Remarks as Prepared for Delivery
Edward J. DeMarco. Acting Director
Federal Housing Finance Agency
2013 Federal Home Loan Banks Directors Conference
Washington, D.C.
May 14, 2013
Introduction
Thank you for inviting me to speak today as part of the annual conference of the Directors of the 12 Federal Home Loan Banks. As members of the Board of a Federal Home Loan Bank (FHLBank or Bank), you each have an important role in setting the direction of your Bank and the Federal Home Loan Bank System.
There are a number of challenges that you all face in setting that direction. Today I will start by focusing on some near-term issues. Then I will discuss some issues to consider as part of the longer-term structure of our housing finance system.
Near-Term Issues
The Federal Home Loan Banks currently have advances outstanding of about $418 billion. At the onset of the economic downturn, advances increased dramatically from $640 billion in June 2007 to $1.0 trillion in September 2008, before declining fairly rapidly to current levels.
The decline in advances to their current level has a number of causes. Some are structural and may produce long-lasting changes for the FHLBanks. Others are cyclical and are likely to ease as the economic climate improves. But the difficulty in projecting future demand for advances lies in assessing the relative importance of the structural and cyclical factors.
Structural Changes Impacting the FHLBank System
Structural changes have affected both the composition of System membership and the value of membership in individual FHLBanks.
Consolidation in the banking industry accelerated during the crisis owing to bank failures and mergers. Consequently, many of the large borrowers of the past are no longer members of the FHLBank System or even in existence. Since 2008, when advance demand was at its peak, three of the top 25 borrowers, which accounted for 37 percent of total advances in 2006, have failed. Another eight have merged with other institutions. And since 2006, overall membership in the FHLBank System has declined from over 8,100 to just over 7,600 in 2012.
Structural changes that may have affected the value of FHLBank membership and the need for advances include the FDIC’s increased deposit insurance coverage from $100,000 to $250,000, and the Federal Reserve’s decision to start paying interest on reserves, making it cheaper for members to maintain higher deposit levels. Further, the FDIC now assesses insurance premiums based on average assets minus average capital rather than on insured deposits only.
Cyclical Changes
Affecting the FHLBank System The fundamental cyclical change is the slow economic recovery, which has spurred an increase in deposits at member institutions while a concurrent tightening of credit standards and reduced investment opportunities have reduced lending. Together these factors have reduced the demand for advances.
Other important cyclical changes include significantly lower than normal interest rates, which have reduced the rate of return on invested capital, and, in turn, earnings of the FHLBanks. The "flight to quality" and the reduced prepayment speeds on mortgage-related assets, have, however, generally helped FHLBank income through the recession.
Capital Levels
Congress created a capital structure for the FHLBanks that allows capital to expand and contract as business expands and contracts. Although the System has worked just as Congress intended in terms of capital, operating costs are not so easy to change prudently in the short run. Expanded enterprise risk management functions along with increased compliance and regulatory costs make prudent operating cost reduction more difficult.
Over the years from 2000-2013, capital in the System has served its intended purpose of protecting FHLBank creditors through one of the worst financial episodes in history. The 2012 capital-to-assets ratio of 6.7 percent compares with a 2001 ratio of 4.9 percent. Much of this increase is accounted for by an increase in retained earnings from 0.11 percent of assets to 1.37 percent. The build-up in retained earnings has been assisted by the retirement of the System’s obligation to the Resolution Funding Corporation, and the decision to use those funds to add to retained earnings. A number of FHLBanks hold substantial amounts of excess capital, and we gain some comfort in the restraint some FHLBanks have shown in leveraging that excess capital.
Core Mission Activities
As stated in a recent letter to the FHLBank presidents, the Federal Housing Finance Agency (FHFA) rule on strategic business plans requires each FHLBank to develop a strategic business plan that, among other things, must include "plans for maximizing activities that enhance the carrying out of the mission of the Bank," consistent with the Agency’s rule on core mission activities. As I noted in previous speeches, the composition of FHLBank balance sheets has changed over time, and it varies considerably among the FHLBanks.
By far the most significant of the core mission activities identified in the core mission activities rule are advances. For certain Banks, acquired member assets (AMA) also represent significant activity. As part of the process of developing the mission asset plan for 2014, we expect that other activities like letters of credit will also be highlighted. Of course, beyond these activities, the FHLBanks’ Affordable Housing Program and Community Investment Program required by statute also serve important mission responsibilities.
As I have noted in past discussions with many of you, the "Mission Letter" is the start of a process. But I would note a few points that have led FHFA to increasing its attention to core mission activities.
As advances and mortgage assets declined during the economic downturn, FHLBank balance sheets became less "mission oriented" and the share of total assets invested in advances plus mortgages shrunk from 75 percent in mid-2004 to their present share of 63 percent.
Now that the nation’s housing markets are beginning to recover, and the FHLBanks are emerging from the effects of the recent financial crisis, FHFA is increasing its regulatory attention on the FHLBanks’ dedication to their mission, and on ensuring that they are not using their GSE funding advantage for purposes other than housing finance and community development.
FHFA recognizes that while advances and AMA are both mission assets, they are not the same from a risk perspective. In 2000 and 2001, the FHLBanks had little in the way of mortgage loan holdings. By 2004, however, mortgages accounted for 13.7 percent of their assets. Since then, mortgage holdings have declined to less than half that level. Today, only the FHLBanks of Cincinnati, Indianapolis, Des Moines, and Topeka are very active in purchasing whole loan mortgages from members. Evidence from the mid-2000s suggests that FHLBanks have difficulty managing the interest rate risk of mortgage portfolios that expand much beyond 15 percent of assets, and some FHLBanks have exhibited such difficulty with even smaller mortgage portfolios. The FHLBanks need to keep this in mind when setting their strategic plans for carrying out the mission of the System.
Our focus on mission assets is not only an exercise in adhering to the essential mission for which Congress designed the System, it stems from safety and soundness concerns based on recent experience. FHLBanks started the previous decade with roughly $50 billion in private-label mortgage-backed securities. These holdings peaked at $85 billion in 2006 before falling to their current level of less than $25 billion. To date, the FHLBanks have incurred credit losses on these securities of $4.1 billion. The losses on private-label securities, though they now appear likely to be significantly lower than earlier feared, provide the FHFA with reason for concern about FHLBanks straying from their core business of making advances. Similarly, large increases in unsecured credit portfolios create FHLBank exposure to counterparty risk.
FHFA recognizes that the pursuit of mission assets may require changes in collateral risk management. For example, one avenue for increasing advances that some FHLBanks have been rigorously pursuing of late is increased lending to insurance companies. Advances to insurance companies have increased from one percent of advances in 2000 to 14 percent in 2013. Advances to insurance companies now exceed 50 percent of total advances at two FHLBanks, Indianapolis and Des Moines, and the number of insurance company members in the System is now 263.
Lending to insurance companies has been permitted since the creation of the FHLBanks in 1932. This is not an issue. The point is that lending to insurance companies presents different risks than lending to insured depository institutions. The differences principally arise from the lack of experience working through an insurance company failure given a dearth of insurance company receiverships. In addition, the FHLBanks have a long-standing working relationship with the FDIC, and limited experience working with state insurance regulators. Hence, our consistent message is for each FHLBank to have a good working relationship with each state insurance regulator and to ensure appropriate control over the collateral for advances.
Another potential source of substantial increases in advance volume is the pursuit of large member borrowers, some of which are separately chartered subsidiaries of bank holding companies with other subsidiaries chartered in other FHLBank districts. As many of you well know, some policymakers have questioned the suitability of FHLBank borrowing by very large depositories given that they have other funding sources. And while lending to large borrowers may appear to be a needed source of revenue, it also creates significant concentration risks for some FHLBanks. A large reduction in borrowing from such members can have a dramatic effect on the Bank’s risk exposures, capital management and asset mix. And if a large member borrower is part of a multi-bank holding company with charters in multiple FHLBank districts, it could also redirect funding from one FHLBank to another and cause price competition for advances among FHLBanks.
Finally, we all need to recognize that, depending on how well advance demand recovers along with the economy, some FHLBanks may have difficulty maintaining both a sufficient focus on mission assets and a sustainable size. Very rough FHFA estimates and conversations with FHLBanks put the sustainable size for a mission-focused Bank to be somewhere in the neighborhood of $20 billion in assets. If maintaining enough mission-focused business to cover operating costs becomes a problem, the System should be prepared to consider the tools available to economize on expenses while ensuring district members retain access to the System’s benefits.
All in all, the mission focus of the System is a crucial issue in front of the FHLBanks and the FHFA in the coming years. We look forward to receiving the FHLBank responses to the "Mission Letter" and to developing a rational way to think about this responsibility as we move forward.
The Future Housing Finance Market and the Federal Home Loan Banks
Let me turn now to the future of the housing finance system and the potential role the FHLBanks may play.
Clearly, resolving the conservatorships of Fannie Mae and Freddie Mac are central to the future of the secondary mortgage market. But the FHLBanks can and should be a part of the larger discussion of our housing finance system. The FHLBanks have long been a conduit to global capital markets and they currently provide secondary mortgage market services to their members in several ways. Through their AMA programs (MPP and MPF), the FHLBanks buy whole loan mortgages directly from members and hold them in portfolio. Importantly, these programs demonstrate one approach to lender risk retention in mortgage lending and the credit performance of these loans was better than most other segments of the market the past several years. Several FHLBanks participate in the MPF Xtra program aggregating loans from originators and passing them on to Fannie Mae for securitization.
When I spoke before you last year, I noted that FHFA had submitted to Congress a Strategic Plan for the next chapter of the conservatorships. Two key goals of this plan are building a new infrastructure for the secondary market and contracting Fannie Mae and Freddie Mac’s market footprint over time.
I recently testified before Congress on some of the options available for fixing the current flawed model of the housing finance market. I think it is clear that the government’s role in housing finance will not recede to zero, but there appears to be consensus among policymakers that we need to get private capital back into the market. Just last week I expanded on two options in a speech before the Federal Reserve Bank of Chicago’s Annual Conference on Bank Structure and Competition.
One way to do it is through issuers of mortgage-backed securities or other financial institutions guaranteeing the credit on those securities by maintaining appropriate levels to capital. Typically, this approach includes an explicit government guarantee on the securities that are issued.
In general, proposals to establish an issuer-based future structure with a government guarantee have some common elements. These proposals would rely on federally chartered or other approved institutions that would have the ability to issue explicitly guaranteed securities. The entities would be regulated for capital adequacy and overall safety and soundness, and there would be a payment of an insurance fee to the federal government for the use of the explicit guarantee. These types of proposals make clear that the government guarantee would only apply to securities issued, and not to the equity of actual issuers.
While that sounds like a novel concept, it is similar to the Fannie Mae and Freddie Mac model. Pre- conservatorship, the Enterprises were said to benefit from an implicit guarantee. There was a safety and soundness regulatory structure, but it did not have a full range of powers. In the end, the securities, both debt and MBS, issued by the Enterprises were provided financial support by Treasury, while the shareholders have not benefited from that support.
There are benefits to this model, like a providing a stable source of funds for housing credit. However there are also a number of questions, like appropriate pricing for the government guarantee, likely interest in the government allocating credit, and a general over allocation of credit to housing.
Clearly, the FHLBanks could continue playing their traditional role under an issuer-based approach. And they may be able to expand upon the limited loan aggregation role they are playing today. Over the years, there has been some discussion of the FHLBanks becoming guarantors of mortgage-backed securities. While that expanded role could be possible under this approach, given past history, and what appears to be a general desire to move away from a government sponsored enterprise-based model, that outcome seems doubtful.
Another approach is for securities to be issued or structured in such a way that market participants themselves advance the capital to absorb credit risk. In a securities-based approach, as opposed to credit risk being absorbed by the equity of the securities issuer, credit risk would be absorbed through capital markets. While this approach could have a government guarantee, it relies on transparency and clear rules to attract private capital.
To a large degree, this is what the old private-label MBS market did. We know that even though the old private-label MBS market functioned in a way to distribute credit risk, in the end it was not durable and led to a misallocation of credit risk in its own right. But was the problem with the concept or the lack of infrastructure, standards, and rules to govern the market? In my own view it was not the concept, but the lack of an appropriate infrastructure.
To a large degree, what I am describing is a standard-setting approach that would replace some of the standard-setting that the Enterprises undertake today. Replacing the Enterprises would be a regulatory regime or a market utility that sets those standards. This model need not rely on a government guarantee to attract funding to the mortgage market, but rather would look to standardization and rules for enforcing contracts.
What the securities-based approach would be establishing is a market infrastructure for the pricing and capitalizing of mortgage credit risk. If such an approach were established, it would allow for the broader disposition of credit risk across capital market investors, as opposed to the equity investors in the issuer-based approach. It also raises a number of questions, like increased volatility and access for smaller institutions.
In a securities-based approach, I would think the role of the FHLBanks could increase in important ways.
To establish a liquid non-government guaranteed market there would seem to be a need to have greater homogeneity in borrower characteristics. For borrower characteristics that do not fit neatly into the secondary market, we need to find a way to get insured depository institutions back into the business of funding mortgages. Understanding individual borrowers and special circumstances is at the heart of the financial intermediation function of banks, thrifts, and credit unions.
The System can help preserve the option for local financial institutions to make mortgages in their communities, and hold those mortgages on the their balance sheet by developing more and innovative funding products that reduce interest rate risk to their members and that global capital markets participants would purchase.
For smaller institutions that do not want to hold mortgages on their balance sheet, a constant question about this approach is how will they have access to capital market investors. An often suggested solution is to establish some type of cooperative to meet the needs of these institutions. I would note that we already have one in the FHLBanks. The aggregation function would seem to be a clear role for the FHLBanks in this type of approach. Much like they do with other functions, the FHLBanks would be providing a service to members, and one that would not require taking on the same amount of credit risk as in a guarantor role.
Conclusion
The FHLBank System has experienced numerous changes over the last few decades, but it has consistently played an important role in housing finance. Over this time, by providing member institutions with reliable funding and other important products and services, the FHLBanks have delivered to their members a reliable source of liquidity to meet short-term and long-term funding needs. As the debate on housing finance reform moves forward, I expect there will increased attention on the activities of the FHLBanks, and how the FHLBanks fit into the future structure housing finance.
I have outlined a few potential roles today, and look forward to further discussing those and other issues with you.
Contacts:
Corinne Russell (202) 649-3032 / Stefanie Johnson (202) 649-3030