Federal Home Loan Bank System: Key Loan Pricing Terms Can Differ Significantly
Published: 2003-09-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Federal Home Loan Bank System's (FHLBank System) traditional approach to providing community and housing finance through 12 regional FHLBanks faces continual challenges due to consolidation in the financial services industry and the emergence of mortgage lenders with nationwide operations. In addition, the Federal Housing Finance Board (FHFB), the System's financial regulator, is analyzing the benefits and costs of potential changes to the System's membership rules that would make it easier for financial institutions to join multiple FHLBank districts (referred to as multidistrict membership). To provide information that would be helpful in assessing the potential safety and soundness implications of these developments, GAO was asked among other items to (1) determine whether key differences exist in the terms--such as interest rates and collateral requirements--that FHLBanks make on loans, also known as advances, to member financial institutions such as banks and thrifts and (2) discuss FHFB's oversight of the FHLBanks and safety and soundness data reporting requirements.
section_title: What GAO Found
paragraphs: Federal statutes and regulations require that the FHLBanks set advance interest rates above their borrowing costs and fully secure advances with eligible forms of collateral, such as single-family mortgage loans. However, within this framework, each of the 12 FHLBanks has independent authority to set advance pricing terms, which can result in several significant key differences among the banks. For example, due to differing costs and business strategies, FHLBank advance interest rates may differ and many FHLBanks charge lower interest rates based on advance size while others do not. Moreover, FHLBanks may set differing collateral requirements for their members. For example, one FHLBank allows its members to borrow up to 60 percent of the value of single family mortgages pledged as collateral to secure advances while another allows up to 85 percent. Among the FHLBanks' differing approaches to setting advance pricing terms, FHFB has not found that any practice results in significant violations of statute or regulation. However FHFB also collects collateral data from the FHLBanks that have questionable value in their current format for monitoring the System's safety and soundness. Because FHLBank officials do not have clear information about how FHFB would like the data reported, the FHLBanks use different reporting definitions and criteria, which limits the data's analytical usefulness. Moreover, FHFB has not collected data necessary to assess the current extent of competition within the FHLBank System and the implications of holding companies with subsidiaries that operate in multiple FHLBank districts as well as multidistrict membership.

section_title: Letter
paragraphs: The Federal Home Loan Bank System’s (FHLBank System) traditional  cooperative approach to providing housing and community finance  through 12 regionally based Federal Home Loan Banks (FHLBank) faces  continual challenges due to consolidation in the financial services industry  and the emergence of mortgage lenders with nationwide operations.   Traditionally, each FHLBank made loans, known as advances, that were  secured by eligible collateral (e.g., single family mortgage loans) to  member institutions—particularly thrifts—located in its district to support  housing finance.  However, many large bank and thrift holding companies  now own subsidiaries located in various FHLBank districts.  Each eligible  subsidiary may join the FHLBank in which district its headquarters is  located, and may obtain advances from that FHLBank.  Thus, these bank  and thrift holding companies may, in effect, have access (through their  subsidiaries) to advances from multiple FHLBanks.
Some observers have expressed concerns that these holding companies  can 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, which were jointly and severally liable for $710 billion in debt  obligations as of June, 2003.  For example, the concern exists that a  holding company could shift assets at a subsidiary located in one FHLBank  district to pledge as collateral at a subsidiary in another district offering  more favorable advance terms.  Recently, these concerns have been  heightened as the Federal Housing Finance Board (FHFB), the FHLBank  System’s financial regulator, has analyzed the benefits and costs associated  with potential changes to the System’s membership requirements that  would allow financial organizations to join more than one FHLBank district  (these potential changes to the System’s membership rules are commonly  referred to as multidistrict membership). Supporters of multidistrict  membership believe that it is necessary to modernize the FHLBank  System’s structure, while critics believe that multidistrict membership  would increase the potential for dangerous competition between the  FHLBanks.
As discussed with your staff, this report provides an overview of advance  term pricing requirements and practices within the FHLBank System that  could be useful in assessing the extent of current competition among the  FHLBanks and the potential competitive impacts of multidistrict  membership.  Specifically, you asked that we  1. describe the laws and regulations pertaining to the terms that  FHLBanks can offer on advances;  2. provide information on whether key differences exist in current  advance pricing and other terms across the FHLBanks;  3. determine whether holding companies face any legal or regulatory  barriers in transferring assets among subsidiaries who are members of  different FHLBank districts; and  4. describe FHFB’s safety and soundness oversight of the FHLBanks’  advance pricing practices and review selected data that FHFB collects  to monitor safety and soundness practices within the FHLBank System.
To address these objectives, we obtained and reviewed applicable federal  laws and regulations pertaining to the terms that the FHLBanks can offer  on advances.  We also interviewed the 12 FHLBank presidents, credit and  collateral staff from 7 of the 12 FHLBanks, and FHFB officials.  We sent a  set of structured questions to each of the 12 banks and reviewed their  credit and collateral policies.  In addition, we obtained and reviewed  applicable laws and regulations regarding the transfer of funds and assets  among holding companies and their subsidiaries, and interviewed  representatives from the Federal Reserve Board and a large holding  company.  The scope of our work included a description of FHFB’s  examination program pertaining to advances but did not include an  analysis of the program’s effectiveness.  However, we did analyze FHFB’s  collateral reporting requirements for the 12 FHLBanks.  Because the  information contained in this report is potentially sensitive, we generally  do not identify individual FHLBanks in this report.  Instead, we identify  each of the 12 banks by the letters A-L.  For each report table, we changed  the individual FHLBanks identified by the letters A-L.  Appendix I contains  a detailed description of the scope and methodology of our work.
We conducted our review from January to September 2003 in Washington,  D.C.; New York, New York; Topeka, Kansas; Dallas, Texas; Atlanta, Georgia;  and Pittsburgh, Pennsylvania, and Indianapolis, Indiana, in accordance  with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Established in 1932, each FHLBank is a government-sponsored enterprise  (GSE) that is cooperatively owned by its members (see fig. 1 for the  location of the 12 FHLBanks).  The 12 FHLBanks, along with the Office of  Finance (which issues debt on behalf of the FHLBanks), comprise the  FHLBank System.  The members of each FHLBank must buy stock in the  FHLBank as a prerequisite for obtaining advances and other FHLBank  services.  FHLBank System assets consist of advances and investments,  such as money market funds and mortgage-backed securities (see table 1).   In addition, FHLBank assets consist of acquired mortgages that the  FHLBanks purchase from their members under the Mortgage Partnership  Finance (MPF) program or Mortgage Purchase Program (MPP).  The  FHLBank-purchased mortgages consist of both conventional mortgages  and federally insured and guaranteed mortgages.
The FHLBank System raises funds in the capital markets partially on the  strength of its ties to the federal government.  Due to these ties, investors  perceive an implied guarantee by the federal government on the System  debt based on the belief that the government would come to the rescue of  the FHLBank System rather than allow it to default on its obligations in the  event of severe financial difficulties.  The primary source of funds for the  FHLBank System is the issuance of debt securities known as consolidated  obligations, through its Office of Finance, which stood at $710 billion as of  June 30, 2003.  Consolidated obligations are the “joint and several”  obligations of the FHLBanks and all of the banks may be required to cover  such obligations of another bank that defaults on its repayment obligations.   Under the joint and several structure, the potential for moral hazard exists.   That is, FHLBanks may have incentives to take financial risks knowing that  their losses would be covered by other FHLBanks or, ultimately, the federal  government.  Federal statutes and regulations as well as FHFB’s oversight  efforts—which are discussed in this report—are designed to help ensure  that the FHLBanks conduct their business in a safe and sound manner.
The FHLBank Act provides that an eligible institution may become a  member only of the FHLBank district in which its principal place of  business is located, or an adjoining district for convenience purposes and if  approved by FHFB. However, bank or thrift holding companies may own  subsidiaries in two or more FHLBank districts and each eligible subsidiary  may become a member of its district FHLBank.  To become a FHLBank  member, each subsidiary must be a separately chartered institution, such  as a national bank or state-chartered bank or thrift.  According to FHFB,  approximately 100 bank or thrift holding companies currently operate in  two or more FHLBank districts by having established separately chartered  subsidiaries in those districts.
In 2000 and 2001, continuing a long standing trend, several holding  companies with subsidiaries that operated in two or more FHLBank  districts merged with or purchased financial institutions that were also  members of FHLBank districts.  These holding companies sought to  consolidate the merged or purchased institutions under one existing  charter and did not want to maintain separately chartered institutions.  For  example, Washington Mutual (WAMU)—a thrift holding company with  subsidiaries in the Seattle, San Francisco, and Topeka FHLBank districts— purchased Bank United, a member of the Dallas FHLBank district, and  Dime Savings, a member of the New York FHLBank district.  WAMU chose  not to maintain separate charters for Bank United and Dime Savings for  business purposes and instead decided to merge the institutions into its  existing subsidiaries.  However, under FHFB regulations Dime Savings and  Bank United could no longer remain members of the FHLBank System and  could no longer obtain new advances or other services from the FHLBank  of Dallas and the FHLBank of New York.  Therefore, WAMU was required  to pay back Bank United and Dime Savings’ outstanding balances under  their original terms.
In 2000, the FHLBank of Dallas submitted to the FHFB an application  (which the FHFB subsequently treated as a petition) to grant approval to  WAMU’s thrift subsidiary’s application for membership in the FHLBank of  Dallas while maintaining its membership in the FHLBank of San Francisco  (the petition has been referred to as advocating multidistrict membership).   The Dallas FHLBank filed the petition under the “demanded by  convenience” standard.  After the initial petition, FHFB received similar  requests from three other FHLBanks, requests to intervene, and comment  letters both in favor and against.  Given the controversy associated with  these petitions and their potential effects on the System (including the  potential for increased competition among the FHLBanks), FHFB did not  act on them and, in October 2001, requested comments from the public on  the petitions. In 2002, FHFB obtained a legal opinion from a law firm  stating that it had the legal authority, under certain conditions, to approve  multidistrict membership under its broad safety and soundness regulatory  authority and requested that the 12 FHLBanks answer questions related to  multidistrict membership, which the FHLBanks did by February 2003.   During 2003, FHFB staff, at the direction of the agency’s chairman,  analyzed the benefits and costs associated with multidistrict membership.
section_title: Statutes and Regulations Establish the General Pricing and Other Terms Each FHLBank Can Offer on Advances to Member Institutions
paragraphs: The FHLBank Act, as amended by GLBA, and FHFB regulations establish  the general pricing and other terms that each FHLBank can offer on its  advances.  Statutory and regulatory provisions establish requirements for  FHLBank pricing on advances, allow for price differentiation at the  FHLBanks, require that advances must be fully secured, and establish  eligible types of collateral.  FHFB regulations establish more specific  requirements to help ensure that the FHLBanks conduct their advance  business in a safe and sound manner.
subsections: section_title: General Requirements for Terms on Advance Pricing
paragraphs: According to FHFB regulations issued pursuant to the FHLBank Act,  FHLBank advances may not be priced below the marginal cost to the  FHLBank of raising matching term and maturity funds in the marketplace,  including embedded options, plus the administrative and operating costs  associated with making advances.  FHLBanks are allowed to differentiate  in advance prices based on the FHLBank’s assessment of the credit and  other risk of lending to any particular member, or other reasonable criteria.
Per FHFB’s guidance, such differentiation could include providing  discounts to members based on the volume of the advance.  Each  FHLBank is to include in its member products policy standards and criteria  for differential pricing and is to apply its standards and criteria consistently  and without discrimination to all members.
The FHLBank Act, as amended by GLBA, requires that FHLBanks fully  secure their advances with eligible collateral.  The eligible collateral, as  listed in table 2, ranges from whole single family mortgages to small  business and agricultural loans.  GLBA, which amended the FHLBank Act,  expanded the collateral that member institutions could use to secure an  advance. In particular, GLBA allowed CFIs, those FHLBank System  members that are FDIC insured depository institutions that currently have  $538 million or less in total assets, to pledge small business and agricultural  loans as collateral.  GLBA allowed CFIs to use the expanded collateral  categories because some small institutions lacked a sufficient quantity of  other types of assets—such as mortgage loans—necessary to secure  FHLBank advances.  GLBA also allowed all FHLBank members to make  greater use of ORERC—such as commercial real estate loans and home  equity loans—as collateral for advances.  The FHLBanks may restrict the  types of eligible collateral available to them as security, based upon the  creditworthiness or operations of the borrower, the quality of the  collateral, or other reasonable criteria.
By fully securing advances with eligible collateral as required by the  FHLBank Act, FHLBanks can protect their interests should one or more of  their members fail.  Typically, FHLBanks make advances on what is known  as a blanket lien; that is, the FHLBank has the authority to take control of  all the assets that are eligible as collateral on a member’s books.  In cases in  which an FHLBank determines that a member is experiencing financial  difficulty, the FHLBank may require the member to list specific assets that  are securing advances or may even require the member to deliver the  collateral to the FHLBank.  Should the member fail, the FHLBank can sell  the pledged collateral to ensure repayment of principal and the interest on  the advance.  Due in part to the collateralization requirements, the  FHLBank System has never experienced a loss on an advance.
section_title: FHFB Regulations Establish Additional Advance Term Requirements
paragraphs: FHFB has issued several regulations that are designed to help ensure that  the FHLBanks make advances in a safe and sound manner.  For example,  FHFB has established regulations pertaining to the use of ORERC and  small business and agricultural loans as collateral, which are generally  considered riskier than other forms of collateral, such as single-family  mortgages.  FHFB regulations require that FHLBanks can reliably discount  the value of ORERC and small business and agricultural loans pledged as  collateral.  Under its regulations, FHFB also has the authority to require an  FHLBank to increase its standards for all forms of eligible collateral.  FHFB  requires through regulation that FHLBanks take the necessary steps to  ensure that collateral is secure and to establish written procedures for  verifying the existence of collateral.
section_title: Significant Differences Exist in Key Advance Pricing Terms among the FHLBanks
paragraphs: Although the FHLBank Act and FHFB regulations establish the advance  pricing framework, each FHLBank has independent authority within the  framework to establish specific policies and procedures to meet its  business and member requirements.  Our review of key advance pricing  terms—advance interest rates, collateral requirements, advance borrowing  capacity, and capital stock purchase requirements—identified several  significant differences among the 12 FHLBanks.  The FHLBanks may  charge different interest rates on advances with comparable maturities,  some may establish interest rates on the basis of advance size while others  do not, and the FHLBanks apply differing haircuts to the same type of  collateral, establish different borrowing limits, and  require members to  purchase FHLBank stock in differing amounts depending upon their levels  of advances outstanding.
subsections: section_title: Advance Interest Rates May Vary Based on FHLBank Operating Costs, Business Strategies, and Competition from Other Sources
paragraphs: The process of setting advance interest rates can depend on several key  factors, including cost of funds, operating expenses, business strategies,  and competition from other sources, and may differ from one FHLBank to  another.  In general, each FHLBank attempts to set advance interest rates  at a level that covers its costs—including cost of funds and operating  expenses—while allowing for the payment of a reasonable rate of return  (typically through the payment of dividends) to member institutions.   Although the FHLBanks generally have the same cost of funds because  they borrow through the Office of Finance, they may have different  operating expenses to administer their advance business.  Moreover, the  business strategies adopted by individual FHLBanks may also influence the  advance interest rates that they charge to members.  In particular,  FHLBank officials said that there can be a connection between the advance  interest rate that they charge and the dividend rate that they pay.  That is,  an FHLBank choosing to pay a relatively high dividend may need to charge  a relatively high advance rate to earn sufficient profits to cover the costs  associated with the dividend.  In contrast, other FHLBanks may decide to  provide value to their members through lowering their advance rates,  which may mean a decrease in their dividend.  Table 3 shows that some  FHLBanks consistently pay higher dividends than others.  For example,  Bank E paid an average dividend of 7.63 percent from 1997 through 2002,  which was 250 basis points higher than the average dividend of Bank L over  the same period.
FHLBank business strategies involving other assets—such as mortgage  purchase programs and other investments—may also influence the interest  rate that they charge on advances.  For example, the potential exists that  the degree to which an FHLBank participates in the MPP or the MPF  program would affect its advance interest rate.  If an FHLBank commits  substantial resources to the MPP or the MPF program, it may use any  profits earned to offset the advance interest rate or it may use funds earned  from advances to support the MPP or MPF program.  Or, the FHLBank  could use the profits to pay a higher dividend and leave advance rates  unchanged or some combination thereof.  Available evidence suggests that  there is wide variation within the FHLBank System on the extent to which  individual banks participate in the asset purchase programs.  For example,  more than 46 percent of the assets at one FHLBank now consist of acquired  mortgages while the ratio is only 1.5 percent at another FHLBank.    Similarly, FHLBanks could also increase investments in other types of  assets, such as mortgage-backed securities, and use the income derived to  offset advance interest rates or pay a higher dividend.
Some FHLBank officials told us that competition from other sources can  also influence the interest rates that they charge on advances.  For  example, officials said that they monitor other financial markets—such as  the repo market—to determine how competitive their advance rates are  with other funding sources.  In addition, some FHLBank officials said that  competition may also arise from the advance interest rates and other terms  offered by other FHLBanks.  The officials said that large bank or thrift  holding companies that have subsidiaries in multiple FHLBank districts  sometimes play one FHLBank against another in an attempt to obtain more  favorable advance pricing terms.  Some FHLBank officials said that they  will adjust their advance interest rates within established parameters to  ensure that their rates are competitive with other sources of funds.  An  individual FHLBank’s willingness to compete with other fund providers  could influence differences in advance rates across the FHLBanks.
Given the variety of factors that may be involved in setting advance interest  rates, we are unable to explain completely why individual FHLBanks  charge the rates that they do.  Nevertheless, limited available data indicate  that these factors result in sometimes significant differences in interest  rates on advances with comparable maturities.  Table 4 shows the advance  interest rates for eleven FHLBanks on June 10, 2003 (the other FHLBank  stated that its advance interest rate data were proprietary).  The  differences between the lowest and highest interest rates can be  significant.  For example, for an advance of 12 months, the difference  between Bank H and D was 36 basis points.
section_title: Most FHLBanks Offer Discounts on Advance Rates Based on Volume
paragraphs: Our review indicates that eight FHLBanks have established specific  programs that offer volume-driven advance rate discounts, while four  others have not established such programs (see table 5).  Under these  programs, also referred to as tiered pricing, the FHLBank may reduce the  standard interest rate charged on advances depending upon the size of the  advance.  The programs operate similarly as each passes on to members  the economies of scale the FHLBanks realize from high-volume  transactions. However, as table 5 illustrates, the number of pricing tiers at  each FHLBank varies; three banks have established two tiers, two banks  have established three tiers, two banks have established four tiers, and one  bank states that it provides volume-driven discounts.  The basis point  discounts that the FHLBanks offer on volume driven discounts can also  vary.  For example, one FHLBank reduces its advance rates 15 to 20 basis  points for advances over $25 million, while another FHLBank reduces its  advance interest rates 6 to 12 basis points.
FHLBank officials said that their large members are the primary  beneficiaries of the tiered pricing programs because they have the capacity  to borrow in large volumes.  However, officials from two FHLBanks also  said that they will aggregate advance requests from smaller members so  that they can benefit from volume-driven rates as well.  Representatives  from several FHLBanks, including those that do not have tiered pricing  programs, said that they also periodically offer “special deals” on advance  rates to all of their members.  If a FHLBank, for example, obtains favorable  borrowing costs, it may pass these savings on to its members through  special deals that are announced by fax or e-mail.
With respect to the four FHLBanks that do not have specific tiered pricing  programs, officials said that they preferred to offer the same advance rate  to all members.  Although these FHLBanks do not have specific tiered  pricing programs based on volume, they may differentiate in price in other  ways.  For example, one FHLBank offers standard rates on all advances  requested by telephone but offers specified discounts on advance requests  made through its secured Web site.  Officials from this bank said that more  than 98 percent of its advances are made through the Web site.  Banks that  do offer tiered pricing programs may also offer differing advance rates on  the basis of the creditworthiness of their members.  For example, one  FHLBank has established 10 separate categories that have different interest  rates and collateral requirements depending upon a member’s  creditworthiness.  This FHLBank, as do other FHLBanks, establishes  members’ creditworthiness through, among other steps, reviewing publicly  available financial information and conducting on-site visits to review  collateral management practices.
We also note that analyzing the FHLBanks’ tiered pricing programs was  difficult, because the programs are not fully transparent as some banks  “negotiate” prices with larger members.  Some FHLBank officials said that  larger members periodically request advance terms that differ from posted  rates and that FHLBank representatives do have some authority to  customize deals.  For example, officials at one FHLBank said that its  representatives had the authority to negotiate the stated advance interest  rates.  None of the FHLBank officials we contacted said that they had  authority to negotiate based on collateral standards.  Some FHLBank  officials said that they notify their members of the terms of negotiated  transactions whenever they take place (for example, by e-mail).  Other  FHLBank officials said that they will make the terms of negotiated deals  available only when another member requests an advance with similar  features.
section_title: FHLBanks Have Established Sometimes Differing Collateral Requirements for Securing Advances
paragraphs: The FHLBanks may also apply differing haircuts to collateral pledged by  member institutions to secure advances.  Table 6 shows the haircuts that  the FHLBanks apply under their blanket liens to single-family mortgage  collateral, which is considered one of the most secure forms of collateral.    Several FHLBanks apply a range of haircuts to single-family collateral (for  example, FHLBank C) based on their assessments of the credit risk of the  collateral.  For those banks that apply one haircut to single-family  collateral, the haircut differences can be significant.  For example, a  member could borrow up to 85 percent of its pledged single-family  collateral at FHLBank L (which has a 15 percent haircut) but only up to 60  percent at FHLBank J (which has a 40 percent haircut).  We note that the  FHLBanks have established other advance borrowing limits for their  members, which are discussed in the next section.
Our review also identified other differences in the FHLBanks collateral  standards.  For example, we found that several FHLBanks require or prefer  their members to pledge all of their single-family mortgages as collateral  before they will consider the use of other types of collateral—such as  ORERC or small business and agricultural loans—to secure advances.  In  contrast, other FHLBanks allow members to pledge any form of eligible  collateral—such as commercial real estate loans—to secure advances  without requiring that other types of eligible collateral be used first.
section_title: Borrowing Capacity Limits Vary Across the FHLBanks
paragraphs: To minimize the risks associated with making advances to their members,  the FHLBanks have also established borrowing capacity limits, which can  vary.  Table 7 shows that three FHLBanks allow their members to obtain  advances equal to the value of all their eligible collateral after appropriate  haircuts have been applied.  These FHLBanks borrowing limits do not  include a specific limit on the ratio of advances to a member’s total assets  as is the case at the other nine banks.  Of the nine banks with specific ratio  limits, the borrowing limits vary to some extent; for example, one FHLBank  sets total advance borrowings at 35 percent of a member’s assets.  Other  FHLBanks may allow members to borrow up to 50 percent of their total  assets without board approval and, in one case, up to 55 percent if  approved by the bank president.  The borrowing capacity of individual  members is determined on a case-by-case basis depending on the  creditworthiness of the member and the member’s collateral.
section_title: FHLBanks Require Members to Purchase Different Amounts of Capital Stock Depending upon Advance Activity
paragraphs: FHLBanks have also established activity based stock purchase  requirements for advances, which can differ (see table 8).  As the table  indicates, the specific capital ratio requirements can differ; for example,  FHLBank L has a 3.5 percent stock purchase requirement while FHLBank  G has a 5 percent requirement.
section_title: Holding Companies Can Generally Transfer Funds and Assets among Their Insured Subsidiaries
paragraphs: Although Section 23A and 23B of the Federal Reserve Act and Regulation W  impose restrictions on the transfer of assets among some subsidiaries of  holding companies, these restrictions generally do not apply to transfers of  assets between depository institution subsidiaries that are federally  insured.  Accordingly, each of the more than 100 holding companies that  have federally insured bank or thrift subsidiaries that are members of  various FHLBank districts may be able to transfer assets among their   insured depository subsidiaries with few restrictions under specified  conditions.  However, holding companies may face some hurdles—such as  managing their balance sheets or meeting capital requirements—when  transferring assets from one insured subsidiary to another.  We also note  that the Federal Reserve has not quantified the extent to which transfers of  assets among subsidiaries take place, and it is not clear  whether holding  companies engage in such transfers to increase competitive pressures  within the FHLBank System.
subsections: section_title: Sections 23A and 23B of the Federal Reserve Act Limit Transactions between Affiliates
paragraphs: Sections 23A and 23B of the Federal Reserve Act set limits on covered  transactions  between  a depository institution and its affiliates.  Sections  23A and 23B are designed to protect against a depository institution  suffering losses in transactions with affiliates.  They limit the ability of a  depository institution to transfer to its affiliates the subsidy arising from  the institution’s access to the federal safety net, including the deposit  insurance funds.  Under section 23A, a bank’s affiliates include, among  other companies, any companies that control the bank, any companies  under common control with the bank, and certain investment funds that  are advised by the bank or an affiliate of the bank.  Affiliate has the same  meaning under 23B as the meaning given under 23A, except that the term  affiliate under 23B does not include an insured bank or an insured savings  association.
According to Section 23A, a bank’s covered transactions with any single  affiliate cannot exceed 10 percent of the bank’s capital stock and surplus,  and transactions with all affiliates combined cannot exceed 20 percent of  the bank’s capital stock and surplus.  All transactions between a bank and  its affiliates must be on terms and conditions that are consistent with safe  and sound banking practices, and a bank cannot purchase low quality  assets from its affiliates.  Finally, section 23A requires that a bank’s  extensions of credit to affiliates and guarantees on behalf of affiliates be  appropriately secured by a statutorily defined amount of collateral.   Section 23B requires that certain transactions between a bank and its  affiliates occur on market terms.  This is defined to mean that the  transaction must take place on terms and under circumstances that are  substantially the same, or at least as favorable to the bank, as those  prevailing at the time for comparable transactions with unaffiliated  companies.
Transactions that are covered by 23A and 23B include (1) purchases of  assets by a bank from an affiliate, (2) extensions of credit by a bank to an  affiliate, (3) investments by a bank in securities issued by an affiliate, (4)  guarantees by a bank on behalf of an affiliate, and (5) certain other  transactions that expose the bank to an affiliate’s credit or investment risk.   Section 23B also applies to any sale of assets by the bank to an affiliate, any  payment of money or furnishing of services by the bank to an affiliate, and  any transaction by the bank with a third party if an affiliate has a financial  interest in the third party or in an affiliate that is a participant in the  transaction.
section_title: Sister Banking Exemption Allows Transfer of Assets among Subsidiaries of Bank and Thrift Holding Companies
paragraphs: Section 23A exempts several types of transactions from certain aspects of  the statute.  One exemption, known as the Sister Bank Exemption, exists  for transactions between a bank or thrift and another bank or thrift if a  company controls 80 percent or more of the voting securities of both banks  or thrifts or if one bank controls 80 percent or more of the voting securities  of the other.  The exemption applies only to transactions between insured  depository institutions.  Because Section 23B exempts banks and thrifts  from its definition of affiliate, sister banks (those banks that qualify for the  exemption) are also exempt from the requirement that transactions  between insured banks or thrifts and their affiliates be conducted on an  arm’s length basis.  According to the Federal Reserve, these exemptions  reflect the fact that, under the cross-guarantee provisions of the Federal  Deposit Insurance Act, an insured depository institution is generally liable  for any loss incurred by the FDIC in connection with the default of a  commonly controlled depository institution. All transactions between a  bank and its affiliates (including sister bank affiliates) are required, though,  to be on terms and conditions that are consistent with safe and sound  banking practices.  In addition, a bank may not purchase a low-quality  asset from an affiliate (including a sister bank affiliate) unless the bank or  its subsidiary, pursuant to an independent credit evaluation, committed  itself to purchase such asset prior to the time such asset was acquired by  the affiliate.  Although a Federal Reserve official could not provide specific  data on the number of insured holding company subsidiaries that qualify  for the exemption, he estimated that more than 90 percent do so.
While Sections 23A and 23B and Regulation W impose few legal restrictions  on holding companies selling assets among their insured depository  subsidiaries for securing advances from different FHLBanks, there can be  some bookkeeping and regulatory hurdles.  Officials from one large thrift  holding company with whom we spoke said that there are balance sheet  management hurdles associated with the sale of assets from one subsidiary  to another.   For example, the officials said that asset sales may involve  “de-pledging” assets pledged as collateral to secure advances at one  FHLBank and pledge them to another FHLBank.  Subsidiaries meeting the  sister bank requirements must also ensure that the sale of assets meets  bank regulatory agency capital requirements.  In addition, each FHLBank  has established membership stock purchase requirements, which would  require a subsidiary that received assets from an affiliate to purchase  additional capital from the FHLBank.  We note that the membership capital  requirements for each FHLBank can differ.
We also note that it is difficult to determine the extent to which holding  companies transfer assets between their subsidiaries and whether any such  transfers result in competition between the FHLBanks.  Federal Reserve  officials said that they do not collect data on transfers of assets among  subsidiaries, although one Federal Reserve official said that such transfers  occur frequently.  FHFB officials commented that it was not clear that  holding companies had financial incentives to move collateral from one  subsidiary to another to obtain favorable advance rates.  The FHFB  officials said that if a subsidiary had sufficient cash to purchase collateral  from an affiliate, it already would have sufficient eligible collateral to  secure advances from its local FHLBank and would not need additional  collateral.
section_title: FHFB Has Not Identified Significant Advance Term Pricing Deficiencies, but FHLBank Safety and Soundness Data Reporting Can Be Improved
paragraphs: FHFB is responsible for helping ensure that the FHLBanks follow statutory  and regulatory requirements in making advances and that competitive  pressures within the FHLBank System do not compromise the System’s  safety and soundness.  Although the FHLBanks have adopted differing  approaches to setting advance pricing terms, FHFB’s examination program  has not identified significant violations in the banks’ practices over the past  several years.  However, as part of its oversight efforts, FHFB collects data  on FHLBank collateral practices that have questionable value in their  current format.  In addition, FHFB does not collect data necessary to fully  assess competition within the FHLBank System, such as data on the  advance terms that holding company subsidiaries may receive from  different FHLBanks.  Such data would also help FHFB assess the potential  risks associated with multidistrict membership.
subsections: section_title: FHFB Examinations Have Not Identified Serious Advance Term Pricing Deficiencies
paragraphs: FHFB carries out its oversight responsibilities through, among other  means, annual examinations and off-site monitoring.  During the  examination process, FHFB examiners review a range of activities at each  FHLBank, such as its asset and liability management, collateral  management practices, and compliance with relevant laws and regulations.   Off-site monitoring is typically carried out by FHFB headquarters staff and  involves the review of financial data that provides information and insights  into the safety and soundness of the FHLBanks.  Regular off-site  monitoring between annual examinations is important because the  FHLBanks’ financial conditions and risks can change significantly in a  short period.  Off-site monitoring can help target examination reviews  towards emerging risks at a particular FHLBank or across the System.
In reviewing advance pricing term compliance, FHFB examiners are  responsible for determining whether the FHLBanks price their advances  above the cost of issuing debt, the FHLBank’s member products policy  clearly outlines the standards and criteria for differential pricing, and the  FHLBanks apply these standards and criteria consistently and without  discrimination to all members.  In reviewing collateral compliance, FHFB  examination teams look at the policies the FHLBanks use to conduct their  collateral verification site visits and the agreements they use to perfect  their liens.  FHFB examiners also review the procedures that the  FHLBanks have established to ensure that they value their members’  collateral frequently so that it is in line with the haircuts that they apply.
FHFB did not identify significant problems in the FHLBanks’ advance term  pricing practices in examinations completed in 2001 and 2002.  FHFB  officials said that their examinations have generally concluded that the  FHLBanks comply with collateral requirements and setting advance  interest rates.  FHFB examinations completed between 2001 and 2002 that  we reviewed identified no serious deficiencies.  According to FHFB  examination criteria, a “violation” represents a significant deficiency at a  FHLBank while a recommendation is less serious.  With the exception of  one violation for failure to perform advance collateral verification, FHFB  examinations regarding collateral contained only recommendations that  FHLBanks develop or expand policies.  Similarly, according to the FHFB  officials, the agency has only recommended that certain FHLBanks  describe more clearly their policies on differential advance term pricing.
section_title: FHFB’s FHLBank System Safety and Soundness Data Reporting Procedures Have Limitations
paragraphs: Although FHFB has collected collateral data from the FHLBanks since 2000  that are intended to assist in monitoring the FHLBanks’ safety and  soundness, the data have questionable value in their current format.  On an  annual basis, FHFB has requested that the FHLBanks provide data on the  level of collateral securing advances. FHFB requests data on, among other  things, the total value of collateral securing advances, collateralization by  member type (such as commercial bank and thrifts), collateralization by  member size (such as members with $10 billion or more in assets), and the  use of eligible collateral by member institutions (such as the use of single- family mortgages and small business and agricultural CFI collateral).   According to the FHFB’s 2003 request letter, these data are “very valuable  in exhibiting the System’s safety and soundness and the extent to which  traditional types of collateral secure advances.”  Additionally, FHFB stated  in the letter that the information would help FHFB ascertain the  acceptance and placement of small business and agricultural collateral by  CFIs.
Although FHFB has identified such data as useful for assessing the  FHLBank System’s safety and soundness, we found that FHLBanks do not  have clear information on how FHFB wants the data to be reported.   Several FHLBanks that we visited report specific collateral—such as  individual single-family mortgages or CFI loans—that has been pledged by  their members to support outstanding advances.   Officials at these  FHLBanks said that they had provided the data in the format requested by  FHFB.  In contrast, other FHLBank officials told us that they reported all of  the eligible collateral on the books of their members.  A senior official from  one of these FHLBanks said that since the bank has access to all the  eligible collateral with whom it has blanket lien agreements, there was no  need to report more specific loan-level data to FHFB.  Officials from one  FHLBank said that FHFB provided only general guidance on what  collateral data to report, which required each FHLBank to develop its own  reporting criteria.
Table 9 illustrates the differing approaches that the FHLBanks use to report  collateral data to FHFB.  The table shows the total advances outstanding,  the reported collateral securing those advances, and the ratio of collateral  to advances at each FHLBank as of December 31, 2002.  The ratios at  FHLBanks B and K show that their collateral to advance ratios are 1.23 to 1  and 1.26 to 1, respectively.  These FHLBanks report to FHFB individual  collateral securing advances.  In contrast, FHLB E’s ratio of 7.15 to 1 is  explained by the fact that the bank reports to FHLBank the value of all the  eligible collateral held by its members.
Because certain FHLBanks may report all of the eligible collateral held by  their members, the data that FHFB receives on the acceptance and  placement of CFI collateral—one of FHFB’s stated reasons for collecting  the data---is difficult to assess.  As of December 31, 2002, the FHLBanks  reported to FHFB that there was $7.2 billon in small business and  agricultural loans securing advances by CFIs.  Of that $7.2 billion figure,  $3.6 billion—or approximately 50 percent—was reported by one FHLBank,  which reported the value of all the collateral on its members’ books.  This  FHLBank reported the highest value of CFI collateral in the FHLBank  System.  However, an official from this FHLBank said that a small number  of its members secured advances with CFI collateral and estimated that the  total amount of such advances was $25 million.
The Director of FHFB’s Office of Supervison said that the agency planned  to review its current collateral data collection and reporting procedures for  the FHLBanks.  The Director said that the collateral data are currently used  to complement FHFB’s safety and soundness supervision program and that  the data provided a broad overview of trends and anomalies.  However, the  Director also said that the collateral data did not substitute for FHFB’s  annual examinations at each FHLBank, which we discussed earlier.   Although the FHLBank collateral data may provide some benefits for  FHFB’s examination program, FHFB’s decision to review current reporting  procedures appears to be appropriate.  The current data do not allow for  meaningful comparisons across the FHLBank System and the reported data  on the placement of CFI collateral are potentially misleading.  With better  collateral data, FHFB’s ability to monitor the FHLBank System’s safety and  soundness could be enhanced.
FHFB’s oversight of the FHLBank System could also be enhanced by  reviewing the extent to which competition may currently take place  between FHLBanks and its potential effects on the System’s safety and  soundness.  Available evidence suggests that competition may take place  between the FHLBanks, including (1) key differences in advance term  pricing across the FHLBank System, (2) statements by some FHLBank  officials that holding company subsidiaries may play one FHLBank against  another to obtain more favorable advance rates, and (3) the legal authority  of holding company subsidiaries to transfer assets between one another  thereby creating the potential that collateral may be moved from one  subsidiary to another to obtain more favorable advance rates.  Although  there is evidence that competition between the FHLBanks takes place, the  evidence is largely anecdotal and has not been quantified.  Given FHFB’s  oversight responsibilities for the FHLBank System, it could benefit by  collecting data necessary to better understand the degree of competition  within the System.  For example, FHFB could collect data on the advance  terms---including interest rates---that the subsidiaries of holding companies  obtain on advances and whether the eligible collateral at each subsidiary  has fluctuated over time.  By collecting such data, FHFB could identify the  potential effects that holding company subsidiaries have on competition  between the FHLBanks and whether such competition in any way has  affected the FHLBanks’ underwriting standards.  Additionally, such data  could assist FHFB in assessing the potential competitive and safety and  soundness implications of multidistrict membership.
section_title: Conclusions
paragraphs: Within the framework established by statute and regulation, the FHLBanks  have independent authority to set advance pricing terms that meet their  business needs and the needs of their members.  As a result, advance  pricing terms vary across the FHLBank System as evidenced by sometimes  differing interest rates, tiered-pricing programs, collateral requirements,  borrowing limits, and advance activity capital requirements.  Because many  holding companies have multiple subsidiaries, each of which may be  eligible for membership in a different FHLBank, they have the opportunity  to obtain advances from those FHLBanks that offer the most advantageous  terms.  Under exemptions to Sections 23A and 23B of the Federal Reserve  Act, moreover, the potential also exists that holding companies can transfer  assets from one subsidiary to another to obtain favorable advance pricing.   These conditions create the potential for competition on advance pricing  among the FHLBanks and any such pressures may be enhanced under  multidistrict membership.
FHFB has a critical responsibility in helping to ensure that the FHLBanks  sometimes differing advance pricing terms are conducted within statutory  and regulatory requirements.  In particular, FHFB is responsible for  ensuring that the FHLBanks do not price advances below the cost of funds  and fully secure advances with eligible forms of collateral.  Although FHFB  has not identified any serious violations in advance pricing terms in recent  years, the agency has an important responsibility to ensure that any  competitive pressures do not threaten the FHLBank System’s safety and  soundness.  However, the data that FHFB currently collects on collateral  from the FHLBanks is of questionable value in their current format for  understanding the System’s safety and soundness.  Moreover, FHFB does  not collect data that could be helpful in assessing the competitive  implications of holding companies whose subsidiaries operate in different  FHLBank districts as well as multidistrict membership.
section_title: Recommendations
paragraphs: To strengthen FHFB’s safety and soundness oversight, we recommend that  FHFB review its current collateral reporting requirements and work with  the FHLBanks to obtain data that are useful in understanding collateral  practices within the System.  We also recommend that FHFB work with the  FHLBanks to obtain data necessary to understand the competitive and  safety and soundness implications of holding companies whose  subsidiaries operate in different FHLBank districts as well as multidistrict  membership.
section_title: Agency Comments and Our Evaluation
paragraphs: We received written comments on a draft of this report from FHFB and the  Federal Home Loan Bank President’s Conference, which are reprinted in  appendixes III and IV, respectively.  We also received technical comments  from FHFB, several FHLBanks, and the Board of Governors of the Federal  Reserve, which have been incorporated into the report where appropriate.
FHFB agreed to implement the recommendations contained in the report.   FHFB stated that while the collateral data discussed in the report were  used during the examination process, the data did not substitute for annual  examinations.  FHFB stated that it planned to examine the effectiveness of  the collateral policies and procedures at each FHLBank and to identify  practices, possibly to include enhanced data collection and reporting, to  further the use of the most effective collateral practices.  FHFB also stated  that it planned to work with the FHLBanks to assess the value of additional  data collection and reporting to monitor the competitive and safety and  soundness influences of holding company subsidiaries that operate in  multiple FHLBank districts.  FHFB stated that its examinations have found  that advance term pricing differed among the FHLBanks for many reasons,  including the trade-offs between dividends and advance rates and  competitive pressures.  FHFB stated that it would be worthwhile to  examine the extent to which competition—both between the FHLBanks  and from the capital markets—can be a healthy influence on the efficient  operation of the FHLBanks.
The FHLBank President’s Conference stated that the report correctly noted  that the advance pricing and collateral practices of the 12 FHLBanks differ.   The Conference stated that the FHLBank Act and FHFB regulations  establish a framework in which individual FHLBanks can establish policies  that meet the needs of their member institutions.  The Conference also  stated that statutory and regulatory provisions that require advance  interest rates to be set above borrowing costs and advances to be secured  by eligible collateral ensure that the FHLBanks operate in a safe and sound  manner.  The Conference also stated that its members were prepared to  work with FHFB to collect data necessary to understand the collateral  practices across the FHLBanks.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date.  At that time, we will send copies of this report to the Chairman  of the Senate Committee on Banking, Housing, and Urban Affairs; and the  Ranking Member of the Subcommittee on Capital Markets, Insurance, and  Government Sponsored Enterprises of the House Committee on Financial  Services.  We will also send copies to FHFB, the FHLBank President’s  Conference, the FHLBanks, and the Board of Governors of the Federal  Reserve.  We will also send copies to others upon request.  In addition, this  report will be available at no charge on GAO’s Web site at  http://www.gao.gov.  Please contact Mr. Wesley M. Phillips or me at   (202) 512-8678, or email (phillipsw@gao.gov or shearw@gao.gov) if you or  your staff have any questions concerning this report.  GAO staff who made  major contributions to this report are listed in appendix V.
section_title: Objectives, Scope, and Methodology
paragraphs: As discussed with your staff, our report objectives are to  (1) describe the  laws and regulations pertaining to the terms that FHLBanks can offer on  advances; (2) provide information on whether key differences exist in  current advance pricing and other terms across the FHLBanks; (3)  determine whether holding companies face any legal or regulatory barriers  in transferring assets among subsidiaries who are members of different  FHLBank districts; and (4) describe FHFB's safety and soundness  oversight of the FHLBanks' advance pricing practices and review selected  data that FHFB collects to monitor the safety and soundness of the  FHLBank System.
To meet objective (1), we reviewed the Federal Home Loan Bank Act as  amended.  We also reviewed the FHFB regulations that govern or describe  the terms that FHLBanks can offer on advances.  We interviewed FHFB and  FHLBank officials to obtain their views on the terms FHLBanks can offer  on advances.
To meet objective (2), we interviewed FHFB, the 12 FHLBank presidents,  credit staff from 7 of the 12 FHLBanks, and we sent a structured  questionnaire to each of the 12 FHLBanks and received responses from  each of the banks.  Additionally, we reviewed the credit policies of each of  the 12 FHLBanks and reviewed data on advance interest rates for those  FHLBanks that post such data on their Web sites.  We note that the data  posted on the FHLBank Web sites are subject to change and that the actual  rates members actually pay may differ due to advance term negotiations  between FHLBanks and their members. Two other FHLBanks separately  provided their advance rates for the dates that we used.  With this  information, we compared advance pricing and other terms across the  FHLBanks to identify key differences.  The scope of our work did not  involve developing a methodology to determine why individual FHLBanks  charge the advance interest rates or other advance pricing terms that they  do.
To meet objective (3), we reviewed applicable laws and regulations  regarding the transfer of funds and assets among holding companies and  their subsidiaries, including the Federal Reserve Act, Federal Home Loan  Bank Act, Home Owners' Loan Act, FHFB regulations, and Federal Reserve  Board regulations.  We also interviewed representatives from the Federal  Reserve Board, FHFB and a large holding company.
To meet objective (4), we interviewed FHFB officials, reviewed FHFB's  advance pricing examination guidelines, and reviewed selected  examination reports for 2001 and 2002 related to advance pricing and  collateral requirements.  We did not evaluate the effectiveness of FHFB's  examination program.  To assess FHFB's collateral data reporting process,  we reviewed FHFB's data request forms and the data provided by the  FHLBanks.  We also interviewed officials at selected FHLBanks to  determine their approach to reporting the collateral and other data and we  interviewed FHFB officials on these issues.
We conducted our review from January to September 2003 in Washington,  D.C.; New York, New York; Topeka, Kansas; Dallas, Texas; Atlanta, Georgia;  and Pittsburgh, Pennsylvania, and Indianapolis, Indiana, in accordance  with generally accepted government auditing standards.
section_title: Comments from the Federal Housing Finance Board
section_title: Comments from the Federal Home Loan Bank Presidents’ Conference
section_title: GAO Acknowledgments and Staff Contacts
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to the individuals named above, Tanya Cruz, Crystal Daniels,  Rachel DeMarcus, M’Baye Diagne, Marc Molino, Andy Pauline, Mitchell B.  Rachlis, and Barbara Roesmann made key contributions to this report.
section_title: GAO’s Mission
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subsections: section_title: Order by Mail or Phone
section_title: To Report Fraud, Waste, and Abuse in Federal Programs
section_title: Public Affairs