Fannie, Freddie & the FHLBs

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Challenging an Empire
Regional Home-Loan Banks Eye Fannie, Freddie's Market
By David S. Hilzenrath
Washington Post Staff Writer
Wednesday, October 8, 2003; Page E01


As Congress considers whether to impose a new regulator on mortgage lending
giants Freddie Mac and Fannie Mae, the activities of another group of
government-sponsored financial institutions, the 12 Federal Home Loan Banks,
are drawing scrutiny as well.

The system was created during the Great Depression to lend money to local
savings-and-loans so they could keep mortgage money flowing to borrowers,
but today its chief customers are large banks, such as Wells Fargo and Bank
of America, that have their own access to capital.

Looking for a new mission, the home-loan banks have in recent years begun
buying and holding mortgages, putting them in competition with Freddie and
Fannie. This strategy exposes the banks not only to greater financial
risk -- mortgage values are highly sensitive to changes in interest rates --
but also to greater political risk. By setting their sites on lucrative
franchises now dominated by Freddie and Fannie, the banks have picked a
fight with two of the most politically well-connected businesses in
Washington.

Recent reports of investment losses at the New York and Pittsburgh home-loan
banks have allowed critics to question the soundness of the system and its
resources-challenged regulator. They also question whether taxpayers could
be liable if the system experienced major financial problems.

A House panel is preparing to draft legislation to shift oversight of
Freddie and Fannie to the Treasury Department. Whether the home-loan banks
should be assigned to the same new regulator is part of a larger debate over
their role in a financial world that has changed dramatically since they
were founded 71 years ago.

Guy D. Cecala, publisher of the trade publication Inside the GSEs, said the
banks' move into mortgage purchasing six years ago made sense partly because
"they're in a dying business."

"There's a possibility that the Federal Home Loan Banks will be irrelevant
in 10 years unless they can come up with an alternative way to serve their
members," Cecala said.

Some critics say the home-loan banks simply have outlived their reason for
being and should be liquidated.

"If there's no justification for an organization, why should the government
keep it in existence?" said Robert E. Litan, a banking specialist at the
Kauffman Foundation.

Executives at the home-loan banks say the system, scattered across 12
regions, remains a financial lifeline for thousands of smaller lenders. They
have an important new role in competing with Fannie and Freddie to keep
low-cost mortgage money flowing, they say.

"Big banks have many sources of liquidity. They can go directly to Wall
Street and issue debt. But community banks . . . don't have that access, and
their lifeline is the home-loan banks," said Alfred A. DelliBovi, president
of the New York FHLB.

DelliBovi said he is not under the same pressure as managers of Freddie and
Fannie to generate profits for investors. While his rivals have publicly
traded stock and compensate their executives with stock options, the 12
regional home-loan banks are owned by their 8,080 banking customers, which
are paid dividends.

"The Federal Home Loan Bank System is absolutely critical to the funding and
survival of community banks," said Diane Casey-Landry, president of
America's Community Bankers, an association of lenders. "Probably a good
half of them rely very seriously on the Federal Home Loan Banks for their
funding."

Fannie, Freddie and the home-loan banks have a similar mission: making money
available to lenders so they can issue more loans and make housing more
affordable. In addition to buying mortgages, Freddie and Fannie repackage
the individual mortgages as securities and sell them to investors, which
pumps liquidity into the mortgage market. But some analysts say those two
government-sponsored enterprises have grown so powerful that they charge
lenders uncompetitively high fees for their services.

Alex J. Pollock, chief executive of the Chicago Federal Home Loan Bank, said
that since the banks began buying mortgages in 1997, they have made the
secondary market for mortgage money "less duopolistically dominated than it
was."

Arne L. Christenson, senior vice president of regulatory policy at Fannie
Mae, said there's already enough competition between Freddie and Fannie to
prevent them from gouging customers. Although certain fees that Fannie
charges lenders have come down over the past few years, the decline is not
primarily a result of pressure from the home-loan bank system, Christenson
said.

When the home-loan banks were created in 1932, Fannie and Freddie didn't yet
exist. Coming up with the money to provide mortgages was typically the job
of small community institutions, which relied on the money they took in from
depositors. When deposits dried up, so did the ability to lend.

The home-loan banks offered another way. Considered almost as creditworthy
as the government that sponsored them, they could borrow cheaply on Wall
Street and then lend that money at favorable rates to institutions that
would issue mortgages. Exemption from federal tax gave the home-loan banks
another economic advantage.

Making loans to member institutions remains the core business of the 12
regional banks, and those loans have been so well secured that even as a
crisis rocked the nation's savings-and-loan industry in the 1980s, the
home-loan banks escaped losses. In the aftermath of the scandal, the
government allowed the system to make loans to banks as well as S&Ls.

Nowadays, the banks' customers may be bigger than the home-loan banks
themselves. In the first half of this year, 17 institutions with more than
$50 billion of assets on their balance sheets -- representing just 0.21
percent of the FHLB System's 8,080 member institutions -- accounted for 20.6
percent of loans outstanding, according to data provided by the system's
regulator, the Federal Housing Finance Board.

At the end of last year, for instance, the Des Moines home-loan bank, with
$42.3 billion of assets, was dwarfed by the parent company of its largest
customer, Wells Fargo Bank Minnesota NA, which reported assets of $349.3
billion. Wells Fargo was on the receiving end of 29.3 percent of the Des
Moines bank's outstanding loans, according to the system's annual financial
report.

At the Seattle regional bank, 30.4 percent of outstanding loans were to Bank
of America Oregon. At the San Francisco bank, 41.1 percent of outstanding
loans were to Washington Mutual Bank FA, whose parent is more than double
the size of the San Francisco bank.

In the home-loan banks' relatively new business of buying mortgages from
lenders, more than 93 percent of the system's purchases last year came from
five big institutions, with Wells Fargo leading the list, according to
estimates by Inside the GSEs.

Regulators and industry executives say those numbers reflect the growth of
interstate banking and the consolidation of the lending industry.

The transformation of the home-loan banks has been rapid. At mid-year, the
banks had $90 billion of mortgages on their balance sheets, more than double
the $38 billion total a year earlier. The Chicago bank's balance sheet now
carries more mortgages purchased than loans outstanding.

Because fluctuations in interest rates affect the value of those assets, the
home-loan banks engage in hedging strategies using complex financial
instruments known as derivatives, and it was a failure of hedging that sent
the Pittsburgh bank's profits plummeting in the second quarter.

The New York bank recently gave the system another jolt when an investment
gone awry triggered a downgrade by Standard & Poor's Corp., the first
downgrade the debt-rating firm has ever given a home-loan bank.

"Basically, we think the system is very strong," said S&P analyst Michael T.
DeStefano. For the system to experience a crisis, "you'd have to go to
extreme interest rate scenarios like rates going up sharply to 20 percent."

Stephen M. Cross, director of supervision at the Federal Housing Finance
Board, said the banks are able to withstand "the worst-case scenarios that
have actually occurred over the past 25 years."

The risks of large, complex financial institutions with overextended
regulators became harder to ignore this year when Freddie Mac disclosed that
it had misstated past earnings by as much as $4.5 billion. Freddie's
overseer, the Office of Federal Housing Enterprise Oversight, had failed to
detect the accounting errors. The home-loan banks are regulated by a
similarly obscure agency, the Federal Housing Finance Board, which oversees
the 12 institutions and their $809 billion of assets with a staff of 17
examiners.

"The Finance Board is grossly inadequate, and its inadequacy is so stunning
that not to insist that it be brought under Treasury . . . would be a
massive mistake," Rep. Jim Leach (R-Iowa) said at a hearing last month.

Some officials in the Federal Home Loan Bank system say they could be left
at a competitive disadvantage, forced to pay higher interest rates, if
Freddie and Fannie got a new regulator but they did not.

The rise of Fannie and Freddie gave lenders an alternative to borrowing from
the home-loan banks. But a recent study by Federal Reserve economist W.
Scott Frame found that the regional home-loan banks appear to offer lenders
more attractively priced mortgage-purchase deals than those offered by
Freddie and Fannie. Even for big banks, the home-loan banks' services offer
special advantages.

"If we did not have the home-loan banks, you would not see Washington Mutual
or other lenders that concentrate in home lending being able to make loans
to all aspects of America," said Scott Gaspard, senior vice president of
government and industry relations at Washington Mutual Inc. Loans from the
home-loan banks give Washington Mutual the flexibility to issue mortgages
that don't conform to the cookie-cutter standards of Freddie and Fannie or
the potentially constraining conditions applied by Wall Street.