oversight

FHFA's Oversight of the Federal Home Loan Banks' Compliance with Regulatory Limits on Extensions of Unsecured Credit

Published by the Federal Housing Finance Agency, Office of Inspector General on 2013-08-06.

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

           Federal Housing Finance Agency
               Office of Inspector General




    FHFA’s Oversight of the
   Federal Home Loan Banks’
Compliance with Regulatory Limits
on Extensions of Unsecured Credit




Evaluation Report  EVL–2013–008  August 6, 2013
                  FHFA’s Oversight of the Federal Home Loan Banks’
                  Compliance with Regulatory Limits on Extensions of
                  Unsecured Credit
                  Why OIG Did This Report
                  The Federal Home Loan Bank System (FHLBank System) was established in
                  1932 to support housing finance among other purposes. The 12 Federal Home
Synopsis          Loan Banks (FHLBanks), which comprise the FHLBank System, fulfill their
                  mission primarily by making secured loans, known as advances, to their
    ———           member financial institutions, such as banks and credit unions. These
                  members can use the advance proceeds to originate mortgages and other loans.
August 06, 2013
                  FHLBanks also make a variety of investments, including extensions of short-
                  term unsecured credit to domestic and foreign-owned financial institutions.
                  Such credit can pose greater financial risks than advances because it is not
                  secured by collateral.
                  In June 2012, we issued a report that identified potentially risky unsecured
                  credit management practices by some FHLBanks. These practices include
                  large exposures to counterparties located in the financially troubled Eurozone.
                  Moreover, the report found that several FHLBanks violated FHFA’s regulatory
                  limits on unsecured credit that exposed them to potentially greater losses in the
                  event of a counterparty’s failure or default. We recommended that FHFA (1)
                  assess the extent of regulatory violations as part of its 2012 horizontal review
                  of unsecured credit risk management practices across the FHLBank System,
                  and (2) consider revising its regulation to mitigate the risks associated with
                  unsecured credit. FHFA agreed with these recommendations.
                  In this follow-up evaluation report, we assessed FHFA’s (1) implementation of
                  the 2012 horizontal review, and (2) supervisory and enforcement responses to
                  identified violations.

                  What OIG Found
                  Finding #1: FHFA’s 2012 Horizontal Review Was Proactive and Thorough
                  FHFA conducted a proactive and thorough horizontal review in 2012 that
                  identified over 900 unsecured credit violations at 7 FHLBanks and risk
                  management deficiencies of varying degrees at the other 5. FHFA established
                  a comprehensive examination workplan for the horizontal review, and our
                  review of examination documentation for three FHLBanks concluded that the
                  Agency largely complied with its workplan in these cases.
                  Finding #2a: FHFA’s 2012 Supervisory Response to the Violations Was
                  Consistent with Agency Policy
                  In 2012, FHFA’s general supervisory response to the unsecured credit
                  violations identified at seven FHLBanks was consistent with Agency policy.
                  In particular, the Agency used its supervisory authority to issue Matters
                  Requiring Attention (MRAs) or other requirements. Under the MRAs and
                  other requirements, the FHLBanks were required to remediate deficiencies in
                  their compliance and risk management systems within specified time periods.
                  Finding #2b: FHFA Must Diligently Monitor and Enforce the FHLBanks’
                  Ongoing Compliance with Its 2012 Supervisory Requirements
                  During 2013, FHFA has been in the process of assessing, among other things,
                  the FHLBanks’ compliance with the MRAs and other requirements it issued in
Synopsis          2012. Although this process is in its initial stages, FHFA has already
                  concluded that one FHLBank, which violated the regulatory lending limits 201
    ———           times between 2005 and 2012 (see table, below), continued to face challenges
                  in implementing several key controls required by the 2012 MRA. In the first
August 06, 2013   quarter of 2013, the FHLBank breached unsecured credit requirements
                  established in the MRA on 5 separate occasions, resulting in potential overages
                  to 12 counterparties.

                      NUMBER OF REGULATORY LENDING LIMIT VIOLATIONS BY AN FHLBANK AND
                                AVERAGE OVERAGE PER VIOLATION, IN MILLIONS

                                                                               Total    Average
                     2005   2006   2007   2008    2009   2010   2011   2012   Period    Overage
                      19     19     38      10     6      39     45     25      201      $208.5

                  Although FHFA has not yet decided on a supervisory strategy for the
                  FHLBank, we believe this case demonstrates that the Agency must diligently
                  monitor compliance with established MRAs and other supervisory
                  requirements on an ongoing basis to ensure that unsecured credit remedial
                  actions are implemented over time. Moreover, FHFA must be willing to use
                  all of the authorities at its disposal—including enforcement actions such as
                  cease and desist orders—when, for example, an FHLBank fails to implement a
                  supervisory directive to improve its unsecured credit risk management
                  practices and avoid further regulatory violations.

                  What OIG Recommends
                  We recommend that FHFA thoroughly assess the FHLBanks’ compliance with
                  its unsecured credit supervisory requirements during the 2013 and 2014
                  examination cycles, and take enforcement actions as required to ensure that
                  corrective and remedial actions are implemented over time. FHFA agreed
                  with these recommendations.
TABLE OF CONTENTS ................................................................

TABLE OF CONTENTS .................................................................................................................4

ABBREVIATIONS .........................................................................................................................6

PREFACE ........................................................................................................................................7

BACKGROUND .............................................................................................................................9
      Overview of FHLBank System Unsecured Credit Extensions .................................................9
      FHFA’s Regulation Establishes Both Limits on Extensions of Unsecured Credit and
      Reporting Requirements .........................................................................................................12
      FHFA’s 2012 Horizontal Review Identified More than 900 Primary and Secondary
      Violations of Its Regulation on Extensions of Unsecured Credit ...........................................14
             Most Violations Appear to Be the Result of System Failures and Personnel
             Errors .............................................................................................................................. 14
             FHLBank B’s Regulatory Violations Appear to Be More Egregious than Those
             of the Other FHLBanks .................................................................................................. 16
      FHFA Has Required the FHLBanks That Committed Violations to Take Corrective
      Actions Within Specified Timeframes ...................................................................................18

FINDINGS .....................................................................................................................................20
      1. FHFA’s Horizontal Review of FHLBank Unsecured Credit Risk Management
      Was Proactive and Thorough..................................................................................................20
      2. Findings Related to FHFA’s Supervisory and Enforcement Responses to the
      Unsecured Credit Violations First Identified in 2012.............................................................20

CONCLUSIONS............................................................................................................................23

RECOMMENDATIONS ...............................................................................................................23

OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................24

APPENDIX A ................................................................................................................................25
      FHFA’s Comments on OIG’s Findings and Recommendations ............................................25

APPENDIX B ................................................................................................................................27
      OIG’s Response to FHFA’s Comments .................................................................................27


                                             OIG  EVL–2013–008  August 6, 2013                                                                    4
ADDITIONAL INFORMATION AND COPIES .........................................................................28




                                 OIG  EVL–2013–008  August 6, 2013                                        5
ABBREVIATIONS .......................................................................

FHFA or Agency        Federal Housing Finance Agency

FHLBank               Federal Home Loan Bank

FHLBank System        Federal Home Loan Bank System

MBS                   Mortgage-Backed Securities

MRA                   Matter Requiring Attention

OIG                   Federal Housing Finance Agency Office of Inspector General




                          OIG  EVL–2013–008  August 6, 2013                       6
PREFACE ...................................................................................

The FHLBank System is comprised of 12 regional FHLBanks whose primary mission is to
support housing finance.1 To carry out this mission, the FHLBank System’s Office of
Finance issues debt, the proceeds of which are lent by the FHLBanks to their members in the
form of secured loans known as advances.2 These member financial institutions can then
use the advance proceeds to originate residential mortgages and other loans.

FHLBanks may also make certain investments, including short-term extensions of unsecured
credit (i.e., loans not backed by collateral), to domestic and foreign-owned financial
institutions.3 Extensions of unsecured credit can help FHLBanks to meet their advance
liquidity needs and generate income. However, such credit extensions may pose higher
credit risks than advances to the FHLBanks because they are not secured by collateral.

As demand for FHLBank advances declined following the financial crisis, system-wide
extensions of unsecured credit to domestic and foreign private counterparties nearly doubled
from $66 billion to $123 billion between 2008 and early 2011. In a June 2012 evaluation
report on extensions of unsecured credit by the FHLBanks during this period, we identified
certain potentially risky practices that raised safety and soundness concerns.4 In particular,
we noted that several FHLBanks had relatively large unsecured credit exposures to
counterparties located in the financially troubled Eurozone.

Moreover, our review of FHFA internal financial reports found that in 2010 and 2011
several FHLBanks violated FHFA’s regulatory limits on unsecured credit extensions. Such
violations are troubling from a safety and soundness standpoint because the regulatory limits
are intended to mitigate the risks associated with extensions of unsecured credit. By



1
  The FHLBanks are chartered by the federal government, but owned as cooperatives by their member
financial institutions, which include banks, credit unions, thrifts, and insurance companies. For more
information on the FHLBank System, see OIG, An Overview of the FHLBank System’s Structure, Operations,
and Challenges (online at http://www.fhfaoig.gov//Content/Files/FHLBankSystemOverview.pdf).
2
  FHLBank advances are secured by eligible collateral such as single-family mortgages or investment grade
securities, among other assets.
3
  FHFA regulation 12 C.F.R. § 1267 restricts FHLBank extensions of unsecured credit to domestic (U.S.)
financial institutions and U.S. branches of foreign-owned banks that are subject to some U.S. governmental
regulation.
4
  See OIG, FHFA’s Oversight of the Federal Home Loan Banks’ Unsecured Credit Risk Management
Practices (EVL-2012-005) (June 28, 2012) (online at http://fhfaoig.gov/Content/Files/EVL-2012-005_1_0.pdf)
(hereinafter, “OIG Unsecured Credit Report”).




                                   OIG  EVL–2013–008  August 6, 2013                                       7
exceeding the limits, these FHLBanks exposed themselves to an increased risk of loss in the
event of a counterparty’s failure or default.

To determine the extent of their violations, we recommended that FHFA assess the
FHLBanks’ compliance with its regulatory limits as part of its 2012 system-wide horizontal
review of unsecured credit risk management practices.5 We also recommended that FHFA
consider revising its regulation because, as currently drafted, it may permit the FHLBanks to
incur large unsecured credit exposures and considerable financial risks. FHFA agreed to
implement these recommendations.

We initiated this follow-up evaluation to assess FHFA’s (1) implementation of the
unsecured credit horizontal review, and (2) supervisory and enforcement response to
identified violations.

This evaluation report was prepared by Jon Anders, Program Analyst; Wesley M. Phillips,
Senior Policy Advisor; Nicole Mathers, Program Specialist; Alan Rhinesmith, Senior
Financial Advisor; and Simon Wu, Chief Economist. The OIG appreciates the cooperation
of all those who contributed to this effort.

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




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




5
  During a horizontal review, FHFA assesses the FHLBanks’ risk management across a particular area – such
as unsecured credit – in conjunction with its annual examination of each FHLBank. The purpose of a
horizontal review is to develop a consistent assessment of risk management practices across the FHLBank
System and ensure comprehensive remediation of identified deficiencies as may be appropriate.




                                  OIG  EVL–2013–008  August 6, 2013                                       8
BACKGROUND ..........................................................................

Overview of FHLBank System Unsecured Credit Extensions

As of December 31, 2012, the FHLBanks’ combined advances of $425.8 billion constituted
56% of the FHLBank System’s total assets of $762.5 billion (see Figure 1). The FHLBanks’
assets also include investment portfolios comprised of, among other things, mortgage-
backed securities (MBS) and extensions of unsecured credit to domestic and foreign-owned
financial institutions. At the end of 2012, the FHLBanks’ investment portfolios totaled
$265.8 billion.
                                                                                             6
             FIGURE 1. FHLBANK SYSTEM ASSETS AS OF DECEMBER 31, 2012, IN BILLIONS

                                  6%          3%
                                 $49.4       $21.5




                 35%
                $265.8                                                     56%
                                                                          $425.8




                 Advances      Investments       Mortgage Loans    Cash and Other




6
  Source: FHLBanks Office of Finance, Combined Financial Report for the Year Ended December 31, 2012,
at F-84 (online at http://www.fhlb-of.com/ofweb_userWeb/resources/12yrend.pdf).




                                 OIG  EVL–2013–008  August 6, 2013                                    9
According to FHFA officials, the FHLBanks’
extensions of unsecured credit typically                     Commercial Paper: Unsecured, short-
involve commercial paper, banknotes, or                      term debt instruments issued by
                                                             corporations, typically for the financing
federal funds.7 Such credit extensions take
                                                             of accounts receivable, inventories,
place either on an overnight basis or for a                  and meeting short-term liabilities.
term of no longer than 270 days.8 FHFA                       Maturities on commercial paper rarely
classifies unsecured credit as a non-core                    range any longer than 270 days.
mission asset.9
                                                             Banknotes: Negotiable promissory
The volume of FHLBank unsecured credit                       notes issued by banks and payable to
                                                             the bearer on demand. The amount
extensions has risen and fallen dramatically
                                                             payable is stated on the face of the
in recent years (see Figure 2, below).                       note.
Although FHLBank advances declined by
more than 50% between 2008 and 2011—                     Federal Funds: Extensions of
                                                         unsecured credit between financial
from $929 billion to $418 billion—
                                                         institutions that are generally made on
extensions of unsecured credit to private                an overnight basis.
financial institutions nearly doubled from
$66 billion at the end of 2008 to $123 billion
in early 2011.10 In our June 2012 report, we observed that much of the unsecured credit
extended by the FHLBanks was to private foreign counterparties, including Eurozone banks
that were placed at risk by the European sovereign debt crisis. We also noted that the
FHLBanks’ unsecured credit exposures declined over the course of 2011 as FHLBank
officials curtailed their activities due to financial instability in Europe as well as increased

7
  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 such funds to
institutions with reserve deficiencies. The FHLBanks are not required to maintain their bank reserves at the
Federal Reserve. However, they may participate in the federal funds market and extend unsecured credit to
domestic and foreign-owned financial institutions.
8
    OIG Unsecured Credit Report, at 11.
9
  FHFA’s regulation at 12 C.F.R. § 1265.2 emphasizes that the FHLBanks’ mission is to provide their
members with financial products and services that assist them in financing housing and community lending.
Activities that FHFA deems to further this mission are referred to as “core mission activities,” e.g., lending
secured advances. See 12 C.F.R. § 1265.3. Extending unsecured credit is not considered a core mission
activity. In other words, FHFA does not view these investments as contributing to the FHLBank System’s
overall goal of promoting housing finance. Furthermore, FHFA’s Acting Director has raised concerns about
the high levels of non-core mission activities of certain FHLBanks. See 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) (online at www.fhfa.gov/webfiles/21197/FHLB51111Final.pdf).
10
  The FHLBanks also purchase unsecured debt from federal agencies and government-sponsored enterprises.
Such debt is not included in the amounts presented above.




                                    OIG  EVL–2013–008  August 6, 2013                                          10
scrutiny by FHFA examiners. In 2012 and 2013, unsecured credit extensions continued to
decline with lending levels reaching $52 billion by March 31, 2013.

        FIGURE 2. FHLBANK SYSTEM UNSECURED CREDIT EXPOSURES TO PRIVATE COUNTERPARTIES,
                                         IN BILLIONS11

           $125



           $100



            $75



            $50



            $25



             $0




                                       Total         Foreign          Domestic



As we noted in our June 2012 report, FHLBank officials have stated that their investments,
such as unsecured credit, 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 available to fund potential advance demand. FHFA officials said
that some FHLBanks also extend unsecured credit because it can yield higher returns than
advances and increase their return on capital. FHFA also concluded that FHLBanks extend
unsecured credit to offset the overall decline in demand for advances by members in recent
years.12

According to FHFA, the primary risk associated with such investments is credit risk, i.e., the
risk that a counterparty may fail or otherwise default on its obligation to repay the loan. As

11
   Source: FHFA. For 2008 and 2009, data are only available for the end of the year. Monthly data are shown
for 2010–2013.
12
     OIG Unsecured Credit Report, at 9–10.




                                    OIG  EVL–2013–008  August 6, 2013                                       11
their name implies, extensions of unsecured credit are not secured or backed by collateral.
Therefore, an FHLBank’s losses, in the event of a counterparty’s default, would be expected
to be greater than would be the case if a member institution failed to repay an advance,
which by definition is secured by collateral.13 FHFA officials view FHLBank extensions of
overnight unsecured credit as being less risky than term extensions of up to 270 days
because counterparties are required to repay overnight extensions on a daily basis.

FHFA’s Regulation Establishes Both Limits on Extensions of Unsecured Credit and
Reporting Requirements

In 2002, the Federal Housing Finance Board, a predecessor agency to FHFA, finalized
12 C.F.R. § 932.9, which governs the FHLBanks’ ability to extend unsecured credit to
individual counterparties. The regulation also establishes reporting requirements associated
with extensions of unsecured credit.

Under the regulation an FHLBank’s ability to
extend unsecured credit to a single counterparty is                Regulatory Capital: FHFA
limited by the counterparty’s overall credit rating.               requires each FHLBank to
The lending limits are greater for higher-rated                    maintain regulatory capital that
                                                                   is equal to at least 4% of its total
counterparties and become progressively more
                                                                   assets. According to FHFA’s
restrictive for lower-rated counterparties.                        requirements, regulatory capital
Specifically, an FHLBank’s exposure to a particular                includes the capital investments
counterparty is a defined percentage of the lesser of              of FHLBank members (i.e.,
the FHLBank’s total regulatory capital or the                      proceeds of stock purchases);
counterparty’s Tier 1 capital. Figure 3, below,                    retained earnings (i.e., profits not
defines applicable percentages based upon the                      paid out as dividends to
                                                                   members); a general allowance
counterparty’s credit rating. Using this method,
                                                                   for losses, consistent with
FHFA seeks to limit the potential for, and severity                generally accepted accounting
of, an FHLBank’s unsecured credit losses in the                    principles; and any other funds
event of a counterparty’s failure or default on its                available to absorb losses.
financial obligation.14




13
   For example, in 2008, Freddie Mac lost $1.2 billion on an unsecured loan to the Lehman Brothers
investment bank when Lehman declared bankruptcy. The $1.2 billion represented the entire value of the
unsecured loan. See, OIG, Case Study: Freddie Mac's Unsecured Lending to Lehman Brothers Prior to
Lehman Brothers' Bankruptcy (EVL-2013-03) (March 14, 2013) (online at
http://fhfaoig.gov/Content/Files/EVL-2013-03_1.pdf).
14
     OIG Unsecured Credit Report at 15.




                                    OIG  EVL–2013–008  August 6, 2013                                   12
                                                                                                            15
            FIGURE 3. MAXIMUM LIMITS ON UNSECURED CREDIT TO A SINGLE COUNTERPARTY

                                                                      Term Lending         Total Exposure
                     Credit Rating of Counterparty                       Limits                Limits
            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

As indicated in Figure 3 above, an FHLBank may offer a term extension of unsecured credit
to a particular institution in an amount up to the limit provided in the regulation. In addition,
the FHLBank may offer an overnight extension of unsecured credit to the same institution in
an amount not to exceed twice the term limit established by the regulation. Thus, for
example, an FHLBank may lend up to 14% percent of its regulatory capital to a AA-rated
institution on a term basis,16 and an additional 14% – for a total exposure of 28% – on an
overnight basis.17

The regulation, 12 C.F.R. § 932.9, also establishes the FHLBanks’ reporting requirements in
association with extensions of unsecured credit. In particular, the FHLBanks must report the
amount of their total unsecured credit extensions, as well as any extension to a single
counterparty that exceeds 5% of the FHLBank’s regulatory capital or the counterparty’s Tier
1 capital.18

FHFA documents indicate that violations of unsecured lending limits are referred to as
“primary violations,” and failing to report such violations can result in “secondary
violations” of the regulation. For each primary violation, FHLBanks are required to report
the counterparty, the amount by which the limit was exceeded, and the dates of non-
compliance, among other items.




15
     Source: 12 C.F.R. § 932.9(a).
16
     Assuming the AA-rated institution’s Tier 1 capital is greater than the FHLBank’s regulatory capital.
17
   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 a
AA-rated borrower.
18
  Historically, the FHLBanks reported on their unsecured credit exposures by counterparty on a monthly
basis. However, in November 2011, amidst heightened concerns about the risks associated with such lending,
FHFA imposed weekly unsecured credit reporting requirements on the FHLBank System.




                                      OIG  EVL–2013–008  August 6, 2013                                        13
In our June 2012 report, we found that the regulation may be overly permissive in that it
does not include an overall limit on an FHLBank’s unsecured credit exposures. That is, the
regulation limits only the FHLBanks’ per counterparty exposures, leaving their overall
exposures unlimited. FHFA officials identified examples of such concerns in internal
analyses undertaken in early 2011. Specifically, the officials noted that some FHLBanks
had overall unsecured credit exposures that were 150% to 400% of their regulatory capital.
Accordingly, we recommended that FHFA consider revising the regulation to mitigate these
potential risks by, for example, placing limits on individual FHLBank’s overall unsecured
credit exposure.19

FHFA’s 2012 Horizontal Review Identified More than 900 Primary and Secondary
Violations of Its Regulation on Extensions of Unsecured Credit

In early 2012, FHFA examiners initiated a horizontal review of regulatory compliance and
unsecured credit risk management across the FHLBank System.20 The review identified
more than 900 primary and secondary violations of the regulation at 7 of the 12 FHLBanks,
and risk management deficiencies of varying degrees of seriousness at the remaining 5
FHLBanks.21 Most of the violations appear to be the result of system failures and personnel
errors at the FHLBanks. However, one FHLBank’s violations appear to be particularly
egregious for several reasons, including the length of time over which they were committed,
the involvement of a senior official who failed to report the violations as required, and the
significant financial risks to which the FHLBank was exposed over the entire period.

     Most Violations Appear to Be the Result of System Failures and Personnel Errors

FHFA examination materials and other records indicate that several FHLBanks accounted
for the vast majority of the regulatory violations of the unsecured credit limits (see
Figure 4). Indeed, FHLBanks A and B accounted for 876 (over 90%) of the 927 identified




19
   FHFA agreed with the recommendation and is in the process of considering revisions to the rule that have
the potential to limit the FHLBanks’ overall unsecured credit risk.
20
  FHFA initiated the 2012 horizontal review based upon concerns about the FHLBanks’ unsecured credit risk
management practices that were identified in 2011.
21
   FHFA examiners also noted varying risk management deficiencies at the five other FHLBanks that did not
violate the regulation. Accordingly, the Agency recommended that some of the FHLBanks undertake
comprehensive counterparty credit analyses on an annual basis, update their risk management systems to
reflect their counterparties’ credit ratings in a more timely fashion, and ensure that controls are in place to
prevent additional extensions of unsecured credit until prior extensions are repaid.




                                    OIG  EVL–2013–008  August 6, 2013                                           14
violations. In contrast, FHLBank F violated the regulation only twice and FHLBank G only
once.22

     FIGURE 4. FHLBANK VIOLATIONS OF 12 C.F.R. § 932.9 IDENTIFIED IN CONJUNCTION WITH THE 2012
                           HORIZONTAL REVIEW OF UNSECURED CREDIT23
                             Number of
        FHLBank              Violations         Time Period                       Causes of Violations
                                              January 2011 –
 FHLBank A               474                                        Automated system error
                                              May 2011
                                                                     Manual update system error
                         201 Primary          June 2005 –            Senior manager aware of violations but did
 FHLBank B
                         201 Secondary        March 2012              not report them to FHFA (Personnel Error)
                                                                     Insufficient oversight by internal audit
                                              January 2010 –
 FHLBank C               33†                                        Automated system error
                                              November 2011
 FHLBank D               9                    December 2011         Automated system error
                                              February 2012 –
 FHLBank E               6                                          Automated system error
                                              June 2012
                         1 Primary
 FHLBank F                                    February 2011         Manual update system error
                         1 Secondary
 FHLBank G               1                    March 2012            Personnel error
 Total Violations        927
† FHFA determined that FHLBank C’s aggregate term extensions of credit to two counterparties exceeded
  the regulatory limits for a combined total of 33 months, 15 months of which are attributable to one
  counterparty, and 18 months to the other. The number of individual transactions in excess of the
  regulation is likely higher.

FHFA records and our discussions with Agency officials indicate that, as a general matter,
regulatory violations are often caused by systems failures. In some cases, the FHLBanks’
manual or automated systems failed to record, in a timely manner, downgrades in their
counterparties’ credit ratings or their placement on “credit watch.”24 In other cases, the
FHLBanks’ systems contained inaccurate information about their counterparties’ capital
levels. As a result, the affected FHLBanks did not lower their counterparties’ unsecured
22
  We do not disclose the identities of the FHLBanks in question in deference to FHFA’s concern that doing so
would constitute the disclosure of confidential information that, in turn, could engender adverse financial
consequences.
23
     Source: FHFA.
24
   A credit rating agency’s review of an institution’s credit rating is referred to as placing the institution on
“credit watch.” This can occur in the wake of circumstances or events that could affect an institution’s credit
rating in the near term, such as the reporting of significantly increased losses. Under 12 C.F.R.
§ 932.9(a)(5)(iv), the lending limit for a counterparty that has been placed on credit watch must be reduced to
the next lowest level.




                                     OIG  EVL–2013–008  August 6, 2013                                            15
credit limits, causing them to breach the regulatory lending limits and incur additional
violations.

FHLBank A, which had the highest number of violations at 474, illustrates how a poor
management system can result in multiple regulatory violations. According to FHFA
records, during the period January 2011 – April 2011, the FHLBank’s credit risk control
system received inaccurate capital numbers from an automatic data feed. This, in turn,
caused the FHLBank to extend unsecured credit averaging $193 million per day above the
regulatory limits.25 As a result, FHLBank A was placed at considerable financial risk given
that some of its counterparties were located in the financially troubled Eurozone.
Eventually, the FHLBank’s internal audit department identified these violations and they
were reported to FHFA as required by its regulation.26 Consequently, the FHLBank did not
commit any secondary violations.

Personnel errors can also cause an FHLBank to violate the regulations. In one case an
FHLBank trader extended unsecured credit in excess of the regulatory limits to a federal
government-sponsored enterprise on the mistaken belief that such unsecured debt is a direct
obligation of the U.S. Government and, therefore, not subject to the regulatory lending
limits. The FHLBank discovered the violation the following day during a routine check of
unsecured credit extensions and reported it to FHFA.

      FHLBank B’s Regulatory Violations Appear to Be More Egregious than Those of the
      Other FHLBanks

While system failures and personnel errors appear to have caused most of the FHLBanks’
primary violations, our analysis of FHFA documents and discussion with Agency officials
indicates that FHLBank B’s violations were of a more serious nature for the following
reasons:

         The FHLBank violated the regulation over the course of eight years, i.e., 2005–2012,
          which is much longer than any of the other FHLBanks that violated the lending
          limits. In fact, the next longest period over which violations occurred was 23
          months;
         A senior manager at FHLBank B failed to report the 201 primary violations although
          he was fully aware of them throughout the 8-year period over which they occurred.
          This, in turn, caused FHFA to find that the FHLBank also committed 201 secondary

25
  This represents the daily average of FHLBank A’s combined overages for 12 term and 462 overnight
extensions of unsecured credit above the regulatory limits.
26
     See 12 C.F.R. § 932.9(e)(3).




                                    OIG  EVL–2013–008  August 6, 2013                              16
           regulatory violations.27 FHFA found that only one other FHLBank, FHLBank F,
           committed a secondary violation – and it committed only one such violation; and
          FHLBank B was afflicted with numerous credit risk management deficiencies that
           inhibited the detection and remediation of its regulatory violations. For example, the
           FHLBank’s internal audit department failed to conduct adequate reviews of
           unsecured credit and, therefore, failed to detect the violations.
Moreover, FHFA records indicate that FHLBank B incurred considerable financial risks
resulting from its unsecured credit violations. Figure 5, below, shows the frequency of the
FHLBank’s violations as well as the average overage per violation from 2005 through 2012
of $208.5 million.

      FIGURE 5. NUMBER OF REGULATORY LENDING LIMIT VIOLATIONS BY FHLBANK B AND AVERAGE
                                                                28
                            OVERAGE PER VIOLATION, $ IN MILLIONS
                                                                                   Total         Average
           2005      2006    2007    2008       2009   2010     2011     2012    Violations      Overage

             19      19       38      10         6      39       45       25         201          $208.5

The dollar value of FHLBank B’s annual average overage per violation often exceeded—or
constituted a significant percentage of—its total retained earnings, which are a critical buffer
against losses.29 In 2005, for example, FHLBank B’s average overage was more than 100%
of retained earnings. In these circumstances, the potential loss from a counterparty’s failure
or default would have been exacerbated because the amount lent over the regulatory limit
alone likely could have eliminated the FHLBank’s retained earnings, thereby diminishing its
financial position and threatening its ability to fulfill its housing mission.30 Over time,
FHLBank B’s annual average overages have decreased as a percentage of its retained
earnings.31 For example, in 2012, FHLBank B’s average overage exceeded 25% of its
27
   According to FHFA, the senior manager was aware of the violations but other FHLBank officials were not.
Nevertheless, FHFA concluded that the senior official’s failure to report the violations resulted in secondary
violations of the regulation. The official departed the FHLBank following an internal review of the violations.
28
     Source: FHFA.
29
     See, OIG Unsecured Credit Report, at 14.
30
  FHFA officials said that the FHLBank’s extension of unsecured credit on an overnight rather than a term
basis somewhat mitigated its risk of losses in the event of a counterparty’s default.
31
   OIG notes that ratio of annual average overages to retained earnings declined between 2005 and 2012, in
part, because—while FHLBank B’s annual average overages generally remained stable during the time period
in question—its retained earnings more than doubled in a manner consistent with retained earnings growth
across the FHLBank System. For more information on FHLBank retained earnings trends, see FHFA, Report
to Congress 2012, at 31, 32 (June 13, 2013) (online at
http://www.fhfa.gov/webfiles/25320/FHFA2012_AnnualReport.pdf).



                                    OIG  EVL–2013–008  August 6, 2013                                           17
retained earnings. While the percentage of annual average overages to retained earnings
declined, the financial effects of a counterparty failure still could have been significant.

FHFA Has Required the FHLBanks That Committed Violations to Take Corrective
Actions Within Specified Timeframes

In early April 2012, FHFA issued an Advisory
Bulletin that establishes categories of safety and             Matters Requiring Attention: MRAs
soundness examination findings at the                          are the most serious supervisory
                                                               matters. They include, among other
FHLBanks.32 The Advisory Bulletin states that
                                                               things, non-compliance with laws or
“examination findings are deficiencies related                 regulations that result or may result in
to risk management, risk exposure, or violations               significant risk of financial loss or
of laws, regulations, or orders that affect the                damage to the regulated entity; repeat
performance or condition of a regulated entity.”               deficiencies that have escalated due to
Effectively, the bulletin establishes a hierarchy              insufficient action or attention; unsafe
of FHFA examination findings based upon                        or unsound practices; and matters that
                                                               have resulted, or are likely to result, in
increasing levels of seriousness. These findings
                                                               a regulated entity being in an unsafe or
serve to identify the affected FHLBank’s                       unsound condition. MRAs also include
remediation priorities and guide FHFA in the                   breakdowns in risk management,
development of supervisory strategies designed                 significant control weaknesses, or
to achieve them.                                               inappropriate risk-taking.

                                                               Violations: Violations are any matter in
In descending order of seriousness, FHFA has
                                                               which the examination discloses reason
identified its three examination finding
                                                               to suspect that a regulated entity is in
categories as Matters Requiring Attention,                     non-compliance with laws, regulations,
Violations, and Recommendations.33 The                         or orders. Violations that have serious
issuance of an MRA or a Violation requires the                 implications regarding the condition or
affected FHLBank to submit to FHFA a                           practices of the regulated entity might
remediation plan containing specific milestones                also be identified as MRAs.
tied to the severity of the matter. FHFA                       Recommendations: Recommendations
examiners are charged with reviewing FHLBank                   are advisory in nature and represent
remediation plans and testing them as                          suggested changes to a policy,
appropriate. The failure of an FHLBank to                      procedure, practice, or control to
implement a remediation plan could result in                   improve or prevent deterioration in
                                                               condition, operations, or performance.



32
   See, FHFA, Advisory Bulletin AB 2012-01, Categories for Examination Findings (April 2, 2012) (online at
http://www.fhfa.gov/webfiles/23874/AB2012-01_Categories_for_Examination_Findings.pdf).
33
     See id., at 2–4.




                                  OIG  EVL–2013–008  August 6, 2013                                        18
FHFA taking an informal or formal enforcement action, such as the issuance of a cease and
desist order.34

In response to the findings in its    FIGURE 7. FHFA’S SUPERVISORY ACTIONS TAKEN IN RESPONSE
2012 horizontal review, FHFA                TO UNSECURED CREDIT REGULATORY VIOLATIONS 35
classified—pursuant to the
Advisory Bulletin standards—the                                          Supervisory     Remediation
examination findings involving          FHLBank           Violations        Action            Date
the seven FHLBanks that              FHLBank A         474              MRA              3/31/2013
violated the unsecured credit                          201 Primary
                                     FHLBank B                          MRA              12/31/2012
regulation (see Figure 7). For                         201 Secondary
example, FHFA assigned MRAs          FHLBank C         33†              MRA              3/31/2013
to FHLBanks A and B because,         FHLBank D         9                MRA              10/31/2012
among other things, they each
committed more than 400              FHLBank E         6                MRA              3/31/2013
violations. In contrast, FHFA                          1 Primary
                                     FHLBank F                          MRA              12/31/2012
assigned a “Violation” finding to                      1 Secondary
FHLBank G in response to its         FHLBank G         1                Violation        9/30/2012
sole violation of the unsecured    † FHFA determined that FHLBank C’s aggregate term extensions of
credit regulation.35                credit to two counterparties exceeded the regulatory limits for a
                                         combined total of 33 months, 15 months of which are attributable
The Agency required the seven         to one counterparty, and 18 months to the other. The number of
FHLBanks to correct their             individual transactions in excess of the regulation is likely higher.
systems and other deficiencies
within specified time periods between September 30, 2012, and March 31, 2013. Further,
FHFA directed the FHLBanks to make significant improvements in their operations, such as
updating counterparty credit ratings on a timelier basis. FHFA also required the FHLBanks
to implement annual audits of their unsecured credit practices and analyze each extension of
credit pursuant to a cost/benefit analysis that encompasses potential risks and related costs.

During its ongoing 2013 FHLBank examination cycle, FHFA is assessing the seven
FHLBanks’ compliance with the supervisory requirements and remedial plans established
in 2012. As described in the next section, FHFA concluded that FHLBank B, which
committed the most egregious violations identified in the horizontal review, failed to adhere
to certain supervisory requirements established in 2012.

34
   According to Advisory Bulletin AB 2012-01, recommendations are discretionary in nature and, therefore, do
not require specific remediation plans. However, if changes based on recommendations are not made, the
finding can be raised to an MRA in the following examination cycle.
35
     Source: FHFA.




                                  OIG  EVL–2013–008  August 6, 2013                                          19
FINDINGS .................................................................................

     1. FHFA’s Horizontal Review of FHLBank Unsecured Credit Risk Management Was
        Proactive and Thorough

In response to the risks in FHLBank unsecured credit practices that it identified in 2011, the
Agency initiated a horizontal review of the FHLBanks’ associated risk management
practices in 2012. For the reasons that follow, we find that FHFA conducted the horizontal
review in a proactive and thorough manner.

        FHFA developed a comprehensive 9-module examination work plan for the
         horizontal review. The plan covered all phases of unsecured credit transactions,
         including their approval, execution, monitoring, and reporting.
        A single FHFA examiner, supported on occasion by other FHFA examiners and
         financial experts, conducted the unsecured credit horizontal review at all 12
         FHLBanks. This process ensured consistency in both the conduct of the horizontal
         review and the reporting of its results.
        FHFA implemented procedures to identify regulatory violations as we recommended
         in our June 2012 report. FHFA’s procedures identified over 900 regulatory
         violations at 7 of the 12 FHLBanks, as well as risk management deficiencies or
         weaknesses of varying degrees at the other 5 FHLBanks.
        We reviewed FHFA’s examination documentation for the work done at three of the
         FHLBanks during the horizontal review. We found that the Agency largely
         complied with its work plans.36
     2. Findings Related to FHFA’s Supervisory and Enforcement Responses to the
        Unsecured Credit Violations First Identified in 2012

     a. FHFA’s General Supervisory Response in 2012 Was Consistent with Agency Policy

As discussed previously in this report, FHFA complied with the Advisory Bulletin in its
2012 supervisory response to the unsecured credit violations identified at seven FHLBanks.
In six of the seven cases, FHFA classified the FHLBanks’ examination findings as MRAs,
which is the most serious supervisory designation. In the other case, FHFA classified the
FHLBank’s single instance of non-compliance with the regulation as a Violation.

36
   Initially, we noted a lack of documentation from which to conclude that work had been performed in some
areas specified in the plan. Upon inquiring with FHFA, however, we were able to determine that the work in
question had been performed to a sufficient extent.




                                  OIG  EVL–2013–008  August 6, 2013                                        20
Consistent with its Advisory Bulletin, FHFA also required the seven FHLBanks to correct
the conditions underlying the violations and other risk management deficiencies within
various specified timeframes between September 30, 2012, and March 31, 2013.

     b. FHFA Must Diligently Monitor and Enforce FHLBanks’ Compliance with Unsecured
        Credit Supervisory Requirements

During its 2013 FHLBank examination cycle, FHFA has been assessing the FHLBanks’
compliance with the MRAs it issued in 2012, as well as other supervisory requirements
FHFA put in place to strengthen their unsecured credit risk management practices. It is still
relatively early in the process and, in many cases, FHFA has not yet reached final
conclusions about the FHLBanks’ compliance or whether additional supervisory or
enforcement steps may be necessary. However, for the reasons set forth below, we believe
the 2013 experience of FHLBank B, which committed the most egregious violations
identified in the 2012 horizontal review, demonstrates the need for FHFA to diligently
monitor and enforce FHLBank compliance with its supervisory requirements.

         FHFA Has Identified Ongoing Control Deficiencies in FHLBank B’s Unsecured Credit
         Risk Management

According to Agency officials and preliminary documentation, although FHLBank B has
taken a number of steps to comply with its 2012 MRA requirements, it nevertheless
continues to experience control deficiencies as follows:

        The FHLBank did not adequately implement a series of requirements designed to
         enhance its ability to monitor its unsecured credit exposures. As a result, on 5
         occasions in early 2013, the FHLBank breached unsecured credit requirements
         established in its 2012 MRA. These breaches resulted in potential overages to 12
         counterparties.37 A senior manager in the credit risk department, who failed to
         ensure implementation of the required unsecured credit controls, was subsequently
         terminated. The FHLBank also transferred day-to-day responsibility for its
         unsecured credit risk monitoring from the credit risk department to another
         department.


37
   FHLBanks generally calculate their regulatory capital based upon the previous month’s ending capital
amount. In its 2012 MRA, FHFA recommended that FHLBank B analyze reducing its regulatory capital figure
for unsecured credit limit calculations more frequently than monthly should its regulatory capital fall by a
certain threshold. The FHLBank’s credit risk department implemented daily monitoring of changes in
regulatory capital, but it failed to identify and report reductions in capital that would have required a
management review of the unsecured credit limits. Upon examination, FHFA determined that, although the
FHLBank breached the internal policies it established to comply with its 2012 MRA, it did not violate the
regulation itself.




                                  OIG  EVL–2013–008  August 6, 2013                                          21
        The FHLBank’s internal audit department failed to detect and communicate
         deficiencies in its unsecured credit practices. As part of its 2012 MRA, FHLBank B
         was required to ensure that its internal audit department did a better job assessing its
         compliance with FHFA’s unsecured credit requirements. However, in early 2013,
         FHFA found that the internal audit department had given the credit risk department a
         “Satisfactory” review despite the deficiencies cited immediately above. Although
         FHFA found that the internal audit department was aware of the deficiencies, it did
         not obtain a commitment from the corresponding department responsible for
         unsecured credit to establish controls and correct the deficiencies.

         FHFA Has Authority to Take Enforcement Actions When FHLBanks Fail to Comply with
         Its Supervisory Requirements

Although FHFA has not yet decided upon a final supervisory strategy for FHLBank B in
response to its control failures in 2013, we observe that the Agency is authorized by statute
and policy to take informal or formal enforcement actions when an FHLBank fails to
comply with its supervisory requirements.38 Formal actions, which are made public by the
Agency, serve to demonstrate that an FHLBank’s failure to undertake a required supervisory
requirement can be consequential. For example, the Agency may require an FHLBank to
incur the cost of its failure to implement a supervisory requirement by directing it to seek
restitution for a loss, limit its growth, or prohibit the payment of dividends or redemption of
capital stock. Some formal actions, such as consent orders, may be enforced through the
federal court system. And an FHLBank’s failure to comply with certain formal actions
could result in the imposition of civil money penalties upon it, or even its placement into
receivership.

In our view, FHFA should be willing to use all of its authorities, including enforcement
actions, to ensure compliance with MRAs and other supervisory requirements. As
documented in this report, seven FHLBanks violated FHFA’s unsecured credit regulation
and another five had varying risk management deficiencies. These violations and
deficiencies across the FHLBank System, as well as FHLBank B’s failure to implement key
controls in 2013 as required, suggest that improving unsecured credit risk management
involves considerable challenges. Moreover, FHFA will need to monitor the FHLBanks’
progress in making needed improvements on an ongoing basis and consider the use of
enforcement actions as necessary to ensure that improvements in unsecured credit risk
management are sustained.

38
  In 2012, FHFA’s Division of Federal Home Loan Bank Regulation implemented an enforcement policy
governing the use of informal and formal enforcement actions against FHLBanks. A key principle of the
policy is that the Agency should take an enforcement action when an FHLBank fails or is unwilling to
implement remedial actions established by MRAs and other supervisory requirements.




                                  OIG  EVL–2013–008  August 6, 2013                                   22
CONCLUSIONS ..........................................................................

In 2012, FHFA conducted a thorough horizontal review during which it identified over 900
primary and secondary unsecured credit regulatory violations at 7 FHLBanks and risk
management deficiencies of varying degrees at the other 5. Moreover, in 2012, FHFA acted
in accordance with Agency supervisory policy in, among other things, directing the seven
FHLBanks that committed violations to undertake remedial actions within specified
timeframes. However, given the widespread nature of the violations and risk management
deficiencies within the FHLBank System, as well as FHLBank B’s failures to implement
certain required controls in 2013, FHFA must exercise diligent and forceful oversight on an
ongoing basis in order to ensure that corrective action is undertaken and sustained over time.


RECOMMENDATIONS ...............................................................

We recommend that FHFA’s Deputy Director, Division of Home Loan Bank Regulation,
ensure that Agency examiners thoroughly assess FHLBank compliance with MRAs and
other supervisory requirements to remediate unsecured credit violations and risk
management deficiencies during the 2013 and 2014 examination cycles. We also
recommend that the Deputy Director, in consultation with the General Counsel and others,
consider the use of informal or formal enforcement actions as appropriate to ensure the
remediation of any further regulatory violations or failures to adhere to supervisory
requirements.




                              OIG  EVL–2013–008  August 6, 2013                                23
OBJECTIVE, SCOPE, AND METHODOLOGY .................................

The objectives of this study were to assess FHFA’s (1) implementation of the unsecured
credit horizontal review, and (2) supervisory and enforcement response to identified
violations.

To address these objectives, OIG interviewed officials in FHFA’s Division of Federal Home
Loan Bank Regulation, Division of Supervision Policy & Support, and Office of General
Counsel.

OIG also reviewed FHFA’s regulation that pertains to FHLBank unsecured credit
extensions; Advisory Bulletins concerning prudential credit risk management, examination
classifications, and the Agency’s enforcement policy; FHLBank examination reports; work
papers and programs, findings memoranda, and MRAs associated with the unsecured credit
horizontal review; and Agency correspondence with FHLBanks concerning examination
findings and MRA remediation.

Further, OIG tested three of the on-site examinations from the horizontal review for
compliance with the work program. To test the depth of review across the FHLBank
System, we purposefully selected two FHLBanks that violated the regulation and one that
did not. We reviewed all of the work papers associated with these examinations for
completeness and compliance with the examination work program.

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 2012), which
was promulgated by the Council of the Inspectors General on Integrity and Efficiency.
These standards require OIG to plan and perform an evaluation that obtains evidence
sufficient to provide reasonable bases to support its findings and recommendations. OIG
believes that the findings and recommendations discussed in this report meet these
standards.

The performance period for this evaluation was March 2013 and July 2013.

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. In
its comments, which are reprinted in their entirety in Appendix A, FHFA agreed with the
evaluation report’s recommendations. FHFA also provided technical comments on report
drafts, which were incorporated as appropriate.




                             OIG  EVL–2013–008  August 6, 2013                             24
APPENDIX A .............................................................................

FHFA’s Comments on OIG’s Findings and Recommendations




                           OIG  EVL–2013–008  August 6, 2013                         25
OIG  EVL–2013–008  August 6, 2013   26
APPENDIX B..............................................................................

OIG’s Response to FHFA’s Comments

On July 19, 2013, FHFA provided comments on a draft of this report in which it agreed with
the recommendations. The Agency also identified the actions that it has taken to date and
will take to implement them. OIG considers FHFA’s proposed actions to be sufficient to
resolve the recommendations, which will remain open until OIG determines that the
Agency’s corrective actions are completed in a manner that is responsive to the
recommendations. OIG has attached the Agency’s full response (see Appendix A), which
was considered in finalizing this report.




                             OIG  EVL–2013–008  August 6, 2013                             27
ADDITIONAL INFORMATION AND COPIES .................................


For additional copies of this report:

      Call: 202-730-0880
      Fax: 202-318-0239
      Visit: www.fhfaoig.gov



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

      Visit: www.fhfaoig.gov/ReportFraud
      Call: 800-793-7724
      Fax: 202-318-0358
      Write to us at:
                   FHFA Office of Inspector General
                   Attn: Office of Investigation – Hotline
                   400 Seventh Street, S.W.
                   Washington, DC 20024




                               OIG  EVL–2013–008  August 6, 2013                         28