oversight

Capital Structure of the Federal Home Loan Bank System

Published by the Government Accountability Office on 1999-08-31.

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

                                                                                                                                 .
eGA0    Accountabilii   * Integrity   l   Reliability

United States General Accounting Office                                                                    General Government Division
Washington, D-C. 20548




                        B-283453

                        August 31,1999

                        The Honorable Richard H. Baker
                        Chairman, Subcommittee on Capital Markets, Securities and Government-Sponsored
                          Enterprises
                        Committee on Banking and Financial Services
                        House of Representatives

                        The Honorable Paul E. Kanjorski
                        Ranking Minority Member, Subcommittee on Capital Markets, Securities and Government-
                          Sponsored Enterprises
                        Committee on Banking and Financial Services
                        House of Representatives

                        Subject: Car&al Structure of the Federal Home Loan Bank Svstem

                        This letter responds to your July 27,1999, request that we summarize our past positions and
                        recommendations regarding the capital structure of the Federal Home Loan Bank System
                        (System). As stated in your request letter, selected House and Senate members will soon
                        confer on H.R. 10 and S. 900, the financial modernization bills (Bills) passed this year. The.
                        Bills provide for changes in the System and its regulator, the Federal Housing Finance Board
                        (FHFB). In our previous work, we recommended that Congress reform the existing capital
                        structure. In your letter, you aclmowledged the extensive body of work we have produced on
                        the System and its capital structure; You further stated that a summary of our past positions
                        and recommendations regarding the capital structure of the System would be useful in
                        reviewing and discussing H.R. 10 and S. 900 during conference.

                        Results in Brief
                        We have consistently supported the establishment of risk-based capital standards applied in
                        combination with a leverage ratio that requires a minimum capital-to-asset ratio for the
                        System.’A risk-based capital standard offers a number of benefits that include giving the

                        ‘See Government-SDonsored Enterorises: A Framework for Limitina the Government’s Exposure to Risks (GAO/GGD-91-90,May
                        22,lSSl); Federal Home Loan Bank System: Reforms Needed to Promote Its Safetv, Soundness. and Effectiveness (GAO/GGD-
                        94-38, Dec. 8,1993); Bill Comment on proposed legislation entitled “The Federal Home Loan Bank System Modernization Act of
                        1995” (Oct. l&1995); and Bill Comment on proposed legislation entitled “The Enterprise Resource Bank Act of 1996”
                        (GAOIGGD-96-140R,June 27,1996).




                        Page    1                                                       GAOIGGD-SS-177R      FHLBank    System   Capital   Strncture
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government a mechanism to influence the System’s risk-taking without involving itself in the
System’s daily business. In supporting the establishment of risk-based capitai standards, we
have recommended that System capital should be made more permanent. There are a
number of ways this could be achieved, including increasing the time period for repayment
after terminating membership or establishing capital requirements that provide for minimum
retained earnings in each Federal Home Loan Bank (FHLBank).

Background
The System is a government-sponsored enterprise (GSE) consisting of 12 federally chartered,
privately owned FHLBanks located in Boston, NLA;New York, NY; Pittsburgh, PA; Atlanta,
GA; Cincinnati, OH; Indianapolis, IN; Chicago, IL; Des Moines, LA; Dallas, TX; Topeka, KS; San
Francisco, CA; and Seattle, WA, with each FHLBank serving a defined geographic region of
the country. The FHLBanks raise funds by issuing consolidated debt securities in the capital
market. Each FHLBank is subject to a capital rule based on a leverage ratio that requires
capital to be at least a fixed proportion of assets. Currently, the combination of statutory
capital requirements and FHFB regulations resuhs in a 4.76 percent leverage requirement.
The System was set up in 1932 to extend mortgage credit by making loans, called advances,
to its member institutions, which in turn lend to homebuyers for mortgages. Advances are
secured by home mortgage loans and other collateral. To date, collateral has included U.S.
Treasury securities, deposits at a FHLBank, and a Iimited amount of other real estate-related
collateral. These advances help member institutions, originally limited to thrifts, by
 enhancing Iiquidity and providing access to national capital markets. In 1989, as part of the
 Financial Institutions Reform, Recovery, and Enforcement Act, Congress opened
 membership to non-thrift federally insured depository institutions that offer residential
 mortgage loans. As of June 30,1999, the F’HLBanks held about $330 billion in advances to
 members; $148 billion in investments; and $25 billion in capital, of which $550 million was in
 the form of retained earnings. In addition, the System had 7,101 members, which included
 5,112 commercial banks, 1,618 thrifts, and 371 credit unions and insurance companies.

The Bills include a number of provisions related to the System that would, among other
things, change the basis for membership in the System from a mix of voluntary and
mandatory to ah voluntary and expand the purposes of System advances with corresponding
expansion in eligible coIIateral.

 Scope and Methodology
 We reviewed provisions concerning reforms in the capital structure of the System in H.R. 10
 and S. 900. To summarize our past positions and recommendations regarding the capital
 structure of the System we reviewed reports and bill comments on the System and FHFB
 that we issued between 1993 and 1998. We also reviewed our 1990 and 1991 reports on the
 government’s exposure to risk from GSE activities.

 We obtained oral comments from FHF’B on a draft of this letter. These comments are
 discussed near the end of this letter. We conducted our work in Washington, D.C., during the
 month of August 1999 in accordance with generally accepted government auditing standards.



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System Capital Should Be Risk-Based and More Permanent
We have consistently supported the establishment of risk-based capital standards applied in
combination with a leverage ratio that requires a minimum capital-to-asset ratio for the
System. For financial purposes, capital is generally defined as the long-term funding for a
firm that cushions the firm against unexpected losses. Losses are caused by exposure to
various risks the financial firm faces in its business activities. The federal government has no
legal obligation to.protect GSE creditors, but there is a widespread perception in the financial
markets that during a financial emergency the U.S. government would rescue a GSE. This
perception weakens private market discipline. A risk-based Capital standard has a number of
benefits that include giving the government a mechanism to influence the GSE’s risk-taking
without involving itself in the GSE’s daily business. Such a mechanism could become more
important for the System as it engages in new FTILBank activities initiated over the past 3
years and because of potential expansions in the purposes of System advances authorized by
the Bills. In addition to supporting the establishment of risk-based capital standards, we have
recommended making System capital more permanent.

FHLBank System Faces a Number of Risks
The primary risks inherent in System activities are interest-rate risk, credit risk, and
operations risk. FHLBanks are exposed to interest-rate risk because they face possible losses
and changes in the value of their portfolios due to changes in interest rates. Credit risk is the
potential for financial loss from a borrower or counter-party failing to perform on an
obligation. Operations risk is the potential for unexpected financial loss arising from
inadequate information systems, operational problems, breaches in internal controls, or
fraud.

Risk-Based Capital Standards Provide Incentives to Avoid Undue Risk
Requiring capital sufficient to balance a GSE’s risks provides several public benefits. It gives
the government a mechanism to influence a GSE’s risk-taking without involving itself in the
GSE’s daily business. A risk-based capital standard also helps ensure that the GSE’s
shareholders have incentives to demand that management not take undue risks, since
increased risk taking would impose costs resulting from raising additional capital to meet a
risk-based capital standard. In addition, a risk-based capital standard gives some assurance
of a buffer adequate to absorb unforeseen GSE losses and thus to prevent or reduce potential
taxpayer losses.

The potential for moral hazard’ exists in the System in three dimensions, with each F’HLBank
having an incentive to take on greater risk because some losses could be borne by others.

‘The term “moral hazard” has been deEned as “a description of the incentive created by insurance that induces those insured to
undertake greater risk than if they were uninsured because the negative consequences are passed through to the insurer.” In this
context, the possibility that a F’HLEWk could become troubled would create a moral hazard.,because U.S. taxpayers, the other
F’HLBanks, and the deposit insurance funds could in effect become the insurers of the troubled F’HLBank’s activities. In such a
situation, the troubIed FHLBank would have incentives to undertake risky activities because profits would accrue to the
FHLBank’s owners, whereas losses could fall on others.




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B-283453


First, US. taxpayers are at risk due to the possibility that the US. government would come to
the rescue of the System during a financiaI emergency. Second, the FTKBanks are jointly and
severally liable for the System’s outstanding debt securities. Therefore, all F’HLBanks are at
risk due to the possibility that a F’HLBank could become troubled and not be able to meet its
debt obligations. Third, the System has lien status in which advances generally have priority
over other security interests, including insured deposits, in the assets of failed insured
financial institutions. Therefore, the deposit insurance funds may be at risk to the extent that
a F’HLBank provided advances to a troubled federally insured member that subsequently
failed. Authorizing F’HFB’s promulgation of risk-based capital standards would provide
FHF’B with a mechanism to limit moral hazard.                    -

In our 1993 report on the System, we recommended that the current capital stock
requirements and the F’HLBanks’debt-to-equity limit be replaced by a risk-based capital
requirement analogous to that used for banks and thrifts3 We stated that the risk-based
capital framework developed by U.S. banking regulators provides only a rough measure of
credit risk and fails to account for interest rate or other risks, such as operations risk. Thus,
we stated that regulators should supplement the risk-based requirement with a leverage
requirement, which requires a minimum capital-to-asset ratio.

Of the methods available for setting capital standards, we have concluded that a combination
of stress tests and a leverage ratio would best cover all the risks undertaken by a GSE such as
the System. Stress tests are empirically based tests that can project capital levels required for
measurable risks-that is, credit and interest-rate risk. These tests are especially applicable
to GSEs in a single line of business, because economic conditions that are adverse to the
business are more easily identified in this case.

Risks in New Activities Should Be Balanced With Adequate Capital
Currently, the principal purpose of System advances is to provide funds to any member for
residential housing finance. The BiUs would expand the purposes of System advances.
Purposes listed in S. 900 include providing funds to any community financial institution” for
small businesses, small farms, and small agribusinesses. Purposes listed in H.R. 10 include
providing funds to any community financial institution for small business, agricultural, rural
development, or low-income community development lending. The Bills specify
corresponding expansions in eligible collateral for System advances.

The broader mission and additional eligible collateral could lead to an increase in the
taxpayers’ potential exposure to risk because it is likely to lead to expanded System activity,
possibly in higher risk assets.’



 “GAOIGGD-94-38,Dec. 8,1993, p. 69.

 “A community financial institution is defined in the Bills as a FDIC-insured institution that has less than $500 million in assets.

 %AO/GGDSB140R, June 27,1996, p. 5.




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The System’s hen status would mitigate, to some extent, each FEiIBank’s credit-risk exposure
resulting from expansion into new advance activities and associated collateral. FHJ?B
regulations require that advances be fully secured and subject to a written security interest in
the collateral. Current law provides that the FHLBank’s security interest generally has
priority over the claims and rights of any party, including receivers, conservators, and
trustees. However, the System’s lien status increases potential credit risk to the deposit
insurance funds to the extent that a FE&Bank provided advances to a troubled federally
insured member that subsequently failed.

As well as being providers of advances, the FHLBanks have Grge investment portfolios. In
addition, over the past 3 years, FHFB has approved pilot programs that have authorized the
FHLBanks to make new types of investments and share risks with System member
institutions. FHLBank investments do not have the same priority over other security
interests as advances, and therefore investments can increase credit risk as well as interest-
rate risk. According to testimony by the FHFB Chairman, FHFB began to follow a strategy
“. . .to encourage the development of additional mission-related assets.. . n as an outgrowth of
concerns about nonmission-related investments.” Thus far, FHFB has authorized four pilot
programs ranging in size from $25 million to $9 billion. In general, the programs involve
FHLBank funding or financing for housing in new ways. For example, in one program, the
FHLBank purchases participation interests in affordable multifamily housing loans originated
by a consortium of small banks that are mostly FHLBank members. Another program offers
?ZHLBankmembers a different alternative to holding loans in their own portfolios. In this
program, the FHLBank is to fund and retain in its portfolio the loans originated, serviced, and
credit-enhanced by members. The risks are to be shared betvveen the members and the
FHL&nk.

Taken as a whole, expansion in new F’HLBank activities and the expansion in eligible
collateral authorized by the Bills could lead to an increase in the taxpayers’ potential
exposure to risk. In previous work, it appeared to us that new expertise would be required of
F’HLBank management in an environment with expanded mission and collateral, because
without a thorough understanding of the risks associated with the new collateral and lending
activities, it may be difficult to properly monitor and manage the risks.’ Here we also note
that each of the 12 FHLBanks serves a defined geographic region of the country. Such
geographic containment may contribute to concentration of credit risk.* Based on these
observations and on our past positions and recommendations, establishment of risk-based
capital standards, in addition to a leverage ratio, could become more important for the
System, considering the potential for increased risk-taking by each of the 12 FHLJ3anks.


%atement of Bruce Morrison, Chairman of the Federal Housing Finance Board, Before the Subcommittee on Financial
Institutions and Regulatory Relief of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 24,1997.
‘GAOIGGD-96140R,June 27,1996, p. 11.
‘Concentration of credit risk could increase risk for (1) all FHJ3ank.s due to the possibility that a FHLBank could become
troubled and not be able to meet its debt obligations and (2) the deposit insurance funds to the extent that a FHLBank provided
advances to a troubled federally insured member that subsequently failed. However, concentration of credit risk would not
likely increase risk for U.S. taxpayers because the FHLBanks are jointly and severally liable for the System’s outstanding debt
securities.




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B-283453


Designing a stress test for the System, given the mix of differenttypes of business a&vi@-the
Bills would authorize, would be a difficult task For example, evaluating the value of
collateral for commercial loans, such as those to finance multifamily housing, small business,
and agricultural activities, can be difficult due to the heterogeneity of the business activities.
For F’HL,Bank investments in such activities, it may not always be possible to design a stress
test to quantify the credit risk. In this and other situations where risks cannot be quantified,
we have concluded that a leverage ratio is still necessary to cover such risks9 Given the
challenge F’HFB would likely have in quantifying credit risk from new activities, the
appropriate role and level for a leverage ratio would logically be inversely related to the
extent to which such credit risk could be quantified.

To Provide a Suitable Cushion Aminst Unexpected Losses, Capital
Should Be More Permanent
Common equity capital provides a cushion against unexpected losses, because individual
stockholders cannot demand that the firm redeem the stock. In contrast, System capital from
voluntary members does not provide a cushion against unexpected losses, because voluntary
System members may withdraw from the System and redeem their stock. Current
requirements for FHLBank capitalization are based on stock purchase requirements by
member institutions. A voluntary member that wishes to withdraw from the System must give
6 months’ notice. If impairment of the FHLBank’s capital is likely, FYIFB can withhold a
portion of a withdrawing member’s capital stock. In our 1993 report, we raised the possibility
that if pending losses threaten the value of a FHLBank’s stock, the FHLBank’s vohmtary
members may try to withdraw their stock before the losses impair its value. We also
concluded that, as a practical matter, the degree to which FHFB’s authority makes FHLBank
stock a buffer for absorbing losses depends on the extent to which FHFB exercises its
authority to withhold stock redemption. We stated that for FHFB to use this authority in a
way that makes capital stock a meaningful buffer, FHFB would have to recognize potential
future losses in a timely manner and be willing to withhold proceeds from stock redemption
requests.

To address this concern, we have recommended that System capital from voluntary member
institutions should be more permanent in order to provide a suitable cushion against
unexpected losses in the System. There are a number of ways greater permanence could be
achieved, two of which were addressed in our previous work. In our 1995 bill comment, we
noted that the pending legislation would have increased the time period for repayment after a
member terminated membership from 6 months to a minimum of 12 months. This is one way
of increasing the permanence of System capital.

 Another way of increasing the permanence of System capital was addressed in our 1993
 report. We recommended that the new capital requirements provide for minimum retained
 earnings in each FHLBank, and that these retained earnings should, at a minimum, protect
 against the measurable risk undertaken by each F’HLBank as well as the associated

 ‘GAO/GGD-96140R, June 27,1996, p. 16.




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B-283453


management and operations risks. Since retained earnings represent funds that are not
distributed to members, they would provide a source of permanent at-risk capita3 held by
FHLBanks.

Conclusions
We have consistently supported the establishment of risk-based capital standards applied in
combination with a leverage ratio for the System. Such a mechanism could become more
important for the System considering new FIXBank activities initiated over the past 3 years
and expansions in the purposes of System advances authorized by the Bills. At the same
tune, some of these additional credit risks may be difficult to quantify, and therefore the role
of the leverage ratio, in combination with a new risk-based capital standard, could also
become more important. Finally, we have also concluded that System capital would have to
become more permanent if it is to provide a cushion against unexpected losses.

Agency Comments and Our Evaluation
We provided a draft of this letter to FHF’B for comment. F’HF’B’sDirector, Office of Policy,
Research, and Analysis, provided comments in two areas discussed below and also provided
a number of technical comments, which we incorporated where appropriate. First, he stated
that real risks need to be backed by real, permanent capital. He cited a principle from our
May 1991 report stating that the elements of regulatory capital should include only those
items that protect the govermnent’s interests. He added that- our December 1993report noted
that capital requirements must ensure an adequate amount of permanent at-risk capital based
on measurable risk and that retained earnings were the only source of permanent capital in
the System. He suggested our letter emphasize that retained earnings are not necessarily the
only source of permanent capital and that Congress could act to create a nonredeemable
class of stock that, in their view, could also serve as a permanent buffer against loss and
provide a positive incentive for building retained earnings.

We added statements to clarify that there are a number of ways to make capital more
permanent in addition to those discussed in our previous work. In our 1993 report, we stated
that, from 1987 through 1991, Congress appropriated most of the System’s retained earnings
to help cover deposit insurance fund losses resulting from savings and loan failures.
Therefore, we emphasized retained earnings as a source of permanent capital. In our 1995
bill comment, we noted that the pending legislation would have increased the time period for
repayment after a member terminated membership from 6 months to a minimum of 12
months. At that time, we emphasized the impact of the legislative proposal on the
permanence of System capital. While a nonredeemable class of stock could also serve as a
permanent buffer against loss, there are tradeoffs between establishing permanent capital
and creating incentives for the System to provide their members with value. In our 1996 bill
comment, we stated that all-voluntary membership should give System managers a stronger
incentive to provide their members with value for their membership, lest the members
redeem their stock and invest their funds elsewhere.




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Second, he stated that statutory capital requirements for GSEs should not create “uneven
playing fields.” He cited a principle from our May 1991 report stating that a minimum capital
requirement should avoid giving any GSE an undue advantage or disadvantage in competing
with other market participants. He added that the capital provisions in H.R. 10 would
establish equal statutory minimum capital leverage requirements for the FHLBanks, Fannie
Mae, and Freddie Mac.

The minimum capital requirement principle discussed in our report addressed the
combination of leverage and risk-based requirements. We have also supported the principle
that capital requirements should take into account differences in the lines of business and
associated risks among financial institutions. Thus, our principles do not necessarily support
the establishment of equal statutory minimum capital leverage requirements for the
FHLBanks, Fannie Mae, and Freddie Mac.

As agreed with your offices, we plan no further distribution until 30 days from the date of
this letter unless you publicly release its contents earlier. We will then send copies to
Representative Jim Leach, Chairman, and Representative John LaFalce, Ranking Minority
Member, House Committee on Banking and Financial Services; Representative Tom Bhley,
Cha&rnan, and Representative John Dingell, Ranking Minority Member, House Committee on
Commerce; Senator Phil Gramm, Chairman, and Senator Paul Sarbanes, Ranking Minority
Member, Senate Committee on Banking, Housing, and Urban Affairs; and the Honorable
Bruce Morrison, Chairman of .FHFB. Copies will be made available to other interested parties
upon request.

Please call me or Bill Shear, Assistant Director, at (202) 512-8678if you or your staffs have
any questions concerning this letter. M. Kay Harris and Orice Williams also contributed to this
letter.




 Thomas J. McCool
 Director, Financial Institutions and Markets Issues




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