oversight

FHFA's Oversight of the Federal Home Loan Banks' Unsecured Credit Risk Management Practices

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-06-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

          FEDERAL HOUSING FINANCE AGENCY
                         3330
            OFFICE OF INSPECTOR GENERAL



     FHFA’s Oversight of the Federal Home Loan Banks’
       Unsecured Credit Risk Management Practices




EVALUATION REPORT: EVL-2012-005           DATED: June 28, 2012
                              FHFA’s Oversight of the Federal Home Loan Banks’
                                Unsecured Credit Risk Management Practices

Why FHFA-OIG Did This Report                                       credit rating was downgraded and it later suffered a multibillion
The Federal Home Loan Bank System (FHLBank System) is              dollar loss. FHFA internal documents from that period also noted
a government-sponsored enterprise (GSE) comprised of 12            the rapid, system-wide growth in unsecured credit, certain
regional Federal Home Loan Banks (FHLBanks) whose                  FHLBanks’ large exposures to particular financial institutions, and
primary mission is to support housing finance. To carry out        the increasing credit and other risks associated with such lending.
this mission, the FHLBank System’s central Office of Finance       Although FHFA identified extensions of unsecured credit by the
issues debt at the relatively favorable rates available to GSEs.   FHLBanks as an increasing risk in early 2010, the Agency did not
The FHLBanks use the proceeds of this debt to make secured         prioritize it in its examination process due to its focus on greater
loans, also known as advances, to member financial                 financial risks then facing the FHLBank System. In 2011,
institutions, such as banks. These member financial                however, FHFA initiated a range of oversight measures that focus
institutions can then use the advance proceeds to originate        on credit extensions, including prioritizing them in the supervisory
residential mortgages. FHLBanks may also extend unsecured          process and increasing the frequency with which the FHLBanks
short-term credit (namely, loans not backed by collateral) to      report on their unsecured credit portfolios.
domestic and foreign financial institutions.
                                                                   FHFA-OIG believes that FHFA’s recent initiatives contributed to
Extensions of unsecured credit by the FHLBanks to, among           the significant decline in the amount of unsecured credit the
others, European banks, grew rapidly to more than                  FHLBanks were extending by the end of 2011. However, FHFA
$120 billion by early 2011. However, they declined sharply         can take additional actions that will further strengthen its oversight
by the end of 2011 as the European sovereign debt crisis           efforts. Specifically, FHFA did not initially pursue potential
intensified.                                                       evidence of FHLBanks’ violations of the existing regulatory limits
The Federal Housing Finance Agency (FHFA or Agency)                and take supervisory and enforcement actions as warranted.
regulates the FHLBanks. FHFA has critical responsibilities to      Further, FHFA’s regulatory limits for unsecured credit may be
ensure that the FHLBanks operate in a safe and sound manner        outdated and overly permissive. Even when an FHLBank operates
and fulfill their housing mission objectives. FHFA’s Office of     within the established limits it can amass the sort of large
Inspector General (FHFA-OIG) initiated this evaluation to          unsecured credit exposure that has been the source of considerable
assess FHFA’s oversight of the FHLBanks’ unsecured credit          regulatory concern.
risk management practices.
                                                                   What FHFA-OIG Recommends
What FHFA-OIG Found                                                FHFA-OIG recommends that FHFA investigate potential
Extensions of unsecured credit by the FHLBanks to, among           violations of its regulations governing extensions of unsecured
others, European financial institutions, increased substantially   credit identified by FHFA-OIG. Further, FHFA should consider
in 2010 and 2011, even as the risks associated with doing so       revising current regulatory limits to mitigate the risks associated
were intensifying. For example, FHFA-OIG found that in             with extensions of unsecured credit by the FHLBanks. FHFA
2011 one FHLBank extended more than $1 billion in                  agreed with these recommendations.
unsecured credit to a European bank despite indications of
increased risks associated with doing so, e.g., the bank’s


EVALUATION REPORT: EVL-2012-005                                                                         Dated: June 28, 2012
TABLE OF CONTENTS
TABLE OF CONTENTS ..................................................................................................................................... 3

ABBREVIATIONS .............................................................................................................................................. 5

PREFACE ............................................................................................................................................................ 6

BACKGROUND .................................................................................................................................................. 8
   I.          As the FHLBanks’ Advances Have Declined, FHFA Has Expressed Concerns About Certain FHLBanks’
               Increasing Reliance on Investments, Such as Extensions of Unsecured Credit ..............................................8

   II.         Unsecured Credit Can Be a Substantial Component of an FHLBank’s Assets and Investments ..................11

   III.        FHLBank Unsecured Credit Exposures Involve Primarily Credit, Housing Mission, and “Image” Risks ..13
          A.     Credit Risk ................................................................................................................................................13
          B.     Housing Mission and “Image” Risks ........................................................................................................14
   IV.         FHFA Regulations Establish the FHLBanks’ Unsecured Lending Exposure Limits, Which Some Agency
               Officials Consider Outdated and Overly Permissive .....................................................................................15
   V.       Unsecured Credit to Borrowers Rose to More than $120 Billion by Early 2011 but Declined Significantly
            by the End of the Year ...................................................................................................................................17
          A. Fluctuations in the Extension of Unsecured Credit ..................................................................................17
          B. Advances Decrease as Unsecured Credit Exposures Increase ..................................................................19
          C. Identity of Foreign Borrowers ..................................................................................................................21
   VI.      Several FHLBanks Violated FHFA’s Regulatory Limits or Extended Unsecured Credit Despite Indicators
            of Heightened Risks .......................................................................................................................................23
          A. Several FHLBanks Violated FHFA’s Unsecured Credit Limits Due to Inadequate Systems and Controls
                .................................................................................................................................................................23
          B. Several FHLBanks Extended Unsecured Credit to Foreign Financial Institutions Despite Indications of
               Heightened Risks .....................................................................................................................................25
   VII.        FHFA Internal Reports Identified Deficiencies in FHLBanks’ Unsecured Credit Risk Management
               Practices ........................................................................................................................................................27

   VIII. FHFA Oversight Activities of FHLBank Unsecured Credit ..........................................................................28

FINDINGS .......................................................................................................................................................... 30
   I.          Although FHFA Did Not Initially Prioritize FHLBank Unsecured Credit Risks, It Has Recently Developed
               an Increasingly Proactive Approach to Oversight in This Area ...................................................................30
   II.         FHFA Did Not Actively Pursue Evidence of Potential FHLBank Violations of the Limits on Unsecured
               Exposures Contained in Its Regulation .........................................................................................................31
   III.        FHFA’s Current Regulation Governing Unsecured Lending by the FHLBanks May Be Outdated and
               Overly Permissive .........................................................................................................................................31

CONCLUSIONS ................................................................................................................................................ 33
                   Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                                                         3
RECOMMENDATIONS .................................................................................................................................... 33

SCOPE AND METHODOLOGY ...................................................................................................................... 34

FHFA’S COMMENTS ON FHFA-OIG’S FINDINGS AND RECOMMENDATIONS ................................... 35

ADDITIONAL INFORMATION AND COPIES .............................................................................................. 37




               Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                                          4
ABBREVIATIONS
CDS ...................................................................................................................Credit Default Swap
DBR ................................................................... Division of Federal Home Loan Bank Regulation
Fannie Mae......................................................................... Federal National Mortgage Association
FHFA or Agency.......................................................................... Federal Housing Finance Agency
FHFA-OIG ..................................... Federal Housing Finance Agency, Office of Inspector General
FHFB...............................................................................................Federal Housing Finance Board
FHLBanks ...............................................................................................Federal Home Loan Banks
FHLBank System ........................................................................ Federal Home Loan Bank System
Freddie Mac .................................................................. Federal Home Loan Mortgage Corporation
GSE ............................................................................................ Government-Sponsored Enterprise
MBS ....................................................................................................... Mortgage-Backed Security
PLMBS ............................................................................ Private Label Mortgage-Backed Security
S&P ...................................................................................................................... Standard & Poor’s




             Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                                     5
                                      Federal Housing Finance Agency
                                        Office of Inspector General
                                              Washington, DC



                                                PREFACE
The FHLBank System is a GSE that was established in 1932 and tasked to promote housing
finance in the United States. A dozen regional FHLBanks and the Office of Finance comprise
the FHLBank System. The FHLBanks support housing finance primarily by making secured
loans, which are called advances, to member financial institutions, such as banks and thrifts.
These members can use the proceeds to originate mortgages.1 FHLBanks also make a variety of
investments, including extensions of short-term (i.e., overnight to no more than 270 days)
unsecured credit to domestic and foreign financial institutions.2 The FHLBank System funds
FHLBank advances and investments through its Office of Finance, which issues debt at the
favorable interest rates available to GSEs.3

As GSEs, there is the potential that FHLBanks may engage in risky activities that could
destabilize their financial conditions.4 FHFA, in its role as the FHLBank System’s safety and
soundness regulator, is responsible for ensuring that the FHLBanks effectively manage their risk
to minimize the potential for such negative outcomes. FHFA is also responsible for ensuring that
the FHLBank System fulfills its housing mission objectives.




1
 FHLBank advances are secured by eligible collateral such as single-family mortgages or investment grade
securities, among other assets.
2
  FHLBanks typically extend unsecured credit to domestic (U.S.) financial institutions. FHLBanks also extend
unsecured credit to foreign financial institutions, e.g., branches of foreign-owned banks that do business in the U.S.
and are subject to some U.S. governmental regulation. In this report, FHFA-OIG uses the terms “foreign banks,”
“foreign financial institutions,” and “foreign borrowers” to refer to foreign financial institutions that do business in
the U.S. and are subject to some U.S. governmental regulation.
3
 The FHLBank System can borrow at favorable rates due to the perception in financial markets that the federal
government will guarantee repayment of its debt even though such a guarantee has not been made explicitly. This
phenomenon is known as the “implicit guarantee.” See FHFA-OIG, FHFA’s Oversight of Troubled Federal Home
Loan (EVL-2012-001, January 11, 2012).
4
  Due to the implicit federal guarantee, FHLBanks can conceivably rely indefinitely on debt issued at favorable rates
to finance their activities. This would enable them to engage in higher risk transactions that could result in financial
deterioration over time. Such deterioration could potentially result in the failure of an FHLBank and in the U.S.
Treasury Department deciding to provide financial support to the FHLBank System as a means to stabilize financial
markets.


            Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                            6
FHFA-OIG initiated this evaluation in early 2012 after
                                                                        The European Sovereign Debt
discussing the risks associated with the FHLBanks’                      Crisis: A continuing financial crisis
unsecured credit practices with FHFA and reviewing                      prompted by concerns about rising
Agency financial data. The data indicate that as of early               levels of public debt in a number of
2011, the FHLBanks had extended more than $120 billion                  European countries. Credit
                                                                        downgrades made it more expensive
in unsecured credit to domestic and foreign financial                   for these countries to borrow against
institutions, including European banks. In light of the                 their debt, giving rise to concerns
financial deterioration of financial institutions associated            about the possibility of defaults on
with the European sovereign debt crisis, FHFA-OIG’s                     sovereign debt. Many European
                                                                        financial institutions, particularly
objective was to assess FHFA’s oversight of the                         banks that hold sovereign debt or
FHLBanks’ risk management practices and the regulatory                  other potentially risky assets, have
framework under which FHFA conducts its oversight.                      suffered significant losses,
                                                                        restructured, or gone out of
This report was written principally by Wesley M. Phillips,              business. The crisis has continued
Senior Policy Analyst; Simon Wu, Ph.D., Chief Economist;                into 2012.
and Jon Anders, Program Analyst. FHFA-OIG appreciates
the assistance of all those who contributed to the preparation of this report.

This report has been distributed to Congress, the Office of Management and Budget, and others
and will be posted on FHFA-OIG’s website, www.fhfaoig.gov.




Richard Parker
Director, Office of Policy, Oversight, and Review




          Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                     7
BACKGROUND
I.    As the FHLBanks’ Advances Have Declined, FHFA Has Expressed
      Concerns About Certain FHLBanks’ Increasing Reliance on Investments,
      Such as Extensions of Unsecured Credit
FHLBank advances to member institutions have fluctuated significantly over the past several
years (see Figure 1). At the end of 2008, member demand for advances jumped to nearly
$930 billion. However, from the end of 2008 through the end of 2011, FHLBank advances
declined more than 50% to $418 billion.5 FHFA officials attribute the sharp decline in advances
to a variety of factors including: (1) the wide availability of lower-cost bank funding sources,
such as retail deposits; (2) the poor state of the U.S. housing market and the associated decline in
mortgage demand; and (3) the mergers or failures of certain large FHLBank members, such as
Countrywide and IndyMac Corporation.

Figure 1: FHLBank System Advances, Year-end 2001 Through Year-end 2011 (in
          Billions)6




As of June 2011, advances to member FHLBank financial institutions constituted the majority of
the FHLBank System’s assets (53%). However, the FHLBanks also hold investments, whole

5
 At the end of 2011, total advances amounted to $418 billion – $54 billion less than at the end of 2001 on a nominal
basis.
6
 Source: FHLBanks Office of Finance, Annual Combined Financial Reports for 2001 through 2011, available at
http://www.fhlb-of.com/ofweb_userWeb/pageBuilder/fhlbank-financial-data-36.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                         8
mortgages purchased directly from their members, and cash and other miscellaneous assets (see
Figure 2). Investments constituted 36% of the FHLBank System’s total assets in June 2011, and
these investments included mortgage-backed securities (MBS) issued by the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac); private label mortgage-backed securities (PLMBS), i.e., MBS that is not issued by Fannie
Mae, Freddie Mac, or the Government National Mortgage Association; and extensions of
unsecured credit.7

Figure 2: FHLBank System Assets as of June 2011 (in Billions)8




The FHLBanks’ investment portfolios generate interest revenue and income that enhances their
financial performance. FHLBank officials have also stated that their investments help them to
meet FHLBank System liquidity needs. For instance, unsecured credit is often extended on an
overnight basis, which means that it can serve as a ready source of liquidity to fund potential
advance demand. Although FHFA officials agreed that unsecured credit can serve as a source of
liquidity for advances, they noted that FHLBanks have other, more significant sources of
7
  Like the FHLBank System, Fannie Mae and Freddie Mac are housing GSEs. To fulfill their missions, Fannie Mae
and Freddie Mac purchase mortgages from lenders and hold them or package them into MBS that is sold to
investors. Non-GSEs, such as banks and mortgage finance companies, may also package mortgages into securities,
known as private-label MBS, or PLMBS.
8
 Source: FHLBanks Office of Finance, Combined Financial Report for the Quarterly Period Ended
June 30, 2011, available at http://www.fhlb-of.com/ofweb_userWeb/resources/11Q2end.pdf.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                      9
liquidity. One official said that the FHLBanks should generally be able to meet advance demand
through debt issuance by the FHLBank System’s Office of Finance.9

FHFA officials also said that some FHLBanks extend unsecured credit because doing so can
generate higher returns than advances, which contributes to return on their capital. FHFA has
also concluded that FHLBanks may extend unsecured credit to offset the overall decline in the
demand for advances by members in recent years.10

FHFA classifies investments in MBS and PLMBS and extensions of unsecured credit as non-
core mission activities.11 FHFA’s Acting Director has expressed concern about the high level of
non-core mission activities of certain FHLBanks. He has stated that “… the FHLBanks’ various
financial problems of the past 20 years have not come from the traditional advance business.
Instead, investments and mortgage purchase programs have been the source of financial
deterioration at some FHLBanks.” He also stated that it “… is not a sustainable operating
condition for an FHLBank” to have a large investment portfolio.12 Indeed, in a report issued
earlier this year, FHFA-OIG noted that several FHLBanks’ large investments in PLMBS caused
them to experience billions of dollars in losses.13




9
 FHFA-OIG is not in a position to dispute the FHLBanks’ view that unsecured credit is generally extended to meet
FHLBank System liquidity needs. Nonetheless, this report demonstrates that from 2008 through the beginning of
2011, extensions of unsecured credit to foreign institutions rapidly increased even as the demand for advances to
members plummeted (see Figures 7a and 7b, below). Thus, it is not clear that this increase in unsecured credit was
undertaken to meet potential advance demand.
10
  FHFA plans to conduct an examination of all 12 FHLBanks’ unsecured credit risk management practices in 2012.
The Agency noted in its internal analysis, which substantiated the need to conduct the examination, that FHLBanks
increased their levels of unsecured credit due, in part, to declining advance demand in recent years. Officials from
one FHLBank concurred that from 2008 to the beginning of 2011, their FHLBank made extensions of unsecured
credit, in part, to offset the decline in the demand for advances.
11
   FHFA’s regulation at 12 C.F.R. § 1265.2 emphasizes that the FHLBanks’ mission is to provide to their members
financial products and services that assist them to finance housing and community lending. Further, FHFA has
defined activities that qualify as core to the FHLBanks’ mission. See, e.g., 12 C.F.R. § 1265.3. Extending
unsecured credit is not included within this definition and, therefore, is not a core mission activity. The regulation
also specifies that investing in MBS is a core mission activity only to the extent that such investment “would
expand liquidity for loans that are not otherwise adequately provided by the private sector and do not have a readily
available or well established secondary market.” Id. Accordingly, an FHFA official confirmed that the regulatory
definition does not cover investment in Fannie Mae and Freddie Mac MBS; it also does not extend to investment in
PLMBS.
12
   FHFA Acting Director Edward J. Demarco, The Franchise Value of Federal Home Loan Banks, 2011 Federal
Home Loan Bank Directors Conference, Washington, DC, May 11, 2011, available at www.fhfa.gov/web-
files/21197/FHLB51111Final.pdf.
13
     See FHFA-OIG, FHFA’s Oversight of Troubled Federal Home Loan Banks, (EVL-2012-001, January 11, 2012).


             Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                          10
Officials from one FHLBank also advised that in recent years its extensions of unsecured credit
to foreign financial institutions have increased due to significant declines in domestic short-term
lending since the 2008 financial crisis.

II. Unsecured Credit Can Be a Substantial Component of an FHLBank’s
    Assets and Investments

Like other financial institutions, the FHLBanks participate                   Commercial Paper: Unsecured,
in short-term, unsecured credit markets.14 According to                       short-term debt instruments issued
FHFA officials, the FHLBanks’ extensions of unsecured                         by corporations, typically for the
credit typically involve commercial paper, banknotes,                         financing of accounts receivable,
                                                                              inventories, and meeting short-
and federal funds.15 Such credit extensions take place                        term liabilities. Maturities on
either on an overnight basis or for a term of no longer than                  commercial paper rarely range any
270 days. For example, in June 2011, 42% of all unsecured                     longer than 270 days.
credit was extended on an overnight basis, 33% had a term                     Banknotes: Negotiable
limit of between 2 and 30 days, 24% had a term limit of                       promissory notes issued by banks
                                                                              and payable to the bearer on
between 31 and 90 days, and 1% had a term limit of
                                                                              demand. The amount payable is
between 91 and 180 days.                                                      stated on the face of the note.
                                                                              Federal Funds: Extensions of
As shown in Figures 3a and 3b, below, extensions of             unsecured credit between financial
unsecured credit to financial institutions accounted for        institutions that are generally made
10.2% of the FHLBank System’s assets in June 2011 and           on an overnight basis.
                                                 16
28.6% of its investment portfolio in June 2011. It can
also vary considerably as a percentage of an FHLBank’s total assets and investment portfolio
(i.e., from 0.4% to 20.2% of total assets and from 0.7% to 42.4% of investments). Further, some
of the smaller FHLBanks engage in relatively more extensions of unsecured credit to domestic

14
   Unsecured credit is a facet of the Interbank Market, which is vital for banks’ liquidity management. Unsecured
credit is offered at a premium due to the heightened credit risk that is transferred to the lender. See Heider and
Hoerova, “Interbank Lending, Credit-Risk Premia, and Collateral,” International Journal of Central Banking, Vol.
5, Number 4, December 2009, p. 5-8.
15
  According to the Federal Reserve Bank of New York, federal funds are unsecured loans of reserve balances at
Federal Reserve Banks between depository institutions. Banks keep reserve balances at the Federal Reserve Banks
to meet their reserve requirements and to clear transactions. Transactions in the federal funds market enable
depository institutions with reserve balances in excess of reserve requirements to lend them to institutions with
reserve deficiencies.
Although the FHLBanks are not required to maintain their bank reserves at the Federal Reserve, they may
participate in the federal funds market and offer to extend unsecured credit to domestic and foreign financial
institutions.
16
  FHFA-OIG chose June 2011 for this comparison because it represents a period of time during which FHLBank
lending raised considerable risk management concerns. As noted later in this report, such lending declined
significantly by the end of 2011.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                          11
and foreign financial institutions than larger FHLBanks. For example, as of June 30, 2011, the
ninth and eleventh largest FHLBanks (as measured by their total assets), Seattle and Topeka, had
the highest percentage of unsecured credit to total assets within the FHLBank System (see Figure
3a). Topeka also had the largest percentage of unsecured credit in its investment portfolio, but
Atlanta and San Francisco, the two largest FHLBanks, ranked second and third in this category
(see Figure 3b).

Figure 3a: Unsecured Credit to Domestic and Foreign Financial Institutions as a
           Percentage of FHLBank Total Assets, June 30, 201117

             FHLBank           Unsecured Credit to Financial        Percentage of Assets     FHLBank
                                 Institutions (in Millions)                                   Size18
             Seattle                        $8,695                          20.2%                9
             Topeka                         $5,560                          15.5%                11
             Boston                         $7,786                          14.9%                6
             Pittsburgh                     $7,331                          14.1%                7
             San Fran.                     $20,196                          14.0%                1
             Atlanta                       $15,155                          13.0%                2
             Cincinnati                     $5,701                           8.6%                5
             Indianapolis                   $2,905                           7.3%                10
             Dallas                         $1,948                           6.2%                12
             New York                       $4,475                           4.6%                3
             Des Moines                     $2,280                           4.4%                8
             Chicago                         $274                            0.4%                4
             Total                         $82,306                          10.2%                 -

Figure 3b: Unsecured Credit to Domestic and Foreign Financial Institutions as a
           Percentage of FHLBank Investments, June 30, 2011

               FHLBank          Unsecured Credit to Financial         Percentage of         FHLBank
                                  Institutions (in Millions)       Investment Portfolio      Size18
               Topeka                        $5,560                        42.4%               11
               Atlanta                      $15,155                        41.0%               2
               San Fran.                    $20,196                        39.4%               1
               Boston                        $7,786                        38.3%               6

17
  The sources for Figures 3a and 3b are FHFA and FHLBank Office of Finance, Combined Financial Report for the
Quarterly Period Ended June 30, 2011, available at http://www.fhlb-
of.com/ofweb_userWeb/resources/11Q2end.pdf.
18
     Ranking within the FHLBank System based on total assets, as of June 30, 2011.


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                         12
             Pittsburgh                      $7,331                           38.2%                  7
             Seattle                         $8,695                           33.4%                  9
             New York                        $4,475                           27.3%                  3
             Cincinnati                      $5,701                           21.7%                  5
             Dallas                          $1,948                           21.0%                  12
             Indianapolis                    $2,905                           19.9%                  10
             Des Moines                      $2,280                           14.9%                  8
             Chicago                          $274                             0.7%                  4
             Total                          $82,306                           28.6%                   -



III. FHLBank Unsecured Credit Exposures Involve Primarily Credit,
     Housing Mission, and “Image” Risks

       A.     Credit Risk

According to FHFA and FHLBank officials, the key financial risk associated with unsecured
lending is credit risk; that is, the risk that an FHLBank’s borrower will fail or otherwise default
on its obligations.19 Generally, the credit risk associated with extensions of unsecured credit is
viewed as being higher than the risk associated with cash advances. This is because cash
advances are secured by eligible collateral such as single-family mortgages or investment grade
securities, among other assets, and – as the name implies – unsecured credit is not backed by any
collateral.

In general, however, FHFA officials consider the credit risk associated with FHLBank unsecured
lending to be a manageable one. In 2003, one of FHFA’s predecessor agencies, the Federal
Housing Finance Board (FHFB), held a one-day review session on the risks associated with
unsecured credit and it periodically revisited the issue. Its overall conclusion was that the credit
risk associated with unsecured lending was mitigated by the short-term nature of it. Moreover,
FHFA officials said that the FHLBanks typically restrict their extensions of unsecured credit to
highly rated private institutions, i.e., institutions rated at the “A” level or above.

Nonetheless, not all FHFA officials fully concur that credit risk is largely mitigated by short
maturity terms and the focus on such lending to highly rated counterparties. One senior

19
   Extensions of unsecured credit may also involve market liquidity risk, i.e., the risk that an FHLBank could not
liquidate its positions if the need to do so arose. But FHFA said that the market liquidity risk associated with
unsecured credit is very low due to the fact that it is typically conducted on an overnight or short-term basis. As
with any loan, there is also operational risk associated with unsecured credit, including technical difficulties, such as
computer malfunctions. It is virtually impossible to quantify such operational risks, but FHLBanks should have
internal controls in place to mitigate them.


            Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                           13
examiner stated that FHLBanks do not always appropriately consider the risk and return trade-
off inherent in their unsecured credit practices. That is, FHLBanks do not always price
unsecured credit sufficiently to offset the increased risk that it poses. The examiner further
stated that large unsecured credit losses could potentially eliminate an FHLBank’s retained
earnings – a component of capital – and thereby compromise its capacity to meet the housing
mission needs of its members.20

In order to examine FHFA’s oversight of the FHLBanks’ unsecured credit practices and the risks
associated with it, FHFA-OIG contacted representatives of four FHLBanks (several of which
have relatively large unsecured credit exposures). All of the FHLBanks’ representatives stated
that they have policies and practices in place to manage and mitigate the risks associated with
extensions of unsecured credit. According to the officials, these policies and practices include
periodic reviews of borrowers and limits on borrower exposure that may be more restrictive than
those permitted by FHFA. The FHLBank officials further stated that they continually monitor
market indicators of prospective borrowers’ financial health, such as credit default swap (CDS)
spreads, and that they immediately limit or eliminate such exposure as warranted.21

       B.     Housing Mission and “Image” Risks

FHFA officials also said that, in addition to credit risk, a high level of unsecured credit
extensions could expose an FHLBank to housing mission and “image” risks. As previously
mentioned, FHFA classifies unsecured credit extensions as non-core mission activities. In other
words, FHFA does not view these investments as contributing to the FHLBank System’s overall
goal of promoting housing finance; and the housing mission may be jeopardized by an
FHLBank’s emphasis on non-core mission activities. FHFA officials also said that FHLBanks
with large unsecured exposures may face challenges in explaining to Congress how such lending
is consistent with their core domestic housing finance mission. Agency officials and documents
refer to this as image risk.




20
  Retained earnings – profits that are not paid out as dividends to members – are a relatively small component of an
FHLBank’s overall capital structure, with member contributions constituting a far larger component. But the FHFA
examiner’s view is that FHLBanks should consider the risk to their retained earnings when deciding on the
appropriate size of their unsecured credit exposures. This is because retained earnings constitute the primary source
of capital that an FHLBank could lose on such extensions of unsecured credit without jeopardizing its ability to meet
member advance demand.
21
  A CDS is a bilateral contract that transfers credit risk from one party to another. A seller, which is offering CDS
protection, agrees, in return for a periodic fee, to compensate the buyer if a specified credit event, such as a default,
occurs. Rising CDS spreads (i.e., an increasing difference between a bench-mark investment’s return – such as the
prevailing interest rate for U.S. Treasury securities – and the CDS’s periodic fee) indicate increasing credit risks.


            Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                            14
IV. FHFA Regulations Establish the FHLBanks’ Unsecured Lending
    Exposure Limits, Which Some Agency Officials Consider Outdated and
    Overly Permissive

In 2002, one of FHFA’s predecessors, FHFB, finalized a regulation that was intended to limit the
risks associated with extensions of unsecured credit by the
FHLBanks.22 The regulation sets limits on the amount of         Regulatory Capital: FHFA
unsecured credit that can be extended to an individual          requires each FHLBank to
                                                             23 maintain regulatory capital that is
borrower based upon the borrower’s overall credit rating.
                                                                equal to at least 4% of its total
The higher a borrower’s credit rating, the more exposure
                                                                assets. According to FHFA
that an FHLBank can have to it; conversely, the lower a         requirements, regulatory capital
borrower’s credit rating, the less exposure permitted. The      includes the capital investments of
exposure limits established in the regulation apply to the      FHLBank members (i.e., proceeds
lesser of the FHLBank’s regulatory capital or the               of stock purchases); retained
                                                                earnings (i.e., profits not paid out
borrower’s total capital.24 Using this method, FHFA seeks       as dividends to members); a
to limit the potential for, and severity of, unsecured credit   general allowance for losses,
losses in the event of a borrower’s failure or default on its   consistent with generally accepted
financial obligation.                                           accounting principles; and any
                                                                               other funds available to absorb
                                                                               losses.
Figure 4, below, shows the amount of unsecured credit as a
percentage of its regulatory capital (or the borrower’s total
capital) that an FHLBank may extend to a single borrower.




22
     The regulation remains in effect today. See 12 C.F.R. § 932.9.
23
   FHFA-OIG notes that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank),
Pub. L. No. 111-203, § 939A, requires FHFA to revise any regulation that contains compliance and implementation
strategies based on ratings issued by Nationally Recognized Statistical Ratings Organizations (i.e., credit rating
agencies), and its regulation of FHLBank unsecured lending falls squarely within this Dodd-Frank requirement.
FHFA’s Deputy Director of the Division of FHLBank Regulation, who is directly responsible for FHLBank
oversight, advised that FHFA will address unsecured lending exposure limits when it amends its regulations in
compliance with Dodd-Frank, but no decisions have been made.
24
  In general, financial institution capital requirements, such as FHFA’s regulatory capital requirement, are an
important means by which regulators seek to ensure the financial soundness of banks and other regulated entities.
Capital serves as a cushion that protects against unanticipated losses and asset declines that could cause a bank to
otherwise fail.


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                           15
Figure 4: Maximum Limits on Unsecured Credit to a Single Borrower25

                    Credit Rating of Borrower                 Term Lending Limits      Total Exposure
                                                                  (percent of              Limits
                                                               regulatory capital)       (percent of
                                                                                     regulatory capital)
           Highest Investment Grade (AAA)                             15                     30
           Second Highest Investment Grade (AA)                       14                     28
           Third Highest Investment Grade (A)                         9                      18
           Fourth Highest Investment Grade (BBB)                      3                      6
           Below Investment Grade or Other                            1                      2



FHLBanks may offer term extensions of unsecured credit up to the limits provided in the
regulation, which are set forth in Figure 4, above. The regulation also permits the FHLBanks to
extend additional unsecured credit, i.e., overnight extensions, as long as the total exposures do
not exceed twice the regulatory limit for term extensions. Thus, for example, an FHLBank may
lend up to 14% percent of its regulatory capital to a AA-rated institution (assuming the AA-rated
institution’s total capital is greater than the FHLBank’s regulatory capital) on a term basis, and
may lend up to an additional 14% – for a total exposure of 28% – on an overnight basis.26

Although they were not speaking on behalf of the Agency, some senior FHFA officials
characterized the limits established in the regulation as outdated and overly permissive. They
expressed particular concern about what they called the “kicker” provision in the regulation, i.e.,
the provision under which the FHLBanks may double their exposures to individual institutions
so long as 50% of the total exposure is lent on an overnight basis. According to these officials,
the regulation should be revised because it permits FHLBanks to establish sizeable unsecured
credit exposures that increase their credit, mission, and image risks.

Additionally, FHFA-OIG observes that the Agency’s decision to regulate the FHLBanks’
unsecured credit business by limiting the amount that an FHLBank may extend to an individual
borrower means that so long as an FHLBank stays within the limits established for each
borrower, its overall exposure can be unlimited. In other words, although the exposure of an
FHLBank’s regulatory capital may be limited with respect to specific borrowers (for instance to
28% for a single borrower in the example set forth above), there is no limit on the number of

25
     Source: 12 C.F.R. § 932.9(a).
26
  Alternatively, FHLBanks may lend up to the total unsecured exposure limits on an overnight basis. Thus, for
example, an FHLBank could extend overnight unsecured credit equal to 28% of its regulatory capital to an AA rated
borrower.


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                         16
borrowers that the FHLBank may lend to, and, thus, there is no overall limit on the FHLBank’s
exposure to unsecured lending.

The regulation’s lack of an overall limit on the amount of unsecured credit that an FHLBank may
extend differs materially from the manner in which the Agency regulates other non-core mission
activities of the FHLBanks. Specifically, the Agency has limited each FHLBank’s overall MBS
investments to 300% of its regulatory capital.27 The stated purpose of the overall limit on MBS
investments is to ensure that they are safe, sound, and consistent with the FHLBank System’s
housing mission. Further, FHFA has stated that, even at 300% of regulatory capital, it still
harbors concern about the overall limit from both a safety and soundness and housing mission
standpoint. In fact, the Agency has stated that it will revisit the matter in a future rulemaking.

V. Unsecured Credit to Borrowers Rose to More than $120 Billion by Early
   2011 but Declined Significantly by the End of the Year

         A.     Fluctuations in the Extension of Unsecured Credit

FHFA financial data indicate that from 2010 through much of 2011, as the sovereign debt crisis
in Europe was intensifying, the FHLBanks substantially increased their lending to foreign
financial institutions. However, as 2011 progressed, FHLBanks began to appreciate fully the
risks associated with such extensions of credit and significantly reduced their exposures.
Meanwhile, unsecured lending to domestic financial institutions remained relatively static.

As Figure 5, below, indicates there was significant fluctuation in the total amount of unsecured
credit extended within the FHLBank System from the end of 2008 through the end of 2011. The
FHLBank System had approximately $66 billion in total unsecured credit outstanding as of
December 2008. By early 2011, however, the total had risen to about $123 billion before
declining to about $57 billion by the end of 2011.




27
     See 12 C.F.R. § 1267.3(c)(1).


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                         17
Figure 5: Unsecured Credit Exposure to Borrowers (in Billions)28

 $130

 $110

     $90

     $70

     $50

     $30

     $10
           Dec-08                         Dec-09                           Dec-10                           Dec-11

                                       Domestic                  Foreign                 Total


Figure 5 also shows that although extensions of unsecured credit to domestic borrowers
remained relatively static between December 2008 and December 2011, such credit extensions to
foreign financial institutions fluctuated in a pattern that mirrored the FHLBanks’ total unsecured
lending. That is, it more than doubled from about $48 billion at the end of 2008 to $101 billion
as of April 2011, and then fell by 59% to slightly more than $41 billion by the end of 2011.29 In
other words, unsecured credit to foreign borrowers was the driving force behind the FHLBanks’
increased unsecured credit extensions in 2010 and early 2011.

Figure 6, below, illustrates the fluctuations in FHLBank unsecured credit extensions to foreign
borrowers relative to domestic borrowers. FHLBank extensions of unsecured credit to foreign
financial institutions rose from 59% of total unsecured lending at the end of 2007 to 87% in the
spring of 2011, before falling back to 72% by the end of 2011.

FHLBank officials said that as 2011 progressed they reduced their exposure to foreign borrowers
in light of the rising concerns about the financial turmoil in Europe.




28
  Source: FHFA. For 2008 and 2009, data are available only for the end of the year. Monthly data are shown for
2010 and 2011.
29
  FHLBank unsecured credit extensions to foreign financial institutions were approximately $43 billion at the end
of the first quarter of 2012 and total unsecured lending approached $60 billion. FHLBank unsecured credit
extensions in 2012 and FHFA’s oversight thereof were outside the scope of this study.


               Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                          18
Figure 6: Percent of Unsecured Lending Exposure to Foreign Financial Institutions –
          FHLBank System30

           90%


           85%


           80%


           75%


           70%


           65%


           60%


           55%
              Dec-07              Dec-08               Dec-09               Dec-10               Dec-11


      B.      Advances Decrease as Unsecured Credit Exposures Increase

From the end of 2008 through mid-2011, there was an inverse relationship between the trends in
FHLBank lending to foreign financial institutions and FHLBank advances to their members (see
Figures 7a and 7b, below). Specifically, as advances to member banks declined, extensions of
unsecured credit to foreign financial institutions increased. Since mid-2011, however, extensions
of unsecured credit to foreign financial institutions have declined sharply. While advances also
continued their longstanding decline in the latter half of 2011, they did so at a more gradual pace
than unsecured credit. Based upon this and other information, it appears that in the aftermath of
the domestic financial crisis some FHLBanks extended unsecured credit to foreign financial
institutions in order to offset declining advance demand. Further, they curtailed their extensions
of unsecured credit to such institutions in late 2011 as they began to appreciate fully the risks
associated with them.




30
  Source: FHFA. Data are only available for the ends of years 2007, 2008, and 2009. For 2010 and 2011, data are
available for each month.


            Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                       19
Figure 7a: FHLBanks’ Advances to Members, 2008 Through 2011 (in Billions)31

              $1,000

                $900

                $800

                $700

                $600

                $500

                $400

                $300
                    Dec-08                   Dec-09                  Dec-10                  Dec-11


Figure 7b: FHLBanks’ Extensions of Unsecured Credit to Foreign Financial Institutions,
           2008 Through 2011 (in Billions)32

              $100

               $90

               $80

               $70

               $60

               $50

               $40

               $30
                  Dec-08                    Dec-09                   Dec-10                  Dec-11



31
  Source: FHLBank Office of Finance, Quarterly Combined Financial Reports for 2008 Through the Third
Quarter of 2011, available at http://www.fhlb-of.com/ofweb_userWeb/pageBuilder/fhlbank-financial-data-36
(accessed March 14, 2012). The data for 2008 and 2009 are end of the year data, and the 2010 and 2011 data are
quarterly.
32
  Source: FHFA. The data for 2008 and 2009 are end of the year data. For 2010 and 2011, data are available for
each quarter.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                       20
        C.    Identity of Foreign Borrowers

As of April 2011, the substantial majority (about 70%) of the FHLBank System’s $101 billion in
unsecured credit to foreign borrowers was made to European financial institutions (see Figure 8).
Specifically, 44% of the short-term unsecured credit extensions were made to financial
institutions in Eurozone countries, e.g., Germany and France, and 25% went to financial
institutions in non-Eurozone countries, e.g., Sweden.33 The remaining exposures were made to
institutions based in Canada and Australia.

Figure 8: Breakdown of FHLBank Unsecured Credit Exposure to Foreign Financial
          Institutions as of April 2011 (in Billions)34




FHFA data provide insights into the increasing risks faced by FHLBanks that extended
unsecured credit to European financial institutions in 2010 and 2011. For example, as of March
2010, FHLBanks had extended a total of about $6 billion – about 8% of all foreign extensions of
unsecured credit – to financial institutions located in Spain. This is potentially significant
because credit rating agencies such as Standard & Poor’s (S&P) rated the sovereign debt of




33
  The euro is a single currency shared by 17 European Union member states: Austria, Belgium, Cyprus, Estonia,
France, Finland, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia,
Slovenia, and Spain. Collectively they are known as the Eurozone or euro area.
34
     Source: FHFA.


             Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                        21
Spain as riskier than that of other European countries in 2010 and 2011.35 However, by the end
of 2011, the FHLBanks had ended their unsecured lending to Spanish financial institutions.

Finally, FHFA data also indicate the extent to which particular FHLBanks had unsecured
exposures to foreign institutions in 2011 (see Figure 9, below). For example:

            The Seattle FHLBank’s unsecured exposure to foreign borrowers as a percentage of
             its regulatory capital was more than 340% in March 2011, but it declined to 190% at
             the end of 2011.

            The Boston FHLBank, which like the Seattle FHLBank has faced significant financial
             and operational challenges since 2008, had unsecured credit exposure to foreign
             borrowers as a percentage of regulatory capital of nearly 300% in March 2011, before
             the ratio declined to about 51% at the end of 2011.36

            The Topeka FHLBank’s unsecured credit exposure to foreign financial institutions as
             a percentage of regulatory capital rose to over 360% in March 2011, before the ratio
             fell to under 140% at the end of 2011.

Although it has not issued regulations capping overall exposure, FHFA considers heavy
exposure to financial institutions, i.e., a high ratio of unsecured lending to regulatory capital, to
be an indicator of risk. Figure 9, below, depicts the three FHLBanks that had the largest
unsecured credit exposures to foreign financial institutions as a percentage of their regulatory
capital.




35
  Sovereign credit ratings can serve as an indicator of the risks associated with lending to financial institutions
located in a particular country. During the period of 2010 and 2011, the majority of the European nations in which
the FHLBank System’s foreign borrowers were located maintained AAA sovereign credit ratings according to S&P.
The exceptions were Belgium, Italy, and Spain.
36
  In its evaluation of FHFA’s oversight of troubled FHLBanks, FHFA-OIG noted that the Agency has a special
responsibility to monitor the risks taken by these FHLBanks. Significant risks exist for troubled FHLBanks because
they can continue to fund themselves at favorable rates due to the FHLBank System’s GSE status while they also
make potentially risky investments in an effort to restore their financial condition. Such actions by the FHLBanks
could prove counterproductive and result in additional losses. See FHFA-OIG, FHFA’s Oversight of Troubled
Federal Home Loans (EVL-2012-001, Jan. 11, 2012).


            Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                        22
Figure 9: Foreign Unsecured Credit Exposures as Percentages of Regulatory Capital for
          Three FHLBanks, 2010 to 201137




VI. Several FHLBanks Violated FHFA’s Regulatory Limits or Extended
    Unsecured Credit Despite Indicators of Heightened Risks

During this study, FHFA-OIG identified examples of increased credit risks associated with some
of the FHLBanks’ unsecured credit practices through much of 2011. Specifically, several
FHLBanks violated FHFA’s regulation that sets maximum exposures for unsecured credit.
Additionally, several FHLBanks extended unsecured credit to particular foreign banks despite
indications of heightened risks associated with doing so. These examples suggest that some
FHLBanks’ risk management practices and controls should be improved. They also indicate the
need for strong FHFA oversight to ensure that unsecured credit risks are adequately and properly
mitigated.

        A.    Several FHLBanks Violated FHFA’s Unsecured Credit Limits Due to
              Inadequate Systems and Controls

Although the vast majority of the FHLBanks’ extensions of unsecured credit appear to take place
within current regulatory limits – which, as discussed in this report, may be already outdated and
overly permissive – FHFA-OIG’s analysis of FHFA data for 2010 and 2011 indicate that, from
time to time, some FHLBanks have exceeded the limits. As illustrated in Figure 10, below, one
FHLBank, FHLBank A, exceeded the regulatory limits on loans to individual institutions by an

37
     Source: FHFA.


             Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                        23
average of nearly ten percentage points over a three month period in 2010. For example, in one
month in 2010, the FHLBank extended unsecured credit equal to 28% of its regulatory capital to
a borrower that was eligible for credit of no more than 18% of FHLBank A’s regulatory capital
per FHFA’s regulatory requirements (the borrower was an “A”-rated institution and the total
exposure limit for such borrowers is 18%).38 For one month in 2011, moreover, FHLBank A
exceeded the limit by 8.3 percentage points. Meanwhile, FHLBank B exceeded regulatory limits
in eight months in 2010 and in five months in 2011, and it did so by an average of two
percentage points above the regulatory threshold. FHFA reviewed FHFA-OIG’s analysis and
concluded that both FHLBanks – as well as a third FHLBank – had violated the regulatory
limits.

Figure 10: FHLBanks that FHFA Data Indicate Exceeded the Agency’s Unsecured Credit
           Limits per Counterparty, 2010 and 201139

                                    201040                                           201139
                                                  Average                                          Average
                 Number of                                        Number of
                                                 Percentage                                       Percentage
                  Months         Number of                         Months         Number of
 FHLBanks                                          Points                                           Points
                 Exceeding       Incidents                        Exceeding       Incidents
                                                   Above                                            Above
                  Limits                                           Limits
                                                 Threshold                                        Threshold

 A                     3               3              9.9              1                2              8.3

 B                     8              11              1.7              5                8              2.0


According to FHFA, the three FHLBanks exceeded the limits because they lacked adequate
controls or systems to ensure compliance. For example, FHLBank A failed to identify that one

38
  FHFA asserts that identifying specific FHLBanks would constitute a disclosure of confidential information and
could result in adverse financial effects.
39
   Source: FHFA-OIG analysis of FHFA data. FHFA-OIG first observed potential violations of FHFA’s regulatory
ceilings on unsecured exposures in internal Agency documents prepared in early- to mid-2011. FHFA officials
offered several explanations for these potential violations, including that the Agency’s 2011 internal reports
employed an incorrect measure of regulatory capital for determining compliance. As a result, FHFA-OIG requested
that FHFA provide the appropriate regulatory capital measure for each FHLBank for 2010 and 2011. FHFA-OIG
then used the procedure described by FHFA to assess compliance with its regulation. Specifically, FHFA-OIG
compared each FHLBank’s regulatory capital to its unsecured exposure for each borrower. FHFA-OIG excluded
cases in which the reported exposure was less than one percentage point above the established threshold. As part of
FHFA-OIG’s quality control procedures, it provided the results of its analysis to FHFA for its review and comment
in early 2012. FHFA’s subsequent analysis concluded that three FHLBanks had indeed violated the applicable
regulation.
40
  Figures represent the total number of borrowers in all of the months when the FHLBanks were above the
regulatory threshold. The same borrower may be counted more than once.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                        24
of the borrowers to which it extended unsecured credit had been subject to a credit rating
downgrade. Consequently, the FHLBank failed to reduce the borrower’s unsecured exposure as
required by the regulation.41 FHFA attributed the regulatory breach to the FHLBank’s use of a
manual system that is being replaced. FHFA stated that FHLBank B failed to recognize that it
was extending unsecured credit to two U.S. branches of a single foreign bank parent. For
regulatory compliance purposes, FHFA said that the FHLBank should have considered these
unsecured exposures to the separate branches of the same foreign bank to be a single exposure.
By failing to do so, FHFA said the FHLBank violated the regulatory limits.42

FHFA officials stated that they are following up on the regulatory violations at the three
FHLBanks through ongoing or planned examinations of them during 2012. For example, FHFA
officials explained that the Agency started the 2012 examination of FHLBank A during the
course of FHFA-OIG’s evaluation, and that its unsecured credit counterparty rating system will
be a focus of the examination. FHFA also said that an employee of FHLBank A, who was
responsible for the regulatory violation, is no longer employed there.

Although FHFA has taken supervisory steps in response to FHFA-OIG’s discovery of these
potential violations, FHFA-OIG is concerned that FHFA did not discover the violations at an
earlier juncture.

         B.     Several FHLBanks Extended Unsecured Credit to Foreign Financial Institutions
                Despite Indications of Heightened Risks

In 2008, a European bank was provided with a multibillion
                                                                               Credit Watch: If circumstances
dollar governmental assistance package due to substantial
                                                                               or events occur that could affect an
losses that it incurred during the financial crisis. Concerns                  institution’s credit rating in the
about the bank’s stability persisted as the European                           near term, such as the reporting of
sovereign debt crisis intensified. In 2011, a credit rating                    significantly increased losses, a
agency placed the bank on a credit watch and then                              credit rating agency may
                                                                               undertake a review of the rating,
downgraded its credit rating several months later due to its                   which is also known as placing the
continued financial deterioration. Later in the year the bank                  rating on “credit watch.” A rating
suffered another multibillion dollar loss and received further                 can be reviewed while on credit
European governmental assistance.                                              watch for upgrade, downgrade, or
                                                                               with the direction uncertain.
Throughout 2010, four FHLBanks extended credit to the
European bank in question, but three of them ceased doing business with it by the end of the

41
  In this case, the FHLBank did not realize the borrower had received a credit downgrade and kept extending credit
to it at the prior and incorrect exposure level.
42
     FHFA officials said that the FHLBank identified this error in December 2011 and corrected it.


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                           25
year. Officials from one of the four FHLBanks told FHFA-OIG that the FHLBank stopped
extending credit to the bank due to heightened risk. For example, an FHLBank official said that
in late 2010 the bank’s CDS spread reached an unacceptably high level in comparison to U.S.
Treasury securities.

Despite the increased risk involved in extending unsecured credit to the bank in question, one of
the four FHLBanks continued to do so during much of 2011 – at times lending more than
$1 billion. Although the FHLBank suspended credit extensions to the European bank while it
was subject to the credit watch, it resumed such credit extensions after the bank’s credit rating
was downgraded. Further, the FHLBank continued to extend credit to the bank after it
announced that it had suffered a multibillion dollar loss. The FHLBank stopped extending credit
to the bank shortly before it received a second round of state-sponsored financial assistance.

Officials from the FHLBank that continued to do business with the European bank in question
said that in 2011 the FHLBank had an effective unsecured credit risk management process for
foreign financial institutions. Under its process, the FHLBank restricted its overnight lending
portfolio and carefully monitored market indicators of risk, such as CDS spreads, on a daily
basis. An FHFA examiner took note of the FHLBank’s risk management process as well as the
fact that it cancelled all of its unsecured credit to the European bank shortly before it received
additional governmental financial assistance. However, FHFA officials said that FHLBank’s
unsecured credit extensions to the bank were an outlier among the FHLBanks in 2011, and that
the Agency counseled the FHLBank’s management about the risks involved.43

During 2011, several FHLBanks also extended unsecured overnight and short-term credit – that
at times exceeded $2 billion – to a second European bank that was also facing financial
challenges. Similar to the case of the first bank discussed above, the second bank received
substantial state-sponsored financial assistance in 2008. Although the second bank was not
subject to a credit downgrade in 2011, it was placed on a credit watch after posting a large and
unexpected financial loss. Yet, it was not until after the second bank reported this large and
unexpected financial loss in 2011 that all of the FHLBanks that had extended unsecured credit to
it discontinued doing so.

In FHFA-OIG’s view, these examples raise questions about FHLBanks’ recognition of the
totality of the risks associated with extending unsecured credit. Despite the various controls that



43
  In this regard, an FHFA examiner said that he maintained ongoing contacts with the FHLBank and expressed his
concern about its exposure to the European bank. He also forwarded to the FHLBank’s managers a copy of a
popular business magazine article on the risks of European banks during 2011, and he said that the FHLBank’s 2011
examination concluded that its extension of unsecured credit to European counterparties warranted close monitoring.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                        26
the FHLBanks employed to monitor regulatory compliance and unsecured credit risks,
undetected violations and risky practices occurred.

VII. FHFA Internal Reports Identified Deficiencies in FHLBanks’ Unsecured
     Credit Risk Management Practices

In connection with the preparation of this report, FHFA-OIG reviewed a variety of internal
Agency documents prepared in 2010 and early- to mid-2011. During this period, the Agency
expressed a growing concern about several of the FHLBanks’ unsecured exposures to foreign
financial institutions and the potential risks associated with such lending. Specifically, the
Agency’s documents indicate that, although the FHLBanks were generally extending unsecured
credit within permitted limits,44 FHFA officials were concerned about the growth of such
lending; the relatively high exposures as a percentage of regulatory capital; increasing housing
mission and image risks; and other risk management issues. For example, a first quarter 2010
financial analysis of the FHLBank System states:

        The large investment portfolio, specifically liquidity investments … has increased
        unsecured credit risk exposure for the System. Private counterparty credit … was
        at $103 billion at the end of the first quarter of 2010… [This included] ...
        significant exposure to foreign banking entities with US operations.

Further, the analysis stated that:

        As of March 31, 2010, notable European exposure included $5.6 billion to … two
        Spanish banking entities that could experience significant problems if the
        European debt crisis extends to Spain.

Likewise, a second quarter 2011 financial analysis of the FHLBank System states:

        The FHLBanks’ liquidity portfolio raises some concerns, particularly credit risk
        and image risk. Fed funds, CDs, and commercial paper comprise 91.3 percent of
        the liquidity portfolio and are unsecured investments, adding credit risk to the
        balance sheet. The image risk arises from the FHLBanks’ lending to foreign
        counterparties. As of June 30, 2011, the FHLBanks had $82.3 billion of
        unsecured credit outstanding to private counterparties, $68.8 billion of it to
        foreign counterparties. Providing credit to foreign institutions is a non-mission
        related activity.
44
  As discussed in this report, FHFA-OIG has identified evidence that several FHLBanks may have, from time to
time, exceeded FHFA’s current unsecured credit limits. FHFA-OIG has also determined that the vast majority of all
unsecured credit exposures appear to fall within regulatory limits.


           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                       27
Similarly, a 2010 FHFA examination of an FHLBank that had a large unsecured credit portfolio
states, in relevant part, that “[t]he FHLBank carries a sizeable liquidity portfolio that exposes the
FHLBank to unsecured credit risk and the size of the portfolio has grown markedly in the past
year.” The report concludes that although the FHLBank had taken some steps to respond to
emerging risks in its unsecured lending to private foreign institutions, “… [the FHLBank’s]
Board needs to ensure that the FHLBank’s activities, including the level of unsecured
investments, are consistent with the System’s housing mission and do not arbitrage the benefits
of a government sponsored charter beyond its housing mission.” A 2011 examination of another
FHLBank noted the relative size of its unsecured lending to foreign entities and concluded that
“[t]he … [investment] portfolio’s size … is inconsistent with normal operations for an FHLBank
and represents an inappropriate use of the GSE funding advantage as it exposes the bank to
excessive credit risk.”

Finally, during early- to mid-2011, FHFA prepared internal analyses on a monthly basis that
signaled varying degrees of concern about several aspects of the FHLBanks’ unsecured credit
exposures to foreign financial institutions, as well as the ratio of some FHLBanks’ unsecured
credit to their regulatory capital, which ranged from 150% to 400%. For example, in an FHFA
report prepared in April 2011, FHFA states that “the FHLBanks may be indirectly exposed to
Greece as the French and other European banks have direct exposure to Greece, which has been
downgraded to junk status.”

In discussions with FHFA-OIG staff, the Deputy Director, Division of Federal Home Loan Bank
Regulation (DBR), and senior DBR officials expressed their belief that the internal Agency
reports were thorough and indicated their emerging recognition of rising credit and mission risks
among some FHLBanks from 2010 through mid-2011. These officials added that FHFA
developed an oversight program to respond to the increasing risks, and that FHLBanks
responded to European market developments during the latter half of 2011 by reducing their
European exposures.

VIII. FHFA Oversight Activities of FHLBank Unsecured Credit

FHFA believes that its management of the risks associated with unsecured lending has been
reasonable under the circumstances. FHFA implements a risk-based supervisory strategy, and an
FHFA official explained that in 2010 the Agency did not view the risk associated with the
FHLBanks’ unsecured lending to be greater than, or equal to, other risks then facing the
FHLBank System. Specifically, FHFA was more concerned with the billions of dollars in losses
that many FHLBanks were suffering on their housing boom-era PLMBS investments. FHFA
consequently considered examination of the FHLBanks’ PLMBS portfolios to be a higher
priority than examining unsecured credit offered to foreign financial institutions.


          Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                     28
FHFA, however, recognized that risks existed. Records of internal assessments made by FHFA
in 2010 contain discussions of the risks to the FHLBank System associated with the FHLBanks’
extensions of unsecured credit, and these risks were also addressed in several 2010 reports of
examination.45 Further, the FHFA documents discussed above reveal that by 2011 the Agency
increasingly identified unsecured credit as a significant risk for FHLBanks, and FHFA examiners
increasingly focused on it during their examinations.46

FHFA officials agreed that in 2011 the Agency’s awareness of the risks associated with
extensions of unsecured credit had sharpened, and they pointed to steps undertaken by FHFA to
enhance its oversight of the FHLBanks’ related activities. Specifically, the Agency:

             Required the FHLBanks to report their unsecured counterparty exposures on a weekly
              basis rather than on a monthly basis (the enhanced reporting was required as of
              November 2011). FHFA officials said that more frequent reporting permits the
              Agency to make more timely and qualitatively better assessments of the risks
              associated with unsecured credit. They also said that the reporting requirement
              permits the Agency to better detect potential violations of regulatory limits.47

             Determined that it will direct examiners to consider unsecured credit at all 12
              FHLBanks in a “horizontal review” to be conducted during calendar year 2012. The
              review will permit FHFA officials to develop a comprehensive assessment of the
              FHLBanks’ unsecured credit risk management processes and determine whether
              system-wide corrective actions are necessary.




45
  Unsecured credit was mentioned in 5 of the 12 FHFA examinations of FHLBanks conducted in 2010. FHFA
officials said that examiners may have assessed unsecured credit during the other seven examinations without
necessarily mentioning their findings in their reports. It was not within the scope of this study to assess the
comprehensiveness of FHFA’s coverage of unsecured credit in its examinations.
46
  Unsecured credit was specifically addressed in 10 of the 12 FHFA examinations of FHLBanks conducted in 2011.
An FHFA official said that unsecured credit was not specifically addressed in the first two exams that were
completed in early 2011, i.e., before unsecured credit was prioritized as a high risk area. It was not within the scope
of this study to assess the comprehensiveness of FHFA’s coverage of unsecured credit in the 2011 examinations.
47
  Prior to November 2011, FHLBanks reported their exposures as of the end of each month. FHLBanks must now
report their average exposures to each borrower on a weekly basis. FHFA officials said that the new reporting
requirements provide a better basis for assessing FHLBank unsecured exposures.


             Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                          29
FINDINGS
FHFA-OIG finds that:

     I.   Although FHFA Did Not Initially Prioritize FHLBank Unsecured
          Credit Risks, It Has Recently Developed an Increasingly Proactive
          Approach to Oversight in This Area

As early as the first quarter of 2010, FHFA internal analyses identified the growing credit and
housing mission risks associated with the FHLBanks’ extensions of unsecured credit. Yet, the
Agency did not immediately prioritize the increasing risks in its examination program or through
other supervisory means. For example, FHFA-OIG’s analysis indicates that only 5 of 12
FHLBank examination reports completed in 2010 specifically addressed the risks associated with
extensions of unsecured credit.48

FHFA officials said that they appreciated the risks associated with unsecured credit in 2010 and
noted that these risks increased in 2011. An FHFA official also stated that at that time the
Agency was dealing with large PLMBS losses that had been incurred by several FHLBanks, and
that extensions of unsecured credit were not viewed as an item of equal or greater risk. FHFA-
OIG notes that the Agency’s capacity to assess the risks associated with extensions of unsecured
credit also may have been diminished by its lack of examiners.49

In 2011, FHFA developed a proactive and ongoing approach to oversee the risks associated with
the FHLBanks’ unsecured credit exposures. FHFA’s approach includes:

              Preparing a monthly internal analysis of the FHLBanks’ exposures and foreign
               borrower risks;

              Specifically addressing FHLBank unsecured credit extensions in 10 of 12
               examination reports;

              Communicating with FHLBanks about their foreign borrower exposures;

              Establishing comprehensive unsecured lending reporting requirements; and

48
  FHFA officials said that the fact that an examination report does not specifically mention an FHLBank’s
extension of unsecured credit does not necessarily mean that it was not covered during the course of the
examination.
49
  For more information on the Agency’s examiner shortage see FHFA-OIG’s evaluation of Agency examination
capacity, Whether FHFA Has Sufficient Capacity to Examine the GSEs (EVL-2011-005, September 22, 2011).


              Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                         30
           Prioritizing FHLBank unsecured lending risk management in a horizontal review of
            the FHLBank System to be conducted in 2012.

FHFA-OIG believes that the Agency’s oversight efforts during 2011 likely contributed to the
significant decline in the FHLBanks’ unsecured exposures to European borrowers by the end of
that year.

 II.   FHFA Did Not Actively Pursue Evidence of Potential FHLBank
       Violations of the Limits on Unsecured Exposures Contained in Its
       Regulation

Despite FHFA’s 2011 initiatives, FHFA-OIG believes that the Agency can further strengthen its
oversight of the FHLBanks’ unsecured credit exposures. Specifically, FHFA did not pursue
through its supervisory processes the suggestion contained in its 2011 internal reports that
several FHLBanks exceeded the Agency’s regulatory limits on extensions of unsecured credit.
When FHFA-OIG informed the Agency of these potential violations in early 2012, the Agency’s
subsequent analysis concluded that three FHLBanks had violated the regulatory limits largely
due to inadequate systems and controls.

FHFA-OIG believes that the Agency has a critical responsibility to ensure compliance with its
regulatory limits on unsecured credit and to pursue actively evidence of potential violations.
Otherwise, FHLBanks may not be deterred from violating the Agency’s regulations in the future.
Moreover, by not initially pursing evidence that FHLBanks may have violated its regulation in
2011, FHFA missed an opportunity to determine at an earlier stage that some FHLBanks lack
adequate systems and controls to ensure compliance. FHFA-OIG notes that the Agency has,
through the 2012 examination process, started to follow up with the FHLBanks on these
violations.

III.   FHFA’s Current Regulation Governing Unsecured Lending by the
       FHLBanks May Be Outdated and Overly Permissive

During the period 2010 through the end of 2011, some FHLBanks amassed large unsecured
lending exposures that subjected them to potentially high levels of credit, housing mission, and
image risks. Although FHFA-OIG identified the fact that several FHLBanks violated FHFA’s
unsecured credit limits, such violations are not necessary components of large unsecured lending
exposures. In other words, FHLBanks may be able to continue to engage in the sort of
unsecured credit practices that have been the source of considerable supervisory concern because
the vast majority of such activity falls within the bounds of the existing regulation.




           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                      31
The following summarizes specific weaknesses noted in the existing regulation:

           There are no limits on overall counterparty risk: Internal Agency documents reveal
            FHFA’s concern about the overall ratio of unsecured exposure to capital at certain
            FHLBanks, particularly when exposures ranged from 150% to about 400% of
            regulatory capital. However, large overall exposures are permissible under the
            current FHFA regulation because of two interrelated aspects: (1) the lack of an
            overall limit on counterparty risk; and (2) the lack of an overall limit on the number
            of institutions to which an FHLBank may extend unsecured credit. As it stands, an
            individual FHLBank may increase its credit risk by lending the maximum permissible
            amount to as many borrowers as it wishes. By contrast, FHFA has established an
            overall limit on an FHLBank’s MBS investments, capping it at 300% of the bank’s
            regulatory capital.

           The maximum permissible exposures to individual institutions may be excessive:
            Some FHLBanks had significant unsecured exposures to foreign institutions
            experiencing financial challenges even though the lending to such institutions was
            still within regulatory limits. This did not go unnoticed by FHFA officials who have
            expressed concerns about the regulation’s current exposure limits.

           It does not account for housing mission and image risks: FHFA officials and
            documents indicate that housing mission and image risks can be a considerable
            concern associated with non-mission activities such as unsecured lending.

In future rulemakings, FHFA has the opportunity to consider whether to adjust its existing
regulation in order to control better the risks associated with extensions of unsecured credit by
the FHLBanks.




           Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                      32
CONCLUSIONS
From 2010 through at least mid-2011 the levels of unsecured credit extended by some
FHLBanks, particularly to foreign financial institutions, increased their credit, housing mission,
and image risks. In response, FHFA initiated progressively more comprehensive oversight
efforts, including requiring the FHLBanks to report additional information on their unsecured
exposures and planning a horizontal review of unsecured lending during the 2012 examination
cycle. This likely contributed to the significant decline in the extension of such unsecured credit
by the end of 2011.

However, FHFA’s current regulation continues to permit FHLBanks to build large unsecured
credit portfolios that may produce unreasonable risk. FHFA should, therefore, reassess the
counterparty risk limits associated with its existing regulation to determine whether its revision is
warranted.




RECOMMENDATIONS
As part of FHFA’s ongoing horizontal review of unsecured credit practices at the FHLBanks,
FHFA-OIG recommends that the Agency:

      Follow up on any potential evidence of violations of the existing regulatory limits and
       take supervisory and enforcement actions as warranted; and

      Determine the extent to which inadequate systems and controls may compromise the
       FHLBanks’ capacity to comply with regulatory limits, and take any supervisory actions
       necessary to correct such deficiencies as warranted.

To strengthen the regulatory framework around the extension of unsecured credit by the
FHLBanks, FHFA-OIG recommends, as a component of future rulemakings, that FHFA consider
the utility of:

      Establishing maximum overall exposure limits;

      Lowering the existing individual counterparty limits; and

      Ensuring that the unsecured exposure limits are consistent with the FHLBank System’s
       housing mission.


          Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                     33
SCOPE AND METHODOLOGY
The objective of this study was to assess FHFA’s oversight of FHLBank unsecured credit risk
management practices, including the regulatory framework under which the Agency conducts
such oversight.

To address this objective, FHFA-OIG interviewed officials in FHFA’s DBR, the Office of
Systemic Risk Oversight, and other units. Further, FHFA-OIG interviewed officials at four
FHLBanks.

FHFA-OIG also reviewed FHFA’s regulation that pertains to FHLBank unsecured lending,
internal Agency reports on unsecured risk, the 2010 and 2011 examinations of the FHLBanks,
and Agency correspondence with FHLBanks regarding their unsecured exposures.

Further, FHFA-OIG reviewed FHFA financial data on the FHLBanks, as described in the report.
FHFA-OIG held discussions with Agency staff on the tests made to verify the reliability of the
data. On the basis of these discussions, FHFA-OIG concluded the data were reliable for the
purposes of the report.

In the course of the evaluation, FHFA-OIG identified internal Agency reports suggesting that
certain FHLBanks may have, at times, exceeded the unsecured lending limits established by
FHFA’s regulation. FHFA-OIG independently analyzed the FHFA data for 2010 and 2011 to
verify these potential regulatory violations. FHFA-OIG also provided the results of its analysis
to FHFA for its review and comment as described in the body of the report.

This study was conducted under the authority of the Inspector General Act, and is in accordance
with the Quality Standards for Inspection and Evaluation (January 2011), which was
promulgated by the Council of Inspectors General on Integrity and Efficiency. These standards
require FHFA-OIG to plan and perform an evaluation that obtains evidence sufficient to provide
reasonable bases to support its findings and recommendations. FHFA-OIG believes that the
findings and recommendations discussed in this report meet these standards.

The performance period for this evaluation was 2010 and 2011.

FHFA-OIG provided FHFA staff with briefings and presentations concerning the results of its
fieldwork, and provided FHFA an opportunity to respond to a draft report of this study. FHFA’s
Deputy Director of DBR provided the Agency’s written comments, which are reprinted below.
FHFA agreed to implement the report’s recommendations within one year. FHFA also provided
technical comments on the draft report that were incorporated as appropriate.



         Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                                    34
FHFA’S COMMENTS ON FHFA-OIG’S FINDINGS
AND RECOMMENDATIONS




   Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                              35
Federal Housing Finance Agency Office of Inspector General • EVL-2012-005 • June 28, 2012
                                           36
ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

           Call the Office of Inspector General (OIG) at: 202-730-0880

           Fax your request to: 202-318-0239

           Visit the OIG website at: www.fhfaoig.gov



To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

           Call our Hotline at: 1-800-793-7724

           Fax your written complaint directly to: 202-318-0239

           E-mail us at: oighotline@fhfaoig.gov

           Write to us at: FHFA Office of Inspector General
                            Attn: Office of Investigation – Hotline
                            400 7th Street, SW
                            Washington, DC 20024




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