oversight

Recent Trends in Federal Home Loan Bank Advances to JPMorgan Chase and Other Large Banks

Published by the Federal Housing Finance Agency, Office of Inspector General on 2014-04-16.

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

          Federal Housing Finance Agency
              Office of Inspector General




 Recent Trends in Federal Home
Loan Bank Advances to JPMorgan
  Chase and Other Large Banks




Evaluation Report  EVL-2014-006  April 16, 2014
                 Recent Trends in Federal Home Loan Bank Advances to
                 JPMorgan Chase and Other Large Banks
                 Why OIG Did This Report
                 The Federal Home Loan Bank System (System) is comprised of 12 regional
                 Federal Home Loan Banks (FHLBanks) and the Office of Finance. The
                 FHLBanks make secured loans, known as advances, to their members and do
 At A            so primarily to promote housing finance. After peaking at about $1 trillion in
                 2008, advances declined 62% to $381 billion by March 2012. However, since
Glance           then, advances have climbed to nearly $500 billion primarily due to advances
                 to the four largest members of the System: JPMorgan Chase, Bank of
   ———           America, Citigroup, and Wells Fargo. From March 31, 2012, to December 31,
                 2013, advances to these four System members surged by 158% to $135 billion.
April 16, 2014
                 This report identifies potential causes for the surge in advances to the four
                 largest members, identifies the associated benefits and risks, and assesses the
                 Federal Housing Finance Agency’s (FHFA/Agency) oversight of this area.

                 OIG Analysis and Finding
                 New Bank Liquidity Standards Contributed to the Recent Surge in Advances
                 According to officials from FHFA and an FHLBank as well as Agency
                 documents, the surge in advances to the four largest members is attributable,
                 in large part, to bank liquidity standards established by the international Basel
                 Committee on Bank Supervision in December 2010. Under these standards,
                 banks, such as JPMorgan Chase, must increase their holdings of high quality
                 liquid assets, such as U.S. Treasury securities, to improve their ability to
                 withstand sudden financial and economic stress. The officials said that large
                 members of the System recently drew FHLBank advances, in part, to purchase
                 the investment securities necessary to meet the new liquidity standards.
                 In written responses to our inquiries, two of the four largest System members
                 confirmed that the new liquidity standards contributed to their increased use
                 of advances. An official from another large System member said the liquidity
                 standards influenced its use of advances but did not say the standards increased
                 their borrowing. The remaining member bank did not respond to our inquiries.
                 Potential Benefits and Risks of Large Members’ Advance Growth
                 The benefits of the surge in advances to the four largest members include an
                 increase in interest income that FHLBanks earn from making advances.
                 Further, FHFA defines all advances as “core housing mission assets.” Thus,
                 increased advances could address FHFA’s concerns about the relatively high-
                 level of System investments in “non-core” housing mission assets, such as
                 mortgage-backed securities issued by Fannie Mae and Freddie Mac.
                 The risks include the significant losses an FHLBank could incur if a large
                 member defaults on its advances, particularly if the advances were improperly
                 collateralized or the value of the collateral had declined significantly. FHFA
                 officials emphasized that FHLBank advances for the purpose of meeting recent
                 liquidity requirements are legal and not inconsistent with the System’s
                 mission. However, they noted that this practice could create an “image risk.”
                 That is, the public might question the FHLBanks’ commitment to their housing
                 mission upon learning that large member banks may be using advances to
                 purchase investment securities to meet liquidity standards.

 At A            FHFA Prioritized Advances to Large Members in its 2013 Examinations
                 FHFA officials said that the surge in advances to large members and the
Glance           associated safety and soundness risks were a priority during the 2013 annual
   ———           examination cycle and will remain so in 2014. After reviewing FHFA’s
                 2013 examination documents, we determined that FHFA had covered the
April 16, 2014   FHLBanks’ management of risks associated with increasing advances to large
                 members. In one examination, FHFA concluded that an FHLBank had failed
                 to properly manage the relatively high-risk collateral pledged by one of the
                 four large System members; and the Agency issued a supervisory directive to
                 correct the deficiency by March 2014.
                 Finding: FHFA Can Enhance Transparency about Recent Advance Trends
                 While FHFA prioritized FHLBank advances to large members in 2013, we
                 believe the trend presents a number of questions and implications, including:
                       Will the surge in advances continue, and will it spread to other
                        members, or has the trend already peaked?
                       How effectively are the FHLBanks managing the advance
                        concentration and other risks associated with such advances?
                       What are the implications for the System’s ability to achieve its
                        housing mission if member banks increasingly draw advances to
                        help meet their liquidity requirements?
                 As the FHLBanks’ regulator, FHFA routinely collects and assesses
                 information and data about the FHLBanks’ advance business.
                 In our view, FHFA could enhance awareness and understanding of FHLBank
                 advances across the government, financial industry, and the general public
                 through its established reporting processes or the issuance of a special report.
                 Such action would render more transparent the System’s operations, its overall
                 safety and soundness, and its success in achieving its housing mission.

                 What OIG Recommends
                 We recommend that FHFA publicly report on FHLBank advances to large and
                 other members in 2014, emphasizing the consistency of such advances with the
                 safety and soundness of the System, as well as its housing mission. FHFA
                 agreed with this recommendation.
TABLE OF CONTENTS ................................................................

RECENT TRENDS IN FEDERAL HOME LOAN BANK ADVANCES TO
JPMORGAN CHASE AND OTHER LARGE BANKS .................................................................2

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

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

CONTEXT .......................................................................................................................................9

      Bank Holding Companies May Own Subsidiaries that Belong to Multiple FHLBank
      Districts .....................................................................................................................................9

      FHLBanks Have Significantly Increased Advances to the Four Largest System
      Members since Early 2012 .....................................................................................................11
             Surging FHLBank Advances to the Four Largest System Members Contrasts
             with Generally Flat Advances to All Other Members ....................................................12
             Concentration of FHLBank Advances to Four Largest Members Has Increased
             Significantly ....................................................................................................................13

      Basel III Liquidity Requirements Contributed to the Surge in FHLBank Advances .............14
             JPMorgan Chase’s Filings with the Securities and Exchange Commission also
             Indicate that it Used Advances to Meet Basel III Requirements ....................................16
              Views of Officials from Three of the Four Largest System Members ...........................16
             DBR Officials Believe “Deposit Run Off” May Have Contributed to Growth of
             Advances to Other Members in the Fourth Quarter of 2013 ..........................................16

      Benefits and Risks Associated with the Surge in FHLBank Advances to Large
      Members .................................................................................................................................17
              Potential Benefits ............................................................................................................17
              Potential Risks ................................................................................................................19

      FHFA Prioritized FHLBank Advances to Large Members in its 2013 Examination
      Oversight Process ...................................................................................................................20

FINDING .......................................................................................................................................22

      FHFA Can Make Recent FHLBank Advance Trends More Transparent ..............................22


                                              OIG  EVL-2014-006  April 16, 2014                                                                   4
CONCLUSION ..............................................................................................................................23

RECOMMENDATION .................................................................................................................23

OBJECTIVES, SCOPE, AND METHODOLOGY .......................................................................24

ATTACHMENT A ........................................................................................................................25

      Large Member Responses to OIG Questions about Their Use of System Advances .............25

APPENDIX A ................................................................................................................................27

      FHFA’s Comments on FHFA-OIG’s Findings and Recommendation ..................................27

ADDITIONAL INFORMATION AND COPIES .........................................................................29




                                            OIG  EVL-2014-006  April 16, 2014                                                             5
ABBREVIATIONS .......................................................................

DBR                Federal Housing Finance Agency Division of Federal Home Loan Bank
                   Regulation

FHFA or Agency     Federal Housing Finance Agency

FHLBank            Federal Home Loan Bank

HQLA               High Quality Liquid Assets

LCR                Liquidity Coverage Ratio

LIBOR              London Interbank Offered Rate

MBS                Mortgage-Backed Securities

MRA                Matter Requiring Attention

OIG                Federal Housing Finance Agency Office of Inspector General

PLMBS              Private Label Mortgage-Backed Securities

System             Federal Home Loan Bank System




                           OIG  EVL-2014-006  April 16, 2014                         6
PREFACE ...................................................................................

The FHLBank System was established in 1932. Its primary mission is to support housing
finance in the United States. The System’s 12 regional FHLBanks support housing finance
primarily by making secured loans, called advances, to member financial institutions, such as
banks, thrifts, credit unions, and insurance companies.1 The members can use the proceeds to
originate mortgages or for other purposes.

The System raises the funds necessary to make advances through debt issuances, known as
consolidated obligations, administered by its Office of Finance. As a government-sponsored
enterprise, the System can issue consolidated obligations at relatively favorable interest rates
and other terms compared to other for-profit corporations.2 In turn, FHLBanks may pass
along the associated savings to their members in the form of relatively low interest rates on
advances.

System advances peaked in 2008, during the financial crisis, at about $1 trillion, but dropped
by about 62% to $381 billion as of March 31, 2012. Since then, however, System advances
have been increasing, reaching $492 billion by yearend 2013. This growth in advances has
been driven primarily by a surge in some FHLBanks’ advances to the four largest members of
the System: JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo.3

This evaluation report provides information and analysis on recent trends in some FHLBanks’
advances to the System’s large bank members. Specifically, it:

            Describes how bank holding company subsidiaries, such as those of JPMorgan
             Chase, may be members of multiple FHLBank districts and, thereby, obtain
             advances from more than one FHLBank;




1
  FHLBank assets must be secured by eligible collateral, such as single-family mortgages or investment grade
securities, among other assets.
2
  The federal government does not explicitly guarantee the System’s consolidated obligations, but creditors,
and other financial participants have traditionally assumed that there is an “implied” federal guarantee on them.
Thus, creditors have traditionally loaned money to the System on terms more favorable than those offered to
for-profit corporations without implicit guarantees, which are viewed as presenting a higher risk of default. For
more information, see FHFA-OIG, FHFA’s Oversight of Troubled Federal Home Loan Banks, EVL-2012-001,
January 11, 2012, http://www.fhfaoig.gov/Content/Files/Troubled%20Banks%20EVL-2012-001.pdf.
3
  The growth in FHLBank advances to JPMorgan Chase was cited in recent articles in the financial press.
See “JPMorgan Taps Taxpayer Backed Banks for Bailout,” Bloomberg, October 10, 2013 (online at
http://www.bloomberg.com/news/2013-10-10/jpmorgan-taps-taxpayer-backed-banks-for-bailout-rules.html).




                                     OIG  EVL-2014-006  April 16, 2014                                            7
            Documents the growth in advances to the four largest members of the System from
             early 2012 to yearend 2013;4
            Discusses the role played by recently adopted liquidity standards in the growth of
             these advances;
            Identifies some of the benefits and risks associated with the surge in advances to
             large members; and
            Assesses FHFA’s oversight of FHLBanks’ management of the risks associated
             with these advances during 2013.
Finally, this report recommends that FHFA publicly report on FHLBank advances to large
and other members in 2014, emphasizing the consistency of such advances with the safety and
soundness of the System, as well as its housing mission.

This report was prepared by Wesley Phillips, Director, Omolola Anderson, Senior Statistician,
Nicole Mathers, Program Specialist, and Irene Porter, Program Analyst. We appreciate the
cooperation of all those who contributed to this effort.

The 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
Deputy Inspector General for Evaluations




4
  In the report context section that follows, we note that the four largest bank holding companies are not
themselves members at the individual FHLBanks. Rather, each has multiple subsidiaries operating in several
FHLBank districts. For presentational purposes, we refer to each of these entities as a “System member.”




                                   OIG  EVL-2014-006  April 16, 2014                                       8
CONTEXT ..................................................................................

Bank Holding Companies May Own Subsidiaries that Belong to Multiple FHLBank
Districts

The Federal Home Loan Bank Act (FHLBank Act)5 provides that an eligible institution, such
as a bank or thrift, may become a member of only one of the 12 FHLBank districts in which
its principal business is located.6 See Figure 1 (the 12 FHLBank districts). According to
FHFA, there were 7,504 members of the System as of December 31, 2013.

                         FIGURE 1. LOCATIONS OF THE 12 FEDERAL HOME LOAN BANKS




Source: FHFA.

Nevertheless, bank and thrift holding companies may own subsidiaries situated in several
FHLBank districts, and each eligible7 subsidiary may become a member of the FHLBank in
the district in which it is situated. According to FHFA, approximately 49 financial companies
currently operate in two or more FHLBank districts through separately chartered subsidiaries.

5
    See 12 U.S.C. § 1424, Section 4, Eligibility for Membership.
6
    The institution may become a member of an adjoining district with approval from FHFA.
7
  To become a member of an FHLBank, a subsidiary of a bank or thrift must be a separately chartered
institution, such as a national bank or a state-chartered thrift.




                                      OIG  EVL-2014-006  April 16, 2014                             9
The bank holding companies for JPMorgan Chase, Wells Fargo, Bank of America, and
Citigroup each have multiple subsidiaries operating in several FHLBank districts. See
Figure 2. These four holding companies are also the largest members of the System as
measured by the total advances held by their subsidiaries.

       FIGURE 2. ADVANCES HELD BY FOUR LARGEST BANK HOLDING COMPANIES’ SUBSIDIARIES
                                  AS OF DECEMBER 31, 2013

              District Memberships                                      % of Holding Company’s
              by Holding Company            Advances ($Millions)            Total Advances
             JPMorgan Chase                          $61,831                        100%
                Pittsburgh                            $9,975                        16.1%
                Cincinnati                           $41,700                        67.4%
                Chicago                               $4,100                         6.6%
                San Francisco                         $5,960                         9.6%
                †
                  Seattle                                $96                         0.2%
             Bank of America Corp.                   $28,938                        100%
                Boston                                   $98                         0.3%
                Atlanta                              $17,263                        59.7%
                San Francisco                         $7,750                        26.8%
                †
                  Seattle                             $3,827                        13.2%
             Citigroup                               $25,202                        100%
                New York                             $22,200                        88.1%
                Des Moines8                               $0                           0%
                †
                  Dallas                                  $1                         0.0%
                San Francisco                         $3,001                        11.9%
             Wells Fargo                             $19,141                        100%
                Des Moines                           $19,000                        99.3%
                Dallas                                    $0                           0%
                †
                  San Francisco                         $141                         0.7%
             Total                                  $135,112
†
 Denotes the FHLBank districts in which a subsidiary of the holding company still has an advance balance but is
no longer a member. The subsidiary may not take out any new advances from the FHLBank.

Source: FHFA.




8
  A subsidiary of Citigroup maintained an active membership in Des Moines during the time period covered by
the table. In January 2014 the subsidiary withdrew its membership with FHLBank of Des Moines.




                                     OIG  EVL-2014-006  April 16, 2014                                          10
FHLBanks Have Significantly Increased Advances to the Four Largest System Members
since Early 2012

FHLBank advances to the four                               FIGURE 3. COMBINED FHLBANK SYSTEM ADVANCES TO
largest System members – the                                  JPMORGAN CHASE, WELLS FARGO, CITIBANK, AND
holding company subsidiaries of                                           BANK OF AMERICA
JPMorgan Chase, Wells Fargo,
Citibank and Bank of America –                            $160,000
collectively increased by 158% to                         $140,000
$135 billion between March 30,                            $120,000



                                             $ Millions
2012, and December 31, 2013. See                          $100,000
Figure 3.                                                  $80,000

While advances to each of the four              $60,000

largest System members have                     $40,000
increased significantly since early             $20,000
2012, JPMorgan Chase and Wells                        $0
Fargo accounted for the fastest                          Mar 12 Jun 12 Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13

growth. See Figure 4. They grew
at triple digit rates while Bank of         Source: FHFA. Data in table represents the total combined advances
America and Citigroup increased             of JPMorgan Chase, Wells Fargo, Citibank, Bank of America, and all
                                            of their subsidiaries throughout the FHLBank system.
at double digit rates. Further,
JPMorgan Chase’s increase in advances of $48 billion accounted for the majority (59%) of
the total increase of nearly $83 billion in advances to the four System members during the
period.

 FIGURE 4. COMPOSITION OF FHLBANK SYSTEM ADVANCES TO THE FOUR LARGEST SYSTEM MEMBERS
                                       ($MILLIONS)

                                                                                                  % of
                                  As of                     As of                              Change in
                                 March 31,                December                             Advances
       Holding Company            2012                     31, 2013     $ Change    % Change    to Top 4
  JPMorgan Chase                     $13,259                  $61,831     $48,572       366%         59%
  Wells Fargo                         $2,552                  $19,141     $16,589       650%         20%
  Bank of America                    $20,036                  $28,938      $8,902        44%         11%
  Citigroup                          $16,508                  $25,202      $8,694        53%         11%
  Top 4 Total                        $52,356                 $135,115     $82,756       158%        100%

Source: FHFA. Numbers may not add exactly due to rounding.




                                  OIG  EVL-2014-006  April 16, 2014                                      11
     Surging FHLBank Advances to the Four Largest System Members Contrasts with
     Generally Flat Advances to All Other Members

The surge in advances to the four largest System members contrasts sharply with the relatively
stable rate at which advances were made to the other approximately 7,500 FHLBank members
over the same period, i.e., March 31, 2012, to December 31, 2013. See Figure 5. While
advances to the four largest bank members increased by 158% over this period, advances to other
System members rose by just 9%. Conclusively, the growth in advances to the four largest
members was primarily responsible for the 29% increase (from $381 billion to $492 billion)9 in
overall System advances during this 21-month period.10

    FIGURE 5. CHANGE IN FHLBANK SYSTEM ADVANCES TO THE FOUR LARGEST BANK MEMBERS VERSUS
                                  OTHER MEMBERS ($MILLIONS)
                                        As of                As of
                                       March 31,         December 31,
         System Member                  2012                 2013               $ Change            % Change
      Top 4                                  $52,356            $135,112             $82,756                158%
      Others                                $328,280            $357,329             $29,049                   9%
      FHLBank System Total                  $380,636            $492,444            $111,808                  29%

Source: FHFA. Numbers may not add exactly due to rounding.

We note that the 9% increase in advances to other members occurred entirely in the last three
months of 2013. Between March 31, 2012, and September 30, 2013, advances to System
members apart from the top four actually declined by 1%. According to FHFA data, the
growth in advances during the fourth quarter of 2013 was largely attributable to System
members other than the four largest.11




9
 The advance totals presented are at par value. The par value of an advance is the amount of funds that the
borrower owes the FHLBank after various accounting adjustments are made to the book value. The book
value – the value at which an asset is carried on a balance sheet – of System advances was $498.6 billion at
December 31, 2013.
10
   System advances increased by $111.8 billion over this period. Advances to the top four System members
accounted for $82.8 billion, or 74%, of this total increase. The growth in advances that began in early 2012
reversed a System-wide decline that began in 2008 after advances peaked at about $1 trillion.
11
   FHFA data indicate that the growth in advances during the fourth quarter extended to System members other
than the four largest, which are the focus of this evaluation report. The reasons for this increase are not clear,
but several, including “depositor run-off” and Basel III requirements, are discussed in the next section of this
evaluation report.




                                     OIG  EVL-2014-006  April 16, 2014                                             12
   Concentration of FHLBank Advances to Four Largest Members Has Increased
   Significantly

As these four largest members have increased their total advances, they have also increased
their relative share of all System advances. In other words, more of the Systems’ total
advances have been concentrated in the four largest members. As of December 31, 2013,
JPMorgan Chase, Wells Fargo, Citibank, and Bank of America accounted for 27% of total
System advances, compared to 14% on March 31, 2012.

FHLBank of Cincinnati’s advances to             FIGURE 6. COMPOSITION OF ADVANCES AT THE
a JPMorgan Chase subsidiary in its            FHLBANK OF CINCINNATI, AS OF DECEMBER 31, 2013
district represented the most significant
concentration of advances to a top
member. At the end of the second quarter                                         JPMorgan Chase
                                                                                 Bank
of 2012, the FHLBank’s advances of                     26%
                                                                                 U.S.Bank
about $4 billion to the JPMorgan Chase
                                             3%                     64%
subsidiary accounted for 11.6% of all its                                        The Huntington
advances. However, by yearend 2013           7%                                  National Bank
such advances accounted for 64% of all of                                        Other Members
the FHLBank’s advances to its members.
See Figure 6.                                Source: FHFA.




                              OIG  EVL-2014-006  April 16, 2014                                 13
Basel III Liquidity Requirements Contributed to the Surge in FHLBank Advances

According to officials from FHFA’s Division of
Federal Home Loan Bank Regulation (DBR) and                            Basel Committee on Bank
an FHLBank12 as well as Agency internal records,13                     Supervision: The Basel Committee is
some large FHLBank members have increased their                        the primary global standard-setter for
use of advances as part of an overall strategy to                      the prudential regulation of banks and
comply with regulatory requirements established                        provides a forum for cooperation on
                                                                       banking supervisory matters. Its
by the international Basel Committee on Bank
                                                                       mandate is to strengthen the
Supervision14 (the Committee).15 In December                           regulation, supervision, and practices
2010 the Committee issued what is known as the                         of banks worldwide with the purpose
Basel III accord (Basel III).16                                        of enhancing financial stability.


Among other things, Basel III establishes
international liquidity requirements17 for                             Liquidity Requirements: The Basel III
commercial banks to help ensure financial stability.                   liquidity requirements are intended to
To meet these liquidity standards, banks may have                      ensure that commercial banks are
                                                                       fiscally stable and responsible in the
to increase their holdings of high quality liquid
                                                                       event of a future financial crisis.
assets, such as U.S. Treasury securities. FHFA and                     Banks are directed to increase their
FHLBank officials said that bank members may                           liquidity via obtaining high quality
use FHLBank advances as a source of funds to                           liquid assets, such as cash and U.S.
purchase Treasury or similar high quality liquid                       Treasury securities.




12
   Officials from another FHLBank that had recently increased its advances to a large System member said that
it was not their policy to inquire about the use to which their members put their advances.
13
   We note that determining how FHLBank members use advances is challenging. Financial institutions use
various sources to fund their operations, and tracing the uses to which specific funds are put is difficult.
Nevertheless, the sources cited in this report, and the analysis of the information provided by them, indicate that
the requirements set forth in Basel III have likely played a significant role in the surge of FHLBank advances to
the four largest members of the System.
14
     See Bank for International Settlements website. http://www.bis.org/bcbs/about.htm.
15
   Moody’s Investors Services has also observed that banks may draw on FHLBank advances to meet Basel III
requirements. See FHLBank System, FAQ, August 1, 2013.
16
   Each country that belongs to the Committee is responsible for enacting laws or regulations that implement its
standards, such as Basel III liquidity requirements.
17
  For more information regarding the Basel III liquidity requirements, see the Bank for International
Settlements website. http://www.bis.org/publ/bcbs238.htm.




                                      OIG  EVL-2014-006  April 16, 2014                                             14
securities and hold them on their balance sheets in order to meet the liquidity standards.18 See
Figure 7.

     FIGURE 7. EXAMPLE OF HOW A BANK MAY SATISFY LIQUIDITY REQUIREMENTS THROUGH FHLBANK
                                         ADVANCES




Source: OIG Analysis.

DBR officials also emphasized that the FHLBanks did not violate the law by extending
advances to their large commercial bank members that, in turn, used the proceeds to purchase
U.S. Treasury securities to comply with Basel III’s requirements. They observed that
FHLBanks are authorized to make advances to their members consistent with collateral
requirements, lending limits, and other statutory, regulatory, and internal standards. The DBR
officials also noted that there are no restrictions on the uses to which members may put the
proceeds of advances other than those that already exist in law and regulation.




18
   According to the Bank for International Settlement’s January 2013 publication entitled “Basel III: The
Liquidity Coverage Ratio and liquidity risk monitoring tools,” the purpose of the liquidity requirements is to
ensure that banks have sufficient high quality liquid assets (HQLA) to meet their liquidity needs for at least 30
days in the event of a stress scenario such as the 2008 financial crisis. Such HQLAs may consist of cash or
assets that can readily be converted into cash in private markets. See http://www.bis.org/publ/bcbs238.pdf, p.4,
item 16.




                                     OIG  EVL-2014-006  April 16, 2014                                            15
      JPMorgan Chase’s Filings with the Securities and Exchange Commission also Indicate
      that it Used Advances to Meet Basel III Requirements

We reviewed JPMorgan Chase’s filings with the Securities and Exchange Commission (SEC).
They suggest that Basel III liquidity requirements have played a role in its recent large draws
of FHLBank advances.19 In its December 2012 annual financial statement, JPMorgan Chase
reported that efforts were underway to fully comply with the new Basel III liquidity
requirements by the end of 2013. JPMorgan Chase describes FHLBank advances as one of
several sources available to provide funding. It also subsequently reported a 53% increase
in its holdings of high quality liquid assets such as U.S. Treasury securities in a matter of a
year – from $341 billion at December 31, 2012, to $522 billion at December 31, 2013 –
during the period it drew $48.6 billion in FHLBank advances.

      Views of Officials from Three of the Four Largest System Members

We spoke with officials from three of the four largest members of the System regarding their
increased use of FHLBank advances since early 2012.20 Officials from two of these three
banks confirmed in writing that Basel III’s liquidity requirements contributed to their
increased use of FHLBank advances.21 In fact, officials from one of the banks said that the
Basel III requirements were the “primary driver” for its increased use of advances. 22

An official from the third bank said that Basel III’s liquidity requirements may influence
its use of advances. However, the official did not specifically state that the liquidity
requirements directly contributed to the bank’s increased FHLBank borrowing since early
2012.

      DBR Officials Believe “Deposit Run Off” May Have Contributed to Growth of Advances
      to Other Members in the Fourth Quarter of 2013

DBR officials also noted that the significant increase in advances to members other than the
largest four during the fourth quarter of 2013 may have been due, in part, to deposit run off at
member institutions. That is, since the members’ depositors were earning low rates, they may

19
   JPMorgan Chase & Co., 2012 Annual Report, Dec. 31, 2012, p. 71 and108, from JPMorgan Chase & Co
investor relations website, http://investor.shareholder.com/jpmorganchase/secfiling.cfm?filingID=19617-13-221
and JPMorgan Chase & Co., 2013 Quarterly Report, September 30, 2013, p. 68 and 71,
http://investor.shareholder.com/jpmorganchase/secfiling.cfm?filingID=19617-13-400.
20
  Officials from one of the four largest members did not respond to our requests for information about its use of
advances.
21
     We do not disclose the identities of these banks so as to facilitate their willingness to speak with us.
22
     See Appendix A for the complete text of the banks’ responses to our questions.




                                        OIG  EVL-2014-006  April 16, 2014                                         16
have withdrawn some of their funds and reinvested them in the stock market where returns
were higher. This, in turn, may have caused the members to increase their advances to help
fund their own operations. However, DBR officials said that the growth in advances to these
members in fourth quarter of 2013 may also be attributable to their efforts to meet Basel III’s
requirements.

Benefits and Risks Associated with the Surge in FHLBank Advances to Large Members

Our discussions with officials from FHFA and the FHLBanks identified both benefits and
risks associated with the recent surge in advances to the four largest members of the System.
See Figure 8 (summary of benefits and risks). In this section we analyze them in more detail.

     FIGURE 8. SUMMARY OF BENEFITS AND RISKS ASSOCIATED WITH THE FHLBANKS’ RISING ADVANCES
                                      TO LARGE MEMBERS

                           Benefits                                            Risks
       Potentially Higher Advance Interest Income           Advance Concentration Risk
       Increased Focus on Housing Core Mission              FHLBanks May Favor Large Members over
       Assets                                               Smaller Members in Advance Term Pricing
                                                            Housing Mission “Image” Risk
Source: OIG Analysis.

      Potential Benefits

Increased Interest Income
The interest income generated by surging advances could help stabilize the finances of
individual FHLBanks and, potentially, the System as a whole. FHLBanks also may pay both
cash and stock dividends to their large and small members alike based on quarterly or annual
profits. Moreover, increased interest income generated by advances would cause the
FHLBanks to contribute more to their Affordable Housing Programs (AHP), which receive
10% of each FHLBank’s net income each year.23

However, FHLBank data indicate that the surge in advances to the largest members has not
yet translated into materially higher interest income. For example, the FHLBank of
Cincinnati saw modest advance interest income increases in 2012 and 2013, the period in
which JPMorgan Chase’s advances increased significantly. Specifically, advance interest

23
   AHP funds are awarded through both a homeownership set-aside program and a competitive application
program. At least one-third of an FHLBank’s aggregate annual set-aside contribution must be used to assist first-
time homebuyers. See, FHFA’s Oversight of the Federal Home Loan Banks’ Affordable Housing Programs
(EVL-2013-04) (April 30, 2013) (online at http://www.fhfaoig.gov/Content/Files/EVL-2013-04.pdf).




                                     OIG  EVL-2014-006  April 16, 2014                                            17
income at the FHLBank of Cincinnati increased by only 31% to $308 million between 2011
and 2013 despite the 134% growth in their advances during that time period. See Figure 9.
Moreover, the FHLBank’s yield on its assets, which is a measure of profitability, actually
declined from 0.81% to 0.50% from 2011
to 2013.
                                                            FIGURE 9. FHLBANK OF CINCINNATI ADVANCE
FHFA officials observed that overall                  INTEREST INCOME AND YIELD ($MILLIONS)
interest rates have declined over the past
several years.24 That is, the interest rates                     Total      Interest      Annual
that large members pay on their advances          Yearend      Advances     Income         Yield
have declined even as their advance balances        2011         $27,838         $236        0.81%
have grown significantly. Additionally,             2012         $53,621         $261        0.80%
officials from an FHLBank said that many            2013         $65,093         $308        0.50%
of the advances to larger members were
                                                 Source: FHFA.
floating rate advances that were at very low
initial market rates at the time the advances were taken. These low rates reduced the relative
interest income.

Increased Focus on Housing Core Mission Assets
FHFA and FHLBank officials also said that the surge in advances to large bank members can
help the System increase its focus on what are known as core housing-mission related assets.
Per FHFA regulations, core housing mission assets are defined as advances and mortgage
assets purchased from members, among others. Thus, FHLBank investments in private-label
mortgage-backed securities (PLMBS) and mortgage-backed securities (MBS) issued by
Fannie Mae and Freddie Mac are not core-mission assets.

In previous reports, we have discussed the FHLBanks’ investment in non-core mission assets
and the criticisms leveled by some FHFA officials at their having done so. Specifically, we
noted that the relatively large investments in PLMBS made by some FHLBanks have
generated significant losses and led to questions about those FHLBanks’ focus on their
housing mission.25 The surge in advances to large members may serve to offset some of the
System’s non-core mission assets.

24
   FHLBank short-term and floating rate advance rates are indexed on the London Interbank Offered Rate
(LIBOR). The LIBOR averaged 0.43% in 2012 and 0.27% in 2013. FHFA says the decline in the LIBOR
primarily contributed to a lower yield on advances in 2013. They also note that as old, high-rate advances
gradually mature or are prepaid, they are replaced with lower yielding assets or not replaced at all.
25
   See, FHFA’s Oversight of Troubled Federal Home Loan Banks (EVL-2012-001) (January 11, 2012) (online at
http://www.fhfaoig.gov/Content/Files/Troubled%20Banks%20EVL-2012-001.pdf) and FHFA’s Oversight of the
Federal Home Loan Banks’ Compliance with Regulatory Limits on Extensions of Unsecured Credit (EVL-2013-
008) (August 6, 2013) (online at http://www.fhfaoig.gov/Content/Files/EVL-2013-008.pdf).




                                    OIG  EVL-2014-006  April 16, 2014                                      18
We asked DBR officials how the FHLBanks’ use of advances to meet Basel III’s liquidity
standards was consistent with the System’s housing mission. They said that all advances are
considered to be core mission assets. They noted that, as a matter of statute and regulation,26
only long-term advances, i.e., those with maturities of five years or more, must be used for
housing purposes. Finally, they said that using FHLBank advances to meet a member bank’s
liquidity requirements is not “necessarily inconsistent” with the System’s mission. Having
said all that, however, the officials noted, as described below, that the practice of using
advances to meet Basel III’s liquidity requirements could create a housing mission “image
risk” for the System.

      Potential Risks

Advance Concentration Risk
FHFA officials noted there are concentration risks associated with some FHLBanks’ advances
to their large members. Under some scenarios, an FHLBank could experience substantial
losses if a large member defaulted on its advances. This could occur if an FHLBank failed
to ensure that its advances were fully collateralized or failed to determine timely that the
collateral securing an advance had declined substantially in value.27 However, both FHFA
and FHLBank officials we contacted said that collateral management is a high priority within
the System, and FHFA evaluates the FHLBanks’ risk management controls at every annual
examination. FHFA examinations of the FHLBanks’ advance collateral risk management are
discussed in the next section of this report.

There is also the possibility that FHLBanks could become overly dependent on the interest
income generated by advances to their large members, according to FHFA. Consequently,
some FHLBanks may face significant financial challenges if a large member sharply reduced
its advances or withdrew its membership from the district entirely. A DBR official said that
some FHLBanks are better able to “scale” their advance activity than others and thereby
mitigate such risks.

FHLBanks May Favor Large Members over Smaller Members in Advance Term Pricing
FHFA officials also said there is a potential that FHLBanks could favor large members over
smaller members to gain their business. Doing so would constitute a violation of Section 7(j)
of the FHLBank Act.28 FHLBanks could accomplish this by lowering advance rates, or

26
     12 U.S.C. 4526 and 12 CFR § 1266.3.
27
   We note that each FHLBank is jointly and severally liable for the System’s consolidated obligations. Thus,
the financial difficulties of one FHLBank could have financial implications for all 12 FHLBanks.
28
  See 12 U.S.C. § 1427(j) (2006). Section 7(j) requires FHLBank directors to administer the affairs of the bank
impartially and without discrimination in favor of or against any member.




                                    OIG  EVL-2014-006  April 16, 2014                                           19
easing collateral and capital requirements for some members. Furthermore, there is some
potential that if a large member borrower is part of a multi-bank holding company with
subsidiaries in multiple FHLBank districts, then it could redirect funding from one FHLBank
to another, causing price competition for advances among FHLBanks.29 Such price
competition among FHLBanks could affect the System’s safety and soundness.30 As
discussed in the next section, FHFA reviewed the FHLBanks’ advance term pricing during
examinations conducted in 2013.

Housing Mission “Image” Risk
Lastly, FHFA officials said there may be an increased “image risk” associated with some
FHLBanks’ advances to their large members. Specifically, concerns about the System’s
housing mission focus could be raised in response to large banks drawing advances to
purchase Treasury securities to meet Basel III requirements. This, the officials conceded,
could occur despite the fact that FHFA considers all FHLBank advances to be core housing
mission assets, and only those with maturities of five years or more must be used specifically
for housing purpose.

FHFA Prioritized FHLBank Advances to Large Members in its 2013 Examination
Oversight Process

DBR officials told us that oversight of the surge in advances to large System members was a
priority during the 2013 examination cycle and that it will remain so in 2014.31 The officials
said that examiners have focused on assessing the FHLBanks’ risk management practices,
such as the manner in which they ensure that advances are properly collateralized. Further,
DBR officials said that they have maintained regular communications with FHLBank officials
about the surge in advances to large members.

Our review of DBR’s 2013 planning materials for three FHLBanks confirmed that the
examiners prioritized the surge in advances to large members and the concentration and
collateral management risks they created.32 The planning materials also identified the steps
that the examiners would take to assess the FHLBanks’ management of these risks.


29
  See Government Accountability Office, Federal Home Loan Bank System: Key Loan Pricing Terms Can
Differ Significantly (GAO-03-973) September 8, 2003.
30
   FHFA regulations permit differential pricing when an FHLBank adopts reasonable criteria and applies them to
all members. See 12 CFR 1266.5(b)(2).
31
  DBR conducts annual on-site safety and soundness and housing mission compliance examinations of each
FHLBank as well as the Office of Finance.
32
  FHFA’s 2013 examination of another FHLBank that has made significant advances to a commercial bank
member did not focus on the FHLBank’s risk management practices as the advances did not start until after the



                                    OIG  EVL-2014-006  April 16, 2014                                          20
DBR’s examination of an FHLBank in 2013 revealed weaknesses in its management of
relatively risky collateral pledged by a large member to secure advances.33 Accordingly, a
supervisory directive was instituted. Under it, the FHLBank must correct these deficiencies
by March 31, 2014. In two other examinations conducted in 2013, DBR assessed whether a
large bank member of the System had double-pledged collateral to obtain advances from two
FHLBanks. 34 DBR concluded that the FHLBanks had controls in place to prevent such
double pledging.

Moreover, DBR exams did not identify evidence indicating that the FHLBanks offered
favorable advance pricing to their large bank members in violation of section 7(j) of the
FHLBank Act.35 Specifically, the examiners assessed whether advances made to the large
members were transparent and consistent with established policies. In one examination a test
was conducted to determine whether the term pricing offered to a large member differed from
that offered to smaller members. No discrepancies were identified.

Finally, DBR officials said that they plan to study at least one of the largest members in the
System to evaluate the risks associated with the concentration of advances. Officials said that
they initiated the study in 2013 given that some holding companies have subsidiaries that are
members of multiple FHLBanks and that advances to these subsidiaries have increased
substantially recently. Officials said that the study would likely assess such members’
advance activity, pricing, and the FHLBanks’ risk management procedures. The DBR
officials noted that the study is intended to inform the Agency’s supervisory processes and
will likely not be made available to the public as it may include proprietary information.




examination was complete. However, FHFA officials said they would review the FHLBank’s risk management
practices during its 2014 examination.
33
   FHFA concluded that the FHLBank did not have adequate controls in place for relatively high-risk collateral
that a large commercial bank member had pledged to secure advances.
34
   Double pledging occurs when a banking organization with subsidiaries in multiple FHLBank districts pledges
the same collateral to secure advances from separate FHLBanks. This creates risks because if the banking
organization’s subsidiaries defaulted on both advances there would not be sufficient collateral to secure the
advances, which would likely result in credit losses for one or both FHLBanks.
35
     See n. 27, supra.




                                    OIG  EVL-2014-006  April 16, 2014                                          21
FINDING ...................................................................................

FHFA Can Make Recent FHLBank Advance Trends More Transparent

While FHFA conducted targeted studies of FHLBank advances to large members in 2013,
we believe the trend presents the following important questions and implications for the
FHLBank System:

            Has the surge peaked, or will it continue and expand to other member banks?36
            Will Basel III’s liquidity standards be a primary driver of increasing advances to
             smaller members as appears to have been the case with large members?
            Will the FHLBanks compete, or plan to compete, for large member bank advance
             business on terms such as interest rates and collateral requirements?
            How effectively do FHLBanks manage risks, such as concentration risk, which are
             associated with their advances to large members?
            What are the implications for the System’s ability to achieve its housing mission
             goals if member banks increasingly draw advances to help meet their liqudity
             requirements?
As the System’s regulator, FHFA routinely collects and assesses data by which these matters
may be addressed. Specifically, the Agency:

            Collects and reviews advance information, including trend data, on advances to
             large members and FHLBank concentration levels;
            Discusses advance trend information with FHLBank officials, including the
             reasons that advances are made to large members;
            Examines the FHLBanks to assess their compliance with safety and soundness and
             housing mission requirements;
            Reviews FHLBank advance pricing terms;
            Consults with other financial regulators on matters such as the reasons large
             commercial banks draw FHLBank advances; and
            Conducts reviews of the roles of at least one large bank within the System.


36
  As discussed earlier, members, other than the four largest, accounted for the increase in System assets in the
fourth quarter of 2013. It is possible, but not clearly demonstrated, that Basel III’s liquidity requirements
contributed to this increase in advances to smaller members.




                                     OIG  EVL-2014-006  April 16, 2014                                           22
In our view, FHFA could enhance awareness and understanding of FHLBank advances across
the government, financial industry, and the general public through its established reporting
processes or the issuance of a special report.37 Such action on FHFA’s part would render
more transparent the System’s operations, its overall safety and soundness, and its success in
achieving its housing mission.




CONCLUSION ............................................................................

Although System advances plummeted by about 62% to $381 billion from 2008 through
March 2012, they subsequently increased to $492 billion by yearend 2013 due primarily to a
surge in advances to the four largest members. This trend, if it continues and spreads to other
members, offers potential benefits to the System, including higher interest income and an
increased focus on regulatory-defined core housing mission assets. However, the surge
in advances to the four largest members also presents safety and soundness risks, such as
concentration risk, that must be mitigated. Further, the increasing use of advances by
members to meet Basel III’s liquidity requirements could raise public concerns about the
System’s commitment to its housing mission obligations. We believe that FHFA can take
steps to enhance transparency about recent trends in FHLBank advances and their potential
implications.




RECOMMENDATION .................................................................

We recommend that as FHFA collects and analyzes information on FHLBank advances to
large and other members in calendar year 2014, it report publicly on such items as advance
trends, the reasons for such advances, the effectiveness of FHLBank risk management
practices, the consistency of such advances with the System’s housing mission, and other
topics as deemed appropriate.




37
   FHFA has discussed critical risks in its previous annual reports to Congress. For example, the 2009 annual
report discussed the risks of the FHLBanks’ PLMBS investments and advances to insurance companies. See
FHFA 2009 Annual Report to Congress (online at
http://www.fhfa.gov/webfiles/15784/FHFAReportToCongress52510.pdf).




                                    OIG  EVL-2014-006  April 16, 2014                                         23
OBJECTIVES, SCOPE, AND METHODOLOGY ...............................

The primary objectives of this report were to document the surge in advances made to the
System’s four largest members, discuss possible reasons for it, identify associated benefits
and risks, and assess FHFA’s oversight activities.

To address these objectives, we interviewed officials in DBR and at two FHLBanks that have
made significant advances to large members.

We also reached out to the four largest System members to obtain their views. Two of the
members responded in writing and their responses are provided in attachment A to the report.
We conducted a telephone interview with a representative from another large member.
Officials from the fourth member chose not to respond to our inquiries. We did not pursue
additional actions to obtain the bank’s views as doing so was not considered critical for the
purposes of this evaluation.

We also reviewed FHLBank advance data provided by DBR, FHLBank financial summaries
and memoranda, financial statements for several large members of the FHLBanks, FHLBank
planning and examination reports, and findings memoranda and supervisory directives
associated with FHLBank examinations.

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
finding and recommendation discussed in this report meet these standards.

A draft of this report was sent to FHFA for comment. As presented in Appendix A, FHFA
agreed to OIG’s recommendation.38

The performance period for this evaluation was December 2013 and March 2014.




38
   OIG also provided sections of this report, respectively, to the FHLBanks and large System members whose
statements were cited in the report. Some responded with their comments and others did not.




                                   OIG  EVL-2014-006  April 16, 2014                                       24
ATTACHMENT A .......................................................................

Large Member Responses to OIG Questions about Their Use of System Advances

     1. We understand that your bank (through all your subsidiaries) has taken about
        $X billion in FHLBank advances since March 31, 2012, which is an X%
        increase in that period of time. Can you tell us what your Bank’s primary
        purpose was in drawing these advances?
        Bank A’s Response: There are actually two factors at play here: 1 – Our borrowings
        from the FHLB’s [sic] were historically low the past two years as we were in a program
        of reducing our “wholesale” funding footprint, both long and short term. The Federal
        Reserve’s long standing program of providing liquidity to the banking system had
        resulted in an outsized accumulation of deposits as a percentage of our aggregate funding
        need (thus reducing the need for wholesale funding). 2 – The increase in FHLB advances
        since our historically low levels of the past two years has been driven specifically by
        legal entity liquidity coverage ratio (LCR) requirements and our desire to build high
        quality and long term funding.39

        Bank B’s Response: The mission of the FHLB is to provide stable, low cost funding to
        mortgage originators in local markets. Bank B is a member of the FHLB system and is
        dedicated to supporting its customers by providing financing of local housing and
        community lending. Mortgage assets originated in local communities are eligible to
        collateralize competitively priced FHLB borrowings. The benefits of competitive FHLB
        pricing are incorporated in the rates offered to Bank B’s customers and support the
        FHLB’s mission to maintain affordable mortgage financing for U.S. consumers. FHLB
        borrowings also provide a diversified source of funding for Bank B.

     2. To what extent, if at all, did Basel III’s liquidity and other requirements play a
        role? Please explain.
        Bank A’s Response: Basel III’s legal entity LCR was the primary driver in our
        increasing FHLB advances in the past year. The increase in outstandings and the
        lengthening of our book directly relates to LCR and not the need for cash.

        Bank B’s Response: Bank B regularly evaluates the mix of liabilities on its balance
        sheet. The evolving liquidity rules under the Basel III regime generally require longer

39
   OIG note: The Liquidity Coverage Ratio (LCR) is the standard that banks must meet to be in compliance with
Basel III liquidity requirements. The LCR establishes the level of high quality liquid assets, such as Treasury
securities, that banks must hold.




                                    OIG  EVL-2014-006  April 16, 2014                                           25
tenor funding to be used to fund assets, including mortgages. As a result, Bank B has
modified the funding mix of its balance sheet and increased issuance across multiple
markets to diversify funding sources and improve its liquidity position as required by
Basel III. FHLB borrowings have expanded over the past 12-18 months to support the
mortgage business under the new liquidity regime.




                       OIG  EVL-2014-006  April 16, 2014                               26
APPENDIX A .............................................................................

FHFA’s Comments on FHFA-OIG’s Findings and Recommendation




                           OIG  EVL-2014-006  April 16, 2014                         27
OIG  EVL-2014-006  April 16, 2014   28
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:

          Call: 1–800–793–7724
          Fax: 202–318–0358
          Visit: www.fhfaoig.gov/ReportFraud
          Write:
                    FHFA Office of Inspector General
                    Attn: Office of Investigation – Hotline
                    400 Seventh Street, S.W.
                    Washington, DC 20024




                                OIG  EVL-2014-006  April 16, 2014                        29