). These disclosures are governed by standards

for private placement securities as established by the SEC.

During an examination of an FHLBank, we reviewed that Memorandum, which the FHLBank had received as an investor in those

securities. The Memorandum includes detailed information on the

mortgage pool. For example, information is provided on credit score

distribution, loan-to-value ratios, geographic distribution of the

mortgaged properties, loan purposes, property types, and documentation types. In addition, information is provided on the risks

associated with investing in these securities, for example, risk of

loss. Without opining as to the legal sufficiency of the Memorandum, our examiners concluded that the Memorandum was comprehensive both as to the characteristics of the underlying assets

and the risks to an investor.

Q.8. Dow Jones reported last month that total Federal Home Loan

Bank operating expenses for the second quarter of 2003 were 17.5

percent higher than operating expenses for the same period last

year (‘‘FHLBanks Report Significant Boost in Operating Expenses,’’

August 15, 2003). Can you explain why operating expenses have increased so dramatically?

A.8. The increase in operating expenses from the second quarter of

2002 to the second quarter 2003 reflects the 13.3 percent growth

in System assets during this same period. Assuming that operating

expenses represent a constant proportion of assets, this growth

would account for more than three-quarters of the increase in operating expenses noted in the question above.

During this period, however, the FHLBanks also began to acquire significant holdings of mortgages under the Mortgage Purchase and Mortgage Partnership Finance® programs, with the

value of combined program assets increasing by 135 percent between the second quarter of 2002 and the second quarter of 2003.

This growth pushed the value of such assets to more than 11 percent of total System assets from 5.4 percent at the beginning of the

period. Because this represents a relatively new line of business for

FHLBanks and because the risks posed by this business are more

complex than those posed by the Banks’ traditional advance products, the Finance Board expects that FHLBank operating expenses

will increase at a faster rate than aggregate assets until the appropriate risk-management programs emerge.

A comparison between publicly available Fannie Mae and

Freddie Mac data underscores this expectation. While FHLBank

System annualized administrative operating expenses represent 5.7

basis points of combined assets, Fannie Mae (2002) and Freddie

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Mac (2001 is the most recent data available) reported administrative operating expenses of 13.7 basis points of assets. Furthermore,

both these institutions reported year-on-year growth in operating

expenses approaching 20 percent, a result of expenses related to

development of updated IT infrastructures and salaries.

Past levels of FHLBank funding for risk management have not

been sufficient to manage their increasingly complex balance

sheets. FHLBank operating expenses can be expected to increase at

a faster rate than aggregate assets until enhanced risk-management programs are in place. The Finance Board has been recommending that the FHLBanks bolster their investments in risk management infrastructures and their expenditures on resources to create and maintain these investments. To measure their success in

doing so, Finance Board examinations and off-site monitoring will

look closely at whether FHLBank outlays are sufficient for, and

sufficiently directed toward, the creation and maintenance of sound

risk-management infrastructures.

Q.9. Does the Finance Board collect information on the Home Loan

Banks’ affordable lending and community development activities?

Is that information considered in your review of the Banks’ compliance with their mission?

A.9. The Finance Board collects information on the Banks’ affordable lending and community development activities for four different mission-related activities of the FHLBanks:

• The Affordable Housing Program (AHP);

• The Community Investment Program (CIP);

• Community Investment Cash Advances (CICA); and

• Acquired Member Assets (AMA).

Congress established the AHP and CIP in 1989 as mission-specific programs to assist in the financing of affordable housing and

community development projects for targeted income levels. The

AHP provides funding solely for affordable housing for very low,

and low- and moderate-income households. The CIP is used for advances to members to fund both affordable housing for targeted

households and community development benefiting low- and moderate-income households. All 12 FHLBanks are required to provide

funding through them. CICA is a regulatory program, implemented

in 1999, for financing community development for which CIP is not

well-suited and is targeted according to household income, geographic areas, such as brownfields or small business eligibility.

FHLBank participation in CICA programs is voluntary. The AMA

program, as adopted by the Finance Board in July 2000, allows an

FHLBank to acquire eligible whole residential mortgage loans, or

interests in such loans, from its members. The Finance Board collects loan level data on all mortgages acquired by the FHLBanks

under the AMA program, including data on property location and

borrower characteristics.

These four programs—AHP, CIP, CICA and AMA—are important, but not exclusive, components of the FHLBanks’ overall activities and operations designed to meet their public policy mission.

The AHP, CIP, and CICA programs are targeted programs that

complement the FHLBanks significantly larger advances operations that support their financial institution members in meeting

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1General Accounting Office. 1998. Federal Housing Finance Board: Actions Needed to Improve

Regulatory Oversight. September. (GAO/GGD–98–203). 2General Accounting Office. 2003. Financial Regulation: Review of Selected Operations of the

Federal Housing Finance Board. February. (GAO–03–364).

the housing and community development needs of their service

areas.

The Finance Board uses the data collected for AHP, CIP, and

CICA to monitor and evaluate the activity levels of these programs

at individual FHLBanks and for the entire System; to assess the

FHLBanks’ compliance with the statutory and regulatory requirements of these programs; and to evaluate and develop policies affecting the operation of these programs. The Finance Board also

uses the AHP data specifically to ensure that all the FHLBanks

contribute the full amount of the required AHP contributions (ten

percent of net earnings each year) and that these amounts are distributed to eligible projects. The Finance Board also uses CICA

data to evaluate the distribution of community development funding among the various targeted purposes.

The Finance Board uses AMA data primarily for the assessment

of the safety and soundness of the FHLBanks mortgage portfolios

and to determine compliance with regulatory requirements.

Since 1990, the FHLBanks have made more than $1.8 billion

available for affordable housing through the AHP; $27.9 billion for

affordable housing through the CIP; and $4.5 billion for targeted

community development projects through the CIP and CICA.

During the past year, the Office of Supervision implemented a

horizontal review of all 12 FHLBanks’ Affordable Housing Programs. This review was comprised of a series of on-site interviews

with the FHLBanks’ community investment staff, senior managers,

and directors, along with an examination of the documents supporting the program. We are currently analyzing the results of this

review. Our analysis will result in a report to be presented to the

FHLBanks.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES

FROM SHELIA C. BAIR

Q.1. What is your assessment of the quality of the FHFB’s safety

and soundness supervisory program as compared to the major bank

regulatory agencies? As compared to OFHEO? What do you view

as the primary weaknesses in the FHFB’s safety and soundness

regulatory regime?

A.1. The FHFB does not publicly disclose as detailed information

about its safety and soundness supervisory program as do the

major bank regulators. Thus, comparisons are difficult to make. A

1998 Report by the GAO 1 identified several deficiencies in the

FHFB’s examination program which FHFB officials then attributed, at least in part, to a shortage of qualified examination staff.

At the time of that GAO report, the FHFB had only 10 examiners.

By late July 2002, the FHFB still had only 10 examiners.2 The current FHFB has placed greater emphasis on safety and soundness,

and according to recent public statements by Chairman John

Korsmo, the number of examiners has been increased to 17. The

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3Testimony of John Korsmo before the Subcommittee on Financial Institutions, Senate Banking Committee (September 9, 2003). 4 Ibid. pgs.10 and 28.

FHFB hopes to increase that number to 24 by the end of this calendar year and 30 by the end of the next fiscal year.3

The number of examiners employed by the FHFB—though on the

rise—still pales in comparison to the large, experienced examination staffs of the major bank regulatory agencies. For instance,

OCC will have 20 to 30 examiners assigned in residence to each of

its largest institutions, in addition to special teams that may visit

the institution as part of the annual examination process. Similarly, the FDIC and OTS—while not utilizing in-residence examiners—will assign teams of 20 to 30 examiners for extended periods

to review their larger institutions. For an institution the size of

Washington Mutual, for instance, the size of the team can go as

high as 50 examiners. OFHEO also has significantly more examiners, a total of 40, who conduct annual examinations and ongoing

monitoring of Fannie Mae and Freddie Mac.

The FHFB and OFHEO do not disclose detailed operating budgets. Thus, it is difficult to compare the amount of resources they

devote to their supervisory programs. OFHEO’s 2002 annual report

to Congress indicated that it spent just 16 percent of its budget on

examinations. However, because OFHEO conducts capital adequacy

reviews separately from the examination process, that number may

understate the resources it commits to supervision. An additional

13 percent of the Agency’s budget is reportedly devoted to capital

adequacy. According to the 2003 GAO report $9.7 million of FHFB’s $27

million budget was devoted to the Office of Supervision (OS),4 or

36 percent. However, that figure may overstate the amount actually spent on examinations because the OS is also responsible for

providing policy advice and analysis and reporting on general economic, housing, finance, community investment, and competitive

environments for the FHLBanks.

In contrast, the Office ofthe Comptroller of the Currency (OCC)

spends 85 percent of its budget on its supervision program, the

bulk of which goes to salary and benefits for its 1,882 examiners.

Similarly, the Office of Thrift Supervision (OTS) spends 77 percent

of its budget on its supervision program, mostly supporting its 526

safety and soundness exammers.

Both OFHEO and the FHFB lack formal training and accreditation programs for their examiners. In contrast, all the major bank

regulators have training and accreditation programs, and the overwhelming majority of their examiners are either accredited or in

training to become accredited.

It should be emphasized that the FHFB and OFHEO have a

number of experienced, knowledgeable examiners dedicated to conducting rigorous oversight of institutions under their authority.

However, the size and the depth of experience of these agencies’ examination staffs do not compare favorably to that of the bank regulators. Both agencies are no doubt impeded in their ability to attract highly qualified staff given their small size and narrow regulatory base, which in turn, limits the opportunities for promotion

and career advancement.

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Q.2. How would the FHFB’s recently withdrawn proposed AMA

rulemaking have affected safety and soundness oversight of the

FHLBanks? In your view, is the Chicago FHLBank’s Shared Funding Program consistent with the current AMA rule?

A.2. Chairman Korsmo’s stated intent behind the recently withdrawn AMA rulemaking was to ‘‘to clarify and simplify the current

rule, while improving oversight.’’ I have no doubt that the Chairman and FHFB members believed the proposed changes were consistent with safety and soundness. However, the impact of many of

the proposed changes would have been to ease important safety

and soundness restrictions currently in place over the FHLBanks

mortgage acquisition programs. The most dangerous of the proposals was to eliminate the requirement that acquired mortgage

assets receive an investment grade rating from an independent

agency such as Moody’s or Standard & Poor’s, instead allowing the

FHLBanks to use their own ‘‘estimated credit ratings.’’ Another

would have eased credit enhancement requirements, and diluted

restrictions on the types of collateral that a member must post to

secure its credit obligations under AMA. The proposed changes

would also have allowed FHLBanks to purchase ‘‘interests’’ in

whole loans, for example, securitizations, in contrast to the current

requirement that they must purchase whole loans. Finally, the proposed rulemaking would have opened the door to allowing System

members to act as conduits for participation in AMA by nonmember finance companies and mortgage bankers.

It does not appear that Chicago’s Shared Funding Program is

consistent with the current AMA rule, which, as mentioned above,

is restricted to purchases in ‘‘whole loans.’’ The FHFB staff quietly

approved the Shared Funding Program last December, with no

public discussion or input. Under the program, Mortgage Partnership Finance (MPF) loans are sold to a member of the Chicago

FHLBank, which issues its own ‘‘private label’’ securities backed by

these loans. Two tranches of securities are created, with the senior

tier being sold to the Chicago FHLBank or other FHLBanks, which

may in turn, sell some or all of the securities to System members.

The member securitizing the loans may sell the securities or ‘‘certificates’’ anywhere in the capital markets or hold them in portfolio.

Shared funding provides a vehicle for the Chicago FHLBank to circumvent charter limitations on its own issuance of MBS by

partnering with one of its member institutions.

As previously mentioned, the FHFB’ s current AMA rule authorizes the FHLBanks to purchase from members only ‘‘whole loans’’

based on the rationale that such purchases are the ‘‘functional

equivalent of an advance’’ to such members. However, Shared

Funding Certificates are clearly ‘‘interests’’ in whole loans. Presumably, one of the reasons the FHFB sought to extend the AMA to

‘‘interests’’ in whole loans was to reconcile the current inconsistency between the Shared Funding Program and FHFB regulatory

requirements.

The FHFB has also exempted Shared Funding Certificates from

the limit FHLBanks otherwise must observe for investing in mortgage-backed securities: Three times capital. The Treasury Department has previously expressed the view that MBS investments are

a way for the FHLBanks to generate arbitrage income, though they

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provide little public benefit. Similarly, MBS acquired through the

Shared Funding Program, while adding interest rate and credit

risk to the books of the FHLBanks, would appear to add no new

value.

These issues and others are discussed in more detail in a comment letter Greg Baer and I filed on the proposed AMA rulemaking, which is attached. Mr. Baer preceded me as the Assistant

Secretary for Financial Institutions in the Clinton Administration.

Q.3. The Pittsburgh FHLBank suffered a very bad second quarter.

Based on its most recent financial reports, its annualized return on

assets is .02 percent. Its capital stands at $2.25 billion, or 4.2 percent of assets, barely above the regulatory minimum. Its second

quarter dividend was subsidized with $10 million from retained

earnings. In your opinion, would a bank regulator allow a bank to

pay a dividend if the bank’s core operating results were so poor?

What types of supervisory action might be taken by a bank regulator when confronted with a bank in this type of financial condition? Based on your research, when will a bank regulator intervene

based on a bank’s deteriorating capital position? Does the regulator

wait until the minimum requirement is breached before taking supervisory steps?

A.3. Federally regulated banks and thrifts generally hold on average at least 50 percent more capital than the regulatory minimum.

If they fall below a sufficient capital level, or if there are other indicators of financial deterioration, Federal examiners will carefully

scrutinize their financial position, request a capital restoration

plan and direct corrective action if there are indications of further

financial deterioration. Federal bank regulators try to identify

early ‘‘red flags’’ of financial troubles and institute corrective action

long before there is a threat that minimum capital will be

breached.

Federal bank regulators look at several factors when determining

the appropriate supervisory action to take. In determining a bank’s

financial condition, they perform an in depth analysis of earnings

to assess their quality, level, and trends. They will seek to identify

the source and cause of earnings issues before making a determination of their severity and the degree of supervisory concern

warranted. In determining the adequacy of a bank’s capital, bank

regulators will evaluate the quality of the bank’s assets, interest

rate sensitivity, and risk management practices. Before a final determination concerning the bank’s capital level could be fully implemented, they would want to know the bank’s availability of

other capital sources and if there were any plans to use those

sources. They would also evaluate the possible adverse impacts of

the bank not paying a dividend before taking action to prohibit

such payment.

If the Pittsburgh FHLBank had been regulated by one of the

Federal bank regulators, I believe it very likely that bank examiners would have taken action to restrict or prohibit dividend payments, and most certainly would not have permitted a dividend

payment that had to be subsidized with retained earnings. (For example, Federal law 12 U.S.C. 56 and 60 restricts the payment of

dividends by national banks; other bank charter types are subject

104

to similar restrictions.) Rather, Federal bank examiners likely

would have acted to restrict asset growth, while protecting capital

to cushion against further losses, and taken action to address any

underlying unsafe and unsound practices that caused or contributed to the bank’s undercapitalized condition, including restricting

the bank’s ability to enter into new contracts or engaging in new

business lines. This would be particularly true if the earnings problems were associated with exponential growth in a new, higher-risk

activity and were expected to persist, which is the case in Pittsburgh. The Pittsburgh FHLBank grew MPF loans from about $2

billion at June 30, 2002 to over $9 billion at June 30, 2003 and is

predicting protracted constraints on earnings arising from losses

associated with prepayments on its mortgage portfolio. And of

course, the Pittsburgh Bank just announced that it is now estimating a third quarter GAAP net loss of $6.5 million.

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