America’s “Other” GSE Problem: The Federal Home Loan Banks, Part I
President Donald J. Trump recently announced that, while his administration intends to “privatize” Fannie Mae and Freddie Mac, both enterprises will retain their guarantee from the federal government. Yet, the nexus between politics and finance in the United States is labyrinthine. Since at least 1916, one of the primary drivers of the federal government’s interference in financial markets has been a gradually expanding network of quasi-governmental enterprises that, through the privileges allotted to them by their congressional charters, exert a strong influence over the direction and kinds of credit available to American consumers. One of the oldest and, until recently, perhaps least well known of these is the Federal Home Loan Bank (FHLB) system.
Created in 1932 to serve as a lender of last resort for thrifts and other mortgage lenders who lacked access to the Federal Reserve (Fed)’s discount window, the banks have since expanded into a generalized provider of liquidity to all member financial institutions. Structured like the Fed, with 11 regional banks serving distinct separate districts across the country, the FHLBs reappeared in the public’s eye in the aftermath of the March 2023 banking turmoil, when it was revealed that Silicon Valley Bank (SVB) and its cohorts had borrowed heavily from their local FHLB. This was only the most recent iteration of the system’s tendency to extend credit to financially struggling or insolvent institutions.
The source of these issues lies in the FHLB’s status as a government-sponsored enterprise (GSE) and the privileges this entails. The system has a credit line with the Treasury, its debt is eligible for purchase by the Fed, and is exempt from taxes on its earnings and interest payments. Moreover, the FHLBs possess a “super lien” that places them ahead of other creditors, including the Federal Deposit Insurance Corporation (FDIC), to be paid back when a borrower institution fails. The cumulative effect of these privileges is that the system, much like Fannie Mae and Freddie Mac, enjoys the backing of taxpayers. As a result, the system can borrow at rates similar to those paid by the Treasury in debt markets, allowing it to provide a substantial subsidy to member institutions, the net value of which has been recently estimated at around $6.9 billion.
The FHLB’s collateralized lending has consistently undermined market discipline and incentivized excessive risk-taking among financial institutions, particularly during periods of economic stress. In so doing, the FHLBs have served to magnify the losses of bank failures and transfer risk to taxpayers. This tendency of the FHLBs to undermine market discipline has been apparent throughout their history, as the following case studies illustrate.
The Savings and Loan Crisis
For the first 50 years of its existence, the thrift industry was the primary client of the FHLB system. With the onset of inflation during the 1960s, many thrifts began to experience financial issues as their borrowing costs recurrently exceeded the revenues from their mortgage portfolios. Congress pursued a variety of remedies to these ongoing problems, including raising the deposit insurance limit, establishing “creative” accounting measures, and expanding thrifts’ lending abilities, allowing them to increase their holdings of risky assets.
Armed with expanded powers, many insolvent thrifts exploited government deposit insurance and FHLB advances to “gamble for resurrection,” making high-risk, high-reward loans. For many, these bets failed, exacerbating the crisis. Indeed, the Government Accountability Office (GAO), in surveying the 155 thrifts that failed between 1984-1987, found that their use of FHLB advances grew by 84 percent in the two years before their failure, while their total assets grew by 51 percent. Elsewhere, a team of Fed economists found that of the 205 thrifts that failed at the crisis’s peak in 1988, 76 percent had borrowed from their local FHLB three years before their failure, sometimes as much as 35 percent of their assets. In the final year of their operation, this percentage rose to as high as 72 percent as dying thrifts increasingly relied on advances to fund assets. This compares to solvent thrifts, only 40 percent of which borrowed from an FHLB. Examining thrift financial data from 1985-1991, the authors also found that “financially distressed thrifts tended to borrow more on average than financially stronger thrifts. We also find that FHLBank advances increase when assets are riskier.” Specifically, advances increased with thrift holdings of commercial real estate, acquisition and development, and non-mortgage loans, all of which were considered riskier than traditional residential mortgages. Moreover, larger institutions tended to make greater use of advances, and because these are not risk-priced, were often used to substitute for fleeing deposits and more expensive forms of liquidity, such as repurchase agreements or brokered deposits.
In sum, failing thrifts took advantage of the subsidized lending offered by FHLB advances to attempt to resurrect themselves by funding riskier asset portfolios and avoiding paying the market rate for cash. When these institutions eventually failed, the FHLB’s super-lien status meant that the banks were ahead of the Federal Savings and Loan Insurance Corporation to be paid back, thereby increasing the cost to the insurance fund and likely contributing to its collapse and bailout. The FHLBs did not create the savings and loan crisis; nevertheless, by insulating poorly managed thrifts from market discipline and by allowing them to shift the costs of their risk-taking onto the insurance fund, they ultimately contributed to the magnitude and expense of the crisis.
The 2008 Financial Crisis
At the outset of the financial crisis, the FHLBs lent heavily to commercial banks and thrifts, outpacing for a period even the Fed and earning the label as the country’s “lender of next-to-last resort.” Commercial banks, particularly large financial institutions, turned to the FHLBs because advances were simply cheaper than borrowing from the Fed or using market-based forms of liquidity. The FHLBs were able to finance this increase in demand for advances because investors turned toward the system’s debt for the security offered by the implied guarantee these instruments enjoy from the federal government. Overall, the FHLB’s dominance lasted until the fall of 2008, when, after creating several special lending facilities and lowering its discount rate, banks began to shift their borrowing back toward the Fed.
There is evidence that FHLB lending during the financial crisis reduced market discipline and was a source of moral hazard. Examining those large financial institutions that failed during the financial crisis, a team of economists from the University of Arkansas found that as the likelihood of their failure increased, the FHLBs failed to restrict their lending to these banks. Indeed, in the eight quarters before they failed, these large financial institutions increased their holdings of FHLB advances from $13.5 billion to $17.2 billion two quarters before failure. It was only in the quarter before their failure that the FHLBs reduced the total advances they had outstanding with these institutions down to $15.7 billion. Summarizing their findings, the authors state “that prior to the financial crisis, FHLBs extended large shares of advances to 16 influential bank members that eventually failed or received FDIC open bank assistance. The FHLBs renewed the funding at four of those banks even when the insolvency risk was sufficiently high that private at-risk lenders restricted lending.” A separate study from the Federal Housing Finance Agency’s Office of Inspector General found similar results.
The March 2023 Banking Crisis
The frailties that gave rise to the failures of SVB, Signature, and First Republic banks in early 2023 bear a striking resemblance to those that caused the savings and loan crisis. All three banks relied heavily upon uninsured deposits (that is, deposits that exceeded the FDIC’s $250,000 insurance limit) to fund long-term, fixed-rate investments. The banks’ failure to manage their interest rate risk properly meant that, as the Fed raised interest rates, the opportunity cost to depositors increased, while simultaneously reducing the value of their assets. As these losses accumulated, uninsured depositors began to pull their funds from the banks.
By early 2023, all three banks were insolvent. Rather than recognize this by selling their depreciated assets, issuing equity, or borrowing at market rates reflective of their troubled financial positions, they turned to their local FHLBs to shore up their balance sheets. The GAO found that “between the first quarter and the fourth quarter of 2022, the three failed banks’ proportions of uninsured deposits decreased, while their proportions of FHLBank advances increased.” By Jan. 1, 2023, SVB and First Republic accounted for 15 percent and 14 percent of the San Francisco FHLB’s borrowing, respectively, while Signature Bank held 11.3 percent of the New York FHLB’s outstanding advances. By March 1, these shares had increased to 20 percent and 19.4 percent for the former two banks, while decreasing for Signature Bank to 8.2 percent. A failed attempt by SVB to raise capital on March 8 precipitated a massive outflow of some $40 billion in deposits on the 9th, resulting in its closure by California regulators on the 10th. By this time, First Republic had also begun experiencing massive outflows, as had Signature Bank, as later revealed by its quarterly financial statements. In all of this, the FHLBs helped carry these banks until finally SVB failed on March 8, followed not long after by First Republic and Signature. Unsurprisingly, both the New York and San Francisco FHLBs were fully repaid on their advances during the resolution process.
Conclusion
As the above illustrates, the issues with the FHLBs have been ongoing. Since 2022, the Federal Housing Finance Agency, along with numerous academics and policy experts, has reassessed the FHLBs and the role they play in the modern financial landscape. As a result, a range of reform proposals have emerged, such as increasing their commitment to supporting affordable housing to limiting large financial institution access to advances to reorienting the system to serve as a backstop for small or community-centric financial institutions. While well intended, these proposals are unlikely to resolve the system’s core problems. As the next post will discuss, each of these proposals fails to address the source underlying the FHLB’s dysfunction: their GSE status.