Federal Home Loan Bank System: An Overview of Changes and Current Issues Affecting the System
Published: 2005-04-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The FHLBank System (FHLBank System or System) is a government-sponsored enterprise (GSE) that consists of 12 Federal Home Loan Banks (FHLBanks) and is cooperatively owned by member financial institutions, typically commercial banks and thrifts. The primary mission of the FHLBank System is to promote housing and community development generally by making loans, also known as advances, to member financial institutions. To minimize the potential for significant financial problems, the Federal Housing Finance Board (FHFB) regulates the FHLBank System's safety and soundness. Over time, a number of developments have affected the System's safety and soundness and have created pressures on its traditional cooperative structure. To assist the committee in understanding the important issues surrounding the FHLBank System and its regulation, this testimony provides information on the development of the System; two legislative changes and FHFB rulemaking that led to changes in membership, asset composition, and capital structure; and important challenges and questions the FHLBank System currently faces.
section_title: What GAO Found
paragraphs: Established in 1932 to facilitate the extension of mortgage credit, the FHLBank System has undergone significant statutory changes in the last 15 years. Between the 1930s and the 1980s, the System consisted primarily of thrift members that accepted advances from the FHLBanks. However, during the 1980s, hundreds of FHLBank member thrifts failed forcing Congress to fundamentally reform the System through the Financial Institutions Recovery, Reform, and Enforcement Act of 1989 (FIRREA). For example, FIRREA permitted commercial banks to join the System. Although FIRREA is credited with strengthening the thrift industry and the System, concerns were raised during the 1990s about the System's capital structure. In particular, commercial bank members could remove stock from their FHLBank on 6-months notice, which raised concerns about the System's financial stability. Among other provisions, the Gramm-Leach-Bilely Act (GLBA) of 1999 created a more permanent and risk-based capital structure for the System. Due to these statutes and FHFB rulemaking, the FHLBank System has evolved substantially since 1990. For example, commercial banks now account for more than 70 percent of all System members. The composition of FHLBank System assets has also fluctuated considerably over the years. For example, FHFB authorized the FHLBanks to purchase mortgages directly from their members in the 1990s. The System's mortgage assets grew to about $113 billion at yearend 2003 representing about 14 percent of total assets. However, the rapid growth in System mortgage assets leveled off in 2004 as two FHLBanks experienced problems managing the interest-rate risks associated with holding mortgages on their books. As provided by GLBA, System capital is now more permanent as members generally must invest capital for a period of 5 years and the FHLBanks are subject to new leverage and risk-based capital requirements. The FHLBank System faces important challenges and questions going forward. For example, FHFB has called the FHLBanks' risk-management practices into question, particularly those related to mortgage purchase programs. Further, proposals to permit the FHLBanks to issue mortgage-backed securities (securitization) could help ensure the growth of the mortgage purchase business and improve risk management, however these proposals raise questions regarding the FHLBanks' capacity to manage the related risks. Additionally, there is limited empirical information available regarding the extent to which the System is fulfilling its housing and community mission. Finally, questions have been raised regarding the potential negative affects that large financial institutions may have on the traditional cooperative structure of the FHLBank System and its programs designed to benefit targeted groups.

section_title: Letter
paragraphs: I appreciate the opportunity to participate in today’s hearing to provide an  overview on the Federal Home Loan Bank System’s (FHLBank System or  System) operations, its federal oversight, and challenges that it faces. As  you know, the FHLBank System is a government-sponsored enterprise  (GSE) that consists of 12 Federal Home Loan Banks (FHLBanks) and is  cooperatively owned by member financial institutions, typically  commercial banks and thrifts (or savings and loans). The primary mission  of the FHLBank System is to promote housing and community  development generally by making loans, also known as advances, to  member financial institutions. These institutions are required to secure  FHLBank advances with high-quality collateral (such as single-family  mortgages) and may use the advances to fund mortgages. To raise the  funds necessary to carry out its activities, the FHLBank System issues debt  in the capital markets at favorable rates compared to commercial  borrowers due to its GSE status. According to the Federal Housing  Finance Board (FHFB), as of December 31, 2004, the System had $855  billion in outstanding debt obligations.
Because the FHLBank System is a GSE, the potential exists that the  federal government would be called on to provide financial assistance to  the System if it was unable to meet its financial obligations. To minimize  the potential that the FHLBank System would experience significant  financial problems, Congress established the FHFB as the System’s safety  and soundness regulator in 1989. FHFB is also responsible for helping to  ensure that the FHLBanks fulfill their housing and community  development mission.
In recent years, the FHLBank System has undergone important changes  and questions have been raised regarding the adequacy of FHLBanks’ risk- management practices and the functioning of the System’s cooperative  structure. For example, since 1997, the FHLBank System has moved  beyond the traditional advance business by establishing programs to  purchase mortgages directly from member financial institutions, an  activity similar to the mortgage purchase business of the two other  housing GSEs: Fannie Mae and Freddie Mac. Although such mortgage  purchase programs have the potential to increase profitability and better  serve member institutions, they also expose FHLBanks to interest-rate and  credit risk. FHFB recently identified interest-rate risk management  deficiencies at two FHLBanks and required them to take corrective  measures. The traditional cooperative structure of the FHLBank System  has also been challenged by sometimes sharp differences in business  strategies among the 12 FHLBanks. In particular, FHLBanks have  disagreed over proposals to permit securitization of mortgage assets.  While securitization may permit FHLBanks to expand their purchase of  mortgage assets, some FHLBanks also regard it as changing the business  of the System and increasing potential risks.
To assist the committee in understanding the important issues  surrounding the FHLBank System and its regulation, my testimony today  is divided into three parts. First, I will provide an overview on the  development of the FHLBank System and its supervision with a focus on  how two statutes: the Financial Institutions Recovery, Reform, and  Enforcement Act of 1989 (FIRREA) and the Gramm-Leach-Bliley Act of  1999 (GLBA) made substantial changes to the System’s original structure  and capital requirements. Second, I will provide more detailed information  as to how FIRREA and GLBA, as well as FHFB rulemaking have changed  the System’s membership, asset composition, and capital structure over  the past 15 years. Third, I will discuss important challenges and questions  affecting the FHLBank System.
Congress established the FHLBank System in 1932 to help rescue the  housing finance market, which had been decimated by the Great  Depression. Between the 1930s and the 1980s, each FHLBank made  advances to thrifts in its district that were required to be members of the  System, and these activities were credited with helping to develop a  unified housing finance market. However, in response to the thrift crisis of  the 1980s, Congress enacted FIRREA which, among other provisions,  opened FHLBank System membership to commercial banks and other  insured depository institutions on a voluntary basis and permitted such  members to withdraw capital from the System with 6-months notice  (whereas thrifts were still required to become members and as mandatory  members could not withdraw their minimum required amount of capital).  In 1999, due to concerns that voluntary members’ ability to withdraw  capital increased risks to the System, GLBA made System membership  voluntary for all institutions but required a more permanent capital  structure with leverage and risk-based capital requirements.
Due to FIRREA, GLBA, and FHFB rulemaking, the FHLBank System has  evolved substantially since 1990. For example, commercial banks now  account for more than 70 percent of all the System members, whereas  thrifts accounted for nearly 100 percent of all members in 1990. The  composition of FHLBank System assets have also fluctuated considerably  over the years, although advances remain the largest asset. In the early to  mid 1990s, advances declined from about 70 percent of the System’s assets  to about 50 percent as the FHLBanks increased investments in mortgage- backed and other types of securities (investments increased from about 27  percent of the System assets in 1990 to 43 percent in 1996). System  investment assets increased as FHLBanks sought higher returns than  those available from the traditional advance business. Between 1997 and  2003, FHLBank System mortgage holdings increased as a percentage of  assets, relative to advances and other investments. However, mortgage  holdings leveled off in 2004 as a result of the financial difficulties some  FHLBanks experienced with their mortgage purchase programs.  Consistent with GLBA, the FHLBank System has also largely implemented  its new capital structure.
The FHLBank System is currently facing several important challenges and  questions regarding its risk-management practices, future business  strategies, mission accomplishment, and organizational structure. As I  described previously, FHFB has entered into written supervisory  agreements with two FHLBanks due to risk management deficiencies in  their mortgage purchase programs—including the Chicago bank which has  been the engine of growth for the System’s mortgage purchases—and  placed limits on future purchases until identified deficiencies are  corrected. Although securitization has been proposed as a means to permit  the FHLBank System to continue expanding its mortgage purchase  programs over the long-term, the idea is highly controversial. Another  challenge facing the System is that there is limited empirical information  on the extent to which FHLBank advances and other services benefit  housing and community finance. Finally, concerns have been raised that  large financial institutions that may have subsidiaries with memberships in  two or more FHLBank districts could generate dangerous competition  within the System and negatively affect its community development  efforts.
To prepare for this testimony, we reviewed several reports and  testimonies that we have completed on the FHLBank System and FHFB.  We also obtained FHLBank System financial data for 2004 from FHFB.  Additionally, we interviewed several FHLBank presidents as well as the  FHFB Chairman, two FHFB board members, and agency officials. We  conducted our work in Washington, D.C., between March and April 2005 in  accordance with generally accepted government auditing standards.
subsections: section_title: Overview of the Federal Home Loan Bank System and Its Regulation
paragraphs: I would like to begin my testimony by briefly describing the development  of the FHLBank System, significant statutory changes to the System, and  its operations. Then, I will describe FHFB’s structure and activities.
subsections: section_title: The FHLBank System Was Established to Facilitate Housing Finance and Has Undergone Significant Changes in Recent Decades
paragraphs: Congress passed the Federal Home Loan Bank Act (FHLBank Act) in 1932  and established the FHLBank System to facilitate the extension of  mortgage credit and the housing finance market, which had been severely  affected by the Great Depression. The FHLBank Act required all federally  chartered thrifts to become members of the FHLBank located in their  districts (see fig. 1) and invest capital in the FHLBanks. The System acted  as a central credit facility that made advances to thrifts which, in turn,  were expected to make additional mortgage credit available to  homebuyers and thereby revive the housing finance market. The act also  established safeguards to help ensure the financial soundness of the  FHLBanks. In particular, thrifts had to pledge high-quality assets in excess  of the value of their advances as collateral. In addition, the act created the  Federal Home Loan Bank Board (Bank Board) to oversee the safety and  soundness regulation of the FHLBanks as well as the thrift industry.  However, between 1985 and 1989, the Bank Board delegated its oversight  responsibility of the thrift industry to each of the FHLBanks.
The business of the FHLBank System and its members essentially  remained unchanged from the 1930s until the 1980s. The System is  generally credited with serving as a relatively low-cost funding source for  thrifts during that period and helping to overcome regional shortages in  housing credit. However, due to regional downturns, sharply rising  interest rates, and poor management, hundreds of FHLBank member  thrifts failed during the 1980s, causing a contraction in FHLBank System  business. As a result, Congress appropriated billions of dollars to cover the  costs associated with ensuring the payment of insured thrift deposits. In  addition, the regulatory structure for the thrift industry—where FHLBanks  supervised thrifts on behalf of the Bank Board—involved significant  conflicts of interest. These conflicts (such as FHLBanks regulating  institutions to which they made advances) compromised the safety and  soundness oversight of the thrift industry. In response to these issues,  Congress enacted the FIRREA, which made substantial changes to the  FHLBank System’s membership, regulation, and mission requirements as  summarized below:    FIRREA opened FHLBank system membership to commercial banks and  credit unions that engaged in mortgage activities. These voluntary  members were required to invest capital in their FHLBank but could  normally withdraw such capital on 6-months notice. However, FIRREA  still required thrifts to be members of their FHLBank and did not allow  them to withdraw their capital contributions.
FIRREA required the System to capitalize the Resolution Funding  Corporation (REFCORP) to help pay for the deposit insurance fund losses  resulting from thrift failures. Furthermore, the System had to pay up to  $300 million per year of annual earnings to contribute towards interest  payments on bonds issued by REFCORP to pay for thrift losses.
FIRREA abolished the Bank Board and established FHFB to regulate the  12 FHLBanks. FIRREA also transferred the Bank Board’s previous  supervisory and regulatory responsibilities for thrift institutions and their  holding companies to the newly created Office of Thrift Supervision.
FIRREA also directed each FHLBank to establish or maintain two low- and  moderate-income housing programs—the Community Investment Program  (CIP) and the Affordable Housing Program (AHP). As part of CIP, each  FHLBank makes advances to finance the purchase or rehabilitation of  housing for eligible households and finance other projects benefiting  residents of low- and moderate-income neighborhoods. AHP requires each  FHLBank to subsidize the financing of eligible low- and moderate-income  housing and FIRREA sets priorities for use of these advances among  eligible projects.
Although FIRREA is credited with helping to restore the financial  condition and supervision of the thrift industry during the 1990s, the  capital structure of the FHLBank System and the financial obligations that  the act imposed on the System and its members subsequently raised  concerns. In particular, the fact that voluntary members, such as  commercial banks, had the option of removing their capital from the  System with 6-months notice appeared to increase financial risks to the  System. Additionally, since the FHLBanks’ earnings had been weakened by  the declining profitability of the thrift industry, the $300 million REFCORP  obligation posed a challenge. Consequently, FHLBanks looked for new  sources of revenue and increased investments in mortgage-backed  securities that offered potentially higher returns, but exposed them to  increased risks.
After years of attempting to resolve these issues, Congress passed the  Gramm-Leach-Bliley Act of 1999 (GLBA), which contained provisions that    Eliminated the requirement that thrift institutions be members of the  FHLBank System and made membership voluntary for all members.  Additionally, GLBA established new capital requirements for FHLBank  members that were intended to make the System’s capital more  permanent. I will describe the capital provisions of GLBA in more detail  later in my testimony;   Revised the System’s REFCORP obligations, moving from a fixed annual  payment of about $300 million to a specified percentage (20 percent) of  the System’s annual earnings after AHP expenses. This change minimized  the financial obligation on the System during periods of relatively low  profitability but increased the total payment when profits increased; and   Expanded the amounts and types of collateral that FHLBanks could  accept for advances from small members known as community financial  institutions (CFI). GLBA permitted CFIs to pledge small business and  agricultural loans as collateral for FHLBank advances.
section_title: The Structure and Operations of the FHLBank System
paragraphs: Each of the 12 FHLBanks has a board of directors of at least 14 persons,  with 8 elected by members and at least 6 appointed by FHFB. The FHFB  appointed directors are commonly referred to as public interest directors.  Additionally, each FHLBank board appoints a president who is responsible  for overseeing the institution’s staff (see table 1). The president and staff  are responsible for such activities as the FHLBank’s asset and liability  management, AHP and other community development activities, and  compliance with laws and regulations.
The FHLBank System raises funds in the capital markets through its Office  of Finance (OF), which has a board of directors consisting of three  individuals who serve 3-year terms. FHFB appoints the OF chair and  selects two FHLBank presidents to serve as the other OF board members.  As I discussed earlier, the FHLBank System can issue debt, generally  referred to as consolidated obligations, at a relatively low cost due to its  GSE status, which may allow members to fund mortgages at lower rates.  Consolidated obligations are the “joint and several” obligations of the  FHLBanks. That is, if an FHLBank defaults on its repayment obligations,  all the other FHLBanks may have to cover its obligations. Although the  federal government does not explicitly guarantee that it would provide  financial assistance to the FHLBank System in a financial emergency,  investors perceive an implied guarantee because of the ties between the  government and the System. For example, each FHLBank has a federal  charter and consolidated obligations are exempt from federal, state, and  local taxes. Moreover, the federal government did provide financial  assistance to other GSEs, such as Fannie Mae and the Farm Credit System,  when they experienced financial difficulties during the 1980s.
In addition to providing advances to its members, the FHLBank System  provides member institutions other benefits and services. For example,  FHLBanks generally pay dividends to their member financial institutions.  Other services FHLBanks may offer members include providing discounts  on advances for large transactions, funding the AHP and CIP programs to  help members finance affordable housing and community development  activities, and offering mortgage purchase programs as discussed next.
Although reportedly no FHLBank has ever suffered a credit loss on an  advance, the business activities of the FHLBanks have become  increasingly complex and potentially risky in recent years largely due to  the implementation of the mortgage purchase programs. All of the  FHLBanks are authorized to purchase mortgages from members through  programs such as the Mortgage Partnership Finance (MPF) program and  the Mortgage Purchase Program (MPP). Through these mortgage  purchase programs, FHLBanks purchase conventional or government- guaranteed mortgages directly from their members. The FHLBanks hold  the mortgages on their books and bear the interest-rate risks associated  with them. To manage the interest-rate risks, FHLBanks must employ  sophisticated risk-management techniques including the use of financial  derivatives. Although such strategies are appropriate for risk management,  they require specialized expertise, sophisticated information systems, and  an understanding and application of sometimes complex accounting rules.  As I discuss later, some FHLBanks recently have encountered financial  problems in managing the interest rate risks associated with their  mortgage portfolios.
section_title: FHFB Regulates FHLBank System Safety and Soundness and Mission Achievement
paragraphs: FHFB is responsible for regulating the FHLBank System’s safety and  soundness as well as its mission achievement. The agency has a five- member board, with the President of the United States appointing four  board members, subject to Senate approval. Each appointee serves a 7- year term. The fifth board member is the Secretary of the Department of  Housing and Urban Development, or the secretary’s designee. The  President also designates one of the four appointed board members as the  chair, subject to Senate approval. FHFB is located in Washington, D.C. and  has a staff of about 124 individuals, including 17 examiners in eight cities  where FHLBanks are located.
FHFB supervises the FHLBanks by conducting annual on-site  examinations and off-site monitoring to ensure that the Banks satisfy  capitalization requirements and maintain their ability to raise funds in the  capital markets. On-site examinations are focused on particular risk areas  (interest-rate risk, credit risk, and operational risk) and compliance with  mission requirements such as the AHP program. Examiners set the scope  for the examinations based on potential issues identified at previous  examinations, as well as through quarterly monitoring. Off-site monitoring  involves FHFB headquarters staff reviewing financial data on the  FHLBanks on a continual basis. FHFB also conducts systemwide reviews  of significant FHLBank operational, governance, and other practices and  uses advisory bulletins and regulatory interpretations to convey guidance  that addresses supervisory issues with systemwide implications.
Under the FHLBank Act, FHFB is authorized to promulgate and enforce  such regulations and orders that it deems necessary to carry out its  responsibilities. The following summarizes several of FHFB’s key  authorities:    FHFB has the authority to issue cease-and-desist orders and other  enforcement actions to address unsafe FHLBank practices. FHFB also has  the authority to remove FHLBank officials and prohibit actions by  FHLBank officers and directors.
FHFB does not have specific statutory authority to establish a prompt  corrective action (PCA) mechanism as do other federal banking regulators  such as the Office of the Comptroller of the Currency and the Federal  Deposit Insurance Corporation. Under such PCA authorities, bank  regulators are required to take specific supervisory actions when bank  capital levels fall below specified levels and may take other actions when  specified unsafe and unsound actions occur. Although FHFB does not  have PCA authority, FHFB officials believe they have all the necessary  authorities to carry out their responsibilities; and   FHFB has the statutory authority to liquidate or reorganize a critically  undercapitalized FHLBank “whenever  finds that the efficient and  economical accomplishment of the purposes of the  will be  aided by such action.”
section_title: FHLBank System Membership, Asset Composition, and Capital Structure Have Undergone Significant Changes in the Past 15 Years
paragraphs: Until 1989, the FHLBank System consisted of the 12 FHLBanks, OF, and  thrifts, which were required to join. However, FIRREA and GLBA made  substantial changes to this traditional structure. In this section, I will  describe in more detail how FHLBank System membership, asset  composition, and capital structure have changed over the past 15 years  after the implementation of these statutes and FHFB regulations.
subsections: section_title: Commercial Banks Currently Account for the Majority of System Members and Advances
paragraphs: Between 1990 and 2004, FHLBank System membership nearly tripled from  2,855 to 8,131 institutions (see fig. 2). As shown in the figure, the vast  majority of membership increase can be attributed to commercial banks;  whereas in the same period, thrift membership declined markedly. In 1990,  thrifts accounted for 98 percent of all the System members but only 16  percent in 2004. In contrast, commercial banks accounted for 2 percent of  all members in 1990 and 73 percent in 2004. A variety of factors may  account for the surge in commercial bank membership. First, FHLBanks  actively recruited commercial banks as members after FIRREA.  Commercial banks may also have been attracted by the fact that FHLBank  advances represent a stable and relatively low-cost source of funding.  Additionally, in an attempt to offset declining membership resulting from  the failure of many thrifts, FHLBanks modified their services and products  to attract new members. For example FHLBanks made changes in advance  pricing and terms in response to market pressures.
Not only do commercial banks represent a large percentage of FHLBank  System members, they also hold a large percentage of System capital and  advances. As shown in figure 3, commercial banks now account for  almost half of the System’s capital and advances. However, member thrifts  still account for 43 percent of all system capital and 50 percent of all  advances. Although thrifts account for a relatively small percentage of  FHLBank members, they have remained significant customers of the  FHLBank System due to their focus on mortgage financing.
section_title: Mix of System Asset Types Has Fluctuated Significantly from 1990 through 2004
paragraphs: FHLBank System assets, which consist of advances, investments, and  mortgages, increased from $165 billion in 1990 to $934 billion in 2004. As  shown in figure 4, the mix of the three asset types has fluctuated in this  time period although advances remained the largest category of assets.  However, I note that the System did not hold mortgage assets until 1997.
In 1990, advances represented about 70 percent of all the System’s assets,  but declined to about 50 percent between 1991 and 1996. In contrast,  FHLBank System investments—such as holdings of mortgage-backed  securities (MBS) issued by Fannie Mae and Freddie Mac—increased from  27 percent of all assets in 1990 to 43 percent in 1996. During that period, as  I have discussed, the number of thrifts declined, resulting in a loss of  System advance customers and concerns were raised that REFCORP  obligations imposed significant financial burdens on the FHLBanks.  Investments in MBS were viewed within the System as more profitable  than traditional advances and a potential means to comply with the  REFCORP obligations. Through rulemaking, FHFB facilitated the  FHLBanks’ ability to invest in MBS. In 1991, FHFB increased the  percentage of MBS that the FHLBanks could hold as a percentage of their  capital from 50 percent to 200 percent and, in 1993, FHFB raised the MBS  to capital ratio to 300 percent. I note that investments as a percentage of  all the System’s assets began to decline in 1995 while advances began to  increase perhaps due, in part, to the increase in commercial bank  members joining the System and taking advances.
As I have discussed, FHFB also authorized the FHLBanks to begin  purchasing mortgage assets through mortgage purchase programs in 1997.  By 2003, such mortgage assets grew to almost 14 percent of all the  System’s assets (about $113 billion in total System mortgage assets at year- end 2003). The growth in mortgages generally occurred relative to  investments which declined from 40 percent of all assets in 1997 to 23  percent in 2003. However, in 2004, the System’s mortgage assets leveled  off, partly because of difficulties identified at some FHLBanks in managing  such assets. I discuss this issue in the next section.
section_title: FHLBank System Has Implemented a New Capital Structure
paragraphs: As I discussed earlier, prior to 1999 voluntary FHLBank members, such as  commercial banks, could withdraw their capital on 6-months notice, which  raised questions about the stability of the FHLBanks’ capital structure. To  address this concern, GLBA established that FHLBank membership was  voluntary but required that financial institutions that choose to become  members invest more permanent stock in their FHLBank. Under the new  capital structure, FHLBanks can 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 times of stress, GLBA does not allow an  FHLBank to redeem or repurchase capital if following the redemption the  FHLBank would fail to satisfy any minimum capital requirement.
Under GLBA, the FHLBanks are also subject to both a leverage  requirement (minimum capital-to-assets ratio) and a risk-based capital  calculation. Under the leverage requirements, each FHLBank must comply  with two minimum capital ratios. First, permanent capital (equal to  amounts paid in for class B stock plus retained earnings) plus class A  stock is to be at least 4 percent of assets. Second, class A stock plus 1.5  times permanent capital is to be at least 5 percent of assets. The risk-based  capital standards account for credit risk, interest-rate risk, and operations  risk. For credit risk, a FHFB regulation specifies capital requirements  according to the mix of activities (advances, mortgages, etc.) in which the  individual FHLBank is engaging. For interest-rate risk, each of the  FHLBanks must have a FHFB-approved interest-rate risk model that  provides an estimate of the market value of the FHLBank’s portfolio  during periods of market stress. The capital requirement for operations  risk is generally 30 percent of the total capital charge for credit and  interest-rate risk.
GLBA required each FHLBank to submit a capital plan to FHFB for review  and approval. FHFB approved all 12 FHLBank capital plans by 2002 and 11  of the 12 FHLBanks have implemented their capital plans. According to  FHFB, 10 of the 12 capital plans rely entirely on class B stock and two of  the capital plans include class A stock. As part of the capital plan  implementation process, FHFB has required the FHLBanks to submit  plans for modeling interest-rate risk and related procedures for managing  these risks.
section_title: FHLBank System Faces Important Challenges and Questions
paragraphs: Finally, I would like to discuss some important challenges and questions  affecting the FHLBank System. They include risk-management practices,  the securitization of mortgage assets, the extent to which the FHLBank  System is meeting its mission requirements, and the alleged impacts that  large financial institutions are having on the System’s traditional  cooperative structure and AHP program.
subsections: section_title: FHFB Has Questioned FHLBanks’ Risk- Management Practices
paragraphs: Over the past year, FHFB identified risk-management deficiencies at two  FHLBanks—Chicago and Seattle—primarily related to their management  of the interest-rate risks associated with mortgage purchases. FHFB  identified weaknesses at these FHLBanks in such areas as corporate  governance, financial recordkeeping, audit, and financial performance.  Additionally, FHFB entered into written enforcement agreements with  both FHLBanks that require improvements in accounting practices and  internal controls. The Chicago and Seattle FHLBanks were both required  to submit 3-year business and capital plans to FHFB and hire outside  management consultants to review the banks’ management and their  board’s oversight of the banks. The Chicago FHLBank has submitted its  plan to FHFB, which accepted it. The Seattle FHLBank received an  extension and submitted its plan to FHFB on April 5, 2005.
The financial problems identified at the Chicago and Seattle FHLBanks  have had significant effects on their operations and business practices. For  example, FHFB required the Chicago FHLBank to restate its financial  results for 2003 and placed limits on the growth of the institution’s  mortgage purchases until its risk-management practices improve.  Previously, the Chicago FHLBank had been the primary engine of growth  for the mortgage purchase programs within the FHLBank System. The  Seattle FHLBank has decided to exit from the MPP program and thereby  stop purchasing mortgages from its members.
FHFB officials told us they continue to monitor risk management practices  within the FHLBank System, particularly the management of interest-rate  risks. FHFB officials said that their examinations continue to identify  deficiencies in these areas and that they are working with the FHLBanks  to correct them.
section_title: Proposals to Use Securitization to Expand FHLBanks’ Mortgage Purchase Programs Are Controversial
paragraphs: In recent years, proposals have been made to permit the FHLBanks to  securitize mortgage assets to provide for the continued growth of the  mortgage purchase programs. Without securitization, which would permit  FHLBanks to remove mortgage assets from their balance sheets, the  System’s ability to increase its mortgage purchases may be constrained by  capital requirements. That is, since the FHLBanks must comply with  capital requirements for assets such as mortgages held on their balance  sheets, they would not be able to expand these programs without  obtaining additional capital from their members, which may prove  difficult. According to FHFB’s chair, the agency should defer to Congress  on the question of whether FHLBanks should be permitted to securitize  their mortgage assets.
Securitization offers potential benefits to the FHLBank System but it raises  questions as well. One potential benefit of securitization is that it would  provide the FHLBanks with an additional tool to manage the interest-rate  risks associated with mortgage purchases. Authorizing the FHLBanks to  securitize mortgage assets has also been advocated as a means to increase  competition in the secondary mortgage market, which could benefit  lenders and homebuyers. However, questions exist on whether the  FHLBanks would be able to develop the necessary infrastructure,  including hiring staff with specialized expertise, to effectively manage  securitization programs. Some FHLBank System members have also  commented that securitization would further alter the System’s traditional  focus on providing advances to member institutions, and therefore, be  undesirable.
section_title: Limited Information Exists on the Extent to Which the FHLBank System Is Meeting Its Mission
paragraphs: Although anecdotal information exists on the benefits of the FHLBank  System, limited quantitative analysis exists on the extent to which the  FHLBanks’ activities benefit homebuyers, mortgage finance, and  community development. We recognize that conducting such research is  challenging. First, isolating the FHLBanks’ effects on mortgage markets is  a complex and technical undertaking. Second, with the addition of  mortgage purchase programs, the financial activities of the FHLBanks  have become more sophisticated, thus complicating any analyses of  benefits and costs. Nevertheless, assessing the outcomes of the FHLBank  System’s activities is important for Congress and others to determine  whether the risks associated with the System are offset by the potential  benefits.
I would now like to highlight information and data limitations that hamper  any assessment of mission achievement:    We are not aware of any studies on the extent to which FHLBank  advances, mortgage purchase, and other activities directly benefit  homebuyers through lower mortgage costs. In contrast, several studies  have estimated the potential savings to homebuyers associated with the  mortgage purchase activities of Fannie Mae and Freddie Mac. Some of  these studies estimate a substantial savings to homebuyers while others  conclude that the savings are small and that Fannie Mae and Freddie Mac  as well as their shareholders are the primary beneficiaries. Although the  studies’ findings may differ, they provide an empirical basis for discussing  the costs and benefits of Fannie Mae and Freddie Mac’s activities.
Similarly, there is minimal empirical evidence on the extent to which the  FHLBank System’s advance business encourages lenders to expand their  mortgage business. We have identified one existing study on this subject: a  2002 report by the Federal Reserve Bank of Cleveland. The study found  that there is a significant positive relationship between an FHLBank  member’s use of advances and its mortgage finance activity. However, we  believe the report has certain methodological limitations and should be  interpreted with caution. For example, the report does not demonstrate  that members increased their mortgage assets as a result of joining the  System, it only shows that System members have relatively high mortgage  assets compared to non-System members (We are also aware that the  FHLBank Council recently released two reports on this subject but we  have not had time to analyze them in preparation for this testimony).
There is limited information as to why the placement of small business and  agricultural collateral by small community financial institutions (CFI) to  secure FHLBank advances has been minimal. GLBA expanded the types of  collateral (including small business and agricultural collateral) that CFIs  could pledge to secure FHLBank advances in the view that doing so would  allow the System to better meet the needs of small institutions. However,  FHFB data indicates that such collateral represents less than 1 percent of  all collateral pledged to secure System advances. On the one hand, it may  be the case that very few institutions are willing to pledge such collateral  to secure advances. However, the potential also exists that FHLBanks  have established such strict underwriting standards—for example by  applying significant haircuts to the collateral—that CFIs have been  discouraged from pledging it. We understand that FHFB is planning a  conference later this year to gather additional information on the use of  CFI collateral.
section_title: Questions Have Been Raised About the Impact of Large Holding Companies on the FHLBank System
paragraphs: In recent years, questions have been raised about the potential impacts of  holding companies who may have mortgage subsidiaries that are members  of two or more FHLBank districts on the FHLBank System structure,  which traditionally involved each financial institution belonging to one  FHLBank. In a 2003 report, we noted that there are about 100 holding  companies that had subsidiaries who were members of two or more  FHLBank districts. Some observers have expressed concerns that such  large financial institutions could pressure the FHLBanks to compete with  one another on advance pricing terms—such as interest rates and  collateral requirements—and that this competition could impair the  overall safety and soundness of the FHLBanks. Our report noted  significant differences in advance term pricing among the 12 FHLBanks  and that the opportunity existed for holding companies to obtain advances  from the FHLBank that offered the most favorable advance terms. Some  FHLBank officials also said that holding companies seek to play one  FHLBank off another creating competition within the System. However,  we also found that FHFB had not identified any material safety and  soundness issues related to FHLBanks’ advance-term pricing. I would  reiterate a statement in our 2003 report that FHFB has a continued  responsibility to monitor the FHLBanks to help ensure that any  competition within the System does not result in unsafe and unsound  practices.
Concerns have also been raised that the activities of large financial  institutions such as holding companies are having negative affects on the  AHP program in certain FHLBank districts. Under FIRREA, FHLBanks  must contribute 10 percent of their previous year’s earnings to subsidize  housing finance for targeted groups. In some cases, financial institutions  located in one FHLBank district have purchased banks or thrifts in other  FHLBank districts. As such financial institutions grow through out-of-area  acquisitions, they may be able to increase their business relations with  their local FHLBank thereby increasing its profitability. For example, such  financial institutions may take out additional advances or sell additional  mortgages to the FHLBank. With potentially increased profits from doing  business with a larger member, the FHLBank would have additional funds  to devote to the AHP program. In contrast, FHLBanks whose members  were acquired potentially lose net income and AHP funding dollars.  According to one FHLBank president, such acquisitions have hurt AHP  funding in his bank’s district. However, according to FHFB officials, recent  research they conducted shows that mergers may have a short-term  impact on AHP funding, but these effects seem to balance out over time.  For example, financial institutions in a FHLBank district that lost  members through acquisitions may purchase financial institutions in other  FHLBank districts thereby recapturing AHP funds. FHFB officials also said  that they may develop a regulation to address any concerns associated  with mergers on AHP funding.
Mr. Chairman, this completes my prepared statement. I would be happy to  respond to any questions that you or other members of the committee may  have at this time.
section_title: Staff Contacts and Acknowledgments
paragraphs: For further information regarding this testimony, please contact me at 202- 512-8678 or mccoolt@gao.gov or William B. Shear, Director, at 202-512- 8678 or shearw@gao.gov, or Wesley M. Phillips, Assistant Director, at 202- 512-5660 or phillipsw@gao.gov. Individuals making contributions to this  testimony include Rachel DeMarcus, Austin Kelly, Jill M. Naamane, Andy  Pauline, Mitchell B. Rachlis, and Barbara Roesmann.
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