Report to Congressional Committees

United States General Accounting Office

GAO

July 2001 FEDERAL HOME

LOAN BANK SYSTEM

Establishment of a

New Capital Structure

GAO-01-873
Page i GAO-01-873 Federal Home Loan Bank System Capital

Letter 1

Results in Brief 2

Background 4

A More Permanent Capital Structure Is Being Established for the

FHLBank System 6

Risk Management Policies and the New Capital Structure Can

Mitigate the Increased Risks Associated With Advances and

Mortgage Acquisitions 12

FHFB and OFHEO Approach Risk-Based Capital Regulations

Differently 31

Conclusions 38

Recommendations 39

Agency Comments 39

Appendix I Scope and Methodology 42

Appendix II Background Information on the FHLBank System,

Fannie Mae, Freddie Mac, and Their Regulators 44

Appendix III Financial Information on the FHLBank System,

Fannie Mae, and Freddie Mac 46

Appendix IV Summary of FHFB’s and OFHEO’s Risk-Based

Capital Requirements 49

Appendix V Comments From the Federal Housing Finance Board 59

Related GAO Products 61

Contents
Page ii GAO-01-873 Federal Home Loan Bank System Capital

Tables

Table 1: Regional Distribution of MPF Mortgage Loan Balances

Outstanding as of Dec. 31, 2000 19

Table 2: FHLBanks’ Consolidated Summary Balance Sheet as of

Dec. 31, 1996-2000 46

Table 3: FHLBank Advances and Total Assets as of Dec. 31, 2000 47

Table 4: Fannie Mae Selected Financial Highlights as of Dec. 31,

1996-2000 48

Table 5: Freddie Mac Selected Financial Highlights as of Dec. 31,

1996-2000 48

Figures

Figure 1: The Farm Credit System’s Experience 11

Figure 2: Double leveraging 28

Figure 3: Simplified Illustration of FHFB’s Approach to Risk

Modeling and Capital Calculation 32

Figure 4: Simplified Illustration of OFHEO’s Stress Test and Capital

Calculation 33

Figure 5: Interest-Rate Risk Stresses in OFHEO’s Risk-Based

Capital Regulation 57

Abbreviations

FCS Farm Credit System

FDIC Federal Deposit Insurance Corporation

FHFB Federal Housing Finance Board

FHLBank Federal Home Loan Bank

FIRREA Financial Institutions Reform, Recovery, and Enforcement

Act

GLBA Gramm-Leach-Bliley Act

GSE Government-Sponsored Enterprise

HUD Department of Housing and Urban Development

MBS Mortgage-Backed Securities

MPF Mortgage Partnership Finance

MPP Mortgage Partnership Program

OFHEO Office of Federal Housing Enterprise Oversight
Page 1 GAO-01-873 Federal Home Loan Bank System Capital

July 20, 2001

Congressional Committees:

This report responds to a mandate in the Consolidated Appropriations Act

of 2001 that we analyze the adequacy of the capital structure of the

Federal Home Loan Bank (FHLBank) System. The FHLBank System—

which consists of 12 regional FHLBanks and the System’s Office of

Finance—is cooperatively owned by member financial institutions.1

Currently, FHLBank capital lacks permanence compared to other firms’

capital because it is redeemable with only 6 months’ notice. As such, its

usefulness as a cushion in times of stress is questionable. The existence of

joint and several liability within the System also means that a FHLBank’s

capital must be available to protect the System if one or more FHLBanks

suffer losses severe enough to erode their capital.2

 In addition, in part

because the FHLBank System is a government-sponsored enterprise (GSE)

whose failure could lead to government intervention and potential losses

to the taxpayer, there are regulatory capital requirements imposed by the

Federal Housing Finance Board (FHFB) in the form of minimum leverage

and risk-based capital levels.3

 The Gramm-Leach-Bliley Act (GLBA) of 1999

mandated a new capital structure that would increase the permanence of

FHLBank capital and require that FHFB promulgate capital requirements

related to the risk of activities undertaken by FHLBanks. The FHLBanks

have not yet completed their plans to implement their new capital

structures, which limited the scope of our analysis.

As agreed with your offices, our objectives were to (1) describe the basic

characteristics of the capital structure being established for the

cooperative FHLBank System; (2) analyze how risk management policies

and the new capital structure address interest rate, credit, and operations

risks that are associated with advances and the direct acquisition of

mortgages; and (3) compare and contrast the risk-based capital standards

proposed by FHFB for the FHLBank System to the standards proposed by

 1

 For financial purposes, capital is generally defined as the long-term funding for a firm that

cushions it against unexpected losses.

2

 The imposition of joint and several liability means that each FHLBank is an obligor on the

consolidated debt obligations of the System.

3

 Generally, a leverage capital requirement is the minimum amount—usually expressed as a

percentage—of capital that must be held against total assets.

United States General Accounting Office

Washington, DC 20548
Page 2 GAO-01-873 Federal Home Loan Bank System Capital

the Office of Federal Housing Enterprise Oversight (OFHEO) for Fannie

Mae and Freddie Mac (the enterprises).

FHFB and OFHEO have proposed new capital standards that are related to

the risks of unexpected losses, but these standards have not been

implemented. To date, FHFB and OFHEO have enforced leverage capital

requirements that are based on asset, debt, and/or activity levels rather

than the risks of specific activities. The FHLBanks facilitate mortgage

financing primarily by making collateralized loans, called advances, to

their members. These loans are funded by issuing consolidated bonds,

which are the joint and several liability of the FHLBanks, through the

System’s Office of Finance. In contrast to the cooperatively owned

FHLBank System, the enterprises are private corporations with publicly

traded stock.

To complete our work, we reviewed FHFB and OFHEO capital standards;

analyzed FHLBank proposals for the use of expanded collateral provisions

and permissible uses of advances under GLBA; analyzed FHLBank

information on direct mortgage acquisition programs; and interviewed

financial institution regulatory body and GSE officials. We did not verify

the accuracy of data provided by FHFB and the FHLBanks. We obtained

and analyzed information the FHLBanks considered to be proprietary.

Therefore, we do not report specific details of the various FHLBank

products. In addition, although we made observations of some elements of

risk management that appear to be implemented at the FHLBanks, we did

not analyze risk management procedures employed by the FHLBanks,

FHFB’s oversight of risk management, nor the risks associated with

FHLBank investments. We also did not analyze the risks of activities that

have been or might be undertaken by either Fannie Mae or Freddie Mac.

We conducted our work in Washington, D.C., between February 2001 and

June 2001, in accordance with generally accepted government auditing

standards. Written comments on a draft of this report from FHFB appear

in appendix V. We also obtained technical comments from the FHLBanks,

enterprises, depository institution regulators, FHFB, and OFHEO that have

been incorporated where appropriate. A detailed description of our scope

and methodology is presented in appendix I. This report does not contain

any recommendations.

The FHLBank System is currently establishing a new capital structure that

will include new risk-based and leverage capital requirements and will also

make capital more permanent. Under this new structure, the FHLBank

members—generally depository institutions—will purchase new classes of

Results in Brief
Page 3 GAO-01-873 Federal Home Loan Bank System Capital

stock that will not be redeemable if a FHLBank fails to meet its minimum

capital requirements.4

 Greater permanence is especially important given

that the FHLBanks are jointly and severally liable for the System’s

outstanding debt securities. With such liability, all FHLBanks are at risk

due to the possibility that a FHLBank could become troubled and not be

able to meet its debt obligations. In addition, the troubled FHLBank would

have incentives to undertake risky activities because profits would accrue

to the FHLBank’s owners, whereas losses could fall on the other

FHLBanks. Thus, joint and several liability creates incentives for the

FHLBanks to monitor each other’s activities, which they do through a

number of System-wide bodies of representatives from the 12 FHLBanks.

The unique characteristics of FHLBank capital and the potential for risk

taking within the System heighten the importance of supervisory oversight

by FHFB.

The new capital structure has the potential to better address the increased

risks associated with advances and the direct acquisition of mortgages,

because it offers greater capital permanence, and includes both leverage

and risk-based capital requirements. However, it is too early to assess

capital adequacy, because the capital plans and risk management practices

to be implemented by the FHLBanks and capital supervision practices to

be followed by FHFB are not yet known. Additionally, the overall amount

of risk introduced into the system will depend on the type and amount of

advances and direct mortgage acquisitions undertaken by the FHLBanks.

Advances utilizing small business and agricultural loan collateral are

activities that are inherently more risky than traditional advances secured

by residential mortgage collateral.5

 While officials from the FHLBanks told

us they currently anticipate a low level of advances utilizing small business

and agricultural collateral, the overall risk in the System could increase if

these advances became an important part of the System’s assets.

Direct acquisition of mortgages also creates additional risks, especially if

these purchased mortgages are not regionally diversified and if member

institutions do not have incentives to limit risks in mortgage origination.

 4

 Historically, the FHLBank System had mandatory and voluntary member institutions.

Voluntary members could redeem stock with 6 months’ notice. GLBA made membership all

voluntary.

5

 GLBA authorized the FHLBanks to provide funds to any member community financial

institution for small business and agricultural loans with corresponding expansions in

eligible collateral. Community financial institutions are defined as FDIC-insured

institutions that have less than $500 million in total assets, adjusted for inflation.
Page 4 GAO-01-873 Federal Home Loan Bank System Capital

Based on activity to date, direct mortgage acquisition appears to provide

regional diversification and incentives to member institutions for sound

mortgage underwriting and servicing through the sharing of credit risks.6

However, this activity is relatively new and its level is expected to grow,

thereby increasing risks. In addition, risks could be affected if changes are

made in the risk-sharing agreements between the FHLBanks and their

member institutions. Increased activity in direct mortgage acquisitions by

FHLBanks could also increase competition with the enterprises in the

secondary mortgage market. Such increased competition could provide

benefits to borrowers, but it could also generate additional risks for the

FHLBanks, the enterprises, depository institutions, and taxpayers.

Both FHFB and OFHEO are implementing new risk-based capital

regulations. Both risk-based capital regulations are intended to help

ensure that the level of capital the FHLBanks and the enterprises maintain

is sufficient to cover the risks that these GSEs undertake. Both regulations

also address credit risk, interest rate risk, and operations risk. The

regulations differ substantially due to the different business activities of

the regulated entities, statutory requirements faced by each regulator, and

conceptual approaches. In addition, the FHLBanks’ leverage requirements

differ from those of the enterprises, which may affect the relative impacts

of the two proposed risk-based capital regulations.

The FHLBank System and the enterprises are GSEs. Congress created

GSEs to help make credit available to certain sectors of the economy, such

as housing and agriculture, in which the private market was perceived as

not effectively meeting credit needs. GSEs receive benefits from their

federal charters that help them fulfill their missions. The federal

government’s creation of and continued relationship with GSEs have

created the perception in the financial markets that the government would

not allow a GSE to default on its obligations, even though intervention is

not required. As a result, GSEs can borrow money in the capital markets at

lower interest rates than comparably creditworthy private corporations

 6

 The FHLBank of Chicago has accounted for a majority of the acquisition activity to date.

Background
Page 5 GAO-01-873 Federal Home Loan Bank System Capital

that do not enjoy federal sponsorship, and market discipline is reduced.7 In

fact, during the 1980s, the government did provide limited regulatory and

financial relief to Fannie Mae when it experienced significant financial

difficulties, and, in 1987, Congress authorized $4 billion to bail out the

Farm Credit System, another GSE. Additional background on the

FHLBank System, the enterprises, FHFB, OFHEO, and financial risks are

presented in appendix II.

Our mandate directs us to analyze interest rate, credit, and operations

risks. Interest rate risk is a component of what is commonly called market

risk. Market risk is the potential for financial losses due to the increase or

decrease in the value or price of an asset or liability resulting from broad

movements in prices, such as interest rates, commodity prices, stock

prices, or the relative value of foreign exchange. Credit risk is the potential

for financial loss because of the failure of a borrower or counterparty8

 to

perform on an obligation. Credit risk may arise from either an inability or

unwillingness to perform as required by a loan, a bond, an interest rate

swap,9

 or any other financial contract. Operations risk is the potential for

unexpected financial losses due to inadequate information systems,

operational problems, breaches in internal controls, or fraud. It is

associated with problems of accurately processing or settling transactions

and with breakdowns in controls and risk limits. Individual operating

problems are considered small-probability but potentially high-cost events

for well-run firms. Operations risk includes many risks that are not easily

quantified, but controlling these risks is crucial to a firm’s successful

operation.

 7

 The enterprises made six commitments in October 2000 regarding, among other things,

the issuance of subordinated debt, liquidity management, and public disclosure of financial

information. They stated that the commitments would improve transparency and market

discipline. While these commitments may be beneficial to the public, Congress, and

regulators, the perception of an implied guarantee will continue to reduce funding costs

and market discipline.

8

 In any financial transaction, each party is the counterparty to the other.

9

 FHLBanks and the enterprises enter into swap agreements. A swap agreement is an

agreement between counterparties to make periodic payments to each other for a specified

period. In a simple interest rate swap, one party makes payments based on a fixed interest

rate, while the counterparty makes payments based on a variable rate.
Page 6 GAO-01-873 Federal Home Loan Bank System Capital

The FHLBank System is establishing a new capital structure that will

include new risk-based and leverage capital requirements and will also

make capital more permanent. FHLBank capital will continue to differ

from capital issued by publicly traded corporations, however, because of

the cooperative nature of the FHLBank System. Additionally, each

FHLBank’s capital is potentially available throughout the System, because

the FHLBanks are jointly and severally liable for the System’s outstanding

debt securities. The unique characteristics of FHLBank capital and the

potential for risk taking within the System heighten the importance of

supervisory oversight by FHFB.

The new capital structure being implemented by the FHLBank System will

include risk-based and leverage capital standards. In January 2001, FHFB

published a final rule to comply with the provisions of GLBA that required

regulations prescribing uniform capital standards applicable for all

FHLBanks. These new capital standards, when fully implemented, will

replace the current “subscription” capital structure for the FHLBanks.

Under the current structure, the amount of capital that each FHLBank

issued was determined by a statutory formula that dictated how much

FHLBank stock each member had to purchase.10 A principal shortcoming

of the subscription capital structure was that the amount of capital each

FHLBank maintained bore little relation to the risks inherent in the

FHLBank’s assets and liabilities. Under the new structure, FHLBanks will

be required to maintain longer-term permanent capital and total capital in

amounts sufficient for the FHLBanks to comply with the minimum riskbased and leverage capital requirements established by GLBA.

We have consistently supported the concept of risk-based capital

standards applied in combination with a leverage ratio that requires a

minimum capital-to-asset ratio for the FHLBanks.11 A risk-based capital

standard has a number of benefits. First, it gives the government a

mechanism to influence risk-taking without involving itself in the

FHLBanks’ daily business. Second, it gives FHLBanks’ shareholders an

incentive to demand that management not take undue risks, since

 10 In accordance with that formula, each member was required to purchase FHLBank stock

in an amount equal to 1 percent of the member’s total mortgage assets or 5 percent of the

advances outstanding to the member, whichever was greater.

11 See Capital Structure of the Federal Home Loan Bank System (GAO/GGD-99-177R, Aug.

31, 1999).

A More Permanent

Capital Structure Is

Being Established for

the FHLBank System

The FHLBank System’s

New Capital Structure Will

Include Risk-based and

Leverage Capital

Standards
Page 7 GAO-01-873 Federal Home Loan Bank System Capital

increased risk taking would impose additional costs resulting from raising

additional capital. Third, it provides a buffer that should be adequate to

absorb unforeseen losses to FHLBanks and thus helps prevent or reduce

potential taxpayer losses.

The new capital structure the FHLBank System is implementing will also

result in more permanent capital. After the enactment of GLBA in 1999,

membership in the FHLBank System became all voluntary. Voluntary

members can generally redeem stock with 6 months’ notice.12 Capital

redeemable on such short notice does not provide a cushion against

unexpected losses. Therefore, the change to all voluntary members

increased the need for more permanent capital that could not necessarily

be redeemed with 6 months notice, and GLBA required implementation of

a more permanent capital structure.

Under the new capital structure, the FHLBanks are permitted to issue

Class A stock, which can be redeemed with 6 months’ notice, and Class B

stock, which can be redeemed with 5 years’ notice, or both. To help ensure

that capital does not dissipate due to redemption in time of stress, GLBA

does not allow a FHLBank to redeem or repurchase capital if following the

redemption the FHLBank would fail to satisfy any minimum capital

requirement. Based on discussions with FHFB officials and their review of

draft capital plans, it appears that a majority of FHLBanks might initially

implement an exclusive Class B stock structure, while other FHLBanks

might implement a mixed structure. The presence of 5-year capital,

combined with the requirement that member institutions lose benefits of

membership in the System if they withdraw capital, acts to create a

financial interest that mirrors some, though certainly not all,

characteristics of publicly traded perpetual equity stock.

 12 If impairment of the FHLBank’s capital were likely, FHFB could withhold a portion of a

withdrawing member’s capital stock. In previous reports, we raised the possibility that if

pending losses threatened the value of a FHLBank’s stock, the FHLBank’s voluntary

members may try to withdraw their stock before the losses impair its value. We also

concluded that, as a practical matter, the degree to which FHFB’s authority makes

FHLBank stock a buffer for absorbing losses depends on the extent to which FHFB

exercises its authority to withhold stock redemption. We stated that for FHFB to use this

authority in a way that makes capital stock a meaningful buffer, FHFB would have to

recognize potential future losses in a timely manner and be willing to withhold proceeds

from stock redemption requests. We have also consistently supported a more permanent

capital structure for the FHLBank System.

FHLBank System Capital

Will Become More

Permanent
Page 8 GAO-01-873 Federal Home Loan Bank System Capital

Permanent capital is defined in GLBA as amounts paid in for Class B stock

plus the retained earnings. Class A stock plus permanent capital is to be at

least 4 percent of assets. Class A stock plus 1.5 times permanent capital is

to be at least 5 percent of assets. Therefore, a FHLBank meeting the 4

percent requirement will also meet the 5 percent requirement if its

permanent capital equals at least 2 percent of assets. In addition, only

permanent capital is included in the capital definition for the risk-based

capital component of the minimum capital standards.

Although the new capital structure will result in more permanent capital,

FHLBank capital will continue to differ from the capital issued by publicly

traded corporations such as the enterprises or banks. The voluntary,

cooperative nature of the FHLBank System means that capital in this

system has characteristics different from capital issued by publicly traded

corporations.

First, the FHLBank stock will not be perpetual equity stock like that issued

by publicly traded corporations. Stock issued by publicly traded

corporations can be bought and sold freely and publicly at a marketdetermined price. In contrast, a FHLBank member institution can redeem

FHLBank stock at par value13 as long as all restrictions are met. For

example, a member can withdraw capital with prior notice (i.e., of 6

months or 5 years) if after redemption the FHLBank satisfies all minimum

capital requirements. However, FHLBank member institutions lose

benefits of membership in the System if they withdraw minimum capital

required for membership.14 This lessens incentives to remove capital, if, for

example, FHLBank earnings declined.

Second, investors cannot be obligated to buy the stock of publicly traded

corporations. However, FHLBank members can be required to buy

additional FHLBank stock to ensure that the FHLBank meets its capital

requirements. Third, corporations with publicly traded stock have

responsibilities to maximize the value of their stock. In contrast,

FHLBanks have incentives to provide the best mix of services and

dividend payments to their member-owners.

 13 With respect to FHLBanks, par value is the price at which the member acquired the

stock.

14 If an institution withdraws from the system, it cannot rejoin for 5 years.

FHLBank Capital Will

Continue to Differ From

Capital Issued by Publicly

Traded Corporations
Page 9 GAO-01-873 Federal Home Loan Bank System Capital

Under the new capital structure, the capital of each FHLBank will

continue to be available to other FHLBanks in the System because the

FHLBanks are jointly and severally liable for the System’s outstanding

debt securities, called consolidated obligations. Joint and several liability

for the payment of consolidated obligations gives investors confidence

that System debt will be paid. Another related characteristic of joint and

several liability is that it potentially creates a large pool of capital from all

FHLBanks to provide a cushion in the event of unexpected System losses.

However, joint and several liability also puts all FHLBanks at risk because

of the possibility that one FHLBank could become troubled and not be

able to meet its debt obligations. In such a situation, the troubled

FHLBank would have incentives to undertake risky activities because

profits would accrue to the FHLBank’s owners, whereas losses and

erosion of capital could fall on others. This scenario creates incentives for

the FHLBanks to monitor each other’s activities, which FHLBank officials

told us they do through a number of System-wide bodies of

representatives from the 12 FHLBanks.

In theory, joint and several liability appears to make most System capital

available in the event of large, unexpected losses in the System. However,

concerns about how joint and several liability would operate in the event

of a default or delinquency on a consolidated obligation prompted FHFB

to issue regulations in 1999.15 The regulations establish a process by which

FHFB will look first to the assets of a FHLBank that received the proceeds

of the consolidated obligation. The regulations also contain certification

and reporting requirements with which the FHLBanks must comply. For

example, the FHLBanks must certify before the end of the each calendar

quarter that they will remain in compliance with the liquidity requirements

and will remain capable of making full and timely payments on their

consolidated obligations. A FHLBank that is unable to provide the required

certification must provide additional notifications to FHFB, such as a

payment plan specifying the measures the FHLBank will take to make full

and timely payments of all its obligations. The regulations also specify that

FHFB may order any FHLBank to make principal and interest payments

 15 The concerns arose out of the municipal bankruptcy and the resulting receivership of the

County of Orange, California, and the ensuing litigation brought by the receiver for Orange

County against the FHLBanks. The litigation raised issues concerning liability allocation

arising from issuing and servicing consolidated obligations. In addition, the new activities

undertaken by the FHLBanks since GLBA prompted at least one FHLBank to suggest that it

would be beneficial to clarify how the joint and several responsibility for the consolidated

obligations would be allocated if a FHLBank were to experience a payment problem.

Each FHLBank’s Capital Is

Potentially Available

Throughout the FHLBank

System
Page 10 GAO-01-873 Federal Home Loan Bank System Capital

due on any consolidated obligation in the System. In this case, each

contributing FHLBank is entitled to reimbursement from the FHLBank

that was responsible for making the payment. Liability is to be allocated

among the other FHLBanks on a pro rata basis in proportion to each

FHLBank’s participation in all consolidated obligations.

Joint and several liability provides incentives for the FHLBanks to monitor

each other and appears to make most System capital available in the event

of large, unexpected losses in the System. However, joint and several

liability in a cooperative system has never been tested. The FHLBanks

have never defaulted on principal or interest payments due on a

consolidated obligation. Another cooperative GSE with joint and several

liability, the Farm Credit System (FCS), experienced severe economic

stress in the middle-1980s. To provide a broader perspective on joint and

several liability, we obtained information on the FCS experience during

and following its financial rescue by the federal government. Figure 1

describes the collapse and bailout of FCS in the 1980s and describes the

problems invoking joint and several liability in FCS.
Page 11 GAO-01-873 Federal Home Loan Bank System Capital

Figure 1: The Farm Credit System’s Experience

FHFB supervisory oversight is a very important aspect of implementing a

new capital structure. The extent to which the new structure results in an

improvement over the old one depends on how the structure is

implemented and on FHFB’s oversight of the process. Many of the details

of the new capital structure will be contained in the capital plans the

FHLBanks are currently submitting to FHFB. The approach and criteria

FHFB will use to review and approve the capital plans are being

determined.

We looked at the Basel Committee on Banking Supervision’s New Capital

Accord, which is based on three pillars: minimum capital requirements, a

supervisory review process, and effective use of market discipline.

Although the New Capital Accord is to be applied to banks and their

holding companies, its principles can be applied to GSEs as well.

Safety and Soundness

Oversight Is Important
Page 12 GAO-01-873 Federal Home Loan Bank System Capital

However, GSE status reduces market discipline, increasing the importance

of supervision.

Beyond the FHLBank System’s status as a GSE, the unique characteristics

of FHLBank capital and the potential for risk taking within the System

heighten the importance of supervisory oversight by FHFB. First, even

after the new capital structure is in place, FHLBank capital will be less

permanent than perpetual equity stock. Therefore, more so than other

regulators, FHFB must be prepared to act in case a FHLBank’s financial

condition weakens. Second, although joint and several liability creates

incentives for the FHLBanks to monitor each other’s activities, the

FHLBanks do not have the authority to direct a financially troubled

FHLBank to take corrective actions. However, FHFB does have authorities

it can use to take enforcement actions in such a situation.16

We last examined FHFB’s supervisory oversight of the FHLBank System in

1998.17 We concluded that FHFB’s safety and soundness regulation is

increasingly important to protect taxpayer interests due to the System’s

expanding activities and the changing business environment. We found

deficiencies in FHFB’s oversight of FHLBanks and made a number of

recommendations to improve it. FHFB officials told us they have made

progress in implementing these recommendations. However, we have not

examined FHFB’s supervisory oversight since completing our 1998 report,

and therefore we have not verified the completeness of these actions.

Expansion in the types of eligible collateral and increased direct mortgage

acquisition will increase interest rate, credit, and operations risks in the

FHLBank System. Interest rate risk, however, will remain unaffected by

the new forms of collateral. The overall amount of risk introduced will

depend on the type and amount of advances and mortgage acquisitions

undertaken by the FHLBanks, the implementation of risk management

practices by the FHLBanks, and oversight provided by FHFB. The new

capital structure has the potential to address the risks associated with

advances and mortgage acquisitions, because of greater capital

permanence, leverage capital requirements, and the development of risk-

 16 See Comparison of Financial Institution Regulators’ Enforcement and Prompt

Corrective Action Authorities (GAO-01-322R, Jan. 31, 2001).

17 Federal Housing Finance Board: Actions Needed to Improve Regulatory Oversight

(GAO/GGD-98-203, Sept. 18, 1998).

Risk Management

Policies and the New

Capital Structure Can

Mitigate the Increased

Risks Associated With

Advances and

Mortgage Acquisitions
Page 13 GAO-01-873 Federal Home Loan Bank System Capital

based capital standards. However, capital requirements will not be

finalized until FHFB approves capital plans developed by the FHLBanks.

GLBA authorizes advances to member community financial institutions

that utilize small business and agricultural loan collateral.18 These

advances are inherently more risky than traditional advances backed by

mortgages and generate credit risk that is more difficult to evaluate.

However, the financial management policies of the FHLBanks, as reported

to FHFB, that we have reviewed reflect the perception that the new

collateral will entail greater credit risks than residential mortgage

collateral, and the policies call for higher collateral levels compared to

traditional advances.

The FHLBanks have also begun implementation of direct mortgage

acquisitions with the program begun by the FHLBank of Chicago

accounting for a majority of the System’s acquisition activity to date.

Based on existing direct mortgage acquisition activity, direct acquisition

appears to provide regional diversification of mortgage acquisitions and

incentives for sound underwriting by member institutions from member

exposure to credit risks. However, this activity is relatively new, and its

level is expected to grow, thereby increasing risks. In addition, risks could

be affected if changes are made in the risk-sharing agreements between

the FHLBanks and their member institutions. Increased activity in direct

mortgage acquisitions by FHLBanks could also increase competition with

the enterprises in the secondary mortgage market. Such increased

competition could provide benefits to borrowers, but could also generate

additional risks for the FHLBanks, the enterprises, depository institutions,

and taxpayers.

Credit and operations risks for traditional advances utilizing home loan

and related types of collateral are relatively low. However, GLBA

authorized advances to community financial institutions utilizing small

business and agricultural loan collateral that will likely introduce greater

credit and operations risk. Interest rate risk will not change, and

FHLBanks will continue to manage this risk as they have managed it for

traditional advances. The FHLBanks have extensive experience in

 18 GLBA also authorized FHLBanks to expand the level of advances utilizing what is called

other real estate related collateral, which includes commercial mortgages and home equity

lines of credit. In this report, the new collateral we focus on is small business and

agricultural loan collateral.

New Forms of Collateral

for Advances Will Increase

Credit and Operations

Risks
Page 14 GAO-01-873 Federal Home Loan Bank System Capital

managing their traditional advance business and have developed financial

management policies for managing risks, as required by FHFB.19 In

addition, according to FHFB, the FHLBanks typically require 10 to 25

percent more than the value of an advance in collateral. Largely due to

collateral protection and the System’s lien status, FHLBanks have never

experienced a credit loss on their advance business.

In contrast to their traditional advance business, advances to community

financial institutions utilizing small business and agricultural loan

collateral are inherently riskier and generate credit risk that is more

difficult to evaluate.20 First, small business and agricultural loans are more

heterogeneous than single-family residential mortgage loans. In particular,

small business loans finance businesses involved in a wide range of

economic activities. Unlike mortgage loans that have fairly homogeneous

characteristics, loans to a wide variety of sectors are more difficult to

analyze. In addition, the value of each business is determined largely by

the performance of those operating it. In contrast, appraising the value of a

housing unit providing collateral for a single-family residential mortgage

loan is more straightforward. Operations risk would also increase, because

FHLBanks have not fully developed the expertise, information systems,

and operational procedures necessary for these new activities.

Both FHFB and the FHLBanks recognize that the new collateral will entail

greater credit risks than residential mortgage collateral. FHFB requires a

FHLBank, prior to accepting the new collateral for the first time, to file a

notice to demonstrate that the FHLBank has the capacity to manage the

risks associated with the new types of collateral to be accepted.21

According to FHFB, the FHLBanks are requiring 65 to 150 percent more

collateral over the size of advances when the collateral is loans secured by

small businesses or farms. Consistent with the stringency of their financial

management policies, officials from the FHLBanks told us that they

currently anticipate a low level of funding utilizing small business and

agricultural collateral.

 19 FHFB officials told us that once FHFB accepts each FHLBank’s capital plan and

implements the new capital structure, FHFB’s financial management policy regulations will

be replaced with new regulations that address each FHLBank’s financial management

policies and take into consideration the new capital requirements.

20 See Comments on Enterprise Resource Bank Act (GAO/GGD-96-140R, June 27, 1996).

21 We reviewed these notifications, which include the relevant credit and collateral policies

to be implemented.
Page 15 GAO-01-873 Federal Home Loan Bank System Capital

The FHLBanks have tools to manage interest rate risk, and the

introduction of the new forms of collateral for advances will not change

the way this risk is managed. The principal source of funds for FHLBanks

is the consolidated debt obligations of the System. According to FHFB,

each FHLBank calculates various measures of its exposure to interest rate

risk. One of the measures is duration of equity.22 This measures the

sensitivity of market value of equity to changes in interest rates. FHFB’s

financial management policy specifies duration of equity limits, and the

FHLBanks are to report the results of their duration of equity calculations

to FHFB each quarter. If interest rate risk is well hedged, the market value

of equity will change little as interest rates fluctuate.

The FHLBanks have lien status in which their rights to the collateral they

hold generally have priority over other security interests, including insured

deposits, in the assets of failed insured financial institutions. Historically,

all advances have been secured with collateral. More recently, FHLBanks

have also required collateral to secure member-provided credit

enhancements on mortgages FHLBanks acquire directly. By statute,

FHLBank security interests generally have priority over the claims and

rights of any party, including receivers, conservators, and trustees. This

preference can result in increased costs to the Federal Deposit Insurance

Corporation (FDIC) in resolving a possible bank or thrift failure. Potential

expansion in FHLBank System advances, collateral, and direct mortgage

acquisition activities could therefore also increase resolution costs to the

FDIC.

Interest rate, credit, and operations risks will increase from the direct

mortgage acquisition programs implemented by the FHLBanks. Holding

mortgage assets exposes FHLBanks to interest rate risk, because the

FHLBanks assume the risk for any changes in the market value of the

retained mortgage assets. If interest rates increase at a time when new

debt has to be issued, borrowing costs will increase while returns from

fixed-rate mortgage asset holdings remain constant. Because borrowers

tend to prepay and refinance their mortgages when interest rates decline,

falling interest rates carry another form of interest rate risk called

prepayment risk. To the extent that FHLBanks rely on long-term debt that

cannot be refinanced, returns will fall without a corresponding decline in

 22 Generally, duration describes the average time to each payment on a financial liability

(such as a bond) or a financial asset (such as an advance).

New Forms of Collateral Will

Not Change Interest Rate Risk

Lien Status May Result in

Increased Costs to Federal

Deposit Insurance Funds

Direct Mortgage

Acquisitions Will Increase

Interest Rate, Credit, and

Operations Risks
Page 16 GAO-01-873 Federal Home Loan Bank System Capital

debt costs. The prepayment risk associated with mortgage holdings differs

from that associated with advances, because the advances to member

institutions carry prepayment penalties. The FHLBanks, however,

currently have experience in managing prepayment risk because they have

investment holdings of mortgage-backed securities (MBS) and the

associated prepayment risk. The FHLBanks and the enterprises tend to

use financial instruments such as long-term, callable debt to limit their

exposure to interest rate risk from holdings of mortgage assets.

FHLBanks use derivatives and callable debt to hedge interest rate risk

resulting from direct investments in mortgage assets. To the extent that

the duration of mortgage assets differs from that of debt obligations,

FHLBanks often enter into a matching interest rate exchange agreement.

This agreement is one form of financial derivative called an interest rate

swap, in which the counterparty pays cash flows to the FHLBank designed

to mirror, in timing and amount, the cash outflows the FHLBank pays on

the consolidated obligation. The FHLBanks also use other financial

arrangements to manage interest rate risk. For example, callable debt

allows the FHLBank as issuer to buy (i.e., call) back issued debt when

interest rates decline. Callable debt is attractive as a source of funds for

mortgage asset holdings, because borrowers tend to prepay their

mortgages and refinance when interest rates decline. FHLBanks had

$224.5 billion of callable debt outstanding as of December 31, 2000, out of

total consolidated obligations of about $592 billion.

Direct mortgage acquisitions expose the FHLBanks to credit risk. To

qualify for FHLBank purchase, as is true for purchase by the enterprises,

mortgage insurance is required for mortgage loans with loan to value

ratios of over 80 percent. FHLBank purchases have included conventional

mortgage loans with private mortgage insurance as well as mortgage loans

with federal guarantees or insurance. The FHLBanks’ credit risk

management includes enforcement of lender guidelines for member

institutions participating in direct mortgage acquisition. The FHLBanks

have established stated actions they will take to ensure that member

institutions follow these guidelines. For example, the FHLBanks are to

collect quality control reports from participating members and perform a

quality control review on a sampling of the mortgages purchased from

each member. Participating members are also subject to audit by the

FHLBank or its designated agents. FHLBank establishment and

enforcement of guidelines for participating members help the FHLBanks

mitigate credit risk by increasing the degree of assurance that lenders

meet fundamental standards for originating and servicing mortgages. The

FHLBanks credit risk management also includes implementation of lender
Page 17 GAO-01-873 Federal Home Loan Bank System Capital

credit enhancement requirements that subject participating member

institutions to credit risk. For example, the FHLBank establishes an

account in which payments to member institutions are reduced in the

event of mortgage defaults. These credit enhancements further help the

FHLBanks mitigate credit risk by creating incentives for sound mortgage

underwriting and servicing by participating members. The FHLBanks also

seek wide geographic distribution of their mortgage acquisitions to limit

their exposure to any particular regional economic downturn.

Lenders who hold mortgages and member institutions use an

infrastructure to manage their credit risk that is different from the

infrastructure used by secondary market entities, such as the enterprises.

These institutions can benefit in their management of credit risk from their

potential ability to better understand their local markets and thereby the

credit risk associated with mortgages they fund or mortgages they sell in

which they still take on credit risk. In addition, institutions that take on

credit risk from mortgages they originate do not face the moral hazard

problems23 secondary market entities have when they purchase mortgages

and take on the associated credit risks. To address the moral hazard

problem, secondary market entities develop infrastructures to oversee the

lending and servicing practices of lenders from whom they purchase

mortgages.

Direct mortgage acquisitions expose the FHLBanks to operations risk,

because in the past the FHLBanks had not developed the expertise,

information systems, and operational procedures to approve and oversee

lenders. Exposure to operations risk is related to the FHLBanks’ exposure

to credit risk, because new operating infrastructure and procedures are

necessary to the extent that member exposure to credit risk reduces the

moral hazard problem faced by the FHLBanks. If the FHLBanks have little

exposure to credit risk and moral hazard, then operations risk will be

lower. The actions taken to avoid moral hazard, including systems used to

provide lender oversight, entail operations risk. In contrast, credit and

operations risks from traditional advances have been minimal because of

collateral requirements.

 23 The term “moral hazard” has been defined as “a description of the incentive created by

insurance that induces those insured to undertake greater risk than if they were uninsured

because the negative consequences are passed through to the insurer.” In a situation where

a secondary market entity purchases mortgages from a lender and takes on the associated

credit risk, the lender would have incentives to originate riskier mortgages because profits

would accrue to the lender whereas losses could fall on the secondary market entity.
Page 18 GAO-01-873 Federal Home Loan Bank System Capital

As of December 31, 2000, the FHLBanks held slightly over $15 billion in

fixed, long-term, single-family mortgages compared to about $1.4 billion as

of year-end 1999. The FHLBank of Chicago held about half of total

mortgage loans in the System.

The majority of direct acquisition activity to date has been accounted for

by the program begun by the FHLBank of Chicago, which is named

Mortgage Partnership Finance (MPF).24 MPF was initiated on a pilot basis

beginning in 1997. The 10 FHLBanks from Boston, New York, Pittsburgh,

Atlanta, Indianapolis, Chicago, Des Moines, Dallas, Topeka, and San

Francisco, currently participate in MPF.

Although MPF offers multiple products, they share some common

characteristics. First, mortgage purchases are limited to mortgage loans

below the conforming loan limit for the enterprises, which is currently

$275,000 for a single-family housing unit. Second, the FHLBank holds an

account with funds generated from transactions between the FHLBank

and the member bank. This account takes the first-loss position after

primary mortgage insurance payments; that is, costs due to borrower

mortgage defaults are taken from this account before other sources of

funds are utilized to cover credit losses. The funds are generated by

providing the FHLBank a price deduction at time of sale and/or from an

annual flow of payments. The latter device is often called a spread

account, because it represents a spread between payments due to the

member institution from the FHLBank (e.g., to compensate the member

for taking on credit risk) and payments actually made by the FHLBank.25

Third, for some MPF products the member institution is required to supply

additional credit enhancements in the form of direct loss guarantees

and/or supplemental insurance to provide a second-loss position before

the FHLBank is exposed to credit losses. The loss positions taken by the

first-loss account and the second-loss supplemental insurance and lender

guarantees are lender provided credit enhancements. By FHFB regulation,

the FHLBank requires the member institution to provide collateral to

secure direct loss guarantees provided by the lender. The collateral is

 24 “Mortgage Partnership Finance” and “MPF” are registered trademarks of the FHLBank of

Chicago.

25 With MPF products, the FHLBank pays the member institution a guarantee fee. For some

MPF products, when defaults occur, guarantee payments to the member institution are

reduced.

The FHLBank of Chicago Has

Developed a Direct Acquisition

Program
Page 19 GAO-01-873 Federal Home Loan Bank System Capital

protected by the lien status applicable to collateral used to secure

advances.

The FHLBank of Chicago has two primary means of achieving regional

diversification of its credit risk. First, it purchases mortgages from

member institutions that are affiliated with large, nationwide lenders, and

second, it invests in the mortgage acquisitions (called participations) made

by the nine other FHLBanks that participate in MPF. Table 1 presents the

geographic distribution of MPF mortgages as of year-end 2000. Based on

all MPF mortgage loans to date, it appears that regional diversification has

been achieved.26 According to FHLBank of Chicago officials, MPF serves

both large and small FHLBank member institutions.

Table 1: Regional Distribution of MPF Mortgage Loan Balances Outstanding as of

Dec. 31, 2000

Region Share of MPF mortgage loans

Northeast 22%

Southeast 15

Midwest 24

Southwest 16

West 22

Note: Regions are as follows:

Northeast—Connecticut, Delaware, Washington D.C., Massachusetts, Maine, Maryland, New

Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia, and West

Virginia; Southeast—Alabama, Florida, Georgia, Kentucky, Mississippi, North Carolina, Puerto Rico,

South Carolina, Tennessee, and Virgin Islands; Midwest—Illinois, Indiana, Iowa, Michigan,

Minnesota, North Dakota, Ohio, South Dakota, and Wisconsin; Southwest—Arkansas, Colorado,

Kansas, Louisiana, Missouri, Nebraska, New Mexico, Oklahoma, Texas, and Wyoming; and West—

Alaska, Arizona, California, Guam, Hawaii, Idaho, Montana, Nevada, Oregon, Utah, and Washington.

Source: FHLBank of Chicago.

The FHLBanks of Cincinnati, Indianapolis, and Seattle participate in the

other direct mortgage acquisition program, which is named the Mortgage

Partnership Program (MPP). MPP was initiated near year-end 2000. As of

year-end 2000, less than $500 million in mortgage loan holdings were

accounted for by the FHLBanks participating in MPP.

 26 We did not analyze the regional diversification of individual loan pools purchased by the

FHLBanks through MPF. A lack of regional diversification of individual loan pools could

affect credit risk exposure to the FHLBank to the extent that a member institution could

not meet its contractual payment obligations.

Three FHLBanks Have Jointly

Developed a Direct Acquisition

Program
Page 20 GAO-01-873 Federal Home Loan Bank System Capital

MPP is in its infancy compared to MPF. The products share some of the

basic characteristics of MPF. A notable difference between MPP and MPF

is that to date MPP participants have only been larger member institutions.

Another difference is that the FHLBank MPP participants generally do not

expect to enter into participations with the other MPP FHLBanks, even

though the program parameters allow for such participations. Without

joint participation among the three FHLBanks on individual mortgage

pools, geographic diversification of mortgage assets might be limited if

small member institutions, which are not diversified geographically,

provide a large share of MPP activity.

Two major FHFB regulatory requirements that limit the risks of MPF and

MPP are (1) the member institution is to assume the first-loss position in

the transaction as defined by FHFB and (2) each loan pool is to receive an

investment grade rating based on FHFB approved rating criteria and loan

pools with ratings below AA (i.e., double-A) must be supported by

additional retained earnings or reserves.27

FHFB regulations require member institutions to be in the first-loss

position (i.e., after primary mortgage insurance). FHFB uses an economic

definition of first-loss position in implementing its regulation. In an

accounting sense, it may not be apparent that the member is in a first-loss

position, because the account that takes the first-loss might not be on the

balance sheet of the member institution. However, the member institution

is at risk because defaults reduce payments from the first-loss account to

the member institution. These payments represent a fee paid to members

for assuming credit risk. When losses from defaults occur, the account

covers the losses and payments to the member are subsequently reduced.

Therefore, this structure should help provide incentives to member

institutions through the sharing of credit risks for sound underwriting and

loan servicing practices.

Another FHFB regulatory requirement that limits the risks of MPF and

MPP is the requirement that each loan pool receive an investment grade

rating based on FHFB approved rating criteria, and loan pools with ratings

below double-A must be supported by additional retained earnings or

 27 FHFB requires an investment grade rating at least equal to the fourth highest rating. The

four highest ratings are triple-A, double-A, A, and triple-B.

Risks Can Be Sensitive to

Changes in Risk-Sharing

Arrangements

The Member Institution

Assumes the First-Loss

Position

Each Loan Pool Is Required to

Receive an Investment Grade

Rating to Mitigate FHLBank

Credit Risk
Page 21 GAO-01-873 Federal Home Loan Bank System Capital

reserves.28 FHFB has approved rating criteria contained in the computer

package LEVELS, a product of the rating agency Standard & Poors. To

date, participating FHLBanks have required a double-A rating. A double-A

rating is the second highest rating attainable. LEVELS considers credit risk

characteristics for loans in a mortgage pool, such as loan-to-value ratio,

mortgage insurance coverage, economic conditions and expected house

price changes in the metropolitan area where the residence is located, and

borrower credit history. Based on these characteristics, LEVELS

calculates the credit support necessary from the first-loss account and,

when applicable, supplemental insurance to achieve the double-A rating.

Standard & Poors officials we interviewed stated that LEVELS provides a

comprehensive credit analysis of a mortgage pool. They also told us that

LEVELS does not consider some factors that could affect FHLBank risk

exposure such as the capacity of the member institution and the first-loss

account to meet continuing obligations.

FHFB’s required investment grade rating, especially if participating

FHLBanks require a double-A rating from LEVELS, should help to limit

credit risk faced by the FHLBanks based on a thorough credit analysis of

each mortgage pool. Participating FHLBanks can further limit credit risk

and thereby improve the performance of their acquired mortgage

portfolios above what the LEVELS’ model predicts by achieving regional

diversification of their portfolios.29 In addition, LEVELS does not consider

factors such as concentrations of FHLBank credit risk with individual

member institutions that may have limited capacity to meet their

continuing obligations. Due in part to strategies to limit credit risk that can

be implemented by participating FHLBanks and risk factors not

considered by LEVELS, capital supervision of direct mortgage acquisitions

by FHFB is important to ensure the safety and soundness of the System.

 28 The latter requirement is effective until FHFB’s risk-based capital rule becomes effective.

29 According to Standard & Poors officials, LEVELS assumes a nationwide worst-case

scenario, and regional diversification by a FHLBank could result in improved economic

performance in the event of a regional economic downturn.
Page 22 GAO-01-873 Federal Home Loan Bank System Capital

FHFB published a risk-based capital regulation on January 30, 2001, that, if

properly implemented, can establish a capital structure with the potential

to address the increased risks of new activities. The capital regulation

establishes classes of capital with varying degrees of permanence,

leverage requirements, and risk-based capital requirements to be

implemented. Each FHLBank is expected to hold capital commensurate

with its credit, interest rate, and operations risk. FHFB’s risk-based capital

regulation requires credit risk to be calculated using four broad categories

based on an evaluation of the credit risk associated with different types of

assets and positions. This evaluation is based in part on the loss history of

relevant assets with particular ratings and maturities. FHFB directed each

FHLBank to develop its own internal risk-based model to estimate interest

rate exposures and calculate risk-based capital requirements for interest

rate risk. These internal models are to be approved by FHFB in connection

with the approval of each FHLBank’s capital plan, which is to be

submitted to FHFB by October 29, 2001. The internal models must meet

FHFB’s technical restrictions and use interest rate scenarios approved by

FHFB. FHFB’s regulation includes a risk-based capital requirement to

cover operations risk.

FHFB’s minimum leverage requirement establishes two activity-based

minimum capital ratios; both ratios must be met. The simplest measure is

total capital equal to 4 percent of assets. The second measure is total

capital equal to 5 percent of assets when permanent capital is weighted by

1.5 and other capital is weighted by 1. Only permanent capital is included

in the capital definition for the risk-based capital component of the

minimum capital standards.

FHFB’s capital regulation included capital requirements for the credit risk

of assets in two categories: advances and rated mortgage assets.30

According to the published regulation, the credit risk capital requirement

for advances was based on the highest estimated (proportional) loss by

rating category and maturity class observed over a 2-year period of actual

corporate bond data from the interval 1970 to 1999. FHFB also used its

judgment to establish capital requirements. FHFB officials told us that the

numeric capital requirements are subject to refinement based on FHFB’s

ongoing research.

 30 FHFB’s capital regulation also included capital requirements for the credit risk of other

rated assets and unrated assets.

The Capital Structure

Being Established Has the

Potential to Address the

Increased Risks of New

Activities
Page 23 GAO-01-873 Federal Home Loan Bank System Capital

FHFB’s risk-based capital requirement for advances assumes little credit

risk exists. Although FHLBanks have never incurred credit losses on

advances backed by traditional mortgage collateral or securities, FHFB

decided to impose capital requirements on advances. The capital

requirement on long-term advances is higher than on short-term advances.

FHFB used its judgement to set a capital requirement on all advances that

includes some credit risk. This capital requirement is intended to reflect

the potential credit risks created by new types of collateral. FHFB

oversight of collateral policies and other aspects of FHLBank risk

management of new collateral will be important, because all advances are

included in the same category, and the new collateral entails greater credit

risk than traditional advances collateral.

Credit risk percentage requirements for residential mortgage assets are

based on FHFB’s analysis of residential MBS and their ratings. In

developing the capital requirements for mortgage assets, FHFB also took

into account the requirements set by other regulators.31 In general, the riskbased capital requirements for mortgage assets, such as mortgages on

both single-family and multifamily units or MBS, vary with the

creditworthiness of the assets.

FHFB’s capital regulation, with its rating-based approach, allows capital

requirements to vary based on the credit risk of the mortgage assets. In the

case of MPF and MPP, participating FHLBanks have required a credit

rating of double-A on each mortgage pool acquired. As stated earlier in this

report, the double-A rating is to be based on a thorough credit analysis of

each mortgage pool acquired. MPF and MPP assets are expected to

become an increasing part of the assets held by the FHLBanks.

FHFB directed each FHLBank to create its own internal risk-based model

to estimate interest rate risk exposures and calculate risk-based capital

requirements for interest rate risk. The exposure to interest rate risk in

each model is to depend on the level of stress from interest rate

movements taking into account any hedges that affect the actual exposure

to interest rate movements. These internal models must meet FHFB’s

technical requirements and use interest rate scenarios approved by FHFB.

 31 Commercial banks have a 400 basis point requirement on residential mortgages, and 160

basis point requirement on mortgage-backed securities issued by GSEs. In addition, the

leverage ratio for the enterprises on their own MBS held by other investors is 45 basis

points.
Page 24 GAO-01-873 Federal Home Loan Bank System Capital

FHFB’s regulation contains a stated preference that the internal models

created by the FHLBanks be based on a value at risk approach. Using this

approach, the loss is estimated based on several possible interest rate

patterns in the future. FHFB must approve the interest rate scenarios used

in the internal models and has placed some technical requirements on the

models themselves. Each FHLBank is required to have sufficient

permanent capital to meet the value at risk level established by FHFB, as

well as other capital requirements.

FHFB’s regulation requires that the FHLBanks maintain sufficient riskbased capital to cover operations risk, although GLBA did not stipulate

such a requirement. FHFB’s capital requirement for operations risk is 30

percent of the total capital required to cover interest rate and credit risk,

but it may be reduced to no lower than 10 percent if a FHLBank can

demonstrate to the satisfaction of FHFB that it has insurance or some

other means to justify the reduction.

Appendix IV contains further discussion of FHFB’s capital regulation.

As alternatives to holding mortgages on their own balance sheet,

depository institutions have a number of ways to obtain GSE funding for

mortgage assets and thereby transfer some or all of the related risks. How

these assets are funded and how the risks are transferred or shared has

important implications for regulatory capital treatment at both the

depository institution and at the GSE. For example, when mortgages along

with all the attendant risks are sold outright to a GSE, the only relevant

capital requirement would be at the GSE level. Alternatively, when a

depository institution purchases an MBS issued by a GSE, there is a capital

charge imposed at the depository level that is to reflect the credit risk of

GSE obligations as well as a capital charge at the GSE level. For those

funding arrangements in which credit risk is maintained, in whole or in

part, at the depository institution level, the capital treatment by the

depository institution regulators and the GSE regulators interact.32 From

an integrated perspective it is important that risks and capital

requirements are in proper relation to one another. Otherwise certain

arrangements can be disadvantaged if capital charges are too high or

 32 A primary purpose of regulatory capital for depository institutions is to protect the

deposit insurance funds. The primary purpose of regulatory capital for the GSEs is to

reduce the probability that a financial emergency leading to government intervention to

rescue a GSE would occur.

Business With GSEs

Affects Members’ Capital

Requirements and Risks
Page 25 GAO-01-873 Federal Home Loan Bank System Capital

advantaged if they are too low. As such, supervision is particularly

important.

Depository institutions that engage in secondary market transactions with

GSEs must hold capital based on (1) the amount of GSE obligations in

their portfolios, (2) their capital investment in the GSEs, and (3) the risks

retained when selling or transferring mortgage assets to a GSE. The

depository regulators we interviewed told us that they generally assign

relatively low credit risk weights to depository institution holdings of GSE

obligations, because they take into account the perception of implied

federal backing of GSE obligations. The regulators told us that depository

institution holdings of FHLBank debt, enterprise debt, and enterprise MBS

are in the 20 percent risk category.33 Thus, rather than the general

requirement of $8 in capital for each $100 of assets in the 100 percent risk

category, such as unsecured loan assets, $1.60 of capital is required (that

is, 8 percent of $20). Therefore, depository institutions that sold mortgages

in the secondary market and purchased an equivalent amount of GSE

backed MBS would lower their credit risk and their capital requirements.

In fact, the combined capital requirement, including the capital

requirement at the GSE level, would be lower possibly reflecting the GSEs’

ability to reduce overall credit risk through geographic diversification.

Currently, depository institutions are required to hold $4 in capital for

each $100 in mortgage loan holdings and $1.60 of capital for each $100 in

enterprise MBS holdings, and the enterprises are required to hold capital

equal to 0.45 percent of MBS issued and held by outside investors. Thus,

the transfer can result in $2.05 of total capital required rather than $4 of

capital required without the transfer of assets.

The depository institution regulators have also established capital

requirements for the risk associated with depository institution

investments in GSE equity. The regulators told us that currently FHLBank

capital is in the 20 percent risk category although they are actively

reviewing this capital treatment and considering the new capital structure

being established for the FHLBank System. In addition, they told us that

enterprise equity is generally in the 100 percent risk category; the one

exception is the Office of the Comptroller of the Currency, the regulator of

national banks, which places enterprise equity in the 20 percent risk

 33 Depository institution regulators have risk-based capital regulations that place assets into

risk buckets based on associated credit risks. For example, unsecured loans are in the 100

percent risk bucket, whole mortgage loans are in the 50 percent risk bucket, and Treasury

securities are in the zero percent risk bucket.
Page 26 GAO-01-873 Federal Home Loan Bank System Capital

weight category. The regulators stated that their supervision activities

address concentrations of pledged assets and risks at individual

depository institutions that could result from heavy reliance on FHLBanks

as a funding source.

The depository institution regulators have provided guidance on the riskbased capital treatment of only one MPF program, MPF 100. Under this

program, the member institution acts as agent for the FHLBank,

underwriting, servicing and providing a credit enhancement for residential

mortgage pools. The member receives fees for the credit enhancement

that it provides. The FHLBank provides a first-dollar loss protection

cushion equal to 100 basis points of the total mortgage pool’s unpaid

balance. As the FHLBank incurs credit losses allocable to this protection,

the credit enhancement fees paid by the FHLBank to the member are

reduced. However, the credit enhancement fees are not recorded on the

balance sheet of the member institution until received. The second-loss

credit enhancement provided by the member institution is sized so that the

senior piece held by the FHLBank would have the credit quality equivalent

to a double-A rating.

The depository institution regulators determined that since expected

receipt of the guarantee fees by the member institution is not a balance

sheet asset, and since the member institution is under no obligation to pay

anything to the FHLBank, there is no risk of loss to the member’s capital.

The only consequence to the member institution in the case of credit

losses is the receipt of a lower level of credit enhancement fees. Because

expected credit losses would not affect the member’s balance sheet, the

depository institution regulators determined that the FHLBank is in the

first-loss position. They determined that the member institution’s capital

requirement would be based on the face value of the second-loss credit

enhancement.

In contrast, the FHFB analysis of the credit enhancement structure of MPF

100 leads to a different result.34 According to the FHFB analysis, because

the member institution’s credit enhancement fees are reduced if the

FHLBank incurs losses from the first-loss cushion due to mortgage

defaults, the member’s fees are contingent upon the performance of the

 34 FHFB regulations require the member institution to bear the direct economic

consequences of actual credit losses in an amount at least equal to the expected credit

losses and positioned in the credit enhancement structure no later than immediately after

expected losses.
Page 27 GAO-01-873 Federal Home Loan Bank System Capital

mortgage pools. FHFB determined that because the member bears the

economic responsibility of the expected credit losses from the first dollar

of loss, the member is effectively in the first-loss position.

While the depository institution regulators have provided guidance on one

particular mortgage participation product, they have yet to opine on

others. It is also likely that new products could arise with various

combinations of credit risk sharing arrangements. The depository

institution regulators have issued proposed regulations that would change

the risk-based capital treatment of credit enhancements. The rules

currently in effect provide for differing capital treatment for credit

enhancements that have the same economic effect, depending on whether

the credit enhancement is retained in a sale of assets or acquired in some

other way. The regulators have proposed a more consistent treatment of

economically equivalent credit enhancements. The cost of regulatory

capital associated with credit enhancements could change based on the

content of final regulations.

During the course of this assignment, enterprise officials we interviewed

raised questions about the adequacy of the capital structure of the

FHLBank System as it relates to the risks posed by the direct acquisition

of mortgages. In particular, it was suggested that if you view the FHLBank

System, including its membership, as if it were a holding company then the

System, in certain cases, could be viewed as engaging in “double

leveraging.” According to this view, the member financial institutions use

their own capital to directly support their own activities but finance their

purchases of FHLBank stock with deposits, debt, or other instruments not

acceptable as regulatory capital. Figure 2 provides more information on

double leveraging.35

 35 The enterprises, at times during the course of this assignment, provided a different

approach to leverage that resulted in higher levels of calculated capital leverage. We

focused on their suggested holding company approach.

The Enterprises Questioned the

Adequacy of the FHLBank

System’s Capital Structure to

Support Direct Mortgage

Acquisitions
Page 28 GAO-01-873 Federal Home Loan Bank System Capital

Figure 2: Double leveraging

Enterprise officials told us that FHLBank capital is not adequate to

support the risks of direct mortgage acquisition, because debt issued to

finance the investment is a liability on the balance sheet of the FHLBank,

the investment is an asset on the balance sheet of the FHLBank, and the

capital of the FHLBank is downstreamed noncapital proceeds from

member institutions.

This approach appears to be an analogy based on accounting flows

resulting from on-balance sheet investments by the FHLBanks. Based on

our analysis, there appear to be countervailing factors that lessen the

applicability of the analogy as a way of analyzing the ability of capital to

address the risks of FHLBank mortgage acquisitions. First, the approach

focuses on leverage directly, rather than on the relationship between

capital and risks. The present risk sharing arrangements, which include

the requirement that the member institution be in the first-loss position,

limit credit risk to the FHLBank. At the member institution level,

depository institution regulators rely on supervisory tools to limit

exposure to potential risks resulting from FHLBank mortgage acquisitions.

As a second countervailing factor, MPF and MPP are not the only

secondary mortgage market programs that reduce total capital

requirements. When the enterprises purchase mortgages from depository

institutions, capital requirements for the depository institutions are

reduced without a corresponding increase in enterprise capital

requirements. As stated above, depository institution regulators generally

assign relatively low credit risk weights to depository institution holdings

of GSE obligations. One reason why the capital requirements at the

enterprise level are lower is that the enterprises can reduce credit risk

through geographic diversification of their mortgage servicing portfolios.
Page 29 GAO-01-873 Federal Home Loan Bank System Capital

However, the relationship between the credit risk reduction from

geographic diversification and the reduction in total capital required has

not been established. As in the case of FHLBank mortgage acquisitions,

depository institution regulators rely on regulatory oversight.

As a third countervailing factor, even if capital should be consolidated

between FHLBanks and member institutions in some manner, the holding

company analogy lacks sufficiency as a method of analysis. Consolidation

of balance sheets has the most merit in the case of a parent holding

company that controls a subsidiary in which the parent funds the closely

controlled subsidiary with instruments not acceptable as regulatory

capital and in turn uses the subsidiary as an investment vehicle. In the case

of the FHLBank System, a parent holding company does not exist. The

FHLBank System is a cooperative in which member institutions provide

System capital, but no one member appears to hold a controlling interest

in the corporate governance decisions of any one FHLBank. In addition,

joint and several liability combined with all voluntary membership

motivates the FHLBanks to monitor each other’s financial activities.

While we have treated the concept of double leveraging as a distinct issue,

the more fundamental concern raised by the enterprises appears to be

associated with the nature of FHLBank capital. While we agree that the

capital is not perpetual equity capital, it will become more permanent.

However, we have not addressed the issue as to whether 5-year capital

combined with statutory and regulatory restrictions on withdrawal of

capital will result in the optimal level of permanence.

MPF and MPP, while structured differently than the secondary market

products offered by the enterprises, can generate increased competition in

the secondary mortgage market. In a 1996 report, we addressed the

implications of authorizing another GSE to compete with the enterprises.36

In that report, we assumed that the newly authorized GSE would have a

similar charter and be subject to the same regulatory requirements to

compete with the enterprises. Therefore, the GSE would also operate in a

similar manner to the enterprises. We indicated that such authorization

could

 36 Housing Enterprises: Potential Impacts of Severing Government Sponsorship

(GAO/GGD-96-120, May 13, 1996).

Increased Secondary

Market Competition Can

Generate Risks
Page 30 GAO-01-873 Federal Home Loan Bank System Capital

• increase the overall amount of GSE activity in the mortgage market and, as

a result, raise the potential amount at risk in case of a government bailout;

• increase the level of GSE risk, because entities operating in new markets

often have greater managerial and operations risk than those operating in

established markets;

• increase credit risk if the new entity attempted to establish market share

by lowering underwriting standards; and

• increase competition and thereby reduce mortgage interest rates to

borrowers.

Risks in the FHLBank System will increase from its direct mortgage

acquisition activity. The acquisition activity could also generate benefits to

borrowers and potential risks for the enterprises. The degree to which

increased competition could affect risk-taking by the FHLBanks and the

enterprises is among the unknowns in this competitive process. However,

such developments also create potential risks for taxpayers and therefore

challenges for both FHFB and OFHEO.

The introduction of the mortgage acquisition programs by the FHLBank

System has implications for competition between and the regulatory

oversight of the System and the enterprises. The mortgage acquisition

programs of the FHLBank System increase competition between the

System and the enterprises. In past reports we have recommended, and we

still support, combining the GSE regulators into one agency and

authorizing the agency to oversee both the safety and soundness and

mission compliance of the FHLBanks, Fannie Mae, and Freddie Mac.37 We

have pointed out the advantages of combining oversight responsibilities in

one agency. Such an agency could be more independent and objective

than the separate regulatory bodies and could be more prominent than

either one alone. Although the GSEs operate differently, the risks they

manage and their missions are similar. The regulators’ expertise in

evaluating GSE risk management could be shared more easily within one

agency. In addition, a single regulator would be better positioned to be

cognizant of specific mission requirements, such as special housing goals

and new programs or initiatives any of the GSEs might undertake, and

should be better able to assess the competitive effect on all three housing

GSEs and better ensure consistency of regulation for GSEs that operate in

similar markets. Having all staff in one regulatory agency should also

 37 See Government-Sponsored Enterprises: Advantages and Disadvantages of Creating a

Single Housing GSE Regulator (GAO/GGD-97-139) July 9, 1997.
Page 31 GAO-01-873 Federal Home Loan Bank System Capital

facilitate coordination and sharing of expertise among staff responsible for

safety and soundness and mission compliance. Given the introduction of

mortgage acquisition programs by the FHLBanks, the ability of a single

regulator to assess competitive effects among the three housing GSEs and

to better ensure consistency of regulation for the housing GSEs becomes

relatively more important.

FHFB and OFHEO risk-based capital regulations are meant to ensure that

the FHLBanks and enterprises maintain sufficient capital to weather

stressful economic conditions and address credit, interest rate, and

operations risks. However, we are unable to assess the relative stringency

of each regulator’s approach to risk-based capital, for two reasons. First,

the final specifications of the risk models for both OFHEO and FHFB are

not yet available. Second, even if the final specifications were available,

differences in the assets and liabilities held by the FHLBanks and the

enterprises create different risk patterns. These differences, in turn, led to

different modeling approaches, making comparisons difficult. Although we

cannot provide an overall assessment of the stringency of each regulator’s

approach, we can compare certain attributes of the modeling approaches

and their strategies and procedures for estimating credit, interest rate, and

operations risk. We also provide a comparison of the effects of the

leverage requirement on the FHLBanks and the enterprises.

GLBA gave FHFB discretion to establish credit and interest rate scenarios

to be covered by permanent capital.38 In implementing GLBA, FHFB

decided to require FHLBanks to hold capital for operations risk. The

amount of permanent capital required under the risk-based capital

regulation is the sum of capital for credit risk, interest rate risk, and

operations risk. Figure 3 is a simplified illustration of FHFB’s approach to

risk modeling and calculating capital.

 38 For consistency throughout this report, interest rate risk is the term used to designate the

effects of movements in market prices on the financial condition of a firm. GLBA used the

term market risk. Interest rate risk is the dominant determinant of market risk for

FHLBanks.

FHFB and OFHEO

Approach Risk-Based

Capital Regulations

Differently

FHFB’s Risk-Based Capital

Regulation
Page 32 GAO-01-873 Federal Home Loan Bank System Capital

Figure 3: Simplified Illustration of FHFB’s Approach to Risk Modeling and Capital

Calculation

Source: GAO analysis of FHFB information.

The Federal Housing Enterprises Financial Safety and Soundness Act of

1992 (the 1992 act) established OFHEO as an independent regulator within

the Department of Housing and Urban Development (HUD). OFHEO’s

mission is to ensure the enterprises’ safety and soundness. The 1992 act

also authorized OFHEO to develop a risk-based capital regulation that

addresses credit, interest rate and operations risks. OFHEO began

developing its regulation upon its creation in 1993. OFHEO has developed

its own cash flow model to estimate risks and calculate the total capital

needed to cover credit and interest rate risk.39 The 1992 act specified the

stresses that the model must address. The risk-based capital regulation

also requires capital for operations risk. For risk-based capital, total

capital is the sum of a general allowance for foreclosure losses, common

stock, perpetual noncumulative preferred stock,40 paid-in capital, and

retained earnings.

 39 This discussion of OFHEO’s risk-based capital regulation is based on the Second Notice

of Proposed Rulemaking, published in the Federal Register on April 13, 1999. Details may

differ in the final rule.

40 Perpetual noncumulative preferred stock is stock that has a priority claim to dividends

over common equity stock. However, if a dividend is missed on perpetual noncumulative

stock, holders of that stock do not receive payment for this missed dividend in future time

periods, while holders of perpetual cumulative preferred stock would receive payment for

missed dividends in the future.

OFHEO’s Risk-Based

Capital Regulation
Page 33 GAO-01-873 Federal Home Loan Bank System Capital

OFHEO did its own modeling of the risks for both enterprises so that the

enterprises would face identical analytical measures of their risks based

on their own assets, liabilities, and off-balance sheet positions. However,

the model this approach uses does not reflect any business strategies that

are unique to either enterprise.

Figure 4 is a simplified illustration of OFHEO’s approach to risk modeling

and risk-based capital calculation. OFHEO runs a single model in which

the capital calculations for credit risk and interest rate risk are based on

the model’s estimates of how much capital each enterprise needs. This

approach ensures that both credit risk, which is based on benchmark41

losses, and interest rate risk are integrated in a cash flow model. Appendix

IV provides a more detailed description of FHFB’s and OFHEO’s riskbased capital requirements.

Figure 4: Simplified Illustration of OFHEO’s Stress Test and Capital Calculation

Source: GAO analysis of OFHEO information.

 41 The benchmark losses are based on criteria established by the 1992 act.
Page 34 GAO-01-873 Federal Home Loan Bank System Capital

Generally, FHFB has not directly modeled risks in its risk-based capital

regulation. For credit risk, FHFB has depended on data on historic losses,

the loss history of relevant assets with particular ratings and maturities,

and its own judgments to determine appropriate levels of risk-based

capital. For interest rate risk, FHFB decided to establish a framework that

each FHLBank must adhere to when it models its own interest rate risk.

This approach made it possible for FHFB to publish its regulation within

15 months of GLBA. However, we have not been able to evaluate the

interest rate risk models that are yet to be developed by each FHLBank

and subsequently approved by FHFB.

In contrast, OFHEO used a complex modeling approach to determine risks

and calculate required capital. This approach permitted OFHEO to finetune feedbacks between interest rate risk and credit risk and explicitly

model the factors that created losses associated with particular assets.

However, this approach was difficult to implement and created delays in

the actual implementation of risk-based capital regulations for the

enterprises.

Under the 1992 act, Congress set criteria for OFHEO to use in establishing

the stress test for credit, interest rate, and operations risk in risk-based

capital regulation. In contrast, GLBA required FHFB to create risk-based

capital requirements for the FHLBanks taking due consideration of any

risk-based capital test established by OFHEO pursuant to the 1992 act.

GLBA allowed FHFB to choose the economic scenarios used in modeling

credit and interest rate risks. On its own initiative, FHFB added operations

risk to its version of risk-based capital regulation.

FHFB developed capital calculations based on balance sheet data, the

market value of the portfolio for interest rate risk, and expected losses for

credit risk. OFHEO developed capital calculations that begin with initial

balance sheet positions but then use a 10-year cash flow stress test based

on specified interest rate scenarios and credit stresses over the 10-year

period. In the 1992 act, OFHEO was directed to run its model assuming

that no new business would occur during the 10-year stress period except

for already committed business of the enterprises. Therefore, enterprise

assets, liabilities, and off-balance sheet positions decline over time in

OFHEO’s model. FHFB’s balance sheet approach estimates the market

value of the FHLBank’s portfolio at risk under the financial stress

scenarios and thus does not require an assumption about new business.

FHFB’s test is to be applied monthly while OFHEO’s test is to be applied

quarterly.

FHFB’s and OFHEO’s

Modeling Approaches

Differ
Page 35 GAO-01-873 Federal Home Loan Bank System Capital

FHFB and OFHEO have different strategies for calculating the capital

needed to cover risks. FHFB requires that the FHLBanks calculate the

capital needed to cover credit risk and interest rate risk separately.

OFHEO jointly calculates capital needed for credit risk and interest rate

risk. FHFB stated that in periods of stress, a positive correlation exists

between interest rate risk and credit risk.42 Given this positive correlation,

they stated that a separate calculation of interest rate risk and credit risk

is a conservative approach to calculating required capital. In contrast,

OFHEO officials stated that their single calculation of the capital needed

to cover credit and interest rate risk permits the model to deal with realworld feedbacks between interest rate movements and credit losses.

FHFB and OFHEO also calculate capital required for operations risk based

on the amount of capital required for credit and interest rate risk, although

FHFB may reduce the amount required if a FHLBank demonstrates that it

qualifies for a lower requirement.

FHFB’s and OFHEO’s actual procedures for estimating credit stresses and

calculating the capital required to cover credit risk differ. FHFB uses asset

and position credit risk categories and assigns credit risk capital

requirements for assets and positions in each category. In making these

determinations, FHFB uses its own judgment and available information on

factors such as default losses, credit ratings, and capital regulations for

other regulated firms. For mortgage assets acquired from members with

credit risk-sharing arrangements, FHFB depends on the results of a model

from a credit rating agency to estimate and limit credit risk. In contrast,

OFHEO uses a more granulated approach based on detailed econometric

modeling. This approach allows the agency to address the effects of

numerous variables on credit losses directly in its own model.

FHFB’s and OFHEO’s approaches to calculating the capital required to

cover interest rate risk differ. FHFB uses a value at risk model that

estimates changes in the value of capital based on hundreds of historical

interest rate scenarios that represent possible stresses on the FHLBanks.

The scenarios are to be applied to each FHLBank’s balance sheet and

should represent periods of significant economic stress. The interest rate

scenarios are based on actual interest rate changes during periods that last

 42 As evidence of this correlation, FHFB cited work by Mark Carey in Prudential

Supervision: What Works and What Doesn’t, ed., Frederic S. Mishkin, National Bureau of

Economic Research, 2001.

FHFB’s and OFHEO’s

Strategies and Procedures

for Calculating Capital

Requirements Differ

FHFB and OFHEO Take

Different Approaches to

Calculating Capital

Requirements for Credit Risk

FHFB and OFHEO Have

Different Procedures to

Calculating Capital

Requirements for Interest Rate

Risk
Page 36 GAO-01-873 Federal Home Loan Bank System Capital

120 business days and cover historical interest rate movements since 1978.

The test requires the FHLBank to hold capital sufficient to cover all but

the worst 1 percent of potential losses. In contrast, OFHEO uses a 10-year

cash flow model and two interest rate scenarios—one for a rising rate and

the other for a falling rate. In each OFHEO interest rate scenario, the

interest rate adjusts during the first year and then remains at the new level

for the remainder of the 10-year period. According to OFHEO officials,

both interest rate changes are greater than what has been observed

historically over any 1-year period. The amount of capital required to

cover interest rate risk is the amount of capital needed to cover the worst

of the two mandated interest rate scenarios.

Although GLBA did not require FHFB to establish a risk-based capital

requirement to cover operations risk, FHFB decided such a requirement

was needed. FHFB’s capital requirement for operations risk is 30 percent

of the total capital required to cover interest rate and credit risk but may

be reduced to no lower than 10 percent if a FHLBank can demonstrate to

the satisfaction of FHFB that it has insurance or some other means to

justify the reduction. In contrast, the 1992 act that directed OFHEO to

establish risk-based capital requirements for operations risk specified that

capital for operations risk be equal to 30 percent of the total capital

required for credit and interest rate risks.

Minimum leverage requirements establish minimum capital levels a firm

must hold irrespective of the level of risk it assumes. The leverage ratios

required by statute differ for the FHLBanks and enterprises. The minimum

leverage ratio for FHLBanks is measured in two ways; both ratios must be

met. The simplest measure sets total capital at 4 percent of assets. The

second measure sets total capital at 5 percent of assets, with permanent

capital weighted by 1.5 and other capital weighted by 1. For the

enterprises, the minimum leverage requirement is based on both the onbalance sheet and off-balance sheet positions. Off-balance sheet positions

are generally guaranteed mortgage-backed securities held by investors but

managed by the enterprises. Thus, the OFHEO rule includes more than

just the assets held by the enterprises. The required leverage ratio for onbalance sheet assets is 250 basis points (2.5 percent), while the ratio for

off-balance sheet positions is generally 45 basis points (.45 percent).

FHFB and OFHEO also define capital for the leverage ratios differently.

OFHEO uses core capital in the minimum leverage requirement. Core

capital is the sum of outstanding common stock, outstanding perpetual

noncumulative preferred stock, paid-in capital, and retained earnings.

FHFB and OFHEO Have

Different Procedures to

Calculate Capital Requirements

for Operations Risk

FHFB and OFHEO

Minimum Leverage

Requirements May Affect

the Regulated Entities

Differently
Page 37 GAO-01-873 Federal Home Loan Bank System Capital

FHFB’s total capital for the leverage ratio includes shorter-term Class A

stock, longer-term Class B stock, and retained earnings. FHFB’s

alternative 5-percent leverage ratio reflects the longer-term nature of Class

B stock and retained earnings by valuing Class B stock and retained

earnings at 150 percent of par value when calculating capital for the 5-

percent leverage ratio. To the extent that FHLBanks develop a capital

structure based on Class B stock, they will be using more permanent

capital. In contrast, enterprise capital is never redeemable.

FHFB officials said they anticipate that when the capital plans are

implemented, the risk-based capital requirement for all FHLBanks will be

below the minimum leverage requirements under GLBA. This will be the

case, in part, because FHLBanks are expected to establish an exclusive

Class B or a mixed Class A and B capital structure. FHFB officials told us

that based on seven draft capital plans submitted to FHFB, six of the

FHLBanks indicated that they expect to establish an exclusively Class B

structure initially because of the adverse tax consequences associated

with a multiple class structure. However, three of these FHLBanks

indicated that they anticipate issuing Class A stock in the future. Over

time, issuing Class A stock and increasing mortgage acquisitions could

cause a FHLBank’s risk-based capital requirement to exceed its leverage

requirement. However, FHFB’s risk-based capital requirement is unlikely

to constrain operations initially, given the current business of the

FHLBanks.

OFHEO’s risk-based capital requirement may limit the enterprises more

than the leverage requirement. In the Second Notice of Proposed

Rulemaking, OFHEO estimated that Fannie Mae would not have had

sufficient capital to meet its the risk-based capital requirement on either

September 30, 1996, or June 30, 1997, although Freddie Mac would have

been in compliance with its risk-based capital requirement. However, both

Fannie Mae and Freddie Mac had sufficient capital to meet the leverage

requirement.

In FHFB’s risk-based capital regulation, the capital structure plan of each

FHLBank is to specify the date on which the plan shall take effect and may

provide for a transition period of up to 3 years to allow the FHLBank to

come into compliance. During the transition period the FHLBanks are

expected to remain in compliance with the preexisting leverage based

requirement. FHFB officials told us that the implementation of the riskbased capital requirements depends on the submission of capital plans,

including internal models for interest rate risk, from all FHLBanks by

FHFB’s Leverage Requirement

Will Initially Affect FHLBank

Capital Levels More Than the

Risk-Based Capital

Requirement

OFHEO’s Risk-Based Capital

Requirement May Limit the

Enterprises More Than Its

Leverage Requirement

FHFB’s and OFHEO’s RiskBased Capital Regulations

Are Subject to Transition

Rules With Differing

Effective Dates
Page 38 GAO-01-873 Federal Home Loan Bank System Capital

October 29, 2001. In addition, FHFB must approve the plans, including any

transition plans needed to ensure that the FHLBanks attain compliance

with risk-based capital requirements.

For the enterprises, the risk-based requirement becomes effective when

the final rule is published in the Federal Register and can be enforced 1

year after it is published. The rule for the capital requirement was cleared

by the Office of Management and Budget on July 16, 2001.

The FHLBank System is currently establishing a new capital structure that,

if properly implemented, is likely to be an improvement over the historic

structure. Capital will become more permanent and new risk-based and

leverage capital requirements will also be implemented. The new capital

structure has the potential to address the risks associated with advances

as well as the direct acquisition of mortgages. However, it is too early to

assess the overall adequacy of the structure, because the capital plans and

risk management practices to be implemented by the FHLBanks and

capital supervision practices to be followed by FHFB are not yet known.

Based on activity to date, direct acquisition appears to provide regional

diversification of mortgage acquisitions and incentives to member

institutions for sound mortgage underwriting and servicing through the

sharing of credit risks. However, risks could be affected if changes are

made in the level of mortgage acquisition activity and in the risk-sharing

agreements that are currently present between the FHLBanks and their

member institutions. Such changes might also increase the importance of

risk-based capital requirements compared to FHFB leverage requirements.

Going forward, risks in the FHLBank System will increase due to

expanded collateral provisions in GLBA and direct mortgage acquisition

activity. Effective mitigation of that risk will depend on risk management

by the FHLBanks, the adequacy of the capital structure, and oversight by

FHFB. In addition to the FHLBanks, the acquisition activity could also

generate additional risks for the enterprises. Although currently the

FHLBank System and the enterprises primarily engage in different

business activities, these differences may decrease if direct mortgage

acquisition activity grows dramatically. Having one housing GSE regulator

for safety and soundness and mission compliance would provide greater

independence and objectivity, greater prominence, improved ability to

Conclusions
Page 39 GAO-01-873 Federal Home Loan Bank System Capital

assess the competitive impact of new initiatives on all housing GSEs, and

improved ability to ensure consistency of regulation of GSEs that operate

in similar markets.43

This report does not contain any new recommendations.

The Chairman of FHFB provided written comments on a draft of this

report, and these comments are reprinted in appendix V. FHFB and

OFHEO provided technical comments on a draft of this report. The

FHLBanks, enterprises, and depository institution regulators also provided

technical comments on draft excerpts of this report that we shared with

them. We incorporated technical comments into this report where

appropriate.

The Chairman of FHFB stated that we did a commendable job of analyzing

important and complex FHLBank System issues. His letter drew attention

to some of our findings related to the potential of the new capital structure

for the FHLBanks to address risks and the MPP and MPF programs. His

letter also stated that our past recommendations, with regard to regulatory

oversight, have been well received with many having been implemented.

FHLBank of Chicago officials wanted us to characterize the MPF first-loss

account as an account established by the FHLBank, rather than as a lender

provided credit enhancement. Our characterization is based on the FHFB

requirement that the member institution bear the economic cost of

expected credit losses. For example, the MPF arrangement in which the

FHLBank is reimbursed by the member institution when defaults occur

through the reduction of fees paid to the member is a mechanism in which

the lender’s credit enhancement is used to improve the rating of the

mortgage pool acquired by the FHLBank.

A Freddie Mac official provided comments addressing Freddie Mac’s

concern about “double leveraging.”

44 He stated that in addition to the risks

posed by the direct acquisition of mortgages, Freddie Mac also has a

 43 See Government-Sponsored Enterprises: Advantages and Disadvantages of Creating a

Single Housing GSE Regulator (GAO/GGD-97-139, July 9, 1997).

44 The draft report excerpt we shared with the enterprises was limited to our

characterization of their views related to double leveraging. Fannie Mae officials thought

that our characterization of their view was accurate.

Recommendations

Agency Comments
Page 40 GAO-01-873 Federal Home Loan Bank System Capital

broader concern that relates to the overall fragility of the FHLBank

System. He stated that the risk of member institutions withdrawing their

capital in response to FHLBank losses is a direct result of the

nonpermanent nature of the FHLBank System capital stock even after the

GLBA reforms. He specifically referred to the potential for a run on the

FHLBank System if member institutions had advanced knowledge of

potential future financial losses.

We have addressed the question of capital adequacy directly by analyzing

the relationship between capital and risks. We have treated the concept of

double leveraging as a separate issue. In our discussion of the double

leveraging concept, we made revisions to reflect the concern about the

nature of FHLBank capital.

We will send copies of this report to the Chairman of the Board of FHFB,

Director of OFHEO, Presidents of the FHLBanks, Chief Executive Officer

of Fannie Mae, and Chief Executive Officer of Freddie Mac. We will also

make copies available to others upon request.

Please contact me or William B. Shear at (202) 512-8678 if you or your staff

have any questions concerning this report. Key contributors to this report

were Rachel DeMarcus, Kristi A. Peterson, and Mitchell B. Rachlis.

Thomas J. McCool

Managing Director

Financial Markets and

Community Investment
Page 41 GAO-01-873 Federal Home Loan Bank System Capital

List of Congressional Committees

The Honorable Paul S. Sarbanes

Chairman

The Honorable Phil Gramm

Ranking Minority Member

Committee on Banking, Housing,

 and Urban Affairs

United States Senate

The Honorable Michael G. Oxley

Chairman

The Honorable John J. LaFalce

Ranking Minority Member

Committee on Financial Services

House of Representatives

The Honorable Richard Baker

Chairman

The Honorable Paul Kanjorski

Ranking Minority Member

Subcommittee on Capital Markets, Insurance,

 and Government Sponsored Enterprises

Committee on Financial Services

House of Representatives
Appendix I: Scope and Methodology

Page 42 GAO-01-873 Federal Home Loan Bank System Capital

To describe the capital structure of the Federal Home Loan Bank

(FHLBank) System, we reviewed Federal Housing Finance Board (FHFB)

capital standards and regulations; conducted research on the role of

capital in government-sponsored enterprises (GSE) with a cooperative

system; reviewed our prior work addressing risk-based capital and the

FHLBank System; and interviewed financial institution regulatory body

and GSE officials. To analyze the adequacy of the capital structure of the

FHLBanks, we also reviewed relevant literature on interest rate, credit,

and operations’ risks; analyzed FHLBank proposals for the use of

expanded collateral provisions and permissible uses of advances under the

Gramm-Leach-Bliley Act (GLBA) of 1999; and analyzed FHLBank

applications to FHFB and other information on FHLBank direct mortgage

acquisition programs.

During the course of this assignment, officials from Fannie Mae and

Freddie Mac made presentations to us and provided extensive information

reflecting their perspectives on the adequacy of the capital structure of the

FHLBank System. On May 17, 2001, Freddie Mac provided us a

consultant’s report addressing the adequacy of the capital structure of the

FHLBank System. We considered the information provided by the

enterprises in conducting our work.

We analyzed information the FHLBanks considered to be proprietary.

Therefore, we did not report specific details of the various FHLBank

products. For example, due to this limitation, we did not report data on

the Mortgage Partnership Program and provided general information on

Mortgage Partnership Finance. To compare and contrast the risk-based

capital standards proposed by FHFB to the standard proposed by OFHEO,

we analyzed the standards; reviewed information provided by and

interviewed officials from the enterprises, the FHLBanks, FHFB, and

OFHEO; and reviewed comments on the proposed standards. The

FHLBanks are yet to complete their capital plans implementing their new

capital structures, which limited the scope of our analysis. In addition,

although we made observations of some elements of risk management that

appear to be present at the FHLBanks, we did not analyze risk

management procedures employed by the FHLBanks, FHFB’s oversight of

risk management, nor the risks associated with FHLBank investments.

Furthermore, we did not verify the accuracy of data provided by FHFB

and the FHLBanks. We also did not analyze the risks of activities that have

been or might be undertaken by either Fannie Mae or Freddie Mac. We

conducted our work in Washington, D.C., between February 2001 and June

2001, in accordance with generally accepted government auditing

standards. Written comments on a draft of this report from FHFB appear

Appendix I: Scope and Methodology
Appendix I: Scope and Methodology

Page 43 GAO-01-873 Federal Home Loan Bank System Capital

in appendix V. We also obtained technical comments from the FHLBanks,

enterprises, depository institution regulators, FHFB, and OFHEO that have

been incorporated where appropriate.
Appendix II: Background Information on the

FHLBank System, Fannie Mae, Freddie Mac,

and Their Regulators

Page 44 GAO-01-873 Federal Home Loan Bank System Capital

The FHLBank System is a GSE consisting of 12 federally chartered

FHLBanks and the System’s Office of Finance that are privately and

cooperatively owned by member institutions. The FHLBanks are located

in Boston, MA; New York, NY; Pittsburgh, PA; Atlanta, GA; Cincinnati, OH;

Indianapolis IN; Chicago, IL; Des Moines, IA; Dallas, TX; Topeka, KS; San

Francisco, CA; and Seattle, WA; with each FHLBank serving a defined

geographic region of the country. The FHLBanks raise funds by issuing

consolidated debt securities in the capital markets. The System was set up

in 1932 to extend mortgage credit by making loans, called advances, to its

member institutions, which in turn lend to home buyers for mortgages.

Home mortgage loans and other collateral secure advances. These

advances help member institutions, originally limited to thrifts and

insurance companies, by enhancing liquidity and providing access to

national capital markets. In 1989, as part of the Financial Institutions

Reform, Recovery, and Enforcement Act (FIRREA), Congress opened

membership to nonthrift federally insured depository institutions that

offer residential mortgage loans. Thrifts with federal charters remained in

the System as mandatory members while nonthrift institutions were

voluntary members. GLBA created all voluntary membership and

expanded the purposes of System advances with corresponding expansion

in eligible collateral for community financial institutions. As of December

31, 2000, the FHLBanks held about $438 billion in advances to members;

$186 billion in investments, $16 billion in directly acquired mortgage

assets; and $31 billion in capital, of which $728 million was in the form of

retained earnings. In addition, the System had 7,777 members, which

included 5,681 commercial banks, 1,547 thrifts, and 549 credit unions and

insurance companies. Additional financial information on the FHLBanks is

presented in appendix III.

Congress chartered Fannie Mae and Freddie Mac as governmentsponsored, privately owned and operated corporations to enhance the

availability of mortgage credit across the nation during both good and bad

economic times. Fannie Mae’s headquarters is located in Washington, D.C.

and Freddie Mac’s is in McLean, Virginia. The enterprises are to

accomplish this mission by purchasing mortgages from lenders (banks,

thrifts, and mortgage bankers) who can then use the proceeds to make

additional mortgage loans to home buyers. The enterprises issue debt to

finance mortgage assets that they retain in their portfolios. A majority of

purchased mortgages, however, are pooled to create mortgage-backed

securities (MBS) that are sold to investors. The enterprises collect fees for

guaranteeing the timely payment of principal and interest on MBS held by

investors. At year-end 2000, the enterprises had combined debt obligations

of about $1.1 trillion and combined MBS obligations to investors of about

Appendix II: Background Information on the

FHLBank System, Fannie Mae, Freddie Mac,

and Their Regulators
Appendix II: Background Information on the

FHLBank System, Fannie Mae, Freddie Mac,

and Their Regulators

Page 45 GAO-01-873 Federal Home Loan Bank System Capital

$1.3 trillion (a total of about $2.4 trillion). Additional financial information

on the enterprises is presented in appendix III.

FIRREA created FHFB as an independent agency within the executive

branch, with a five-member board of directors. FHFB is organized into 6

offices and had about 95 permanent employees as of December 31, 2000.

FHFB’s annual budget is about $24 million, which is financed with

assessments on the FHLBanks. The functions of three offices are most

relevant to capital supervision of the FHLBanks. The primary

responsibility of the Office of Supervision is to ensure the safety and

soundness and mission-compliance of the FHLBanks; it conducts the

federally mandated annual examinations of all FHLBanks. The Office of

Policy and Office of General Counsel provide assistance to and share

oversight responsibility with the Office of Supervision. These three offices

have about 54 employees, of which 14 are in the Office of Supervision.

The Federal Housing Enterprises Financial Safety and Soundness Act of

1992 (the 1992 act) established OFHEO as an independent regulator within

the Department of Housing and Urban Development (HUD) whose mission

is to help ensure the enterprises’ safety and soundness. Under the 1992 act,

OFHEO’s director has independent authority pertaining to matters of

safety and soundness. OFHEO’s primary means for fulfilling its mission

are establishing capital standards for the enterprises and conducting onsite examinations to assess their management practices and financial

condition. OFHEO has about 87 full-time equivalent employees and an

annual budget of about $20 million. OFHEO’s expenses are funded with

assessments on the enterprises. However, unlike FHFB, OFHEO is subject

to the annual appropriations process.
Appendix III: Financial Information on the

FHLBank System, Fannie Mae, and Freddie

Mac

Page 46 GAO-01-873 Federal Home Loan Bank System Capital

This appendix provides basic financial information on the FHLBank

System, Fannie Mae, and Freddie Mac. Table 2 is a consolidated summary

balance sheet of the FHLBank System. Table 3 presents information on the

advances45 and total assets of each FHLBank as of December 31, 2000.

Tables 4 and 5 provide selected financial highlights for Fannie Mae and

Freddie Mac.

As indicated in table 2, the FHLBank System has grown substantially over

the past 5 years. The total assets in the FHLBank System increased 124

percent between December 31, 1996 and December 31, 2000; and advances

increased 171 percent over the same time period. At the end of 2000, the

assets in the FHLBank System totaled nearly $654 billion. In comparison,

the assets of Fannie Mae and Freddie Mac totaled $675 billion and $459

billion, respectively. (See tables 4 and 5.)

Table 2: FHLBanks’ Consolidated Summary Balance Sheet as of Dec. 31, 1996-2000

2000 1999 1998 1997 1996

Dollar amounts in millions

Assets

Advances $437,861 $395,747 $288,189 $202,265 $161,372

Mortgage Loans, net 16,149 2,026 966 37 —

Investments 186,437 171,425 137,193 140,106 125,231

Other assets 13,240 14,014 7,654 6,167 5,432

 Total Assets $653,687 $583,212 $434,002 $348,575 $292,035

Liabilities

Consolidated obligations $591,606 $525,419 $376,715 $304,493 $251,316

Deposits and borrowings 17,100 17,624 25,805 18,445 18,257

Other liabilities 13,716 11,154 8,730 6,463 5,586

 Total Liabilities $622,422 $554,197 $411,250 $329,401 $275,159

Capital

Capital stock outstanding $30,537 $28,361 $22,287 $18,833 $16,540

Retained earnings 728 654 465 341 336

 Total Capital $31,265 $29,015 $22,752 $19,174 $16,876

Source: Federal Home Loan Banks 2000 Financial Report.

 45 FHLBank advances are essentially collateralized loans to member institutions—which

include savings banks, commercial banks, savings and loans, credit unions, and insurance

companies.

Appendix III: Financial Information on the

FHLBank System, Fannie Mae, and Freddie

Mac
Appendix III: Financial Information on the

FHLBank System, Fannie Mae, and Freddie

Mac

Page 47 GAO-01-873 Federal Home Loan Bank System Capital

Table 3 presents the level of advances and total assets at each FHLBank at

the end of 2000. The FHLBanks vary significantly in size. Total assets

ranged from about $27 billion at the FHLBank of Topeka to $140 billion at

the FHLBank of San Francisco. The amount of advances outstanding

ranged from about $18 billion to $110 billion at the same FHLBanks. The

percentage of total assets made up of advances also varied among the

FHLBanks. At the FHLBank of Chicago, advances made up only 52 percent

of total assets, while at the FHLBank of San Francisco, advances made up

78 percent of assets. Other assets at FHLBanks may include cash or

investments such as U.S. government-agency securities or high-quality,

short-term investments like federal funds sold, certificates of deposit, and

commercial paper.

Table 3: FHLBank Advances and Total Assets as of Dec. 31, 2000

FHLBank

Advances

outstanding Total assets

Advances as a

percentage of total

assets

Dollars in millions

Boston $21,594 $38,282 56%

New York 52,396 76,600 68%

Pittsburgh 25,946 45,063 58%

Atlanta 58,249 80,641 72%

Cincinnati 31,935 55,615 57%

Indianapolis 24,073 33,391 72%

Chicago 18,462 35,389 52%

Des Moines 21,158 35,531 60%

Dallas 30,195 43,843 69%

Topeka 17,582 26,787 66%

San Francisco 110,031 140,190 78%

Seattle 26,240 45,392 58%

Source: Federal Home Loan Banks 2000 Financial Report and GAO analysis of data.

As shown in Tables 4 and 5, Fannie Mae and Freddie Mac have also grown

substantially over the past 5 years. Fannie Mae’s total assets increased 92

percent between December 31, 1996 and December 31, 2000; while Freddie

Mac’s assets increased 164 percent over the same time period. Their offbalance sheet obligations also increased.46 For example, Fannie Mae’s

 46 Off-balance sheet obligations may include guaranteed mortgage-backed securities (MBS),

commitments to purchase mortgages or to issue and guarantee MBS, credit enhancements,

and certain hedge instruments.
Appendix III: Financial Information on the

FHLBank System, Fannie Mae, and Freddie

Mac

Page 48 GAO-01-873 Federal Home Loan Bank System Capital

outstanding net MBSs increased 29 percent from $548 billion in 1996 to

$706 billion at the end of 2000. Freddie Mac’s participation certificates

(PC) increased 22 percent from $473 billion to $576 billion.

Table 4: Fannie Mae Selected Financial Highlights as of Dec. 31, 1996-2000

2000 1999 1998 1997 1996

Dollar amounts in millions

Retained mortgage portfolio,

net $607,399 $522,780 $415,223 $316,316 $286,259

Total assets 675,072 575,167 485,014 391,673 351,041

Debt securities, net 642,682 547,619 460,291 369,774 331,270

Total liabilities 654,234 557,538 469,561 377,880 338,268

Stockholders equity 20,838 17,629 15,453 13,793 12,773

Total MBS, net 706,100 678,600 636,600 578,700 548,173

Source: Fannie Mae Annual Reports and OFHEO’s 2000 Report to Congress.

Table 5: Freddie Mac Selected Financial Highlights as of Dec. 31, 1996-2000

2000 1999 1998 1997 1996

Dollar amounts in millions

Retained mortgage portfolio,

net $385,693 $324,443 $255,009 $164,421 $137,755

Total assets 459,297 386,684 321,421 194,597 173,866

Debt securities, net 426,754 360,581 287,234 172,321 156,491

Total liabilities 443,865 374,602 309,978 186,154 166,271

Stockholders’ equity 14,837 11,525 10,835 7,521 6,731

Total PCs, net 576,101 537,883 478,351 475,985 473,065

Source: Freddie Mac Annual Reports and OFHEO’s 2000 Report to Congress..
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 49 GAO-01-873 Federal Home Loan Bank System Capital

This appendix summarizes FHFB’s and OFHEO’s risk-based capital

requirements for the FHLBanks and the enterprises, respectively.

FHFB’s risk-based capital requirements are meant to ensure that the

FHLBanks maintain sufficient capital to weather stressful economic

conditions. The requirements address credit, interest rate, and operations

risks.

FHFB’s capital requirements separate FHLBank assets and positions into

four credit risk categories and establish capital levels within these

categories. The four categories are (1) advances, (2) rated mortgage

assets, (3) rated assets and positions other than advances or mortgages,

and (4) unrated assets. For the first three categories, maturity and/or a

credit rating from a nationally recognized credit rating agency are the

factors determining the capital charge for an asset or position. Longer

terms to maturity and lower credit ratings increase the capital requirement

because they tend to increase credit risk. All unrated items have an 8-

percent capital requirement, except for cash, which has a zero capital

requirement. The capital requirements extend to off-balance sheet items;

also credit enhancements such as guarantees can reduce the credit

requirements, if the providers have credit ratings superior to that of the

FHLBank asset or position.

Although FHLBanks have never incurred credit losses on advances backed

by traditional mortgage collateral or securities, FHFB decided to impose

capital requirements on all advances, including short-term advances.

FHFB’s requirement assumes that advances will exhibit the same losses as

the highest investment grade (triple-A) corporate bonds and that advances

would have a recovery rate of 90 percent. FHFB stated this recovery rate is

consistent with overcollateralization and other protections afforded

advances. Additionally, longer term advances have higher capital

requirements, because risks tend to increase with terms to maturity.

Even though traditional advances have little credit risk, FHFB recognized

that new expanded collateral available to support advances may have

greater credit risk. As a result, it set a capital requirement for advances

that includes some credit risk. The expanded collateral includes real estate

related collateral, such as commercial mortgages and home equity lines of

credit, as well as nonmortgage agricultural loans and small business loans.

Because of the unknown risk created by new types of collateral, FHFB

used its judgment to set the capital requirement on all advances. For

Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

FHFB’s Risk-Based

Capital Requirement

FHFB’s Capital

Requirements for Credit

Risk

Risk-Based Capital Required

for Advances Assumes Little

Credit Risk Exists
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 50 GAO-01-873 Federal Home Loan Bank System Capital

example, advances with less than 4 years maturity have a 7 basis point

capital requirement even though FHFB had calculated the appropriate

capital requirement to be 0 basis points.47 This imposition of 7 basis points

reflects, in part, concerns about potential credit risks in the new types of

collateral. In contrast, when the term to maturity on advances exceeds 10

years, the capital requirement is 35 basis points.

To ensure sufficient collateral protection is available against advances, the

extent of overcollateralization for different assets varies.

Overcollateralization is the extent to which the book value of collateral

exceeds the book value of the advances it secures. Overcollateralization

increases for riskier assets. FHFB expects FHLBanks to determine the

appropriate level of overcollateralization to be imposed on nontraditional

collateral permitted by GLBA. During the regular examination of

FHLBanks, FHFB will examine the amount of overcollateralization

required by the FHLBanks for different assets, if they permit

nontraditional collateral to back advances. Based on FHFB’s supervision

and examination approach to collateral policies, the risk-based capital

regulation assumes that credit risk is equalized across all advances.

The credit risk requirements for residential mortgage assets was based on

credit ratings by major credit rating agencies. When developing the capital

requirements for mortgage assets, FHFB also took into account the

requirements set by other regulators.48 In general, the risk-based capital

requirements for mortgage assets, such as mortgages on both single-family

and multifamily units or MBSs, vary with the creditworthiness of the

assets.

The final rule is based on the assumption that the collateral underlying the

residential mortgage assets will typically consist of conforming, prime

quality loans with loan-to-value ratios below 80 percent as well as loans

with higher loan-to-value ratios with appropriate mortgage insurance.

FHFB also assumes that the performance of any credit enhancement is

reasonably ensured in all relevant economic stress scenarios and that the

FHLBank’s portfolios of residential mortgage assets will have appropriate

 47 A basis point is one one-hundredth of a percentage point.

48 Commercial banks have a 400 basis point capital requirement on residential mortgages,

and 160 basis point requirement on MBSs issued by GSEs. In addition, the leverage ratio for

the enterprises on their own MBSs held by other investors is 45 basis points.

Risk-Based Capital

Requirements for Residential

Mortgage Assets Reflect Credit

Ratings
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 51 GAO-01-873 Federal Home Loan Bank System Capital

diversification and that credit enhancements will take account of any

geographic or other concentrations that increase credit risk.

Based on the above constraints, FHFB assigned credit risk requirements.

For example, for unsubordinated49 residential mortgage assets in the

highest investment grade—triple A—residential mortgage assets have a 37

basis point capital requirement; unsubordinated mortgage assets in the

second investment grade—double A—have 60 basis points capital

requirement, and unsubordinated mortgage assets in the fourth highest

investment grade—triple B—have a 120 basis points capital requirement.

In contrast, subordinated residential mortgage assets with ratings below

triple-A can have higher capital requirements. For example, subordinated

residential mortgage assets with a triple-B rating have a 445 basis point

capital requirement.

Risk-based capital requirements are set on residential mortgages assets

acquired by the FHLBank, where the FHLBank and the member selling the

mortgage asset share credit risk as is the case in MPF and MPP. To date,

participating FHLBanks have required the equivalent of a double-A on

each residential mortgage asset acquired based on a model created by

S&P. These mortgage assets have a 60 basis points capital requirement—

the requirement for any double-A rated residential mortgage asset.

Mortgage assets, where credit-risk is shared with members, are expected

to become an increasing part of the assets held by the FHLBanks.

FHFB has established risk-based capital requirements for assets other

than advances or mortgages that are also rated. Risk-based capital

requirements for such assets increase with decreasing creditworthiness

and increasing terms to maturity. For example, U.S. securities of any

maturity have 0 basis point capital requirement while for triple-A rated

corporate assets the requirement ranges from 15 basis points to 220 basis

points, with the requirement increasing with an increasing term to

maturity. Lower rated assets carry a 100-percent capital requirement.

 49Unsubordinated residential mortgage assets based on a given pool of mortgages receive

full payments of what is due to them before subordinated residential mortgage assets of

that pool receive any payments.

FHFB Risk-Based Capital

Requirements for Assets Other

Than Advances and Mortgages
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 52 GAO-01-873 Federal Home Loan Bank System Capital

Capital requirements for unrated assets are set according to type of asset.

This category includes cash, premises and equipment, and investment

assets that have not received ratings from the major rating agencies. Cash

has a zero capital requirement, while premises and equipment have an 8-

percent capital requirement. FHFB has assigned an 8-percent capital

requirement to all investment assets that are unrated. This is the same as

the requirement that the Basel Committee of Bank Supervisors assigns to

unrated assets in its proposed revision of the bank capital standards.

Risk-based capital requirements are also established for off-balance sheet

assets such as commitments to purchase loans and standby letters of

credit.50 The risk-based capital rule establishes credit conversion factors

that convert off-balance sheet positions into asset equivalents. Each

position is multiplied by its credit conversion factor, measured as a

percent, to obtain the nominal value needed to determine the credit risk

capital requirement.

Risk-based capital requirements for derivatives are based on their current

and potential risks and vary by type of derivative and term to maturity.

Potential future risk exposures can be determined from a table in the

regulation or a FHFB approved internal model. For example, in the table,

interest rate derivative contracts with a term less than 1 year have a

conversion factor of 0 percent, while for equities, the conversion factor is

6 percent. When the term exceeds 5 years, the conversion factor for

interest rate derivative contracts is 1.5 percent, and the conversion factor

for equities is 10 percent. The final regulation also establishes procedures

to address the effects of multiple derivatives between two parties.

The FHFB’s capital requirements can reflect credit enhancements such as

third-party guarantees of an asset held by a FHLBank. If the credit

enhancement or its provider has a rating from a major rating agency, the

capital requirement will accord with the enhancement, if the FHLBank

asset is lower rated or unrated.

 50 A standby letter of credit is a commitment by a FHLBank to make a payment if certain

conditions are met. Such payments are made on behalf of a customer.

Unrated Items Are Given

Specific Risk-Based Capital

Requirements

FHFB’s Capital Structure

Encompasses Off-Balance

Sheet Items and Credit

Enhancements
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 53 GAO-01-873 Federal Home Loan Bank System Capital

The risk-based capital regulation requires each FHLBank to hold capital

for interest rate risk equal to the sum of two calculations. One calculation

estimates the potential losses in the FHLBank’s portfolio under

parameters specified by FHFB. The other measure is the amount by which

the market value of total capital falls short of the adjusted book value of

capital, in the event that the market value of capital is below this

accounting benchmark.

FHFB prefers that the internal models be based on a value at risk51

approach, which estimates level of capital that will prove sufficient to

absorb losses in all but the worst 1 percent of the time. In a value at risk

approach, the loss is estimated based on alternative possible interest rate

patterns over the chosen time period. However, if approved by FHFB, a

cash flow model can be used by a FHLBank as an alternative to a value at

risk approach. When estimating interest rate risk and calculating capital

required, each FHLBank is required to have sufficient permanent capital to

meet the value at the risk level established by FHFB. The exposure to

interest rate risk in each model is to depend on the level of stress from

interest rate movements and any hedges used which affect the actual

exposure to interest rate movements. These internal models must meet

FHFB’s technical restrictions and use interest rate stress scenarios

approved by FHFB.

Additionally, added permanent capital will be required if the FHLBank’s

current market value of total capital, based on the estimated market value

of assets minus market value of liabilities, at the time of the capital

requirement analysis, is less than 85 percent of the FHLBank’s book value

of capital. The added capital will be the difference between the market

value of the capital and 85 percent of the book value52 of the FHLBank’s

capital. This requirement was implemented because FHFB was concerned

that the book value of capital might not adequately reflect the economic

value of capital in some cases. This requirement forces the capital

 51 Value at risk is an estimate of the potential losses that might occur in a portfolio due to

changes in market rates, based on a specified period of time during which the rates change,

and at a specified probability level. For example, a firm may generate a value at risk

estimate for a 10-day period at 99 percent probability and arrive at a figure of $1 million.

This means that 99 percent of the time it would expect its losses during a 10-day move of

rates to be less than $1 million.

52 The book value of capital is calculated under Generally Accepted Accounting Principles

and can differ from the market value of capital, which is adjusted for changes in interest

rates and other market prices.

FHFB Requires Each

FHLBank to Hold Capital

for Interest Rate Risk

Based on the FHLBanks’

Internal Models
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 54 GAO-01-873 Federal Home Loan Bank System Capital

available to cover interest rate risk to have a market or economic value of

at least 85 percent of the book capital value. This requirement is consistent

with a value at risk approach, which calculates the market value of capital

available under different economic stresses.

FHFB also established technical restrictions on how the internal value at

risk model was to be designed in its risk-based capital regulation. FHFB

required that the probability of a loss greater than the estimate of the

market value of the bank’s portfolio at risk shall not exceed 1 percent.53

Thus, the estimated net market value of the portfolio will cover estimated

losses 99 percent of the time. In the regulation, FHFB directed each

FHLBank to assume a stress period of 120-business days, based on historic

interest rates from 1978 to 1 month before the capital requirement is

calculated. FHFB stated that the periods chosen should be representative

of the periods of greatest potential stress in the market given the

FHLBank’s portfolio. FHFB officials told us that the 120-day periods will

overlap. A new period will start at the first of each month since 1978. This

provides about 270 periods for the analysis. In a value at risk analysis with

a 1 percent confidence interval, this means capital required for interest

rate risk will be sufficient to cover estimated losses in 267 out of a total of

270 stress periods.

FHFB directed each FHLBank to develop a model that is comprehensive

given the FHLBank’s capabilities. In addition, FHFB stated that the

internal models may incorporate empirical correlations among interest

rates or other market prices.54 Lastly, FHFB required that the model be

independently validated and satisfactory to FHFB.

Although GLBA did not require FHFB to establish a risk-based capital

requirement to cover operations risk, FHFB decided such a requirement

 53 To the extent the FHLBanks appropriately hedge their positions in terms of match

funding or hedging instruments, there is less chance that movements in interest rates will

lead to large losses.

54 Another technical restriction is that FHLBank models should also address nonlinearities

where the value of certain positions may not change for small changes in interest rates,

even though larger changes in interest rates can create significant changes in the value of

those positions. Mortgage prepayments can exhibit nonlinearity because borrowers may

not prepay for a small decline in market rates. However, if rates decline enough,

prepayments can accelerate as the market rate falls below the rate on a higher percentage

of existing mortgages.

FHFB Requires Capital for

Operations Risk
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 55 GAO-01-873 Federal Home Loan Bank System Capital

was needed. FHFB’s capital requirement for operations risk is 30 percent

of the total capital required to cover interest rate and credit risk, but it

may be reduced to no lower than 10 percent if a FHLBank can

demonstrate to the satisfaction of FHFB that it has insurance or some

other means to justify the reduction.

OFHEO’s risk-based capital requirements are meant to ensure that the

enterprises maintain sufficient capital to weather stressful economic

conditions. These requirements also address credit, interest rate, and

operations risks.

OFHEO has developed its own cash flow model to estimate risks and

calculate total capital needed to cover credit and interest rate risk. OFHEO

runs a single model in which the capital calculations for credit risk and

interest rate risk are based on the model’s calculation of how much capital

is needed by each enterprise. To determine credit risks the model must

include information on housing prices, vacancies and credit

enhancements, as well as other variables that affect credit risk. To

determine interest rate risk the model must include information on

interest rates, interest rate hedges and other variables that affect interest

rate risk.

The purpose of OFHEO’s stress test is to calculate whether sufficient

capital was set aside at the beginning of the 10-year stress test period to

cover all benchmark losses and interest rate stress losses and to leave the

enterprise with a positive capital amount in each accounting period and at

the end of the stress period. Once the capital needed for credit and interest

rate risk is calculated in the stress test, total required capital is the sum of

capital for interest rate risk and credit risk plus 30 percent of this sum to

cover operations risk.

The intent in integrating the stresses for credit risk and interest rate risk is

to permit the OFHEO model to better deal with feedbacks between

interest rate movements and losses due to credit risk. For example, when

interest rates fall, prepayments accelerate, and this leads to a decline in

the value of mortgages on the balance sheets of each enterprise. At the

same time, the level of credit risk in the remaining mortgages may increase

if borrowers with poorer credit ratings cannot prepay. In addition, other

factors such as the recent history of interest rates and the number of

mortgages at different interest rates may interact with declining rates to

affect prepayments. Consequently, the cash flow model can only calculate

OFHEO’s Risk-Based

Capital Requirement

OFHEO Calculates RiskBased Capital

Requirements for Credit

and Interest Rate Risk in

an Integrated Model
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 56 GAO-01-873 Federal Home Loan Bank System Capital

credit risk changes due to prepayments, if the values of all variables that

affect prepayments and credit risk are fully specified in the model. To fully

understand how interest rate risk and credit risk interact, a modeler would

have to test different mixes of input variables, including interest rate

changes. However, the accuracy of any feedbacks found in the model

would depend on the quality of the model and how well it specified the

underlying economic relationships that create losses due to interest rate

movements and defaults.

The credit stress, during the stress period, is specified in the 1992 act. The

benchmark loss for credit risk is the “worst cumulative credit losses for 2

consecutive years in contiguous states encompassing at least 5 percent of

the U.S. population”.

55 The actual area chosen by OFHEO to create

benchmark credit losses is Arkansas, Louisiana, Mississippi, and

Oklahoma, in 1983 and 1984.

OFHEO determined the factors or input variables that affected losses and

prepayments due to credit stress. To identify the input variables, it

reviewed the available literature on defaults and modeled defaults

separately for single family and multifamily mortgages as well as other

assets held by the housing enterprises. To actually estimate potential

losses due to credit risk, OFHEO created numerous asset classifications

based on factors such as:

• single-family or multifamily;

• loan-to-value ratio;

• retained in portfolio or in MBS;

• type of recourse available;

• fixed or variable rate mortgage;

• conventional, FHA, or VA mortgages;

• interest rate at origination; and

• origination date.

Given these characteristics, each loan is placed in a loan group, which

determines its expected default loss. Credit enhancements can affect

default losses in OFHEO’s model, but the credit risk of the credit enhancer

is also taken into account. Similar classification schemes are developed

for other assets. Given this level of detail, OFHEO was able to create a

 55 12 U.S.C. 4611 (a) (1).

Congress Established Criteria

to Create Benchmark Losses

for Credit Risk Stress in the 10-

Year Stress Test
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 57 GAO-01-873 Federal Home Loan Bank System Capital

finely granulated sense of what creates losses and what credit losses

would occur during the stress test.

The 1992 act, which created OFHEO, established criteria for the size of the

interest rate shocks the enterprises are required to withstand over the 10-

year stress period. The criteria was based on a 10-year stress period for

both an increasing rate and decreasing rate environment that could affect

losses for an enterprise. In both environments, the rates move during the

first year and stay constant for the rest of the 10-year period. The act

specifies that capital must be sufficient to cover the more stressful of the

two interest rate environments. (See fig. 5 for a detailed enumeration of

the interest rate environments that the 1992 act required OFHEO to use.)

Figure 5: Interest-Rate Risk Stresses in OFHEO’s Risk-Based Capital Regulation

Congress Established Interest

Rate Scenarios for the 10-Year

Stress Test for the Enterprises
Appendix IV: Summary of FHFB’s and

OFHEO’s Risk-Based Capital Requirements

Page 58 GAO-01-873 Federal Home Loan Bank System Capital

According to the 1992 act, OFHEO must assume that the enterprises

acquire no new mortgages other than those deliverable under existing

commitments at the beginning of the 10-year stress period.56 This approach

focuses on the risks embedded in the book of business that existed at the

beginning of the stress test period. This restriction on new business forces

the model to act as if the enterprises are winding down their business

during the stress period.

Operations risk is also specified in the 1992 act and is equal to 30 percent

of the sum of interest rate risk and credit risk.57 Consequently, total capital

requirement for the enterprises for risk-based capital is always equal to

130 percent of the sum of capital needed to cover interest rate and credit

risk.

 56 12 U.S.C. 4611 (a)(3). According to 12 U.S.C.4611 (a) (3) (C), within 1 year of the first

issuance of the risk-based capital regulation for the housing enterprises, the GAO and

Congressional Budget Office will submit studies to the appropriate Congressional

committees addressing the advisability and appropriate form of any new business

assumptions for OFHEO’s risk-based capital regulation.

57 12 U.S.C. 4611 (c)(2).

Congress Mandated That

OFHEO Assume a Limited

Amount of New Business in 10-

Year Stress Test Period in the

Stress Test

Congress Established the

Stress for Operations Risk

as 30 Percent of the Sum

of Capital for Interest Rate

and Credit Risk
Appendix V: Comments From the Federal

Housing Finance Board

Page 59 GAO-01-873 Federal Home Loan Bank System Capital

Appendix V: Comments From the Federal

Housing Finance Board
Appendix V: Comments From the Federal

Housing Finance Board

Page 60 GAO-01-873 Federal Home Loan Bank System Capital
Related GAO Products

Page 61 GAO-01-873 Federal Home Loan Bank System Capital

Comparison of Financial Institution Regulators’ Enforcement and

Prompt Corrective Action Authorities (GAO-01-322R, Jan. 31, 2001).

Capital Structure of the Federal Home Loan Bank System (GAO/GGD-99-

177R, Aug. 31, 1999).

Farmer Mac: Revised Charter Enhances Secondary Market Activity, but

Growth Depends on Various Factors (GAO/GGD-99-85, May 21, 1999).

Federal Housing Finance Board: Actions Needed to Improve Regulatory

Oversight (GAO/GGD-98-203, Sept. 18, 1998).

Federal Housing Enterprises: HUD’s Mission Oversight Needs to Be

Strengthened (GAO/GGD-98-173, July 28, 1998).

Government-Sponsored Enterprises: Federal Oversight Needed for

Nonmortgage Investments (GAO/GGD-98-48, Mar. 11, 1998).

Federal Housing Enterprises: OFHEO Faces Challenges in Implementing

a Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 22, 1997).

Government-Sponsored Enterprises: Advantages and Disadvantages of

Creating a Single Housing GSE Regulator (GAO/GGD-97-139, July 9,

1997).

Housing Enterprises: Investment, Authority, Policies, and Practices

(GAO/GGD-97-137R, June 27, 1997).

Comments on “The Enterprise Resource Bank Act of 1996” (GAO/GGD96-140R, June 27, 1996).

Housing Enterprises: Potential Impacts of Severing Government

Sponsorship (GAO/GGD-96-120, May 13, 1996).

Letter from James L. Bothwell, Director, Financial Institutions and

Markets Issues, GAO, to the Honorable James A. Leach, Chairman,

Committee on Banking and Financial Services, U.S. House of

Representatives, Re: GAO’s views on the “Federal Home Loan Bank

System Modernization Act of 1995” (B-260498, Oct. 11, 1995).

FHLBank System: Reforms Needed to Promote Its Safety, Soundness,

and Effectiveness (GAO/T-GGD-95-244, Sept. 27, 1995).

Related GAO Products
Related GAO Products

Page 62 GAO-01-873 Federal Home Loan Bank System Capital

Housing Finance: Improving the Federal Home Loan Bank System’s

Affordable Housing Program (GAO/RCED-95-82, June 9, 1995).

Government-Sponsored Enterprises: Development of the Federal Housing

Enterprise Financial Regulator (GAO/GGD-95-123, May 30, 1995).

Farm Credit System: Repayment of Federal Assistance and Competitive

Position (GAO/GGD-94-39, Mar. 10, 1994).

Farm Credit System: Farm Credit Administration Effectively Addresses

Identified Problems (GAO/GGD-94-14, Jan. 7, 1994).

Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,

Soundness, and Effectiveness (GAO/GGD-94-38, Dec. 8, 1993).

Improved Regulatory Structure and Minimum Capital Standards are

Needed for Government-Sponsored Enterprises (GAO/T-GGD-91-41,

June 11, 1991).

Government-Sponsored Enterprises: A Framework for Limiting the

Government’s Exposure to Risks (GAO/GGD-91-90, May 22, 1991).

Government-Sponsored Enterprises: The Government’s Exposure to

Risks (GAO/GGD-90-97, Aug. 15, 1990).

(250040)
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