America’s “Other” GSE Problem: The Federal Home Loan Banks, Part II
The Federal Home Loan Bank (FHLB) system is a government-sponsored network of cooperatively owned wholesale banks established during the Great Depression to support housing finance by providing liquidity to savings and loans and insurance companies. Following the Savings and Loan Crisis, membership eligibility was extended to all federally insured depository institutions and credit unions, provided they had at least 10 percent of their assets in residential mortgages at the time of application. Community Development Financial Institutions became eligible for membership in 2008. In this evolution, the FHLB has come to function as another provider of wholesale liquidity to member financial institutions. As discussed in Part I of this essay, the effects of the FHLB’s lending have often been perverse, permitting insolvent financial institutions to gamble on their recovery by shifting risk onto taxpayers.
As a government-sponsored enterprise (GSE), the FHLB’s chartering act contains a number of provisions that distinguish the system from both private corporations and public bureaucracies. These include a $4 billion credit line with the Treasury Department and the eligibility of its debt for purchase by the Federal Reserve (Fed). Additionally, the system’s debt is classified under securities law as government securities, and it also has the option of using the Fed as its fiscal agent. The system’s earnings are exempt from federal, state, and local income taxes, and the interest investors earn on their holdings of FHLB debt is exempt from state income taxes. Lastly, should a borrower institution fail, the FHLB enjoys priority over other unsecured creditors, including the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration, in the bank resolution process via its statutory “super lien.” While these privileges distinguish the FHLB from purely private corporations, each regional bank is capitalized and cooperatively owned by their member institutions, thereby distinguishing them from government agencies. This unique combination of public and private characteristics places the FHLB, along with the other GSEs, within the realm of “quasi government.”
The combined effect of their charter privileges is that capital markets view the FHLB system as enjoying the federal government’s implicit backing and allow them to borrow at rates similar to those paid by the Treasury. This borrowing advantage allows them to deliver a sizable subsidy to their member institutions, the net value of which has been estimated at $6.9 billion.
The perverse effects of the FHLB’s lending aside, critics have also touched upon the system’s mission creep, its shift in focus from housing finance to providing sizable rents to its member institutions, and management. As a result, numerous proposed reforms have been advanced; these proposals can be roughly categorized as maintaining the status quo, making adjustments to the existing system, and total elimination. Part II focuses on assessing the merits of these various proposals.
Maintaining the Status Quo
Amidst the current wave of criticism levied against the FHLB and calls for reform, several analysts have defended the system, citing the role played by FHLB loans (i.e., “advances”) in supporting the financial system during times of economic stress. The varied maturity structure of advances, combined with their availability to member institutions at a low cost, can help member institutions manage interest rate and liquidity risk. Advances can also provide these institutions with the breathing room needed to rearrange their balance sheets to ensure their continued viability. There is some evidence for this effect. An Urban Institute paper assessing bank failures since 2001 found that increases in bank holdings of FHLB advances reduced the probability of their failure, leading the authors to conclude that “[t]he results of the analysis support our view that the FHLBs are a source of stability to the financial system, not instability. If anything, the system should be expanded rather than diminished.” Another study found that FHLB advances respond to increases in systemic risk and help reduce the detrimental effects of this risk on the broader economy. Thus, the case is made that, in serving as an additional source of stressed market liquidity, the FHLBs contribute to the stability of financial markets.
Yet, these beneficial effects must be weighed against the perverse incentives created by the provision of government-backed liquidity. The combination of privileges entailed by their GSE status and the overcollateralized nature of advances means the FHLB faces little incentive to charge rates that reflect the risk profile of borrower institutions. Thus, the ability to borrow from the FHLB offers financial institutions an alternative to either paying risk-adjusted rates for liquidity on the market or facing the stigma of borrowing from the Fed’s discount window, weakening incentives for prudent risk management while creating incentives for increased risk-taking. This latter effect can be particularly pronounced for borrower institutions facing deteriorating financial conditions, if not insolvency. In so doing, FHLB lending contributes to the fragility of financial institutions, thereby creating risks to the broader system and taxpayers through the bank resolution process.
As discussed in Part I, the FHLB system has historically extended credit to distressed or insolvent financial institutions. Due to its super-lien status and overcollateralized advances, this practice can increase the risk of losses to the Deposit Insurance Fund (DIF), which is absorbed by taxpayers who stand as the ultimate guarantors of the insurance fund. This risk isn’t merely theoretical, and it’s been noted by both researchers and regulators alike. A working paper from the Federal Reserve Bank of Richmond provides estimates of the losses to the insurance fund of resolving banks under two scenarios: all banks with failure probabilities above 2 percent and those banks with advance-to-asset ratios above 15 percent. Compared to their baseline resolution cost estimates, average estimated losses to the insurance fund increased by $145.9 million in the first scenario and $3.07 billion in the second. When excluding the unrealistic counterfactual in which advances replace insured deposits, the increase in losses rises to $182 million and $4.1 billion, respectively. Moreover, the authors find that greater use of advances by member banks modestly increases their likelihood of experiencing a risk downgrade. Notably, the authors state that their sample period of 1992-2003 likely leads their results to understate the losses the FDIC would suffer as well as the effect of advances upon bank risk-taking. This aligns with other research findings that the moral hazard effects of FHLB lending, and the corresponding risks to taxpayers are more pronounced during periods of economic stress. The March 2023 failures of Silicon Valley, Signature, First Republic, and Silvergate banks provide the most recent evidence of this effect.
Material loss reviews (MLR), the post-mortem reports issued by bank regulators’ inspector generals when failures result in DIF losses of $50 million or more, provide further qualitative support for this point. Examining the 264 MLRs issued between 2008 and 2016, researchers found that 110 (41.6 percent) mentioned the FHLB, while 78 (29.5 percent) cited the FHLB as contributing to the failure of banks or thrifts, and thus to the losses suffered by the DIF. Another study that examines 50 MLRs issued between 2007 and 2009 found that 39 of these cited banks’ usage of volatile funds, with 29 mentioning banks’ heavy reliance on FHLB advances as contributing to their failure. Separately, the Federal Housing Finance Agency (FHFA) inspector general found the FHLBs extended 45 percent of their total advances to members with weakened financial conditions and that the system “might have over-extended lending to some members with higher levels of nonperforming assets.” Between 2007 and 2011, 204 of these borrower institutions failed within the Atlanta and San Francisco FHLB districts, with their outstanding advances either being absorbed by acquiring institutions or by the DIF, rather than the FHLB.
In summation, evidence that the FHLB has helped promote financial stability must be balanced against the moral hazard created by the offer of this liquidity at sub-market rates backed by the system’s super lien and the significant material risks this practice poses to financial stability and taxpayers alike. Of course, it would be wrong to argue that the FHLB system bears sole responsibility for undermining market discipline and injecting moral hazard into financial markets. Numerous studies have established that government deposit insurance, the Fed’s emergency lending facilities, as well as the federal government’s various lending programs and loan guarantees have all been powerful sources of systemic vulnerabilities, entailing substantial costs for the taxpaying public. Rather, the purpose is to highlight the FHLB’s underappreciated role as another source of such vulnerabilities.
Revamping the FHLB’s Housing Mission
Among the various reform proposals for the system, perhaps the most salient are those focused on reinforcing the FHLB’s commitment to supporting mortgage finance and affordable housing. FHLB advances are secured by single-family mortgages, mortgage-related assets, and other assets with the expectation that providing financial institutions an avenue by which to borrow against their mortgage portfolios at sub-market rates (again, owing to their GSE status) will encourage them to originate more mortgages than they would otherwise. In effect, FHLB advances are meant to serve as a subsidy to mortgage finance. However, there are no restrictions as to how borrowers utilize the proceeds from advances. Moreover, member institutions are not required to have ongoing business in mortgage finance, although they are required to pass the so-called “10 percent test” during the application process. As a result, researchers have found that member financial institutions use advances as a general source of wholesale liquidity rather than to narrowly support new mortgage origination. Moreover, some affordable housing groups and advocates have highlighted the system’s lack of support for its Affordable Housing Program (AHP), which mandates that banks devote 10 percent of their annual earnings to subsidizing homeownership or the creation of rental properties for medium- and low-income households. To address these issues, the FHFA stated in its centennial report its intention to institute a rule that member institutions must maintain at least 10 percent of their assets in residential mortgages on an ongoing basis. Legislation has also been introduced to increase the system’s AHP contributions to 30 percent of its net earnings.
Given that housing affordability is a particularly salient issue in the current political climate, subsidies purportedly aimed at increasing the supply of housing credit or helping the least well off afford homes seem a natural solution. However, despite decades of support for housing finance, government policy has failed to produce lasting gains in homeownership. Indeed, the U.S. homeownership rate has remained relatively unchanged since the mid-1960s. As of 2025:Q1, the U.S. homeownership rate stands at 65.1 percent—the same level as 2019:Q4 and 1996:Q1 and barely above the 1965:Q1 rate of 63 percent where the data series begins. Comparing the United States to other Western, developed countries paints an equally lackluster picture. A recent comparative analysis found that, as of 2019, the U.S. homeownership rate fell below the average for other countries in the Organization for Economic Co-operation and Development (64.2 percent vs. 71.1 percent), including its two closest neighbors, Canada (68.8) and Mexico (68.3). Moreover, as another study pointed out (see Chapter 1), the United States has experienced higher volatility in both house prices and construction starts as compared to other Western European countries. Notably, the superior performance of many Western European countries was achieved with less government intervention in their mortgage markets and without U.S.-style GSEs. Thus, increasing the level of government-backed subsidies in the housing finance market, either by requiring FHLB member institutions to hold a certain percentage of their assets in mortgages or by providing greater support for the AHP, seems unlikely to improve either homeownership or stability in housing markets. Indeed, there is reason to believe that offering a further subsidy to housing demand may actually worsen housing affordability.
Current affordability issues reflect both constraints on the supply of housing and policies that artificially inflate housing demand. Housing supply issues are, to a large extent, driven by local regulatory barriers to new construction. Thus, providing still-greater subsidies to housing demand is simply the wrong approach and would likely inflate housing prices further in an already supply-constrained environment. Indeed, recent empirical work illustrates that housing supply regulation liberalization is insufficient to stem the appreciation in housing prices when demand is strong. Since many of the barriers to increased housing supply are beyond the federal government’s control, reforms should aim to eliminate demand-side subsidies that effectively place a floor beneath housing prices.
Repealing the System’s Congressional Charter
A third reform option is to eliminate the FHLB system as a whole. The FHLBs were created to serve as a backstop for thrifts, insurance companies, and other lenders focused on mortgage finance that were legally barred from accessing the Fed’s discount window. The near-total collapse of the thrift industry in the 1980s deprived the system of its primary constituency; nevertheless, Congress retained the system to avoid recognizing the full costs of the Savings and Loan Crisis, shifting part of this onto the FHLB in exchange for allowing commercial banks and other federally insured depository institutions into the system. As part of this deal, the system was also saddled with a new affordable housing and community development mission to appease various consumer and community interest groups and their congressional supporters.
As it stands presently, the FHLB system functions as a kind of rent-sharing arrangement, wherein advantages created by the system’s implicit backing by the federal government are shared between member financial institutions and system management. In addition to having access to a non-stigmatized source of subsidized liquidity, member institutions also earn a substantial dividend on their shares in the regional FHLBs. For instance, the New York FHLB announced an 8 percent dividend for the first quarter of 2025, whereas the Des Moines bank announced a dividend of 9.75 percent and 6 percent, depending on the stock type. Insiders within the banks also benefit, as one recent analysis found that FHLB chief executives earned on average about $2.3 million in 2024, a decrease from their average annual earnings of $2.9 million in 2023. In total, the FHLBs spent approximately $859 million on compensation and benefits in 2024. A third leg of this arrangement is the affordable housing and community groups, construction companies, and real estate developers who benefit from the grants and subsidized credit provided by the AHP and community development programs. As discussed earlier and in Part I, these rents represent off-balance sheet liabilities borne by taxpayers who absorb the risks created by the system’s lending and serve as its de facto guarantors.
If the system is to be retained, Congress should (at minimum) strike the super lien from the system’s chartering act. While experts from the FHLBs have downplayed the importance of the lien in recent years, it remains on the books as an option. Removing the lien would reduce the incentives the system faces to lend or extend existing commitments to weakened financial institutions during periods of economic stress. This would reduce risks to the DIF and taxpayers alike. However, the best course of action would be for Congress to fully privatize the system by repealing its congressional charter. If the FHLBs truly provide value to their members and customers independent of their implicit backing and privileges, they will surely find their niche competing on a level playing field with other market actors.