Federal Home Loan Banks: Collateral Requirements Discourage Some Community Development Financial Institutions from Seeking Membership
Released: 2015-05-22T00:00:00

Letter

Background

The CDFI Fund provides certification to CDFIs that meet the six statutory and regulatory criteria of the Fund.on CDFIs that have the primary mission of providing capital and development services to economically distressed communities generally underserved by conventional financial institutions. CDFIs provide products and services (such as mortgage financing for low-income and first-time homebuyers and financing for not-for-profit affordable housing developers) that otherwise may not be accessible in these communities. CDFIs can be for-profit or nonprofit institutions and can be funded by private and public sources. Depository CDFIs such as community development banks and credit unions obtain capital from customers and nonmember depositors. Depository and nondepository CDFIs may obtain funding from conventional financial institutions, such as banks, in the form of loans. In addition, both types of CDFIs may receive funding from corporations, individuals, religious institutions, and private foundations. Finally, CDFIs may apply for federal grants and participate in federal loan programs. For example, Treasury’s CDFI Fund makes grants, equity investments, loans, and deposits to help CDFIs serve low-income people CDFI Fund certification is conferred and communities.administered by the Department of Agriculture and the Small Business Administration. As of December 31, 2014, there were a total of 933 certified CDFIs (411 depository and 522 nondepository).

Other federal funding sources include loan programs The 12 FHLBanks are regionally based cooperative institutions owned by member financial institutions (see fig. 1). regional FHLBank, a financial institution (such as a nondepository CDFI) must meet certain eligibility requirements and purchase capital stock; thereafter, it must maintain an investment in the capital stock of the FHLBank sufficient to satisfy the minimum investment required for that institution in accordance with the FHLBank’s capital plan.

On February 27, 2015, the FHLBank of Des Moines and the FHLBank of Seattle announced that the members of both FHLBanks had ratified an agreement approved by their boards of directors in September 2014 to merge. The FHLBanks anticipate that the merger will be effective by the middle of 2015.

Single-family mortgage loans are loans for 1–4 unit properties. risk-management policies of the FHLBank.haircuts based on factors such as risks associated with the member’s creditworthiness, the type of collateral being pledged, and illiquidity of the collateral.

Nondepository CDFIs Differ from Other FHLBank Members in Several Ways

The differences among nondepository CDFIs and other FHLBank members range from the degree to which they focus on community development to differences in size and supervision. Two member types— nondepository and depository CDFIs—share a primary community development focus. As noted previously, both types of CDFIs must have a primary mission of promoting community development to be certified by the CDFI Fund. CDFIs serve as intermediary financial institutions that promote economic growth and stability in low- and moderate-income communities. Frequently, CDFIs serve communities that are underserved by conventional financial institutions and may offer products and services that generally are not available from conventional financial institutions. Such products and services include mortgage financing for low-income and first-time homebuyers; homeowner or homebuyer counseling; financing for not-for-profit affordable housing developers; flexible underwriting and risk capital for needed community facilities; financial literacy training; technical assistance; and commercial loans and investments to assist start-up businesses in low-income areas. Although other FHLBank members may provide similar services to similar populations, community development may not be their primary mission.

Nondepository CDFIs are smaller in asset size than most depository institution and insurance company FHLBank members. As of December 31, 2014, active members of the FHLBank System had approximately $20 trillion in assets. As shown in table 1, as of the same date, median assets for nondepository CDFI members (approximately $43 million) were lower than median assets for both depository members (approximately $207 million) and insurance company members (approximately $975 million). The largest nondepository CDFI had about $708 million in assets, while the largest insurance company member had assets of about $393 billion and the largest depository member had assets of about $2 trillion. In addition, the 30 nondepository CDFI members altogether accounted for about .01 percent of the total assets of all active FHLBank members, whereas depository and insurance company members held about 77 percent and about 23 percent of FHLBanks assets, respectively.

In addition, nondepository CDFIs are not supervised by a prudential federal or state regulator unlike other FHLBank members. Depository FHLBank members are regulated and supervised by federal and state agencies that have responsibility for helping ensure the safety and soundness of the financial institutions they oversee, promoting stability in the financial markets, and enforcing compliance with applicable consumer To achieve these goals, regulators establish capital protection laws.requirements for banks and conduct on-site examinations and off-site monitoring that assesses their financial condition, including assessing their compliance with applicable laws, regulations, and agency guidance. The insured depository institutions also must submit to their regulators quarterly financial information commonly known as Call Reports that follow generally accepted accounting principles (GAAP). Insurance companies are regulated primarily by state insurance commissioners and are subject to examination. While the CDFI Fund’s review standards are not equivalent to the examination standards applicable to regulated depository institutions, the Fund requires a nondepository CDFI to submit its most recent year-to-date financial statements prepared in conformity with GAAP for certification and funding eligibility. The CDFI Fund also requires nonprofit and for-profit nondepository CDFIs receiving awards to annually submit financial statements—including information on financial position, operations, activities, and cash flows—that have been audited by an independent certified public accountant. However, only a subset of CDFIs receives CDFI Fund awards and is subject to such reporting.

In addition to financial statements of individual nondepository CDFIs, other sources can provide information on the financial performance of nondepository CDFIs overall or individually. For example, the CDFI Fund reports on its analysis of financial data from nondepository CDFIs. The CDFI Snapshot Analysis for fiscal year 2012 (the most recent available at the time of our review) notes that community development loan funds, one type of nondepository CDFI, had rates of loan loss (loans that may prove uncollectible) of 1 percent, which compared favorably with depository CDFIs and mainstream financial institutions. A national network of CDFIs reported that its members’ annual net charge-off rate (debts an entity is unlikely to collect) was the same as for all FDIC- insured institutions in fiscal year 2012. It also noted that its members had provided more than $33 billion in cumulative financing for community development activities from their inception through the end of fiscal year 2012. This financing, the network reported, helped to create or maintain nearly 600,000 jobs, support the development or rehabilitation of more than 960,000 housing units, and start or expand nearly 94,000 businesses and microenterprises. And, for a fee, a community development loan fund can be assessed by an independent third party, and receive a financial strength and performance rating.rates a CDFI using a methodology similar to that used by banking regulators.

In the case of financial failure, nondepository CDFIs and depository members also undergo different processes for liquidating assets to repay the FHLBanks for any advances. Depository members, including depository CDFIs, are insured by FDIC or NCUA, which means that FDIC or NCUA would serve as the receiver in the event of failure. In a typical bank or thrift failure, FDIC, acting as receiver, is responsible for outstanding advances of the failed institution. FDIC will facilitate a purchase and assumption transaction with another financial institution or sell the failed institution’s assets, including collateral that had been pledged to secure the advances, to mitigate losses to FDIC’s Deposit Insurance Fund.state insured, according to FHFA, the FHLBanks likely would go through the federal bankruptcy process to settle claims should a nondepository CDFI with FHLBank advances fail.

Collateral Requirements Pose Greatest Challenge for Nondepository CDFIs

Collateral requirements (which must be met to obtain advances) rather than the membership requirements themselves can discourage nondepository CDFIs from seeking FHLBank membership. Because regulations allow the FHLBanks to set their own thresholds for meeting some membership requirements, the requirements varied. The rates of nondepository CDFI membership also varied by FHLBank and were low. The FHLBanks generally impose collateral requirements on nondepository CDFIs that are comparable to those imposed on depository members categorized as higher risk and in some cases, comparable to those imposed on insurance companies. Officials from the nondepository CDFIs we interviewed generally cited steep haircuts (discounts) and the availability of eligible collateral as the primary challenges to obtaining advances; in addition, some viewed the requirements as a disincentive to seeking membership (because advances are a primary benefit of membership).

Although FHLBanks Had Varying Thresholds for Some Membership Requirements, Most Nondepository CDFIs We Interviewed Were Able to Meet the Requirements

Certain Membership Requirements Varied

While nondepository CDFIs must meet seven standards for FHLBank membership, the thresholds the FHLBanks set for meeting certain of the requirements varied. The Federal Home Loan Bank Act and FHFA’s regulations establish the membership requirements for nondepository CDFIs. Nondepository CDFIs must be duly organized under tribal law, or the laws of any state or the United States. be certified by the CDFI Fund. make long-term home mortgage loans, which are defined by statute to include loans secured by first liens on residential real property. Under FHFA regulations, institutions satisfy this requirement if they originate or purchase long-term first mortgage loans on single-family or multifamily residential property, or certain farm or business property that also includes a residence, or purchase mortgage pass-through securities representing an undivided ownership in such loans. By regulation, FHFA has defined “long-term” loans to include those with an original term to maturity of 5 years or more. be in a financial condition that would allow advances to be safely made to it. FHFA developed four financial condition standards for the FHLBanks to use in their assessments—a net asset ratio of at least 20 percent; positive average net income over the preceding 3 years; a ratio of loan loss reserves to loans and leases 90 days or more delinquent of at least 30 percent; and an operating liquidity ratio of at least 1.0 for the 4 most recent quarters, and for 1 or both of the 2 preceding years. If the nondepository CDFI met the standards, it would be presumed to be financially sound, and satisfy the requirement. If the CDFI did not meet one or more standards, the CDFI may offer a rebuttal and the FHLBank would perform a separate analysis to determine if the CDFI was financially sound. have management whose character is consistent with sound and economical home financing. Under FHFA’s regulations, an applicant meets this requirement if it certifies to the FHLBank that neither the CDFI nor its senior officials have been the subject of any criminal, civil, or administrative proceedings reflecting upon creditworthiness, business judgment, or moral turpitude in the past 3 years and that there are no known potential criminal, civil, or administrative monetary liabilities, lawsuits, or unsatisfied judgments arising within the past 3 years that are significant to the applicant’s operations. have a home financing policy that is consistent with sound and economical home financing. Under FHFA regulations, applicants meet this requirement if they provide a written justification, acceptable to the FHLBank, explaining how and why their home financing policy is consistent with the FHLBank System’s housing finance mission. have mortgage-related assets that reflect a commitment to housing finance. They are not required to meet the statutory requirement that applies to certain insured depository institutions to hold at least 10 percent of their assets in residential mortgage loans to be eligible for FHLBank membership.

In addition, the FHLBanks also must require all new members to purchase capital stock.

The FHLBanks have discretion in developing rules to assess compliance with some of the listed requirements. For example, the FHLBanks can set thresholds (such as dollar amounts or percentages) to satisfy requirements for which FHFA has not set thresholds—such as the requirement for making long-term home mortgage loans and the requirement to hold mortgage-related assets.develop its own requirement for membership stock purchases, subject to FHFA approval. We reviewed the three requirements for which the FHLBanks have discretion in making rules and found that the requirements varied across the FHLBanks.

Making long-term mortgages. Eight of the 12 FHLBanks we reviewed had not developed a threshold for nondepository CDFIs to satisfy the long-term mortgage requirement, while four had specified a dollar amount or percentage of assets in long-term mortgage loans. FHFA expects that in assessing the applicant, the FHLBanks will assess the extent to which nondepository CDFIs have a commitment to housing finance requirements in light of their unique mission and community development orientation. The four FHLBanks that had quantitative minimums had minimum requirements that ranged from $1,000 to $1 million in dollar amounts, and from 1 percent to 2 percent of total assets. One FHLBank’s stated policy included an exemption from its particular minimum requirement for nondepository CDFIs that plan to incorporate long-term mortgage loans into future business strategies. Another FHLBank that had a dollar minimum recently gave a nondepository CDFI an exemption from the minimum requirement based on the assessment that the CDFI had significant commitment to housing in accordance with regulatory and membership requirements. For the remaining eight FHLBanks that did not set a minimum requirement, nondepository CDFIs can satisfy the long- term mortgage requirement by documenting that they have originated or purchased more than one such loan or qualifying mortgage investment.

Mortgage-related assets. Four of the 12 FHLBanks we reviewed did not have minimum requirements for the mortgage-related asset requirement, 5 had quantitative and qualitative measures (such as an assessment of the CDFI’s housing-related activities and mission), and 3 had only quantitative measures. The highest minimum quantitative requirement for mortgage-related assets as a percentage of total assets was 10 percent. The three FHLBanks with only quantitative requirements had the lowest requirements, with one FHLBank requiring two mortgage-related assets, another requiring $1,000 in mortgage-related assets, and another requiring the lower of 1 percent of total assets or $10 million in mortgage- related assets.

Stock purchases. The amount of stock that members must purchase varied according to each FHLBank’s funding strategy (see table 2). FHLBank members must hold a certain amount of membership capital stock as a continuing condition of membership. Each FHLBank determines as a part of its capital plan the amounts that all members must purchase in membership capital stock and sets its requirement based on the FHLBank’s business model. Five of the 12 FHLBanks we reviewed calculated the membership stock purchase as a percentage of the member’s total assets. The other 7 FHLBanks calculated the purchase as a percentage of a specific asset category, such as mortgage-related assets or certain assets eligible to be pledged as collateral.

The FHLBanks also require members to purchase activity-based stock. That is, members must acquire a specific amount of stock based on the product—such as advances or letters of credit—the FHLBank provided to that member. The purchases are specified as a percentage of the dollar amount of each transaction the member conducted with the FHLBank. For example, among the 12 FHLBanks, the purchase requirements on advances ranged from 2 percent to 5 percent. For instance, if a member had a $2 million advance transaction with the FHLBank, it would have to purchase from $40,000 to $100,000 in capital stock.

Most CDFIs Were Able to Meet Membership Requirements

While FHLBank and CDFI industry officials we interviewed cited several membership requirements that could pose a challenge for nondepository CDFI applicants (including financial condition, long-term home mortgage loan, mortgage-related assets, and stock purchase requirements), most of the nondepository CDFIs we interviewed were able to meet these requirements or stated that they would be able to meet the requirements.

Financial condition requirements. Officials we interviewed from 9 of the 12 nonmember nondepository CDFIs stated that they would be able to meet the financial condition standards, while 2 stated that they would potentially face challenges with the financial condition standards. In addition to interviewing officials from nondepository CDFIs that were nonmembers, we reviewed the applications of the 27 nondepository CDFIs that were members as of September 2014. Seven of the 27 nondepository CDFIs did not meet at least one of the financial condition standards at the time of their application, but made successful rebuttals and became members.

Making long-term mortgages. Of the 12 nonmember nondepository CDFIs we interviewed, officials from 1 cited the “makes long-term home mortgage loans” requirement as a challenge for membership. In addition, officials from 1 of the 10 member nondepository CDFI we interviewed cited this as a challenge, but noted that they received an exemption from the minimum quantitative requirement imposed by the FHLBank. The officials from the remaining 11 nonmember and 9 member CDFIs did not identify this requirement as a challenge. Officials from two FHLBanks stated that CDFIs in general may face challenges meeting this requirement, as some nondepository CDFIs may not make or hold long- term home mortgage loans if they are not involved in mortgage lending.

Mortgage-related assets. Although the mortgage-related asset requirement varies among the FHLBanks, none of the officials from the 12 nonmember nondepository CDFIs we interviewed stated that they would face challenges meeting this requirement.

Stock-purchase requirements. Officials from 1 of the 12 nonmember CDFIs we interviewed stated that the amount of membership stock they would be required to purchase was cost prohibitive, while officials from the 10 member CDFIs we interviewed stated that the amount required was not a challenge to membership. Nondepository member CDFIs we interviewed were able to purchase the required amount of membership stock. Officials from one nonmember nondepository CDFI in the FHLBank-Chicago district said that the CDFI was approved for membership, but did not become a member because the stock purchase requirement was too high. FHLBank-Pittsburgh recently amended its capital plan by lowering the membership and activity-based stock purchase calculations, citing benefits to CDFIs. In addition, FHLBank- Chicago recently reduced its minimum membership stock purchase requirement to make it less costly for nondepository CDFIs and others to join. (We discuss these and other changes later in this report.)

Rates of Nondepository CDFI Membership Were Low

The rates of nondepository CDFI membership generally were low, ranging from 2.08 percent to 15.38 percent of nondepository CDFIs in each FHLBank district (see fig. 2). As of December 31, 2014, 30 of the 522 nondepository CDFIs were FHLBank members, and 6 of the 12 FHLBanks had membership rates of less than 5 percent for the nondepository CDFIs in their districts. The number of nondepository CDFI members has increased every year since the first joined in 2010. Forty percent (12 of 30) of the current nondepository CDFI members joined the FHLBank System in 2014. As of the end of 2014, all 12 FHLBanks had at least one nondepository CDFI member; 2 approved their first nondepository CDFI member in 2013 and another 3 did so in 2014.

According to FHFA officials, some nondepository CDFIs may not be good candidates for FHLBank membership. They noted that the majority of nondepository CDFIs make nonhousing loans such as microloans, small business loans, and commercial loans. In addition, FHFA officials stated that many of the nondepository CDFIs engaged in housing-related activities have low asset volumes.

Nondepository CDFIs Are Subject to Comparatively More Stringent Collateral Requirements, Which Can Be a Disincentive for Obtaining Membership

Due to the differences between nondepository CDFIs and other FHLBank members discussed earlier, representatives from the FHLBanks stated that nondepository CDFIs have certain risks that depository members do not have. The risks cited included the lack of supervision by a regulator and uncertainty related to the liquidation process in the event of insolvency. As noted previously, the FHLBanks are required by statute and FHFA regulations to develop and implement collateral standards and other policies to mitigate the risk of default on outstanding advances. To address risks associated with nondepository CDFIs, the FHLBanks can place limits on eligible collateral and generally impose collateral requirements on nondepository CDFIs seeking advances that are comparable to those imposed on depository members categorized as higher risk and, in some cases, insurance companies. Some of the CDFIs and FHLBanks we interviewed cited these collateral requirements as a disincentive for nondepository CDFI membership.

Eligible Collateral for Nondepository CDFIs Varied among FHLBanks

Although they are allowed by regulation to accept certain types of collateral from all of their members, some FHLBanks have chosen to limit the types of eligible collateral that nondepository CDFIs can pledge. (This is also sometimes the case for other nondepository members such as insurance companies.)

FHLBanks can accept FHLBank deposits as collateral.

The securities collateral FHLBanks can accept includes U.S. Treasury and agency securities, U.S. agency mortgage-backed securities, and privately issued mortgage-backed securities (including residential and commercial).

The types of mortgage collateral that FHLBanks can accept include single-family and multifamily mortgage loans; mortgage or other loans issued, insured, or guaranteed by the U.S. government or its agencies; commercial real estate loans; and home equity loans or lines of credit.

Nondepository CDFIs are eligible to pledge FHLBank deposits, securities, and mortgage loans as collateral for advances at all 12 FHLBanks. During the course of our work, three FHLBanks—Atlanta, New York, and Pittsburgh—changed their policies to allow mortgage loans as eligible collateral from nondepository CDFIs. Pittsburgh changed its policies in August 2014, New York in September 2014, and Atlanta in December 2014. All the other FHLBanks have had policies that allowed mortgage loans as eligible collateral from nondepository CDFIs since nondepository CDFIs became eligible for membership in 2010. Officials from FHLBanks in Atlanta, New York, and Pittsburgh stated that due to the different risks posed by nondepository CDFIs, they initially took conservative stances on accepting loan collateral. The risks they cited included the lack of a clear resolution mechanism in the case of bankruptcy and the FHLBank not being able to obtain blanket liens on pledged collateral.

Within the general collateral categories (such as securities and mortgage loans), each FHLBank can impose specific collateral eligibility requirements, such as the quality of the collateral. For example, for nondepository CDFIs, one FHLBank disallows nonagency mortgage- backed securities, another FHLBank disallows commercial real estate collateral, and five FHLBanks disallow home equity lines of credit or home equity loans. At two FHLBanks, nondepository CDFIs can pledge mortgage loan collateral only if the CDFIs have certain credit ratings.

Collateral Requirements for Nondepository CDFIs Are Comparable to Those for Higher-Risk Institutions

The collateral requirements—specifically, the pledge method and haircuts—applicable to nondepository CDFIs seeking advances are comparable to those generally imposed on depository members categorized as higher risk and, in some cases, to those imposed on insurance companies. Based on our review of each FHLBank’s policies, all FHLBanks evaluate the creditworthiness and financial condition of their members, including nondepository CDFIs. Factors included in many of the evaluations are capital adequacy, asset quality, management quality, earnings, and liquidity. Additionally, the FHLBanks (with the exception of Topeka) assign credit ratings to their depository members that indicate Of the the creditworthiness and financial condition of these members.11 FHLBanks that assign credit ratings to depository members, 9 also assign credit ratings to nondepository CDFIs, with 2 (Atlanta and San Francisco) using a separate rating system specific to nondepository CDFIs. The remaining FHLBanks (New York and Indianapolis) do not assign credit ratings to nondepository CDFIs. While the metrics and methodology used to evaluate members differ, policies across FHLBanks generally reflect differential treatment between depository institutions and nondepository CDFIs (and other nondepository institutions such as insurance companies). For example, all FHLBanks require nondepository members to deliver collateral but generally only depository members with low credit ratings are required to list or deliver collateral.

The FHLBanks differed in the extent to which they varied haircuts (discounts) for nondepository CDFIs and depository institutions. For securities collateral, eight FHLBanks imposed the same haircut on nondepository CDFIs as on depository members for all eligible types of securities collateral. In contrast, four imposed higher haircut ranges on nondepository CDFIs. For loan collateral, six FHLBanks generally applied the same haircuts to nondepository CDFIs and depository institutions. One applied a higher-range haircut for single-family mortgages to nondepository CDFIs than to depository institutions; five FHLBanks applied higher haircut ranges to nondepository CDFIs than to depository institutions; and another FHLBank applied the lower end of the haircut range to nondepository CDFIs.

FHLBanks generally varied the haircut based on the types and quality of collateral, credit score or financial condition of the member, and pledge method (for loans). In general, haircuts were higher for collateral with lower ratings or of lower quality. See tables 3 and 4 for the specific haircuts each FHLBank imposed on nondepository CDFIs and depository In all cases, each FHLBank institutions for securities and loan collateral.may change these requirements at its discretion. See appendix II for more information on each FHLBank’s credit rating system and collateral requirements for advances, and how they may differ for nondepository CDFIs and depository institutions.

Four FHLBanks—Des Moines, New York, Pittsburgh, and San Francisco—had conditions on advance terms and borrowing limits specific to nondepository CDFIs. In general, advance terms and conditions varied widely. For example, FHLBanks offered advances with terms to maturity ranging from overnight to 30 years. FHLBanks may establish an overall credit limit for their borrowers. For example, the overall credit limit for FHLBank-Chicago was 35 percent of a member’s total assets. However, the amount a borrower can obtain is also partly dependent upon the amount and value of qualifying collateral available to secure the advance. FHLBanks may impose additional restrictions depending on the financial condition of the borrower, such as restrictions on the type of product, term of advance, and amount of credit available. Examples of specific conditions imposed on nondepository CDFIs by the four FHLBanks include the following:

FHLBank-Des Moines imposed a maximum amount of borrowing capacity and term available based on member credit ratings. Nondepository CDFIs were subject to a lower borrowing capacity than depository institutions with the same ratings.

FHLBank-New York limited the maximum advance term to 5 years for nondepository CDFIs.

FHLBank-Pittsburgh limited the maximum advance term to 2 years for nondepository CDFIs.

FHLBank-San Francisco had a term limit of 7 years for its nondepository CDFIs.

For more information on each FHLBank’s advance terms and borrowing limits for nondepository CDFIs and depository institutions, see appendix III.

Lack of Eligible Collateral Viewed as Primary Challenge to Obtaining Advances and Steep Haircuts Viewed as Disincentives

Officials from most of the nondepository CDFIs we interviewed cited access to low interest-rate advances from the FHLBanks as the primary benefit of membership, and some FHLBanks and nondepository CDFIs officials cited collateral requirements as challenges or disincentives to obtaining advances. Officials from three FHLBanks stated that the lack of eligible collateral was a disincentive for nondepository CDFIs seeking membership.

Officials from 21 (10 members and 11 nonmembers) of the 22 nondepository CDFIs we interviewed cited access to low interest-rate advances from the FHLBanks as the primary benefit of membership.

Officials from 5 of the 12 nonmember nondepository CDFIs interviewed said that they would not be interested in membership if they could not obtain advances.

Officials from 10 FHLBanks and 12 (6 members and 6 nonmembers) nondepository CDFIs stated that lack of eligible collateral was a challenge to obtaining advances for nondepository CDFIs. The reasons the officials provided for lack of collateral eligibility included not possessing mortgage-related collateral, not having unencumbered assets (those free and clear of liens or claims by other creditors), and not having quality collateral that met FHLBank standards.

For example, officials from FHLBank-Chicago stated that most nondepository CDFIs possessed assets, such as small business loans, that did not qualify based on statute and regulation as eligible collateral. Officials from four FHLBanks and seven nondepository CDFIs (three members and four nonmembers) stated that the requirement to pledge unencumbered assets was a challenge for nondepository CDFIs. Collateral encumbrance may occur when a CDFI is also a loan consortium that makes loans to borrowers on behalf of its members. Quality of collateral also affected collateral eligibility. For instance, officials from FHLBank-Cincinnati provided an example of a nondepository CDFI member whose collateral consisted exclusively of subprime mortgage loans. Due to the FHLBank’s constraints on exposure to subprime residential mortgage loan collateral (no more than 60 percent of borrowing capacity could stem from these loan types), the FHLBank was not able to accept the loans as collateral.

Steep haircuts were cited as a disincentive to applying for advances.

Officials from 6 (2 members and 4 nonmembers) of the 22 nondepository CDFIs we interviewed cited high haircuts as a disincentive for obtaining advances. For example, officials from a nondepository CDFI member said that their haircuts were very steep and that they likely will not obtain advances again unless the FHLBank eased the requirements. Officials from a nonmember nondepository CDFI in another district stated that the haircut was too restrictive.

Officials from all the member nondepository CDFIs we interviewed said that FHLBank membership had not affected their business activities or that they had not considered changing their business activities to better meet the collateral requirements. However, officials from three of the nonmember nondepository CDFIs we interviewed said that they have been taking actions to obtain assets that could be used as eligible collateral. One of these nonmember nondepository CDFIs was buying mortgage-backed securities to better meet collateral requirements. Additionally, officials from five FHLBanks said that their nondepository CDFI members had changed the structure of certain loans or repositioned their assets to create eligible collateral for advances.

Less Than Half of Nondepository CDFI Members Have Borrowed from FHLBanks

From October 2010 to September 2014, less than half of the nondepository CDFI members obtained advances from the FHLBanks. Six FHLBanks provided 115 advances totaling about $306.7 million to 12 nondepository CDFIs during this period (see fig. 3). However, two FHLBanks provided 57 advances to four nondepository CDFIs that accounted for almost 98 percent of the total advance amount. Of the 115 advances, approximately 36.5 percent had terms of less than 1 year (including advances with overnight terms), 15.7 percent had terms of more than 1 year to less than 5 years, 44.3 percent had terms of 5 years or longer, and 3.5 percent had open terms.

FHFA and FHLBanks Have Made Efforts to Facilitate Broader Participation of Nondepository CDFIs in the FHLBank System

FHFA and FHLBanks have made efforts to broaden the participation of nondepository CDFIs in the FHLBank System. According to FHFA officials, FHFA’s final rule implementing the HERA provisions that allow nondepository CDFI membership in the FHLBank System allows for certain flexibilities in meeting membership requirements. FHFA oversight of FHLBanks did not focus on FHLBanks’ membership approval process or advance and collateral practices as it relates to nondepository CDFIs and did not identify any safety and soundness concerns or action plans. FHFA and the FHLBanks have undertaken several efforts to help promote membership of nondepository CDFIs in the FHLBank System.

FHFA Final Rule on Membership for Nondepository CDFIs Includes Flexibilities

As noted previously, FHFA’s final rule to implement HERA provisions on nondepository CDFI membership in the FHLBank System allows for certain flexibilities in meeting membership requirements. In 2009, FHFA drafted a proposed rule that sought to amend the membership regulations and issued it for public comment. The substantive issues raised in the comments on membership focused on the criteria that FHFA proposed for FHLBanks to use in evaluating the financial condition of nondepository CDFIs applying for membership. According to FHFA officials, the CDFI community also was concerned about nondepository CDFIs not meeting basic membership requirements, such as making long-term mortgage loans and carrying mortgage-related assets.

FHFA reviewed the comments and issued a final rule in January 2010. If an applicant cannot meet the presumptive financial conditions, the final FHFA regulations allow nondepository CDFIs to submit additional information demonstrating that the applicant is in sufficiently sound condition to obtain membership and advances. The final rule also did not extend the requirement to demonstrate that 10 percent of their total assets are in residential mortgage loans to nondepository CDFI applicants.

Examinations of FHLBanks Found No Safety and Soundness Concerns with Advance Practices

FHFA oversight of FHLBanks as it relates to nondepository CDFIs did not focus on membership processes due to the low risk posed, and its oversight of collateral practices did not identify areas of concern. FHFA conducts annual examinations of the FHLBanks that cover these topics, among others. According to FHFA officials, FHFA examines FHLBanks’ membership approval processes to ensure that they comply with FHFA’s eligibility requirements and implement a risk-management process that is intended to mitigate the FHLBanks’ exposure to significant risks, especially legal, credit, and operational risk.

FHFA reviewed aspects of each FHLBank’s membership process periodically in 2010 through 2013. However, according to FHFA, it did not focus on processes specific to nondepository CDFIs because nondepository CDFIs pose low safety and soundness and credit risks, in aggregate, to FHLBanks due to their low rates of membership and advances. According to FHFA officials, FHFA currently reviews each nondepository CDFI’s application for membership and has not objected to any nondepository CDFI application submitted by the FHLBanks. It primarily reviews applications to gather information about the FHLBanks’ membership approval process.

In annual examinations of each FHLBank in 2010 through 2013, FHFA reviewed the FHLBanks’ collateral and advance practices for nondepository CDFIs and did not find any safety and soundness issues. FHFA’s advances and collateral examination manual calls for it to evaluate the FHLBanks’ procedures for analyzing and monitoring members, including nondepository CDFIs, and their outstanding advances. The manual also advises that special attention be given to FHLBanks’ collateral practices for CDFIs because nondepository CDFIs have no dedicated regulator. Furthermore, FHFA advises that FHLBanks’ credit risk-management procedures be tailored to address risks unique to each member type. For example, FHLBanks should consider that nondepository CDFIs likely are covered by federal bankruptcy statutes and not by the same receivership laws as insured depository institutions.

Efforts to Facilitate Nondepository CDFI Participation in the FHLBank System Include Education and Outreach

FHFA and the FHLBanks have undertaken several efforts to help educate nondepository CDFIs about and promote membership in the FHLBank System. According to FHFA officials, FHFA conducted a training session and webinar on the membership rule in February 2009, followed up on questions from CDFIs about the regulations, and tracked the progress of nondepository CDFIs in gaining membership. Officials from FHFA have made themselves available for questions about and problem solving in relation to the rules. According to FHFA and FHLBank officials as well as nondepository CDFIs we interviewed, FHFA has been encouraging FHLBanks to discuss ways in which they could increase nondepository CDFI membership and access to advances in a safe and sound manner. For example, at a speech to the FHLBank boards and executive management in early 2014, FHFA encouraged all the FHLBanks to meet collectively to discuss collateral practices that might facilitate advance activity with nondepository CDFIs, and emphasized the importance of the FHLBanks’ understanding of CDFI business models and funding needs. According to FHFA officials, as a result of that speech, the FHLBanks held a conference in August 2014 with the nondepository CDFI community to discuss facilitating membership and better understand the business of nondepository CDFIs. As a follow-up to the conference, FHLBank credit officers held nondepository CDFI credit review training in October 2014. Furthermore, the FHFA Director also met with nondepository CDFI officials and trade groups in July 2014.

In addition, all FHLBanks performed their own outreach to the nondepository CDFI community. For example, all the FHLBanks met with FHFA and nondepository CDFI members and nonmembers at the August 2014 conference to better understand nondepository CDFIs. Ten of the FHLBanks we interviewed have initiated discussions with and solicited membership applications from nondepository CDFIs since the conference. Some FHLBanks made changes in response to feedback from nondepository CDFI members. As noted previously, three of the FHLBanks that had restrictive collateral eligibility requirements amended these requirements to make obtaining advances easier for nondepository CDFIs. Two FHLBanks also made changes to their capital stock purchase requirements to allow a nondepository CDFI to be able to meet the stock purchase amount. According to the FHLBank officials, FHFA has been supportive of the changes they made to better accommodate nondepository CDFI membership and access to advances. FHFA officials told us that they have continued to encourage the FHLBanks to facilitate broader nondepository CDFI membership and access to advances.

Agency and Third Party Comments and Our Evaluation

We provided a draft of this report to FHFA and the 12 FHLBanks for their review and comment. FHFA and four FHLBanks (Chicago, Cincinnati, Indianapolis, and Topeka) provided technical comments, which we incorporated as appropriate. The other eight FHLBanks did not provide any comments.

In its comments, FHLBank-Chicago also stated that our report unfairly compares nondepository CDFIs with depository institutions and that a better comparison would be regulated institutions versus nonregulated or less regulated institutions (because claims would be handled similarly for regulated institutions). Specifically, FHLBank-Chicago noted that an FHLBank likely would go through the federal bankruptcy process to settle claims if a nondepository CDFI with FHLBank credit outstanding failed, whereas a federal or state regulator would facilitate the process to settle claims if a regulated institution such as a bank, credit union, or insurance company with FHLBank credit outstanding failed. However, the purposes of our report explicitly include discussing how nondepository CDFIs differ from other members of the FHLBank System (in particular, depository members) and the membership and collateral requirements for these CDFIs. We understand that risks vary by type of institution and noted several differences—including in supervision and the liquidation of assets—between nondepository CDFIs and other types of FHLBank members in our report. Comparing the collateral requirements for nondepository CDFIs with those for depository institutions enabled us to determine how the FHLBanks address the different risks posed by nondepository CDFIs. Moreover, in terms of resolution treatments, there is no uniform approach to settling claims even within the category of “regulated institutions.” For instance, FHFA stated in one of its advisory bulletins that “FHLBanks face risks lending to insurance companies that differ in certain respects with lending to federally-insured depository institutions” and noted that “laws dealing with a failed insured depository institution are well known and uniform across the country, whereas, the laws dealing with the failure of an insurance company are less well known to the FHLBanks and, though similar, may vary somewhat from state to state.” Therefore, we maintain that our comparisons were fair and made no change to the report in response to this comment.

In another comment, FHLBank-Chicago stated that the report implies that by loosening collateral requirements (some of which are dictated by law or regulation), more nondepository CDFIs would be eligible or willing to become FHLBank members. It noted that this was not necessarily the case, as a majority of nondepository CDFIs would not qualify for membership because of their lines of business (small business lending, microlending, and commercial lending) and because they have encumbered assets. We believe that these points are already adequately addressed in our report. Specifically, in the report we note that the types of eligible collateral are dictated by regulation. In addition, we state in the report that FHFA officials told us that some nondepository CDFIs may not be good candidates for FHLBank membership because the majority of nondepository CDFIs make nonhousing loans such as microloans, small business loans, and commercial loans. Furthermore, we note that several FHLBanks and nondepository CDFIs we interviewed told us that the requirement to pledge unencumbered assets was a challenge for nondepository CDFIs. We undertook these interviews to help understand the level of demand for FHLBank membership and obtain views on any challenges associated with obtaining membership and advances. Therefore, we made no change to the report in response to this comment.

In its comments, FHLBank-Indianapolis stated that the report could do a better job of making it clear that (1) FHLBanks accept assets as collateral and develop haircut methodologies to comply with regulations and an expectation of no losses in the event of default and (2) pledging illiquid assets can increase the haircut. In response, we added language in the body of the report that reiterated language in our background section stating that FHLBanks are required by statute and FHFA regulations to develop and implement collateral standards and other policies to mitigate the risk of default on outstanding advances. We also added language to the report noting that the illiquidity of assets can affect haircuts.

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 to the appropriate congressional committees and members, the Director of FHFA, the Council of the FHLBanks, and the 12 FHLBanks. This report will also be available at no charge on our website at http://www.gao.gov.

Should you or your staff have questions concerning this report, please contact me at (202) 512-8678 or garciadiazd@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix IV.

Appendix I: Objective, Scope, and Methodology

The objectives of this report were to discuss (1) how nondepository community development financial institutions (CDFI) differ from other members of the Federal Home Loan Bank (FHLBank) System, in particular depository members; (2) the membership and collateral requirements for nondepository CDFIs and challenges posed by these requirements; and (3) Federal Housing Finance Agency (FHFA) oversight of FHLBanks in relation to nondepository CDFIs and efforts by FHFA and FHLBanks to increase participation of nondepository CDFIs in the FHLBank System.

To describe differences between nondepository CDFIs and other members of the FHLBank System, we reviewed relevant sections of the Housing and Economic Recovery Act of 2008 (HERA) and FHFA’s final rule on nondepository CDFI membership in the FHLBank System. In addition, we reviewed other relevant information from the FHLBanks and CDFI industry, such as reports by the Department of the Treasury’s Community Development Financial Institutions Fund (CDFI Fund) and the Opportunity Finance Network. We determined that these studies were methodologically sound and reliable for our purposes. To compare the asset sizes of different types of FHLBank members (nondepository CDFIs, depository institutions, and insurance companies), we analyzed available data on their assets from FHFA’s membership database as of December 31, 2014. For these institution types, we calculated the distribution of their assets (minimum assets, 25th percentile, median assets, 75th percentile, and maximum assets). To assess the reliability of these data, we reviewed information about the system, interviewed knowledgeable officials, and analyzed the data for logical consistency and completeness. We found that these data were sufficiently reliable for the purpose of comparing the asset sizes of different types of FHLBank members.

To address membership and collateral requirements, we reviewed relevant legislation and regulations, such as the Federal Home Loan Bank Act and FHFA’s final rule on nondepository CDFI membership. We also reviewed documentation—such as nondepository CDFI membership applications and available FHLBank guidance on assessing nondepository CDFIs for membership—from each of the FHLBanks to determine membership requirements and identify any differences among FHLBank policies.FHLBank’s requirements for membership and identified differences. For example, in the three areas where FHLBanks had discretion, the analyst determined whether FHLBanks had set a minimum quantitative or qualitative threshold that an applicant needed to meet. A second analyst then verified the accuracy of this information. Nondepository CDFIs are subject to specific financial condition requirements. We requested and received financial data from the CDFI Fund but determined that the dataset did not contain relevant data needed to determine how many nondepository CDFIs could meet these financial condition requirements.

Specifically, one GAO analyst reviewed each To determine the number of nondepository CDFIs that were members from calendar years 2010 through 2014, we analyzed data from FHFA’s membership database as of December 31, 2014. To calculate the membership rate (the percentage of nondepository CDFIs in each district that were members), we used (1) data from FHFA’s membership database on the number of members as of December 31, 2014, and (2) data from the CDFI Fund on the total number of nondepository CDFIs as of December 31, 2014. We assessed the reliability of data from both systems by reviewing any relevant documentation, interviewing knowledgeable officials, and analyzing the data for logical consistency and completeness. We determined that the data were sufficiently reliable for the purposes of assessing rates of membership for nondepository CDFIs.

To determine each FHLBank’s requirements for obtaining advances and any differences among the FHLBanks, we reviewed relevant documentation such as each FHLBank’s collateral guidelines and product and credit policies. Using these documents, we identified the haircut (discount) for eligible collateral types for depository and nondepository institutions and other collateral requirements, such as the term of advances and collateral pledging methods. Our review of FHLBank documents showed that FHLBanks do not describe their collateral requirements uniformly. Although we took several steps that enabled us to present comparable categories of collateral across the FHLBanks, our analysis did not account for differences in the eligibility criteria for collateral that may be accepted, such as quality of collateral. As a result, the haircuts for different FHLBanks are not comparable. First, we excluded from our analysis the following types of collateral because they were only mentioned in some FHLBanks’ documents: U.S. Treasury separate trading of registered interest and principal securities, agency structured bonds, agency collateralized mortgage obligation accrual bonds, second mortgage-backed securities, student loan asset-backed securities, agricultural real estate loans, land loans, construction loans, student loans, mutual funds, and municipal or state and local securities. Second, because some FHLBanks identified specific haircuts for securities, such as those originating from the Federal Deposit Insurance Corporation, while other FHLBanks listed haircuts for a general category of agency securities, we grouped all the agency securities and provided the range of haircuts. We included in the agency securities category any securities issued or guaranteed by the U.S. government, including those originating from the Federal Deposit Insurance Corporation, National Credit Union Administration, Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Home Loan Banks, and the Small Business Administration. Third, because some FHLBanks identified specific haircuts for specific government-guaranteed loan collateral while others did not, we grouped all government-guaranteed loan collateral together, including loans originating from the Farm Service Agency, Department of Agriculture, Small Business Administration, Federal Housing Administration, and Department of Veterans Affairs. Fourth, because haircuts can vary based on the quality of the collateral pledged, we provided the range of haircuts for each type of collateral accepted by each FHLBank. While we were able to review each FHLBank’s collateral policies and procedures, the confidentiality of such information limited what we could publicly disclose in our report. Specifically, because the collateral haircut policies of the FHLBanks generally are considered proprietary information, we were unable to attribute specific policies to individual FHLBanks. Where appropriate, we used randomly assigned numbers when discussing FHLBank collateral policies to prevent disclosure of FHLBank identities.

Additionally, we obtained data from each FHLBank on the amount of advances secured by each nondepository CDFI member from October 2010 to September 2014 (the most recent data available at the time of our request). We assessed the reliability of these data by obtaining information from the six FHLBanks that provided advances to nondepository CDFIs on the system they used to store the data and the procedures in place for recording and ensuring the accuracy of the data. We also reviewed the data for logical consistency and completeness. We determined that the data were sufficiently reliable for reporting the amount of advances obtained by nondepository CDFs. We also interviewed officials from the 12 FHLBanks, 3 trade groups, 10 nondepository CDFIs that were members of the FHLBanks, and 12 nondepository CDFIs that were not members to understand the level of demand for FHLBank membership and obtain views on any challenges associated with membership processes and obtaining advances.

To develop the purposive, nonrandom sample of 10 nondepository FHLBank member CDFIs to interview, we selected a nondepository CDFI from each of the 10 FHLBanks that had a nondepository CDFI member as of March 31, 2014 (the most recent data available when we began our work and selected members to interview). In addition to geographic diversity, we sought variation in asset size, financial institution type, and FHLBank advance status. We also selected a purposive, nonrandom sample of 12 nondepository CDFIs that were not members of the FHLBank System, one from each of the 12 FHLBank districts. We selected these 12 from a sample of nondepository CDFIs that were identified during our meetings with member CDFIs and CDFI trade groups as being interested in FHLBank membership. In addition to geographic diversity, we sought variation in asset size when selecting nonmembers to interview. We interviewed officials from all 22 nondepository CDFIs by telephone, focusing on the background of the CDFI and its experience with and opinions of the FHLBank membership and advance processes. The views expressed by the nondepository CDFIs in our sample cannot be generalized to the entire population of nondepository CDFIs.

To evaluate FHFA’s oversight, we reviewed relevant laws, legislative history, and regulations (including its final rule on nondepository CDFI membership) to identify FHLBanks’ authority to expand membership to nondepository CDFIs and FHFA’s oversight authority. We also reviewed FHFA examination policies related to membership and collateral requirement to obtain advances. To determine if membership and advance practices were reviewed and there were any findings, we analyzed each FHLBank’s examination results for fiscal years 2010 through 2013 (the most recent examinations available at the time of our request). We interviewed FHFA and the 12 FHLBanks to further understand examination policies and practices for membership and advances and discuss any FHFA efforts to facilitate broader nondepository CDFI participation in the FHLBank System.

We conducted this performance audit from May 2014 to April 2015, in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Federal Home Loan Bank Collateral Requirements for Nondepository Community Development Financial Institutions and Depository Institutions

The collateral requirements—specifically the pledge method for loan collateral and haircuts (discounts)—assessed on advances to nondepository community development financial institutions (CDFI) vary from those imposed on depository members. For example, all Federal Home Loan Banks (FHLBanks) require nondepository CDFIs to deliver collateral (a requirement that also would be applied to higher-risk depository institutions), and in some cases, nondepository CDFIs receive higher haircuts than depository institutions. For each FHLBank, we compare the pledge method and haircuts applied to depository institutions and nondepository CDFIs below (see table 5).

Appendix III: Federal Home Loan Bank Advance Terms and Borrowing Limits for Nondepository Community Development Financial Institutions and Depository Institutions

Most Federal Home Loan Banks (FHLBanks) do not have advance terms and borrowing limits specific to nondepository community development financial institutions (CDFI). However, four FHLBanks (Des Moines, New York, Pittsburgh, and San Francisco) do have specific advance terms and borrowing limits. We summarize the advance terms and borrowing limits for each FHLBank below (see table 6).

Appendix IV: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Paige Smith (Assistant Director), Akiko Ohnuma (Analyst-in-Charge), Farah Angersola, Evelyn Calderon, Pamela Davidson, Kerri Eisenbach, Courtney LaFountain, John McGrail, Marc Molino, Barbara Roesmann, Jim Vitarello, and Weifei Zheng made key contributions to this report.