[Senate Hearing 108-834]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-834


                              OVERSIGHT OF
                   THE FEDERAL HOME LOAN BANK SYSTEM

=======================================================================

                                HEARING

                               before the

                 SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

 THE OPERATIONS OF THE FEDERAL HOME LOAN BANK SYSTEM, FOCUSING ON THE 
  RESPONSIBILITY THAT CONGRESS HAS PLACED WITH THE FEDERAL HOME LOAN 
BANKS TO ENHANCE THE LIQUIDITY OF FINANCIAL INSTITUTIONS, PARTICULARLY 
  AS THE FEDERAL HOME LOAN BANK MEMBERS MEET SUCH COMMUNITY NEEDS AS 
                        PROMOTING HOMEOWNERSHIP

                               __________

                           SEPTEMBER 9, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


   Available at: http: //www.access.gpo.gov /senate /senate05sh.html


                                 ______

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                   Sarah A. Kline, Democratic Counsel

             Jonathan Miller, Democratic Professional Staff

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

                 Subcommittee on Financial Institutions

                   ROBERT F. BENNETT, Utah, Chairman

               TIM JOHNSON, South Dakota, Ranking Member

ELIZABETH DOLE, North Carolina       ZELL MILLER, Georgia
LINCOLN D. CHAFEE, Rhode Island      THOMAS R. CARPER, Delaware
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
RICK SANTORUM, Pennsylvania          JACK REED, Rhode Island
CHUCK HAGEL, Nebraska                EVAN BAYH, Indiana
JIM BUNNING, Kentucky                DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho

                    Michael Nielsen, Staff Director

             Naomi Camper, Democratic Legislative Assistant

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                       TUESDAY, SEPTEMBER 9, 2003

                                                                   Page

Opening statement of Senator Bennett.............................     1
    Senator Johnson..............................................     3
    Senator Corzine..............................................    10
    Senator Hagel................................................    12
    Senator Reed.................................................    14
    Senator Bunning..............................................    16
        Prepared statement.......................................    46
    Senator Allard...............................................    17
        Prepared statement.......................................    46
    Senator Miller...............................................    20
    Senator Sarbanes.............................................    34

                               WITNESSES

Wanye A. Abernathy, Assistant Secretary for Financial 
  Institution, U.S. Department of the Treasury...................     4
    Prepared statement...........................................    46
John T. Korsmo, Chairman, Federal Housing Finance Board..........     6
    Prepared statement...........................................    50
    Response to written questions of Senator Sarbanes and Senator 
      Carper.....................................................    77
Norman B. Rice, President and Chief Executive Officer, Federal 
  Home Loan Bank of Seattle......................................    21
    Prepared statement...........................................    56
Michael Middleton, Vice President, Federal Home Loan Bank of 
  Atlanta, Chairman and Chief Executive Officer, Community Bank 
  of Tri-County, Waldorf, MD.....................................    24
    Prepared statement...........................................    60
Shelia C. Bair, Dean's Professor of Financial Regulatory Policy, 
  Isenberg School of Management, University of Massachusetts.....    27
    Prepared statement...........................................    64
    Response to written questions of Senator Sarbanes............   100
Terry Smith, President, Federal Home Loan Bank of Dallas.........    30
    Prepared statement...........................................    67
David W. Hemingway, Director, Federal Home Loan Bank of Seattle, 
  Executive Vice President, Zions First National Bank, Salt Lake 
  City, UT.......................................................    32
    Prepared statement...........................................    75

              Additional Material Supplied for the Record

Letter to John W. Snow, Secretary, U.S. Department of the 
  Treasury from George J. Parseghian, Chief Executive Officer and 
  President, Freddie Mac dated July 14, 2003.....................   116
``Is the Federal Home Loan Bank System Forsaking its Roots?'' by 
  Shelia C. Bair, dated June 2003................................   117

                                 (iii)

 
                              OVERSIGHT OF
                   THE FEDERAL HOME LOAN BANK SYSTEM

                              ----------                              


                       TUESDAY, SEPTEMBER 9, 2003

                                       U.S. Senate,
      Subcommittee on Financial Institutions, Committee on 
                       Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Subcommittee met at 2:05 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Robert F. Bennett (Chairman of 
the Subcommittee) presiding.

         OPENING STATEMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. The hearing will come to order. We 
appreciate the witnesses' being here and look forward to 
hearing their testimony, and making this a worthwhile hearing.
    One of the fundamental roles of Congress and this 
Subcommittee is to provide periodic oversight, and that is why 
we are here today. We have no specific legislation before us. 
But it has been a considerable amount of time since Congress or 
the Banking Committee has held an oversight hearing on the Home 
Loan Bank System, and we recognize that periodic oversight 
helps keep houses in order.
    President Eisenhower, when he was a general, used to say 
that areas that are not periodically inspected tend to 
deteriorate. Those of us who have been in the military know 
what periodic inspections are like, and we do not want to make 
this hearing quite like that.
    This is not to say that this particular house is not in 
order or that it has tended to deteriorate. But we have not 
looked at any part of the Home Loan Bank System since Gramm-
Leach-Bliley where we made adjustments to the membership rules, 
collateral options for advances, and the capital requirements 
of the System. Since Gramm-Leach-Bliley, our banking and 
finance system has continued to evolve to meet the demands of 
an important and ever changing marketplace.
    We have had consolidations that have brought efficiencies 
and synergies that have undoubtedly played a major part in the 
sustained success we have been experiencing in the housing and 
housing financing market. I believe the Home Loan Banks, along 
with the other housing GSE's, have played a vital role in 
funding this growth.
    My own State of Utah is a net borrower. Utah's future 
housing growth and economic vitality depends upon the capital 
that can come partly from Home Loan Banks and others that can 
access Wall Street and bring investment to my State. The role 
of the Home Loan Banks and other housing GSE's play in 
communities across the Nation is, in my opinion, invaluable.
    We are currently experiencing what I hope, and still 
believe, is just a hiccup in our housing GSE system, but given 
the importance of the housing finance system and the billions 
of dollars that move daily through the GSE's from investors all 
around the world and then into our communities, even this 
little hiccup requires Congress to act to ensure that safety 
and soundness and the confidence of the markets in the GSE 
system is maintained and, we would hope, be even strengthened.
    This is a good time for Congress to take a look at the 
entire system, and while this Subcommittee does not have 
jurisdiction over all of the GSE's, we do have the 
responsibility for the Federal Home Loan Banks, and that is why 
we are concentrating there today.
    Since Gramm-Leach-Bliley, several issues have emerged in 
the Home Loan Bank System that Congress has not reviewed, and 
these issues relate directly to safety and soundness and the 
mission of the System. So we will begin to create a record on 
these issues here this afternoon.
    The issues are: one, whether or not the Home Loan Banks 
should register with the SEC; two, whether or not a member 
institution of the System should be permitted to be a member of 
more than one regional Home Loan Bank; three, at what level 
should the Home Loan Banks be permitted to participate in the 
secondary mortgage market; and, four, whether or not we should 
have a single regulator for all of the housing GSE's. And all 
of these issues are closely related to the safety and soundness 
and the mission of the System.
    I understand, to put it somewhat mildly, that these issue 
remain unagreed upon, both inside and outside the System, and I 
believe that all would agree that each of them could have a 
major impact on housing finance, homeownership costs, and, 
therefore, the economy, particularly the economy at this point 
where housing has led the recovery. That usually is not the 
case. Housing is usually the last thing to recover. But in this 
very unusual recession and recover, housing has been one of the 
strongest parts. That is another reason why we need to pay 
attention.
    In bringing up the final question of whether Congress 
should create a single regulator for all of the GSE's, I want 
to make sure that I acknowledge the efforts of Chairman Korsmo. 
Mr. Chairman, you have put forth tremendous effort to 
strengthen the regulation of each institution individually as 
well as the System as a whole through a more thorough 
examination regime, and I congratulate you for that.
    Mr. Korsmo. Thank you, sir.
    Senator Bennett. Regardless of the quality of regulation, 
there are those who believe that all the housing GSE's should 
operate under a coordinated regulator with appropriate 
authority, believing that separate can never be equal, at least 
in perception of the markets. I will continue to reserve 
judgment on that, but we are going to hear from Treasury 
Secretary Snow tomorrow before the House. I expect he will 
address that issue, and we will look at his testimony with 
great interest.
    Secretary Abernathy, we welcome you back to the Committee, 
where you served so ably for such a long period of time. I 
suspect you will feel the same way and reserve judgment until 
after your boss has spoken. But if you want to surprise us----
    [Laughter.]
    --we would be happy to have you surprise us.
    Senator Johnson, I appreciate very much your attendance, 
not only at this hearing but your diligence in this issue in 
the past, and we would be delighted to hear from you.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Thank you, Chairman Bennett, and welcome 
to Secretary Abernathy and Mr. Korsmo. I thank you, Mr. 
Chairman, for holding this afternoon's hearing on oversight of 
the Federal Home Loan Bank System. I cannot think of a more 
timely hearing given recent attention on Government Sponsored 
Enterprises and debate over the nature and scope of their 
regulatory agency.
    Today is a good opportunity to take stock of the role, 
mission, and regulation of the Home Loan Banking System. I 
apologize in advance if my schedule will not allow me to stay 
for the entire hearing. As usual, I have competing and 
overlapping obligations, and I know that we are in good hands 
under your leadership.
    The Federal Home Loan Banks play a critical role in our 
Nation's housing finance and community lending system. Since 
the Home Loan Banks were created in 1932 with the mission of 
helping to make homeownership more affordable, the positive 
impact and the mission of the Bank has grown significantly.
    In my State of South Dakota, the Home Loan Banking System 
has provided critical funding for community lending needs. 
Until a recent flight to safety of financial assets, our small 
community banks faced serious funding issues, related in part 
to the continued erosion in the value of deposit insurance. The 
Home Loan Banks provided advanced services to counteract those 
funding shortfall, ensuring that South Dakota consumers had 
access to loans that they needed to keep our rural areas 
economically viable.
    I should also note that since 1990, South Dakota has 
received $8.6 million from the Federal Home Loan Bank of Des 
Moines' affordable housing program. This investment has 
assisted 66 affordable housing projects throughout our State.
    Mr. Chairman, today's hearing is also well-timed because it 
is not in response to a crisis. The Committee has important 
responsibility to conduct regular oversight, and this is 
especially important with respect to the Federal Home Loan 
Banking System because of the central role that it plays in 
today's financial marketplace. Few would dispute that the Banks 
play a different role than they did back in the 1930's. Some 
do, however, dispute whether these new activities fall within 
the proper mission of the Banks. That is a legitimate question. 
I am pleased we will have a chance to hear from a variety of 
witnesses today.
    In addition, we should also consider whether the Federal 
Housing Finance Board has the tools it needs to regulate what 
have become increasingly complex and sophisticated financial 
institutions. At least one witness has advocated that the Home 
Loan Banks share a regulator with the other housing GSE's. This 
hearing could not be better timed to hear both sides of that 
debate as we move toward consideration of possible changes in 
the regulation of Fannie Mae and Freddie Mac.
    Finally, some of us here have had the chance to hear from 
SEC Chairman Donaldson this morning about the implementation of 
Sarbanes-Oxley. I hope that the witnesses will describe for the 
Subcommittee their experience with any corporate governance 
reforms and their position on disclosure proposals currently 
under discussion.
    Chairman Bennett, thank you for holding today's hearing, 
and I look forward to hearing from these excellent witnesses.
    Senator Bennett. Thank you very much.
    Secretary Abernathy, we will start with you.

                STATEMENT OF WAYNE A. ABERNATHY

         ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Abernathy. Thank you, Mr. Chairman, Senator Johnson, 
Members of the Subcommittee. Thank you for this opportunity to 
testify this afternoon on the Federal Home Loan Bank System. I 
would like to focus on three topics this afternoon: First, the 
need for the Federal Home Loans Banks to register with the 
Securities and Exchange Commission under the terms of the 
Securities Exchange Act of 1934; second, I would like to talk 
about multidistrict membership; and, third, Treasury's current 
review of the Federal Home Loan Bank System.
    The observance of good, fundamental practices of corporate 
governance is a high priority for this Administration. For more 
than a year, the Administration has been urging that all GSE's 
comply with the same corporate disclosure requirements of the 
Securities Exchange Act of 1934. We are pleased that Fannie Mae 
has complied with this request. Freddie Mac has also agreed, 
though we are disappointed to learn that Freddie Mac may not be 
registering until sometime in 2004. The sooner they register, 
the better.
    The Administration has continued to urge that the Federal 
Home Loan Banks also move forward with voluntary registration. 
Some have argued that the unique characteristics of the Banks 
lessen the need for registration under the 1934 Act. All of 
these facts are important and must be, and I believe can be, 
taken into account.
    However, the differences do not change the fundamental fact 
that the Home Loan Banks are significant participants in our 
capital markets. Investors should have the same information 
regarding the condition of the Home Loan Banks as they have for 
other significant participants in the capital markets.
    At the end of June, the Federal Home Loan Banks had 
outstanding consolidated obligations of $713 billion. The 
individual Banks are each large financial institutions. As of 
year-end 2002, the largest Bank, the Bank of San Francisco, had 
$135 billion in total assets. The smallest, the Bank of Topeka, 
had $33 billion in total assets, while the average was $58 
billion in total assets. Even the smallest would rank among the 
top 40 commercial banks in the United States.
    Investors would benefit from the added oversight of the 
SEC, both in terms of reviewing financial disclosures and 
through uniform enforcement of current standards. And investors 
would have a basis for making comparable evaluations of the 
variety of institutions that are competing for their investment 
dollars. Our system of securities regulation should offer 
investors nothing short of that standard.
    The continued operation of the Banks outside of the SEC-
administered corporate disclosure regime is inconsistent with 
our objectives of a sound and resilient financial system. We 
understand that the Banks have some remaining concerns with how 
certain aspects of their business operation would be treated. I 
would remind all concerned that the Federal Home Loan Banks are 
not the only corporate institutions in America that have unique 
characteristics. Given the flexibilities that the SEC has to 
address individual circumstances, we are confident that the 
Banks' concerns can be worked out.
    We appreciate the discussions that several of the Banks 
have had with the SEC earlier this year, and we look forward to 
these discussions being renewed in the immediate future, within 
a context of acceptance of the public interest that would be 
served by the Federal Home Loan Banks registering under the 
1934 Act.
    We understand that the Board of Directors of the Bank of 
Cincinnati recently announced that the Bank will be taking the 
next step in the process. In a recent letter to Secretary Snow, 
HUD Secretary Martinez, and Chairman Korsmo, the Board of 
Directors of the Federal Home Loan Bank of San Francisco 
expressed their goal ``to enable the Federal Home Loan Banks to 
become role models for corporate transparency.'' That is our 
goal as well, to which registration under the Securities 
Exchange Act of 1934 is essential.
    Let me just talk about multidistrict membership, in 
context. While there continues to be debate over a number of 
Home Loan Bank activities, one current issue, the question of 
multidistrict membership, raises particular concern. The 
appropriate forum for the resolution of this issue must be kept 
in mind. As the Treasury Department has written in a comment 
letter to the Finance Board, regardless of whether allowing 
multidistrict membership is wise, a plain reading of the 
statute finds little room to conclude that the Finance Board 
has the legal authority to approve it. It provides, and I quote 
from the statute,

    An institution eligible to become a member under this 
section may become a member only of, or secure advances from, 
the Federal Home Loan Bank of the district in which is located 
the institution's principal place of business, or of the Bank 
of a district adjoining such district, if demanded by 
convenience and then only with the approval of the Board.

    I have played with that language many times trying to make 
sure how does that ``or'' work, and I have thought of it in 
terms of my children at home. I can say to my son, ``You may 
have your army toys in your room or you may have it in the 
playroom.'' To my mind, that is one room. If I wanted to say it 
could be either one of those two and both of them, I would say, 
``You can have your toys in your room and the playroom.'' But 
if I use an ``or,'' it brings into my mind there is only one 
place where those are going to be located. The statute provides 
for an ``or,'' and it seems pretty clear to us.
    Now, to say this is not to render a policy point of view. 
There are compelling arguments on both sides of the question. 
Clearly, our financial system has changed dramatically since 
1932. In the intervening years, however, Congress has revised 
the governing statutes on several occasions. But they have 
never changed that particular requirement. It is to the 
Congress that these arguments should be offered and where any 
change in the statute will have to be made.
    The third point I would like to raise. Earlier this year, I 
requested the Office of Financial Institutions Policy at 
Treasury to conduct an in-house review of the Federal Home Loan 
Bank System, with particular but not exclusive, consideration 
of the effect of the changes enacted as part of the Gramm-
Leach-Bliley Act of 1999. As I announced at that time, the 
review would consider the following points: how these changes 
have affected the ability of the Federal Home Loan Banks to 
meet their statutory mission; implications for the financial 
strength of the Banks individually and the System in general; 
how the business operations of the Banks contribute to 
accomplishing their statutory mission; issues regarding 
governance structure and management, including executive 
compensation; effect of new capital structures on operations; 
and other issues regarding the strength of the System and the 
structure of Federal oversight.
    We are now about 4 months into that process, nearing 
completion of our first phase. Again, I would like to emphasize 
that Treasury's review of the Federal Home Loan Bank System is 
part of what we normally do at Treasury, and what I envision 
for our current review is a more specific look at how the 
changes made to the Federal Home Loan Bank System as part of 
the GLBA have been implemented. Treasury is not primarily a 
regulatory agency. We see as part of our important function, 
however, providing executive branch oversight of the activities 
of the independent financial regulators, and this study is part 
of meeting that obligation and responsibility.
    The Federal Home Loan Bank System presents policymakers 
with issues that deserve continued attention. We must continue 
to evaluate the System to ensure that it is achieving the 
objectives set forth by Congress, meeting the needs of our 
communities that might not be otherwise met.
    Thank you again for providing me this opportunity to 
present our views before you today and to discuss these 
important issues, and I would be glad to answer any questions.
    Senator Bennett. Thank you very much for your testimony.
    Chairman Korsmo, we appreciate your being here and look 
forward to hearing from you.

                  STATEMENT OF JOHN T. KORSMO

            CHAIRMAN, FEDERAL HOUSING FINANCE BOARD

    Mr. Korsmo. Thank you, Chairman Bennett, Ranking Member 
Johnson, and distinguished Members of the Subcommittee, I 
appreciate the opportunity to speak with you today about the 
Federal Housing Finance Board and the Federal Home Loan Bank 
System. I have a brief opening statement, but I have also 
brought prepared testimony with more thorough discussion of 
several key topics affecting the Federal Home Loan Banks I have 
been asked to address.
    Senator Bennett. Without objection, your testimony shall 
appear in the record.
    Mr. Korsmo. Thank you, Mr. Chairman.
    Many important issues are facing the Nation's Government 
Sponsored Enterprises, including, certainly, the Federal Home 
Loan Banks. In the interest of time, I highlight the aggressive 
steps we have taken at the Federal Housing Finance Board, the 
System's regulator, first, to strengthen the agency's oversight 
capabilities and, second, to improve financial disclosures by 
the Federal Home Loan Banks through voluntary registration with 
the Securities and Exchange Commission.
    These initiatives will benefit not just the Federal Home 
Loan Banks and their more than 8,000 member institutions, but 
also the investors who purchase their debt, and ultimately the 
homebuying public and the taxpayers.
    Soon after President Bush named me Chairman in December 
2001, I determined that the Finance Board lacked many of the 
necessary resources to effectively oversee the Federal Home 
Loan Banks for safety and soundness and achievement of their 
housing finance mission. Just one example demonstrates this 
point. At the time, the Finance Board had only eight bank 
examiners on staff to review and supervise 12 financial 
institutions with, at the time, more than $700 billion in 
assets, more than $30 billion in capital, and some $650 billion 
in outstanding debt. Yet, at the same time, the agency had 
eight people in its Office of Public Affairs. The relative 
allocation of resources simply did not meet the agency's 
statutory mandates.
    I immediately addressed these problems beginning with the 
recruitment of new leadership for the agency's Office of 
Supervision. After a national search, the Finance Board hired a 
new Director and a new Deputy Director of Supervision, who, 
between them, have 40 years of Federal bank regulatory 
experience.
    Mr. Chairman, I appreciate your comments about the 
improvements we have made in our supervisory and examination 
function. I should say that while often much is made of the 
times that my Finance Board colleagues and I do not agree, on 
this issue, as on most issues, my colleagues deserve equal 
credit for our initiatives in this area. My fellow Finance 
Board members and I acting together increased the resources 
available for supervision, expanding our examination staff to 
17 full-time examiners. Our goal is to have 24 in place by the 
end of this calendar year and 30 by the end of the next budget 
year.
    We are now conducting more thorough examinations, focusing 
on the Banks' risk assessment processes, internal control 
systems, and systems of corporate governance. And we are 
communicating the results of those examinations more 
effectively to the Banks. Now our examinations recognize that 
banking, even AAA-rated, GSE banking, is a business of managing 
risks, and the responsibility of bank supervisors is to ensure 
that the institutions they regulate understand those risks and 
that they monitor and control them through prudent practices.
    On the subject of enhanced financial disclosures, last 
summer I formed a working group with the Finance Board and the 
Federal Home Loan Banks to review the issues associated with 
voluntary registration of the Banks with the Securities and 
Exchange Commission.
    Earlier this year, I concluded that voluntary registration 
is indeed the best approach to enhancing public disclosure of 
the governance and finances of these important institutions. I 
reached this conclusion based on two premises.
    First, the Banks' long-term access to global capital 
markets will be enhanced by providing investors in consolidated 
obligations with maximum reliable transparency into the 
finances and governance of each of the 12 Banks. Markets 
function best, especially in times of stress, when needed 
information is readily available and reliable.
    Second, as public trusts, these 12 GSE's have a duty to 
contribute both to the smooth functioning of capital and 
mortgage finance markets and to public confidence that the 
benefits of GSE status are used wisely.
    The Federal Home Loan Banks and the staff of the SEC have 
held numerous meetings to address the process for voluntary 
registration. In fact, another meeting was held only yesterday. 
It is now time, I believe, to bring this process to a positive 
conclusion.
    I note that this summer the boards of the Federal Home Loan 
Bank of San Francisco and the Federal Home Loan Bank of 
Atlanta, as Secretary Abernathy mentioned, resolved that if SEC 
registration was the determined course of action, then the 
Federal Housing Finance Board should adopt a regulation 
requiring it.
    In response to those requests, tomorrow at our regularly 
scheduled meeting the Federal Housing Finance Board will 
consider a proposed regulation requiring the Banks to register 
a class of their securities with the SEC.
    The proposed rule provides for a lengthy, 120-day comment 
period, during which, I hope, the Banks will each meet with the 
SEC to work out the necessary details to effectuate 
registration and begin meeting the periodic financial reporting 
requirements of the 1934 Act.
    Mr. Chairman, distinguished Members of the Subcommittee, I 
focused on these two areas of safety and soundness oversight 
and improved financial disclosures because of their importance 
to the strength and resiliency of the Federal Home Loan Banks. 
Certainly we are dealing with many other issues at the Finance 
Board, which are addressed in my written testimony, and I 
welcome the opportunity to discuss any and all of them with 
you.
    Thank you again for your time this afternoon. I look 
forward to addressing your questions.
    Senator Bennett. Thank you very much.
    The Federal Home Loan Bank System has traditionally focused 
on providing advances to their members. In the last couple of 
years, Home Loan Banks have initiated a program of directly 
acquiring loans from their members. At what level should the 
Home Loan Banks participate in the secondary market in this 
way, in your opinion? And should securitization be considered 
as an option for the Banks?
    Do either one of you want to go first on that question?
    Mr. Abernathy. I am happy to proceed, Mr. Chairman. Let me 
deal with the securitization issue first, if I may.
    Senator Bennett. Certainly.
    Mr. Abernathy. I think it is important to understand the 
nature of the Federal Home Loan Bank System as a cooperative 
system. It is different than a lot of other systems. They were 
put together as a cooperative system. The Banks are owned by 
their members. They are governed by their members. The Banks 
have this joint and several liability responsibility to shore 
up and assist each of the other members.
    I think that is important to keep in mind when you are 
looking at the question of securitization. These institutions 
were created to serve their membership, and in our view, 
anything that would suggest that they should be securitizing 
something for sale outside of that membership is something that 
is outside of the concept of the Federal Home Loan Bank System 
as it is presently constituted.
    On the other hand, I think with regard to some of the 
innovative programs that have been established that are 
currently in operation, those are all kept within the System. 
They provide an important source of liquidity to the member 
banks, and by that I mean the member banks of the Federal Home 
Loan Bank System, the ones that are members of each of the Home 
Loan Banks. And as far as we can see, they are providing an 
important service both with regard to the individual banks and 
the people who are most impacted, the people who take out the 
mortgages and buy and sell their homes based upon that 
financing.
    Mr. Korsmo. Mr. Chairman, do you want me to respond?
    Senator Bennett. Yes.
    Mr. Korsmo. Secretary Abernathy has outlined the concerns 
in the larger context very well. I think it is appropriate to 
mention that right now Federal Housing Finance Board 
regulations do not permit Federal Home Loan Banks to issue or 
guarantee mortgage-backed securities. There has been no request 
from any Bank or from any Bank's Board of Directors to seek 
such approval.
    I think if the question does come before us, obviously we 
will have to look at the whole question of legal authority and 
the safety and soundness basis for making a judgment. I do not 
know if there is anything more to say about that at this point, 
but that goes to the point of your question.
    Senator Bennett. I want to go back to the first part of my 
question. At what level should the Banks participate in the 
secondary market in this way? Because, again, traditionally, as 
you pointed out, Secretary Abernathy, the Banks exist to serve 
their members. Now they have gone in the direction of acquiring 
loans from the members as opposed to making advances to the 
members. And is there a financial level for this activity that 
would raise any concern on your part, or do you assume that 
that would be fine and this is where we go?
    Mr. Abernathy. Well, I think perhaps the most flexible 
definition of how far they should go would be how far their 
capital and resources can appropriately finance the risk that 
would be involved with purchasing the mortgages from their 
entities. But so far, the requirements for purchasing the 
mortgages from their member banks has been that the mortgages 
must be just as good as if they were being held for collateral, 
in which case it is difficult to say that they are taking on 
much more of a risk than they would by holding these merely as 
collateral.
    I think that is an important requirement, that the quality 
of the loans they purchase be of a high level so that they can 
manage that risk appropriately.
    Senator Bennett. Looking ahead to the debate as to whether 
or not they should be allowed to compete directly with Fannie 
Mae and Freddie Mac, is that the same level of safety that is 
required for Fannie and Freddie?
    Mr. Korsmo. In fact, sir, I would argue it is higher. The 
risk-based capital standards under which the Federal Home Loan 
Banks act are actually higher. I think Secretary Abernathy is 
right in portraying this particular aspect of the Banks' 
function, which is indeed providing more direct liquidity for 
mortgage lending. Advances, of course, are fungible, and to 
some extent, while they have to be collateralized with approved 
collateral that meets the standards of our regulations, the 
reality is that while advances remain by far the most 
significant aspect of Federal Home Loan Bank portfolios, the 
growth of acquired member asset programs truly reflect a member 
need.
    Senator Bennett. Okay. Quickly, because my time has 
expired, but I want to follow up before we have lost the 
thought. Assuming that you are correct that the standard for a 
Home Loan Bank is higher than the standard for the other GSE's, 
does that mean if you get into direct competition that in the 
Home Loan Bank System they would like to lower the standard to 
that that exists with Fannie and Freddie?
    Mr. Abernathy. I think there is direct competition. I think 
everybody recognized that when they made their most recent 
filing with the SEC. They listed who their competitors were, 
and they indicated they are the Federal Home Loan Banks. But 
they are a competition at a certain level. It is a competition 
for those higher quality----
    Senator Bennett. Yes. At a certain level do we see----
    Mr. Abernathy. In a different form, I should mention.
    Senator Bennett. Would we see a lowering of the standard 
that you have just described? Do you think that is going to 
happen?
    Mr. Korsmo. I would certainly hope not. That would not be 
the view of this regulator, anyway, to permit it, and right now 
the statute would not.
    Mr. Abernathy. I think there is a certain value in making 
sure that the mortgages purchased are very similar to the 
collateral requirements.
    Senator Bennett. Okay. Thank you.
    Senator Johnson has left, so, Senator Corzine, you came in 
next on the minority side. We will turn to you.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman, for holding this 
important and timely hearing.
    I guess I have to ask the following question: What is the 
basis to say that the standards of the Home Loan Bank are 
superior to the ones for other GSE's? Is it a risk-based model? 
Does it take into account the prepayment exposures and convects 
the exposures that are so difficult to manage in all financial 
institutions, in my perspective? And, second, what type of off-
balance-sheet exposures, if any, letters of credit or other 
forms, exist in the Home Loan Bank System? And how can we be 
certain that those are factored into the risk-based models?
    Mr. Korsmo. Certainly, sir, I am not exactly sure where to 
start on that question, but certainly we could assure you that 
the oversight that we provide and the constraints that the 
regulatory environment that we have created or the Finance 
Board has created are extremely strict. These are very 
conservative institutions. They are driven by a very 
conservative model and driven by, as I mentioned, a very 
conservative regulatory structure.
    Senator Corzine. Was the Treasury prepared to make that----
    Mr. Abernathy. I do not know that I would have phrased it 
the same way as Chairman Korsmo with regard to the Federal Home 
Loan Banks having a higher quality of portfolio. Fannie and 
Freddie were created particularly to establish secondary 
markets, and their mandate is broader. They are required to go 
into more markets than the Federal Home Loan Banks are. Because 
the Federal Home Loan Banks are required to have a very high 
level of collateral for the advances they give, and their 
program was designed to match that standard with regard to the 
loans they purchase, they are only targeting a certain segment 
of the home mortgage market.
    Fannie and Freddie were required to address a much broader 
range, in fact, with a particular emphasis on middle to lower 
income. And so because of that you would expect that they would 
be taking on what might be considered riskier mortgages, but 
they also have hedging and other types of strategies to manage 
that risk. And so as institutions, I would not like to have on 
the record the concept that Fannie and Freddie are riskier 
institutions than the Federal Home Loan Banks. They are 
required to have a broader portfolio, I think is the point I 
would make.
    Mr. Korsmo. I would certainly agree with that, but I would 
mention that the leverage requirements of our risk-based 
capital regulation are higher in the sense that we have a 4-
percent leverage requirement versus the 2.5 that applies, I 
believe, to Fannie and Freddie. I really am not terribly 
familiar with the Fannie and Freddie model, frankly.
    Senator Corzine. They have a minimum of 2.5, and then they 
have a risk-based standard.
    Mr. Korsmo. Right, exactly.
    Senator Corzine. As an add-on.
    Mr. Korsmo. You also asked about off-balance-sheet items. 
Our regulations require that derivatives be used only for 
hedging. Federal Home Loan Banks cannot use them for investment 
purposes. Eighty-two percent of the derivative use makes a 
perfect match with advances in consolidated obligations. So, 
again, I think the short answer is that the regulatory 
environment that we have created is very strict, and I think 
there is no question about that these institutions operate in a 
very high plane in terms of safety and soundness, which, after 
all, is our primary mission as the Federal Housing Finance 
Board.
    Senator Corzine. As an individual that has looked at risk-
based models off and on, it is hard to know, except through 
practical experience through time and different stresses, 
whether those models are as effective as one might always 
imagine in circumstances. I am not challenging whether it is or 
not, but I think it is very hard to say whether one model is 
better than another given the complexity of so many of the 
financial instruments. It really is a test of those that 
oversee, from my perspective, anyway, the building of those 
models, that they have the capacity to make a judgment about 
whether they are fully impacting all the issues.
    Thank you, Mr. Chairman.
    Senator Bennett. Thank you.
    Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Gentlemen, welcome. We appreciate your appearance today. As 
each of you may be aware, some of my colleagues on this 
Committee and I introduced legislation before the August break 
that would reform oversight for two of the other GSE's, Fannie 
and Freddie. And my question to each of you is: Do you think we 
should explore including the Finance Board in that legislation 
as well? Secretary Abernathy?
    Mr. Abernathy. Well, if I could, Senator, Secretary Snow is 
going to speak directly to that point tomorrow, and I certainly 
do not want to front-run him, presenting any views. But I will 
say this: We looked carefully at your legislation as we were 
evaluating those issues, and so we have taken very much into 
account your legislation and the reasoning behind it. And I 
believe that has been an excellent contribution to the debate.
    But with regard to whether or not we should include them, I 
would like to save that for Secretary Snow's statement 
tomorrow, if I may.
    Senator Hagel. Do you know if the Secretary will address 
that issue tomorrow in the House?
    Mr. Abernathy. That is in the whole panoply of things that 
he is presenting. That is right. We are looking at the GSE's in 
their totality, the housing GSE's, all of them together.
    Senator Hagel. So you do not want to venture any 
speculation on whether we should take the Finance Board and 
include that?
    Mr. Abernathy. I will be happy to after Secretary Snow 
does.
    [Laughter.]
    I will let him make the news.
    Senator Hagel. He is Gramm-trained, you can tell, cannot 
you, Mr. Chairman?
    [Laughter.]
    Mr. Korsmo.
    Mr. Korsmo. At the risk of being the second duck in this 
shooting gallery, for a different reason, obviously I think the 
primary role of any regulator is to ensure the safety and 
soundness of those institutions it regulates. I think to the 
extent that we create as strong as possible regulatory 
oversight, not just for the 12 GSE's that I oversee but for all 
14, I think that is important. Given the fact that I am the 
Chair of a five-person Board who is reluctant to take a 
position that has not been adopted by that Board, I guess I 
would also be reluctant to speculate as to where the best site 
is for that oversight function to take place. I think it is an 
important debate. Let me leave it at that. I look forward as 
well, needless to say, to hearing the Secretary's comments 
tomorrow.
    Senator Hagel. Spoken like a true Chairman. Thank you.
    Well, obviously, we will be talking to Secretary Snow and 
you, Mr. Secretary, about this, as well as the Federal Home 
Loan Bank officials, and we would welcome at the appropriate 
time your input, which I am sure we will receive.
    Mr. Chairman, you have developed a very impressive array of 
additions and completions since you have been Chairman on the 
Finance Board--objectives, responsibilities--and I think it had 
redounded, as the Chairman noted and others here today, to more 
confidence in your organization's oversight, safety, soundness, 
and credibility. Any additional changes, thoughts, practices, 
activities, or actions that you are anticipating that you can 
tell this Committee about to further enhance the effectiveness 
of the Finance Board?
    Mr. Korsmo. Yes, sir. Thank you for asking that question. 
Obviously, I would hate to make it sound like all it takes is 
more dollars. We have the luxury as an independent financial 
regulator that is a nonappropriated agency and can, in essence, 
adopt its own budget and pass the cost of that budget on to 
those we regulate.
    We are in the process really of a 2-year program to enhance 
and improve our oversight capacity. It is not something that 
can change overnight. The difficulty of adding to a staff, 
frankly, has been an important lesson to us. We had budgeted 
for this fiscal year to increase our number of examiners, for 
example, to 24. The reality is we have been unable to hire that 
many top-quality people and integrate them into our system fast 
enough.
    That having been said, we are continuing that process. We 
are going to add in this year's budget accountants, some 
financial analysts who will be assigned specific 
responsibilities with each of the Banks. I would be remiss if I 
did not touch quickly on our initiatives in the area of board 
governance. Board governance has in the last year or so become 
a watch word, and it has been a focus for the Finance Board as 
well. We have recently conducted a systemwide audit of board 
governance at each of the 12 Federal Home Loan Banks. We have 
an ongoing process to review board governance. We are 
scheduling a hearing tentatively for October 15, next month, 
where we will hear from the Banks and from other interested 
parties about recommended changes, both statutory that we could 
recommend and regulatory that we could implement that would 
improve the job that our boards of directors do.
    All of those come together, I think, to create a picture. 
We are not where we want to be, but we are headed in the right 
direction.
    Senator Hagel. Thank you.
    Mr. Chairman, thank you.
    Senator Bennett. Thank you.
    Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman, and, 
gentlemen, thank you for being here today.
    Both of you have alluded to, at least in your testimony, 
the multidistrict membership banks issue. Mr. Secretary, do you 
have a position on that issue?
    Mr. Abernathy. In our view, the question begins with is 
there authority for the Federal Housing Finance Board to make a 
determination. In our view, the statute does not leave that 
issue to the Finance Board to decide. It has really left that 
issue with Congress. The statute seems pretty clear that a bank 
has perhaps an either/or choice, but it is still one district.
    Senator Reed. Would you urge that Congress give the Board 
that authority?
    Mr. Abernathy. We have not addressed the question of 
whether it is wise to do that or not, and I think at some point 
we need to do that. And, in fact, if Congress wants to take 
that issue on, we would be glad to take a look at it and 
perhaps come back with recommendations.
    Senator Reed. Thank you.
    Chairman Korsmo, do you have a position?
    Mr. Korsmo. Let me just say that, first of all, no action 
by the Finance Board in this area is planned, and while I 
appreciate Secretary Abernathy's plain reading of the statute, 
sometimes a plain reading is not enough. As a regulator, I 
think I would be remiss in suggesting that the Federal Home 
Loan Bank Act does not provide broad authority to the Federal 
Housing Finance Board to take any action to the extent that it 
goes to meeting the primary mission, that is, ensuring the 
safety and soundness of the Banks.
    Unfortunately, sometimes when all one does is recite that 
circumstance and talk about how the financial services industry 
has changed and the membership in the Bank System has changed, 
it has taken for support for a particular policy position. I 
want to make clear here, because I think there may be some 
question based on comments others have made about my position, 
I am neither an advocate of nor an opponent of multidistrict 
membership. The Chairman alluded earlier to there are many 
unagreed-upon issues in this system. This is certainly one of 
them. I think you will find disagreement even among the 
boards--on boards of directors of individual banks as how to 
best deal with the changing circumstances in the housing 
finance industry.
    It is an issue that, as I say, at this point we have no 
plans to take action on.
    Senator Reed. I think we can mark you down as scrupulously 
noncommittal.
    Mr. Korsmo. Thank you. Yes, sir.
    Senator Reed. Chairman Korsmo, I am concerned about the 
process that the Finance Board has followed to make some 
important decisions, specifically the shared funding program 
operated by the Chicago Home Loan Bank Board. As I understand 
it, the staff approved under Section 955.2, and this would be 
for the purchase of interest in whole loans. But as I 
understand the Section, it only authorizes purchase of whole 
loans, not interest, or certain types of State and local 
housing finance agency bonds. Is that correct?
    Mr. Korsmo. No, sir. I think a broader reading of the 
regulation, again, particularly as it exists on the books now, 
is that the Banks have authority to purchase mortgage assets 
both in the form of whole loans and----
    Senator Reed. Interest loans.
    Mr. Korsmo. Thank you. I am losing my train of thought 
here. Interest in loans as well.
    Senator Reed. Can I just work my way through here? Because 
my notes indicate that the only reference to interest in whole 
loans was in the preamble of the regulation.
    Mr. Korsmo. That is correct, sir.
    Senator Reed. Which was a response to a comment made.
    Mr. Korsmo. That is correct, sir, but our general counsel 
and Office of Supervision's reading of that was that the 
regulation did indeed provide the authority for banks to apply 
for new business activity--excuse me, permission to engage in 
this activity.
    I think that it would be good to understand the process, 
however.
    Senator Reed. May I make one other point?
    Mr. Korsmo. Yes, sir.
    Senator Reed. Apparently, in July of this year, the Finance 
Board put this issue out for comment. Is that correct?
    Mr. Korsmo. Yes, we put out a draft of a revised AMA reg, 
yes, sir, for comment.
    Senator Reed. So why would you ask for comment after the 
approval of the program, which you say----
    Mr. Korsmo. The comment was not on this particular item, 
although broadly speaking, of course, commenters on this 
particular proposal, the revision of the entire AMA reg, 
certainly could have commented on this particular provision. 
But it was the provision as a whole that was being put forward 
for comment.
    Let me just mention that at our meeting tomorrow, because 
of the confusion that has developed over what exactly our 
proposal was and what it entailed, when it was unanimously 
adopted by the Board on June 18 at our regular meeting, we 
have--in consultation with my colleagues--all agreed that we 
will withdraw the proposed regulation, revise it to perhaps 
clarify what our intentions were in the regard not just of the 
item that you have mentioned, but some other areas that have 
been misunderstood as to intention, and reissue--assuming 
Finance Board adoption of a reissued proposed draft--that for 
comment.
    Senator Reed. Well, thank you, Mr. Chairman. I think this 
raises a very specific issue, but a more general issue of the 
process of approving and interpretation of your own regulations 
and public comments on proposed changes. We hope you would act 
on those general issues.
    Mr. Korsmo. Yes, sir, I recognize your concern in this 
area, and we will take it into consideration.
    Senator Bennett. Thank you very much.
    If Secretary Abernathy is right and the law is clear, the 
law is clear. So, I think you better, if you are going to argue 
with that, have the firm legal position rather than a general 
statement that, well, we have the right to do whatever is best 
for the System. Just an editorial comment as I listen to this 
back and forth.

                COMMENTS OF SENATOR JIM BUNNING

    Senator Bunning. Mr. Chairman, I would like to put in 
opening remarks.
    Senator Bennett. Without objection, it will appear in the 
record.
    Senator Bunning. Secretary Abernathy, does the Treasury 
believe that all GSE's, including the TVA, should register with 
the SEC?
    Mr. Abernathy. I would have to say, Senator, when we made 
the statement with regard to all GSE's, it was a general 
blanket statement. We did not limit it. With regard to the TVA 
itself, that is not one type of entity that I have been looking 
very closely at with regard to----
    Senator Bunning. To GSE, though?
    Mr. Abernathy. Senator, our view is that entities that are 
putting significant capital into the markets should be 
providing the full set of disclosures that other capital 
participants are required to follow.
    Senator Bunning. Would $30 billion be a----
    Mr. Abernathy. That is significant to me.
    Senator Bunning. It is significant, okay. I just want to 
make sure that is the Treasury's position, then; that all GSE's 
should----
    Mr. Abernathy. That is our position, yes.
    Senator Bunning. Thank you very much.
    Do you believe all--this is for either--housing GSE's 
should have the same regulator?
    Secretary Abernathy.
    Mr. Abernathy. If I could take a pass on that, Senator, and 
the reason why is tomorrow Secretary Snow is going to be 
addressing that very issue, and I would prefer to let him 
address it first.
    Senator Bunning. And obviously you will take the same pass.
    Mr. Korsmo. As a sitting regulator, I will take the same 
pass, please.
    Senator Bunning. I just had a very good meeting with the 
Federal Home Loan Bank Board of Cincinnati. They have agreed to 
voluntarily register alternative of their securities with the 
SEC. Some of the other banks I just was surprised that in your 
statement you said San Francisco seems to be now more 
cooperative in registering.
    Mr. Abernathy. They certainly seem to be laying the 
predicate for doing so, but they have not yet made that same 
commitment that the Cincinnati Bank has. And I certainly would 
like to praise the Cincinnati Board for making that 
determination.
    Senator Bunning. Does that trouble you, though, that just 1 
out of 12 would come forward and voluntarily register?
    Mr. Abernathy. I remain troubled until we have all of them 
registered, frankly, because we do not have the information 
about those entities that we need to have otherwise.
    Mr. Korsmo. Senator, in fairness to some of the other 
Banks, there has been a varying degree of participation. In 
fact, all 12 of the Banks have been actively engaged in the 
process of discussing this issue. There was a meeting 
yesterday, I believe, of the committee representing 10 Banks, 
but representing specifically the New York, the San Francisco, 
and the Pittsburgh bank with SEC officials. I know the Chicago 
Bank is also going through the process of preparing some draft 
documents for the SEC to look at.
    While certainly the Cincinnati Bank deserves being singled 
out for particular praise in their willingness to move ahead in 
this project, I would be reluctant to characterize the 
involvement of any of the Banks as being dilatory. They have 
all, to one degree or another, have recognized their 
responsibility to provide enhanced disclosures to the 
marketplace. At this point, we are debating what form that is 
going to take.
    Senator Bunning. Well, you both realize that registration 
with the SEC was the red flag for Freddie. When they were 
trying to get prepared to register with the SEC is when the big 
red flag went up for them. I hope that is not the case in any 
Federal Home Loan Bank Board or any area of the country, but to 
register with the SEC you have to undergo certain registration 
scrutinies, and I want to make sure, if somebody is reluctant 
because of that, you should know that as the chief regulator.
    Mr. Korsmo. That is correct, sir, and my sincere hope is 
that the reluctance is based on principle and not on any 
reluctance that some action or practice would be revealed which 
would embarrass the Banks. I can assure you that the job we are 
doing as the safety and soundness overseer and supervisor is 
sufficient to assure that that is not the case.
    Senator Bunning. Last, but not least, I disagree with your 
definition of ``or.''
    [Laughter.]
    I have more than one child, and I would make comparisons 
equally as distinguishing as you did in either/or or and/or, 
and I would be with the Chairman on that regulation. Thank God 
I am not a lawyer. I do not get confused with the facts, you 
know.
    [Laughter.]
    But I believe ``or'' means exactly what it says. Thank you.
    Senator Bennett. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, thank you. I have a statement 
I would like to have put in the record.
    Senator Bennett. Without objection, it will be placed in 
the record.
    Senator Allard. I have a question for Mr. Abernathy. In 
your testimony, you noted that investors in GSE securities 
should have access to the same corporate disclosures as they 
have for other companies who publicly offer their securities 
for investment. In your opinion, how do the current disclosures 
compare?
    Mr. Abernathy. The most significant thing that I think that 
we obtain by having the Federal Home Loan Banks register with 
the SEC, even if they did not disclose an additional piece of 
information that they are currently not disclosing is the 
timing, by registering with the SEC, that the timing of 
disclosures will be the same to provide comparability for 
investors, the standards for disclosure and the standards for 
review of those disclosures will become the same, and it is a 
high standard, and those who are doing those particular reviews 
will be the same.
    The penalties for false filings would become the same, and 
it is that high standard that I think has elicited the point 
that Senator Bunning mentioned. Before Freddie Mac agreed, and 
they did agree to register the SEC, they were, for a time, 
saying there would be nothing new that would be disclosed if we 
agreed to this regime. Then, they agreed to it and discovered 
maybe it does mean a higher standard. Maybe it does mean that 
what we are required to comply with is more meaningful. We 
think that would probably be similar with regard to the Federal 
Home Loan Banks, not that there is anything hidden, but that it 
provides a more rigorous standard of comparability, 
particularly.
    Senator Allard. Chairman Korsmo, you mentioned in your 
testimony, the Federal Housing Finance Board is a 
nonappropriated agency and enacts its own budget and assesses 
the Banks for the cost of its operation. How important is this 
authority in your ability to carry out your mission?
    Mr. Korsmo. It is extremely important. I think I am still 
too early in my tenure, frankly, and not having served in a 
situation where that was not the case, it is hard for me to 
make a comparison. But I think the fact that we can structure a 
budget responsibly that provides us the resources we believe we 
need to carry out our responsibilities is significant. Again, 
given the fact I have never operated under a different system 
makes it difficult for me to compare, but I will say that it 
certainly makes our job easier.
    Senator Allard. Now, that I have given you both softball 
questions, I would like to hear the pros and cons from each one 
of you about this proposal to have a consolidated approach to 
regulation. One regulator for all financial institutions. I 
would like to hear your pros, and I would like to hear your 
cons.
    Mr. Abernathy. Well, if I could take a pass, Senator. 
Secretary Snow is, I understand this is an important issue, and 
I am uncomfortable and have not been able to lay it out for you 
like I would like to lay the issues before you, but at the risk 
that if I presented the pros and cons, I am not very good at 
hiding where I think the weight of the good opinion rests. 
Rather than laying out the pros and cons and disclosing where I 
think we are, I will leave that for Secretary Snow, if I might.
    Senator Allard. Well, then, let me put it this way--you 
both have the same response about the mission of safety and 
soundness; would you talk a little about that?
    Mr. Abernathy. I think the mission of safety and soundness 
needs to be understood in a large context, and that is not just 
with regard to the safety and soundness of an institution 
itself, but also with regard to the markets in which it 
operates, and that is an important responsibility for the 
regulators. That is the way our bank regulators operate, and I 
think that is the way our GSE regulators should operate.
    They are looking at the safety and soundness, not just of 
the institutions, but of the financial system that those 
institutions are participants in. That is obviously the most 
important function the regulator has.
    Senator Allard. I think the farm loans or the home loan, at 
Farmer Mac, as well as the Fannie Mae and Freddie Mac have all 
had in the past, at some time or another, some problems with 
bad debt. Do you think it is the appropriate role of Government 
to come in and bail them out when they have debt problems like 
that or is it that you do not have any choice? Are we 
absolutely required to?
    Mr. Abernathy. I do not think that we are required to. I 
think that we have tried to make it very clear, and----
    Senator Allard. Well, let me put it this way. Does the 
``too big to fail'' principle come in line, and we simply have 
to bail them out in order to sustain the economy?
    Mr. Abernathy. Yes. I think, on many occasions, we have 
tried to emphasize the fact that there is no Federal guarantee 
standing behind any of the obligations of the Government 
Sponsored Enterprises. And those who invest in their debt or in 
their stocks, where they are publicly traded stocks, they have 
to evaluate just what is the risk involved with those 
securities and should not take into account thoughts that there 
is some Federal guarantee.
    Now, what would happen if one of those institutions was on 
the point of failure? Frankly, we have good regulators, 
hopefully, to prevent that from happening, to make sure that 
there is adequate levels of capital maintained by each of these 
institutions and that the----
    Senator Allard. How do we make sure that happens?
    Mr. Abernathy. The best way to do that, I think, is by a 
system of ongoing, on-site examination. We have a lot of 
enthusiasm for the steps that Chairman Korsmo has brought to 
pass on the Federal Housing Finance Board to beef up that 
examination pool.
    Senator Allard. Does that mean bringing all of the 
regulators into one, uniform approach?
    [Laughter.]
    Mr. Abernathy. Well, I will let Secretary Snow give his 
views on that, if I may.
    Senator Allard. Mr. Korsmo, would you respond to that.
    Mr. Korsmo. Obviously, Secretary Abernathy has a larger 
responsibility, and my context is to focus on the Federal Home 
Loan Bank System, and I have ducked the question as 
effectively, as Secretary Bunning will tell you, perhaps not as 
effectively, but I have made the effort.
    Let me say one thing, however, I think there is a----
    Senator Bennett. At least as often.
    Mr. Korsmo. At least as often. Thank you, Mr. Chairman.
    [Laughter.]
    Let me say one thing, in terms of a pro and con, I think 
the argument in favor of a single regulator will be how will 
the larger market look at the particular Government Sponsored 
Enterprise who is not subject to the same regulatory oversight 
in terms of site, as opposed to quality that is not included in 
that process.
    The flip side of that, of course, is the familiarity that a 
particular regulator can develop with the policies, practices, 
and institutions over which that regulator has responsibility 
is certainly easier if it is focused on a particular entity. I 
think there is some concern, and I do not mean to speculate on 
this part, but I think there is some concern among the Federal 
Home Loan Banks what would happen to us if we were buried, if 
you will, with Fannie Mae and Freddie Mac.
    And I think that is perhaps a legitimate concern, but I too 
will wait for Secretary Snow's view tomorrow.
    Senator Allard. Mr. Chairman, I was going to yield some 
time for my colleague, the Senator from Kentucky, but I see my 
time has expired.
    Senator Bennett. Senator Miller has joined us, so we will 
go to Senator Miller and then come back to Senator Bunning.

                COMMENTS OF SENATOR ZELL MILLER

    Senator Miller. I do not think I want to just get here and 
start to speak. Let me listen for a while, Mr. Chairman.
    Senator Bennett. Okay.
    Senator Bunning. I just have one question, Mr. Chairman.
    Senator Bennett. Sure. Senator Bunning.
    Senator Bunning. Secretary Abernathy, you made the 
statement about oversight and watching closely those entities, 
GSE's particularly. I am going to bring the TVA back to you. 
They are unregulated by anyone. No one, except these three 
commissioners, has anything to say about TVA. They sell up to 
$30 billion worth of debt. It is AAA because everybody else 
thinks that it is backed by the full faith and credit of the 
U.S. Government.
    FERC, who oversees almost every other entity in electric 
generation, has not one thing to say about the TVA. I suggest 
that the Treasury makes very sure that if you are going to 
include people in oversight and regulation that you look at a 
GSE called the TVA, which is unregulated and governed by three 
people.
    Senator Allard. That is a powerful argument, Senator. Thank 
you. We will look at it.
    Senator Bennett. Thank you, both.
    Secretary Abernathy, you made note in your comments that 
Freddie Mac has so far failed to register, in spite of the fact 
that they promised.
    Senator Allard. And I will say, if I could, Mr. Chairman, 
we have no doubt about Freddie Mac's willingness and intention 
to comply. We are eager to see it happen as soon as possible, 
but we have no doubts that they will comply.
    Senator Bennett. Very good.
    Thank you, both. We appreciate your testimony here today, 
and we appreciate your service to the Nation in the various 
positions that you hold.
    Mr. Abernathy. Thank you, Mr. Chairman.
    Senator Bennett. We will look forward, with great interest, 
to Secretary Snow's answers to the questions you have so 
artfully dodged here today.
    [Laughter.]
    Mr. Abernathy. Thank you, Mr. Chairman.
    Mr. Korsmo. Thank you, Mr. Chairman.
    Senator Bennett. We now move to our second panel.
    We are going to hear from them in this order, regardless of 
where their name tags go. We will hear first from Norman B. 
Rice, who is the President and CEO of the Federal Home Loan 
Bank of Seattle; Mike Middleton, the President and CEO of the 
Community Bank of Tri-County, Waldorf, Maryland. Senator 
Sarbanes had hoped to be here, Mr. Middleton, to introduce you 
to the Committee, and he may yet appear. If he does, we will 
take appropriate notice of that.
    Sheila Bair, who is the Dean's Professor of Financial 
Regulatory Policy at the Isenberg School of Management at the 
University of Massachusetts. Sheila is well known to this 
Committee and its Members and staff; Terry Smith, President of 
the Federal Home Loan Bank of Dallas; and David Hemingway, 
Executive Vice President of Zions First National Bank in Salt 
Lake City, Utah.

    I must exercise the hometown prerogative of introducing Mr. 
Hemingway to the Committee. He has been a witness before the 
Committee before on other issues and is very knowledgeable. I 
do recall a conversation with one of my colleagues in the House 
about an issue where Zions Bank was involved, and the House 
Member said to me, ``Now, let us see, was that Roger Zion that 
owns that bank?''

    And I said, ``No, it was Brigham Young that started that 
bank.''

    [Laughter.]

    And Zion has a reference to something other than a family. 
With that, we welcome you all, and, Mr. Rice, we will start 
with you.

                  STATEMENT OF NORMAN B. RICE

             PRESIDENT AND CHIEF EXECUTIVE OFFICER

               FEDERAL HOME LOAN BANK OF SEATTLE

    Mr. Rice. Good afternoon, Mr. Chairman and Members of the 
Subcommittee. I am Norman B. Rice, President and Chief 
Executive Officer of the Federal Home Loan Bank of Seattle, and 
I would like to thank Chairman Bennett and the Subcommittee for 
the opportunity to provide my perspective on the critical role 
the Federal Home Loan Banks play in building strong communities 
and healthy economies across America.

    The 12 Federal Home Loan Banks have a long history of 
service and accountability to the more than 8,000 financial 
institutions we serve, to the millions of individuals and 
families we help realize the American Dream of homeownership, 
and to the regulators and Congress who oversee our system.

    It is not the history of our Banks that I want to talk 
about this afternoon. Where we have been and what we have 
accomplished as a Bank System is significant and well 
documented. My focus is on the relevance of the Bank System 
today--and in the future--and the essential role we play on 
behalf of our financial institution members, and the economic 
health of our country.

    I will start with what I consider to be the most important 
element of the Federal Home Loan Banks. We are a cooperative. 
Our members own the Bank System, and we are accountable to 
them. These are the Banks, credit unions, thrifts, and other 
institutions that give our communities critically needed access 
to credit. These are the risk-takers whose leadership and 
resources build stronger towns, cities and, to a very real 
extent, a stronger Nation.

    They are able to do that as part of a cooperative that 
provides each member, small and large, the same access to a 
stable, low-cost, and reliable source of wholesale funding. No 
other housing GSE or financial institution can replicate our 
System's unique partnerships of bank, member, and community.
    As I sit here before you today, the Federal Home Loan Banks 
and the housing GSE's are facing significant challenges and 
changes regarding their business practices, regulatory 
structure, and mission-based programs and activities. In the 
weeks and months ahead, as this Subcommittee and other Members 
of Congress debate the future of the Federal Home Loan Banks 
and the housing GSE's, I would like to offer some questions and 
principles for you to consider in your discussion, as well as 
clear evidence of the powerful impact our bank system has on 
the economic health of our country.
    Over the course of any week, I am asked by a number of 
people what the Federal Home Loan Bank of Seattle is and what 
it does. And my short answer is this: We help ensure that 
Americans have homes and a stable local economy. That is a good 
quick response for anyone unfamiliar with the Home Loan Banks, 
but for the purpose of our discussion today, I would like to 
offer a more comprehensive--and slightly different--way to look 
at the value and the benefits provided by the Bank System.
    Imagine, if you will, our country with the 12 Home Loan 
Banks and then consider the following: The Bank System extends 
nearly a half-trillion dollars in advances, what we call loans, 
to our member financial institutions annually, strengthening 
those local economies, and homeownership. Imagine those dollars 
gone.
    Since 1991, the Federal Home Loan Banks have awarded $1.6 
billion in Affordable Housing Programs grants, helping to 
create 360,000 low-income housing units across the country. 
Imagine those homes gone.
    Since 1990, the Bank System has provided nearly $36 billion 
in reduced-rate, long-term loans for low-income housing and 
economic development. Imagine those dollars, and homes, and 
businesses gone.
    Now, imagine the collective impact on our national economy. 
I would urge you to ask yourselves how would your local banks 
compete if they did not have access to the capital markets? 
Where would your constituents go to get loans to buy homes and 
run their businesses? Now, go one step further. If the housing 
GSE's did not exist today, what would you put in their place? I 
believe you would come back to something that looked a lot like 
the Federal Home Loan Bank System as it is, and here is why.
    The Bank System is funded entirely through private capital. 
The cooperative is built by private owners who have put more 
than $36 billion of their own money at risk to capitalize the 
system. The Bank System is cooperatively owned to support, 
rather than compete, with the private marketplace. Our stock is 
not publicly traded, and we do not have third-party investors 
pulling out value. The Bank System is organized by region, 
ensuring that each Bank is connected and responsive to local 
markets.
    The Bank System pays its fair share of taxes. The Home Loan 
Banks carry a special tax burden that cannot be sheltered and 
is equivalent to a Federal corporate tax rate. The Bank System 
has been required, since 1989, to pay off the REFCORP debt and 
provide 10 percent of its net income in support of low-income 
housing. This is the single largest private source of housing 
subsidy in the United States.
    The Bank System is a critical source of liquidity through 
all parts of the economic cycle. So this country's network of 
community banks relies on our capacity to access the capital 
markets on their behalf.
    The Bank System has the capacity to innovate and keep pace 
with an evolving financial services industry. This is why we 
offer mortgage purchase programs. Our members have told us they 
can better serve homebuyers and local markets if there is more 
competition in the secondary mortgage market. It is no accident 
that our program volume has accelerated from zero to almost 
$100 billion.
    As you can see, it is not a difficult task to illustrate 
the benefits provided by the Home Loan Banks. Today, as one of 
the 12 Presidents within the System, I stand committed to work 
with you to further the mission and the vision of our Bank 
System and meet the evolving needs and issues facing our 
housing GSE's.
    On the matter of consolidation of GSE regulators, whether 
or not Congress determines that a single regulator is the 
appropriate direction or not, all three housing GSE's must have 
strong, consistent regulatory oversight to ensure both safety 
and soundness and mission achievement. There can be no debate 
on this point.
    And that means it is time to straighten out the wide 
variety of requirements and oversight regarding the housing 
GSE's. For example, why did two housing GSE's have lower 
capital requirements than the 12 Home Loan Banks which carry 
less credit risk? Why is there inconsistent mission oversight, 
with the Home Loan Banks delivering cash grants, while the 
other housing GSE's hit a different set of affordable housing 
goals?
    What public policy goal is advanced when roadblocks are put 
in front of our Bank System, when we respond to our members' 
stated desire to have greater competition in the secondary 
mortgage market, and when, in fact, those roadblocks actually 
hinder our ability to drive more funding to our member 
financial institutions and their communities? I have heard it 
called ``mission creep,'' but from my point of view, it is more 
like ``mission leap.'' When our mortgage purchase programs are 
allowed to grow, they allow us to take significant steps toward 
fulfilling our mission and not walking away from it.
    I want to be clear today that I believe the onus for 
strengthening our system lies not only with Congress and 
regulators, but also with the Home Loan Banks themselves. We 
need to continue to step up and accept the risk in our System 
and our industry and embrace the fact that more intense public 
oversight is inevitable. We welcome that public oversight 
because, if done smartly, it will strengthen our Bank System, 
ultimately, and the economy of this country.
    In closing, I would like to leave you with five principles 
that I believe should inform your discussions and decisions in 
the months to come:
    One, private capital is the most effective cushion to guard 
the public against the risks inherent in our enterprises. As a 
cooperative, the Home Loan Banks are capitalized by their 
customers who monitor risk-taking in a way that third-party 
shareholders cannot.
    Two, insist on competition among housing GSE's, rather than 
competition with the private financial services industry.
    Three, demand that more of the value created by the housing 
GSE's be delivered to the housing finance system and consumers, 
rather than private investors.
    Four, demand consistent strong and smart regulatory 
oversight for all housing GSE's and recognize the critical 
differences between the Bank System and publicly traded housing 
GSE's.
    And last, but not least, demand an intense focus on our 
mission, hold us accountable, and keep in mind what America 
would look like if the Federal Home Loan Banks did not exist.
    That concludes my remarks, and I thank you, again, for 
allowing me to testify today, and I will be happy to answer 
questions at the appropriate time.
    Senator Bennett. Thank you very much. We appreciate that.
    Mr. Middleton.

                 STATEMENT OF MICHAEL MIDDLETON

        VICE-CHAIRMAN, FEDERAL HOME LOAN BANK OF ATLANTA

              CHAIRMAN AND CHIEF EXECUTIVE OFFICER

        COMMUNITY BANK OF TRI-COUNTY, WALDORF, MARYLAND

    Mr. Middleton. Good afternoon, Chairman Bennett, Senator 
Bunning, Senator Miller and, hopefully soon, Senator Sarbanes.
    [Laughter.]
    Thank you for the opportunity to discuss something that----
    Senator Bennett. You are among friends, even if he is not 
here.
    [Laughter.]
    Mr. Middleton. He is a good friend.
    Thank you for the opportunity to discuss something that is 
very important to my business and my community, which is the 
Federal Home Loan Bank System. I am Michael Middleton, Chairman 
and CEO of the Community Bank of Tri-County, which is a $300-
million community bank located in Waldorf, Maryland.
    I serve as Maryland's elected Director to the Federal Home 
Loan Bank of Atlanta's Board, and I am honored to serve as Vice 
Chairman on that Board. I am also a Member of the Board of the 
Council of the Federal Home Loan Banks.
    I am testifying today on behalf of the Federal Home Loan 
Bank of Atlanta. Mr. Chairman, while I have covered details in 
my written testimony, I would just like to highlight some of 
the more important issues.
    As a member and a long-time user of the Federal Home Loan 
Bank advances, as well as other products, as well as a Director 
to the Atlanta Bank, I have gained a broad perspective on the 
system, and I hope it will be of use to the Subcommittee.
    The Community Bank of Tri-County serves southern Maryland. 
Our customer base draws from a broad economic range. We tailor 
our services and our products to meet the needs of our 
communities, while competing with larger regional and national 
financial institutions.
    At my bank, we take our CRA responsibilities very 
seriously. Many community banks, are faced with the challenges 
of meeting their CRA requirements. And the Federal Home Loan 
Banks provide us with the tools and the skills to meet those 
challenges.
    The Federal Home Loan Bank System helps level the 
competitive playing field in many, many ways. As GSE's, the 12 
Federal Home Loan Banks were created to stabilize and improve 
the availability of funds to support homeownership. Today, 
capitalized by the cooperative stock of its member owners, the 
Banks still fulfill that mission. The Banks and their members 
are the largest source of residential and community development 
credit in the United States.
    Through the work of many on this Committee, including 
Senators Hagel, Johnson, and Bayh, to modernize the Federal 
Home Loan Bank System in the Gramm-Leach-Bliley Act, it helped 
direct and expand the reach of the Banks and their members by 
providing critical residential community development credit to 
rural and urban communities.
    I believe it is important to note that the Federal Home 
Loan Bank is the only institution in the United States that 
fulfills this mission. The Banks are a stable, low-cost, 
reliable source of short- and long-term funding. For the many 
small and medium-sized community banks, the Federal Home Loan 
Banks are essential because direct borrowing from the capital 
markets is not a 
viable option for us.
    The Bank System enables us to remain independent and to 
continue to be an economic engine in our communities. That, of 
course, translates into jobs.
    The Federal Home Loan Banks developed their programs in 
response to their members. For example, in response to member 
demand, the Atlanta Bank now offers both the MPP and the MPF 
Acquired Member Assets Program. The Bank's members that use 
these programs are pleased that they have yet another financial 
tool in delivering competitive credit products.
    Like the advance programs, the AMA programs, again, help 
level the competitive playing field for community banks. At my 
bank, Community Bank of Tri-County, we rely on Atlanta's 
programs to deliver financial service to our communities. Like 
many other areas, our communities need more affordable housing, 
improved medical school, and volunteer and rescue support 
facilities. The Federal Home Loan Bank is often an invisible, 
but vital, partner fulfilling these needs.
    Community Bank has partnered with nonprofit CDC's in using 
the Federal Home Loan Bank programs to create layered funding 
that supports affordable housing and infrastructure 
development. We do this with programs, like the AHP, or the 
Atlanta Bank's EDGE program. These, and similar Federal Home 
Loan Bank programs, make affordable housing and community 
development projects economically feasible in communities such 
as mine.
    A good example of this is the Yardley Hills project in 
Calvert County, Maryland. I am sure Senator Sarbanes is 
familiar with that section of Maryland. That project, as an 
example, used $2.7 million in complex, layered funding through 
our partnership with the Atlanta Bank's AHP.
    In another project, we used the EDGE program to provide the 
Jarboe Family Head Start Center in St. Mary's County with 
permanent funding, when other traditional banking sources of 
larger regional banks became unavailable.
    The Federal Home Loan Banks also helped their members 
provide other needed forms of community development credit. 
Community Financial Institutions, CFI's, may now pledge, as 
collateral for advances, small business, small farm, and small 
agribusiness loans. This may allow smaller institutions, 
particularly in rural areas, to better serve the community 
development credit needs of their neighborhoods and their 
farmers.
    I strongly believe that the Federal Home Loan Bank System 
is able to provide these important benefits because of its 
dynamic membership of both large and small institutions and its 
regional, decentralized, and cooperative structure. I can say, 
unequivocally, that without the Federal Home Loan Banks and the 
programs they provide, it would be far more difficult for my 
bank, and the thousands of other community banks, to remain 
independent, competitive, and capable of extending important 
housing and community development credits.
    I have given you examples of why the Federal Home Loan Bank 
System is so vital for community banks like mine, but I am also 
a Member of the Board of Directors of the Federal Home Loan 
Bank in Atlanta, and that imposes additional important 
responsibilities.
    The Atlanta Bank and its Board support the Administration's 
position that housing GSE's should provide complete and 
transparent financial disclosures that constitute the best of 
class. That is why we, along with other Federal Home Loan 
Banks, have been working with all relevant parties to resolve 
the specific issues presented by the Federal Home Loan Bank 
statutory mission, cooperative structure, and joint several 
liability.
    In fact, the Atlanta Bank will file its annual financial 
reports for 2003 in SEC 10-K format.
    Senator Bennett. Could you summarize?
    Mr. Middleton. Thank you.
    I will tell you what. This is the summary.
    Senator Bennett. All right.
    Mr. Middleton. I am sorry if I have taken too much time of 
the Committee.
    As a director, I want the Atlanta Bank to meet the highest 
standards of disclosure. At the same time, and this is an 
important distinction, as a director, I have an obligation to 
the member owners of the FHLB to be certain that the 
disclosures are administered in a manner that would not impair 
the mission or the operation of the Bank or increase its cost 
of funds.
    Again, as a director, if I vote to voluntarily register the 
Atlanta Bank's equity with the SEC, not only do I assume 
additional personal, civil, and criminal liabilities for the 
relevant statutes, but I also assume a liability to our members 
for my decision to voluntary register.
    Thus, it is most compelling that the critical issues have 
been satisfactorily resolved and sustainable written agreements 
reached. Reasonably known issues, critical accounting issues, 
must be resolved in a way that all Federal Home Loan Banks and 
their members can rely on going forward without the threat of 
quarter-to-quarter, year-to-year reconsideration with each SEC 
filing.
    And there I will abbreviate my text. Thank you, Senator.
    Senator Bennett. Thank you very much.
    Mr. Middleton. It has been a great opportunity.
    Senator Bennett. Yes. We will be happy to put the entire 
statement in the record.
    Mr. Middleton. Thank you.
    Senator Bennett. Ms. Bair, again, welcome to the Committee, 
where you are well-known and spent a good portion of your 
career working on both sides of the aisle.

                  STATEMENT OF SHEILA C. BAIR

        DEAN'S PROFESSOR OF FINANCIAL REGULATORY POLICY

                 ISENBERG SCHOOL OF MANAGEMENT

                  UNIVERSITY OF MASSACHUSETTS

    Ms. Bair. Thank you, Mr. Chairman. It is good to be back. 
Senator Bunning and Miller, thank you for being here.

    It is a pleasure to appear before you today to assist you 
in your oversight of the Federal Home Loan Bank System. It is 
in the spirit of System supporter that I come to you this 
morning to raise two issues that I believe warrant your 
attention: Multidistrict membership and expansion of the 
System's mortgage acquisition programs.

    These issue are important because their resolution will 
help determine the future of the System and its long-term 
stability. They are examined in detail in a paper I recently 
completed that was funded by a grant to the School of 
Management from the Fannie Mae Corporation, which I would like 
to submit for the record.

    Senator Bennett. Without objection, it will be put in the 
record.
    Ms. Bair. Thank you.
    Ms. Bair. Thank you. The conclusions reached in the paper 
are my own and do not reflect the views of the research 
sponsor.

    After summarizing my paper, I will make some general 
observations about the FHLB systems regulatory structure in 
relation to efforts underway to improve safety and soundness 
regulation of Fannie Mae and Freddie Mac.
    Recent industry consolidations have prompted some to call 
for allowing members to belong to more than one district 
Federal Home Loan Bank.
    My primary objection to multidistrict membership is that 
Congress, not the FHFB, should decide whether such a 
fundamental change should be made to the System's historic 
regional and cooperative nature. I am also concerned that 
multidistrict membership could have a destabilizing influence 
on the System. Multidistrict membership would allow large 
institutions to ``shop'' their advance activity among multiple 
FHLBanks, but because all of the FHLBanks raise funds in the 
same way, their ability to compete, based on price, will be 
limited. As a consequence, they will likely compete on 
collateral and credit standards. Allowing one member to have 
multiple relationships with FHLBanks would also increase 
operational risk, since the System lacks safeguards to obviate 
the multiple pledging of collateral or the prospect of 
competing blanket liens. Moreover, allowing multiple 
memberships could increase large borrow activity in the System 
as a whole, thus, exacerbating large borrower concentrations. 
Nearly 24 percent of all advance activity is already 
concentrated in the System's 10 top borrowers.
    Multidistrict membership would, by definition, help only 
institutions large enough to take advantage of it, and 
fundamentally alter the basic concept of the System--a 
cooperative of regional banks existing to serve the funding 
needs of institutions headquartered in their districts. 
Moreover, given the seismic consolidation activity that 
occurred in the 1980's, which the System weathered quite well, 
it is difficult to see why current consolidation activity 
should provide the impetus for such a dramatic restructuring.
    The System's mortgage acquisition programs also primarily 
benefits the System's largest members. Begun in 1997 as a small 
pilot capped at $750 million, these programs have grown 
exponentially. The System now holds $90 billion worth of 
mortgages in portfolio, representing over 10 percent of its 
assets.
    There is nothing in the System's legislative history or 
authorizing statute that grants authority for direct mortgage 
purchases, and the other two major housing GSE's--Fannie Mae 
and Freddie Mac--were established and chartered by Congress 
expressly for that purpose. Congress, not the individual 
FHLBanks or the FHFB, should decide whether it wants the System 
to be a major player in the secondary mortgage market, and if 
so, the terms and limitations that should apply.
    The risk associated with mortgage acquisition are 
distinctly different from those associated with the System's 
traditional role of making fully collateralized advances. 
Advances have prepayment penalties and call features that allow 
the FHLBanks to effectively manage their interest rate risks. 
Different, more complex, tools are needed for the interest 
rate/prepayment risk presented by mortgages held in portfolio. 
Operational risk is also significant. There is a serious 
question as to whether the System has sufficient numbers of 
qualified staff or infrastructure needed to manage even the 
day-to-day risk associated with secondary mortgage market 
participation. Regarding credit risk, the mortgage acquisition 
program's proponents boast that the originators, not the 
FHLBanks, retain the credit risk. In truth, the originators 
provide credit enhancements that are only as good as the 
FHLBanks require them to be based on their own interpretation 
of historical default data, which again is outside the 
traditional mission and expertise. It is telling that a recent 
FHFB proposed rulemaking, now withdrawn, would have eliminated 
one of the program's most important tools in managing credit 
risk; the requirement that pools of purchased mortgage assets, 
achieve an investment grade rating from an independent rating 
agency.
    No adequate public policy basis has been advanced for the 
System's foray into this new, riskier line of business. Though 
promotional materials for the programs claim that they are 
designed to help smaller institutions, available data suggests 
that they are being run overwhelmingly for the benefit of large 
originators. According to trade journal reports, the top five 
mortgage originators sold $42.7 billion in mortgages to the 
FHLBanks in 2002. Assuming the accuracy of this report, these 
five institutions would account for almost all of the $45.7 
billion in FHLBank mortgage acquisitions in 2002.
    Questions about the capability of the System to manage new 
risks associated with multidistrict membership and mortgage 
acquisition programs are heightened by longstanding weaknesses 
in the FHFB examination process, identified by the GAO in 1998 
and again in 2002. Though the FHFB has taken a number of steps 
to address these weaknesses, including increasing the number of 
examiners and putting greater focus on major risk and the 
quality of controls at FHLBanks, the GAO found, in a report 
released last February, that it is still too soon to evaluate 
the effectiveness of these measures. We heard from Chairman 
Korsmo earlier that they are now up to 17 examiners, with plans 
to increase that total to 24 by 2004, and I believe he said 30 
by the end of 2005. However, according to its fiscal year 2003 
budget, only $9.7 million of its $27 million budget was 
allocated for the Office of Supervision. By way of comparison, 
Treasury's two bank regulatory bureaus, the Office of the 
Comptroller of the Currency and the Office of Thrift 
Supervision, were typically assigned teams of 20 to 30 
examiners to each of its large institutions, and will spend 70 
to 80 percent of their budgets in direct support of 
supervision.
    More fundamentally, the structure of the FHFB suffers from 
many of the same defects now being scrutinized at the Office of 
Federal Housing Enterprise Oversight. It is a small, low-
profile agency that simply cannot attract and retain the 
quality of staff that it needs. It exists outside the financial 
regulatory mainstream and, thus does not benefit from the 
routine, day-to-day interaction that occurs among the major 
bank regulatory agencies. It is responsible for only 12 banks, 
plus the Office of Finance, and narrow constituent base that 
creates the perception of ``captive regulator.'' Other major 
financial regulators have a much broader regulatory base, and 
their actions are generally reflective of the views and 
interests of diverse and competing constituencies. When a 
regulator's jurisdiction is confined to a small group of 
closely aligned institutions, the pressure and input it 
receives can become narrowly focused and one-sided. It becomes 
difficult for that regulator to stay objective and ``above the 
fray.''
    Should a new agency be created at the Treasury Department 
for oversight of Fannie Mae and Freddie Mac, I believe it would 
be a stronger agency if it also included oversight of the FHLB 
System. The new regulator would have a bigger, better view of 
the housing finance market and would be in a better position to 
evaluate the advantages and dangers of the major housing GSE's 
competing directly with each other in the same lines of 
business. From the standpoint of systemic risk and taxpayer 
exposure, it is just as important to the Government for the 
FHLB System to have quality safety and soundness oversight, as 
it is for Fannie and Freddie. At year-end 2002, the System had 
$668 billion in outstanding debt, compared to Fannie's $884 
billion and Freddie's $644 billion. It enjoys the same implied 
Government guarantee, with an even more generous line of credit 
from the U.S. Treasury.
    The competitive impact on FHLB funding costs should also be 
weighed in the balance when considering whether to merge the 
FHFB into the new agency. The creation of a credible, high-
quality GSE regulator within the Treasury will likely receive a 
positive reaction in the capital markets, which could reduce 
Fannie and Freddie's funding costs. If the FHLB System is left 
out, that could widen spreads between FHLBank securities and 
those issued by the enterprises. Wider spreads would in turn 
mean the higher cost of funds for the FHLBanks, which would 
adversely impact the price of advances and ultimately raise 
costs for homeowners.
    Strong momentum is building with the creation of a 
credible, high-quality regulator within the Treasury Department 
to replace OFHEO. Now would be a propitious time for the 
Congress to consider whether oversight of the FHLB System 
should also be placed under this new regulator. To be sure, 
there are important policy determinations that Congress needs 
to make regarding the FHLB System's mission and future, and it 
is important not to impede the momentum behind the transfer of 
OFHEO's safety and soundness functions. However, concurrent 
action could assure quality regulation of all three major 
housing GSE's and prevent a widening of spreads which could 
further weaken the System.
    Thank you, Mr. Chairman.
    Senator Bennett. Thank you very much.
    Mr. Smith, we appreciate your being here.

                    STATEMENT OF TERRY SMITH

          PRESIDENT, FEDERAL HOME LOAN BANK OF DALLAS

    Mr. Smith. Mr. Chairman, Senator Sarbanes, Senator Bunning, 
I appreciate the opportunity to speak to you today about the 
Federal Home Loan Banks. My name is Terry Smith. I am the 
President of the Home Loan Bank of Dallas. I am pleased to 
provide an update on the Bank's activities and our progress 
implementing the Home Loan Bank provisions of Gramm-Leach-
Bliley. My written statement includes an overview of a range of 
issues related to those banks, and since my colleagues are 
addressing some of those same issues, I will limit my oral 
remarks and ask that the remainder of my statement be accepted 
for the record.
    Senator Bennett. It shall be printed in the record.
    Mr. Smith. Thank you.
    I would like to stress four points related to the Federal 
Home Loan Banks.
    First, the Banks are a valuable resource for more than 
8,000 member financial institutions, representing 78 percent of 
all FDIC-insured depository institutions. Those members, 
primarily community banks and thrifts, use the Banks' advances 
and housing 
programs to meet the mortgage and community lending needs of 
their local markets and use our affordable housing programs to 
make housing more affordable for thousands of low-income 
families in those communities. This is our primary purpose, and 
we are proud of our accomplishments.
    Second, the Banks continue to be financially strong and 
conservatively managed cooperative institutions. The Banks are 
well capitalized, maintaining capital asset ratios between 4 
and 5 percent. The Banks' advances are fully collateralized, 
allowing the Banks to maintain their enviable record of never 
having suffered a credit loss on a member advance in their 71-
year history.
    The Banks also manage interest rate risk very 
conservatively, using derivatives in a very precise and prudent 
way to minimize the difference between the maturities of their 
assets and liabilities. These risk management practices enable 
each of the Banks individually to maintain a AAA rating and for 
the Banks collectively to enjoy the same high ratings on their 
consolidated obligations, the debt of the 12 banks issued 
jointly.
    Third, the Banks' cooperative corporate structure 
reinforces our conservative approach to risk management and 
eliminates many of the incentives that a publicly traded 
company might have to increase its risk profile in hopes of 
achieving higher returns for its shareholders. There is no 
stock compensation for management, directors, or employees of 
the Banks.
    Only members may purchase a Bank's capital stock, which 
they do in order to obtain access to the Bank's products, and 
not primarily as a stand-alone investment. The price of a 
Bank's capital stock does not fluctuate, but can only be 
purchased or repurchased at its par value.
    Members expect stability, reliability and consistency of 
dividends, and credit product pricing, rather than a high 
yield. And our boards of directors are structured to ensure 
that outcome.
    No members of management serve on the board of directors. A 
majority of each bank's directors are elected representatives 
of member institutions, primarily from community financial 
institutions, who have a vested interest in the Bank's long-
term viability and stability. The remaining directors are 
public interest directors appointed by the Finance board.
    Fourth, the Banks are subject to rigorous safety and 
soundness oversight and regulation. Finance Board regulations 
govern every facet of the Bank's operations, from advances 
pricing to eligible collateral, to risk management, to capital 
plans, to directors' responsibilities, and so on.
    The Finance Board also collects and monitors financial and 
risk management data from the Banks each month, performing 
ongoing reviews of various aspects of the Bank's operations and 
conducts annual on-site examinations of all 12 Home Loan Banks.
    When Congress enacted the Gramm-Leach-Bliley Act in 1999, 
it included several provisions related to the Banks' 
operations. The new law provided for universal voluntary 
membership and equal access to the Banks for all types of 
financial institutions. It established a framework for more 
permanent capital structure that includes total leverage- and 
risk-based capital requirements for the Bank for the first 
time.
    It also expanded the types of collateral the community 
banks can pledge to secure advances which has allowed those 
institutions to take greater advantage of their access to the 
Banks and to meet the credit needs of their communities.
    These changes have, and will continue to have, a positive 
impact on the Banks' ongoing ability to fulfill their statutory 
role and to do so safely and soundly.
    I would be happy to answer questions of the Committee at 
the appropriate time.
    Senator Bennett. Thank you.
    Mr. Hemingway.

                STATEMENT OF DAVID W. HEMINGWAY

          DIRECTOR, FEDERAL HOME LOAN BANK OF SEATTLE

                    EXECUTIVE VICE PRESIDENT

        ZIONS FIRST NATIONAL BANK, SALT LAKE CITY, UTAH

    Mr. Hemingway. Thank you. Good afternoon, Chairman Bennett 
and Senator Sarbanes.
    My name is David Hemingway, and I am Executive Vice 
President of Zions First National Bank, based in Salt Lake 
City, Utah. I am also a Member of the Board of Directors of the 
Federal Home Loan Bank of Seattle.
    I would like to thank Chairman Bennett and the Subcommittee 
for the opportunity to speak this afternoon on behalf of the 
Federal Home Loan Bank System.
    First, I would like to discuss why Zions Bank and other 
regional and community financial institutions across our 
country use the Home Loan Banks and then address the issue of 
corporate governance and the responsibility within the Bank 
System.
    In 1932, the Bank System was created to provide liquidity 
to the savings and loan industry. At that point in history, 
there was no secondary market for mortgages, and the S&L's 
needed a way to borrow against the mortgages in their 
portfolio, so the Federal Home Loan Bank System was created, 
providing low-cost advances to meet the needs of community 
financial institutions and their customers.
    This need for liquidity in our Nation's network of 
community banks is as real today as it was in 1932, and the 
only housing GSE that can meet this need is the Federal Home 
Loan Bank System. Let me briefly explain how this works.
    Banks accept deposits, as you all know, and then make loans 
with a portion of those deposits. The deposits not invested in 
loans are invested in securities, such as U.S. Treasury notes.
    There is no rule that says, in the real world, that 
deposits will always be greater than the loans outstanding in a 
financial institution. These fluctuate from day-to-day. There 
is also no rule that says depositors cannot withdraw their 
funds at will simply by writing checks.
    So, in the case of Zions First National Bank having the 
balance in Zions' checking account at the Federal Reserve Bank 
of San Francisco, where banks have their checking accounts in 
the Federal Reserve System, having that balance increase or 
decrease by $200 to $300 million in a day is not unusual. And a 
bank is trying to manage its checking account the same way as 
you might be managing your own checking account, and a 
fluctuation of a couple of hundred million dollars is something 
to be noticed.
    Zions has a $1-billion liquidity line from the Federal Home 
Loan Bank of Seattle. Now, this line of credit from the Federal 
Home Loan Bank overdraft protection is secured with mortgages, 
first mortgages, in Zions First National Bank's loan portfolio 
of about $1.2 billion. When Zions' depositors withdraw $300 
million in a day, and I assure you this does happen on a 
regular basis, we call up the Federal Home Loan Bank of Seattle 
and borrow $300 million overnight to replace those deposits 
until they can be replenished in the normal course of business. 
Now, no other GSE or 
financial partner can provide or does provide this type of 
service.
    Another area where the Bank System is unique is in 
providing liquidity in the form of low-cost and long-term loans 
to regional and community banks that do not have access, and I 
think the important part here, is do not have access to the 
capital markets which most community banks do not have access 
or even smaller regional banks.
    Developers of low-income housing projects need long-term 
fixed-rate loans. The only source of long-term low-cost 
liabilities for a community bank is the Bank System advance. I 
have often said that the Home Loan Banks are the savior of our 
regional and community banks. The System, with its GSE status, 
AAA rating, cooperative equity structure, and low overhead is 
the best, and in many cases, the only source of low-cost long-
term liquidity for regional and community banks.
    I would respectfully and forcefully request that no changes 
be made to the basic structure of the Bank System which was 
created to address a very real problem of liquidity for our 
country's financial institutions, a problem that the Federal 
Home Loan Banks continue to solve every day.
    I will now address the issue of corporate governance and 
the responsibility within the Bank System.
    As both a community banker, for the better part of three 
decades, and as an elected board member of the Seattle Bank, 
the issue of board governance is of paramount importance to the 
financial institutions and communities we serve, and to me, 
personally.
    As a director, I have been elected by the bankers of Utah 
to watch over their investment in the Seattle Bank. While I am 
not alone in that role--I share it with 17 other directors, and 
the management team of the company--I consider it my job to 
ensure that the financial management of this $47-billion bank 
is effective over the long-term, including proper stewardship 
of our shareholders' capital. That is a staggering 
responsibility when you consider that the funding provided 
within the Seattle Bank district fuels housing finance, 
affordable housing initiatives, and economic development in 
communities from Pago Pago to Walla Walla, Washington, to 
Blanding, Utah.
    When I was elected to serve as a director, I understood the 
critical importance of my role and what I needed to bring to 
the Board; namely, my personal integrity and accountability, my 
financial services and community banking experience.
    We are all aware that a quantum shift has occurred in how 
American corporations, large and small, privately held or 
publicly traded, must be run. We share with our regulator the 
Federal Housing Finance Board, the Treasury, and Congress, the 
sense of urgency that is so pervasive today regarding the need 
for increased accountability, and we have worked hard over the 
last several years to significantly strengthen the leadership 
and oversight of our Banks.
    Over the course of the last year, the Seattle Bank board 
has created, adopted, and publicly disclosed a set of core 
principles and guidelines relating to board governance. In 
addition, we have realigned our board committee structure to 
more effectively oversee all facets of the Bank's operations, 
upgraded education and training for all directors, and created 
a website that provides directors with faster access to a wide 
range of information critical to their board roles.
    Our regulator, the Federal Housing Finance Board, is also 
diligent in overseeing and supporting sound corporate 
governance practices across the Bank System. The Finance Board 
just recently completed a horizontal review designed to assist 
the Agency in directing and developing its supervisory and 
regulatory initiatives. The Finance Board interviewed 
management and board members and reviewed a wide range of bank 
documents with respect to the board policies, practices, and 
decisions.
    Key questions asked by the Finance board include:
    Does your board audit committee provide sufficient 
oversight of internal and external auditing functions?
    Is the audit function independent, reporting only to the 
board, and is it supported appropriately by directors?
    Does the board ensure that material risks are accurately 
and consistently assessed by management and reported to the 
board, in compliance with regulation and prudent practices?
    I am pleased to say that Seattle Bank has ``yes'' answers 
to each of these questions, but that is today. The board's job 
is to ensure that we have ``yes'' answers tomorrow, the next 
day and next year.
    As one of 216 bank directors of the various different 
Banks, I am proud to be a director of the Federal Home Loan 
Bank System, and I would not have it any other way.
    Mr. Chairman, that concludes my testimony. Thank you.
    Senator Bennett. Thank you very much.
    Senator Sarbanes, we welcome you. We, by proxy, introduced 
Mr. Middleton to the Committee, but I understand you wanted to 
welcome him, and we are happy to hear from you.

              COMMENTS OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Mr. Chairman, I am sure it has certainly 
been done adequately by you, but I just wanted to take a moment 
to say that Mike Middleton is a very distinguished business 
leader in our State and also a distinguished leader in the 
community. He, in fact, is the Chairman of the Charles County 
Economic Development Commission's Board of Directors, and I 
want to just mention one thing.
    He has taken, as a volunteer, an active role in teaching 
ethical decisionmaking to high school students in Charles 
County, and we very much appreciate that commitment on his 
part. Of course, he has been a very successful head of the 
Community Bank of Tri-County in Waldorf, Vice Chairman of the 
Board of the Federal Home Loan Bank of Atlanta, and we are very 
pleased he was able to come and be with us today.
    Senator Bennett. He did you proud with his testimony.
    Senator Sarbanes. Thank you.
    Senator Bennett. While you have the microphone, do you want 
to either make an opening statement or ask questions? Go ahead.
    Senator Sarbanes. I will defer to you.
    Senator Bennett. Thank you.
    I thank you all. This has been a very informative 
expression of how the Home Loan Bank System works.
    May I go back to the issues that I outlined in my opening 
statement and see if any of you have any particularly burning 
opinion that you want to express on these? The first one, 
whether or not the Home Loan Bank should register with the SEC, 
we heard that discussed by the first panel, and some of you 
have mentioned it in passing, but if you have any additional 
comment that you need to make there, we would appreciate that.
    Whether or not a member institution of the System should be 
permitted to be a member of more than one regional Home Loan 
Bank, Ms. Bair has made that very clear, as far as her 
position. If some of the others want to argue with her or 
support her, whatever, we would look at that.
    At what level should the Home Loan Banks be permitted to 
participate in the secondary mortgage market? And, again, you 
have discussed that, but if you want to be more sharply focused 
on that question.
    And then, finally, whether or not we should have a single 
regulator for all of the housing GSE's. I do not want to 
recover the question of what kind of a regulator that should 
be. Some of you have outlined your feelings about a regulator, 
but just the overall question of whether or not Congress should 
move in the direction of trying to create a single regulator. 
Those are the four issues that were driving us behind the 
calling of the hearing, and along with the general comments 
that you have made, which I stress, again, have been very 
educational and very helpful, if someone has a very specific, 
pointed comment they want to make on any one of those four, now 
is the time.
    Mr. Rice. I would make one quick comment, as it relates to 
the Mortgage Purchase Program, Mr. Chairman. At the Seattle 
Bank last year, our Mortgage Purchase Program created about 
$1.75 million in profit that went directly for our Affordable 
Housing Programs. And at this point in time, about 42 percent 
of our mortgage purchase loans are for low- and moderate-income 
individuals. And just in 2 years, we have made extraordinary 
gains in making sure that the return from the mortgage purchase 
program goes back to the members and goes back to affordable 
housing.
    That is one point. And the second point is that our members 
are desirous of having choice; choice to sell their mortgages, 
and I think choice is fundamental in their decisionmaking, 
rather than being limited.
    We created a program, in direct response to our members' 
needs, and we are now organizing and setting ourselves up to 
run it in a safe and sound manner, to come up with some level 
or cap I think is difficult. I believe the biggest issue is to 
make sure we have a regulator who can oversee and make sure 
that we are managing the program in a safe and sound manner.
    Mr. Middleton. May I?
    Senator Bennett. Mr. Middleton, yes.
    Mr. Middleton. As a $300-million community bank, for us to 
lend in more residential lending is just part of the business 
plan. I can tell you we have been doing this for five decades, 
and we have been selling to the housing GSE for the last two 
decades. They have had a zero-loss experience.
    Senator Bennett. Which GSE have you utilized?
    Mr. Middleton. Freddie Mac.
    Senator Bennett. I see.
    Mr. Middleton. However, due to our volume, we get charged a 
fairly significant guarantor fee. With the MPP, our credit loss 
experience is reflected in the pricing, and it will allow us to 
make a business decision to continue this product line in our 
community because it becomes more profitable for us. So this is 
a very important service to a community bank.
    Senator Bennett. So you are saying that if you had the 
opportunity to have a larger secondary mortgage market than 
exists currently with your choice of Freddie Mac, specifically, 
if you could do it through a Home Loan Bank, you would either 
be able to make more money or charge less to your customer or 
both?
    Mr. Middleton. That is correct, sir.
    Senator Bennett. I see. Any other comment?
    Ms. Bair, yes, go ahead.
    Ms. Bair. Just a couple of things. First and foremost, my 
objection to the Mortgage Acquisition Program is that it has 
not been authorized by Congress. And I think a lot of people 
were looking the other way when it started as a small program. 
A lot of people were assuming that because of the capital 
structure of the Federal Home Loan Bank System, it could not 
really grow to sizeable levels. It is, in fact, growing 
exponentially, primarily the Chicago program. I think Seattle 
has maybe progressed in a little more responsible fashion.
    I also think one of the reasons Chicago has been able to 
grow so exponentially under the existing capital structure is 
the shared funding program. And to Senator Reed's question 
earlier, I think there is a real process issue about the way 
that shared funding came about. The regulations only refer to 
purchase of whole loans.
    Under shared funding, basically, a member of the Chicago 
Federal Home Loan Bank securitizes the pool of mortgages, 
creates two tranches, sells the senior tranche back to the 
Chicago Bank, so it is not a direct securitization. A member is 
used to securitize, but then the interest and the mortgages are 
sold back to Chicago Bank. It can then sell those throughout 
members of the System. In this way, it has been able to get a 
lot of assets off of its balance sheet and get around the 
capital problems it would otherwise have.
    There is really no public comment. It is questionable 
whether the regulations currently allow them to be purchasing 
interests in whole loans, as opposed to the whole loan itself, 
to Senator Reed's comment.
    I believe there are just some process issues and some 
significant policy issues that need to be dealt with that 
really are not. These programs are really growing quite 
rapidly, and I am just concerned that there is not anybody 
really in charge taking a close look to make sure it is not 
undermining safety and soundness. It is just not the System. 
This thing keeps going. You talk about the high credit quality 
of the loans.
    If this is coming out of the Fannie and Freddie business I 
assume it is, you know, what type of destabilizing effect would 
this have on the overall market? Nobody is really looking at 
that. And I think, again, a single regulator, with all three 
major housing GSE's, could get a better handle about whether 
this is a good thing or a bad thing, in terms of the overall 
housing market.
    I would also add that I think, to the extent there is a 
good justification for the System being in this business, it is 
for the community banks, and I wish I saw, in the numbers that 
I am reading, more marketing and delivery of services to the 
smaller banks, as opposed to the large originators.
    Thank you.
    Senator Bennett. Anyone else?
    Mr. Hemingway.
    Mr. Hemingway. Yes, Senator. I was going to change and talk 
about a different subject.
    Senator Bennett. Please, go ahead.
    Mr. Hemingway. SEC registration.
    Senator Bennett. Right.
    Mr. Hemingway. I would like to speak from my experience as 
a banker on this area, but also, as you may remember, I am also 
a member of the board of directors of Farmer Mac. I have some 
experience in the area of being involved with a GSE, where 
Zions is a large shareholder, for an entity that is regulated 
by the SEC. One of the issues that needs to be taken into 
consideration is the mission of the SEC is quite different than 
the mission of a safety and soundness regulator, whether it be 
the Comptroller of the Currency or the Federal Housing Finance 
Board or, in the case of Farmer Mac, the FCA.
    The mission of the SEC is to protect investors, and 
particularly small investors in public securities. The mission 
of a safety and soundness regulator is to make sure that the 
financial institutions that they regulate are safe and sound. 
So they approach problems differently, and I will give you an 
example, which raises some of the concerns here.
    The example is take loan loss reserves. Anybody that has 
been in banking very long knows that the regulators love to see 
large loan loss reserves. They would like to see them as large 
as possible because that gives protection to the Bank and to 
the FDIC, ultimately, and the U.S. Government if there are 
losses in the loan portfolio.
    But the SEC takes an exact opposite position. They believe 
that the loan loss reserves in the various different financial 
institutions are too large, and they view the large loan loss 
reserves being a way for financial institutions to manage their 
earnings. They believe that transparency would require smaller 
loan reserves. And, of course, they have the accountants, with 
GAAP, who come out to enforce their views.
    You get a board of directors and a management that are 
being told exactly the opposite from their two regulators, if 
they, in fact, have two regulators. Their safety and soundness 
regulator telling them that we believe we would like to see 
some higher reserves so that you will be safer and sounder or, 
at the same time, the SEC is saying, no, you have too much in 
reserves and, in fact, we believe that you are approaching the 
point of managing earnings, which is not good for the public 
markets.
    This is not fiction. This is real. It is happening today. 
One of the concerns I have is how we deal with two regulators, 
and we deal with it in banking all the time, but it is a 
problem when you get two regulators with different views, and 
both of them having the power to regulate a single financial 
institution.
    One of the concerns, not to drag it on, but the safety and 
soundness regulators, which I have already mentioned the names, 
have the power to remove an executive or remove a member of the 
board of directors. The SEC has the power to send you to jail. 
And so, at the end of the day, the boards tend to be more 
responsive to the SEC because of the more power and the threat 
of criminal activity if, in fact, you do not follow their 
rules.
    Senator Bennett. I assume, when you go to jail, you are 
also removed from the board.
    [Laughter.]
    Mr. Hemingway. Well, you know of an incidence in Utah where 
that was not the case, but that is usually the case.
    [Laughter.]
    Senator Bennett. Well, let us go back to Senator Bunning's 
comment, then, when he raised the suggestion that it was 
potential registration with the SEC that caused Freddie Mac to 
get in the situation where they restated their earnings. Do you 
accept that as a cause-and-effect relationship?
    Mr. Hemingway. I think there is another issue there, is 
they changed accountants. You will probably recall that Arthur 
Andersen was the accountant for Freddie Mac, and I am 
personally not aware which of those instances caused this to 
come to light; was it the new accounting firm or was it 
registering with the SEC, a combination of both or neither. I 
do not know, personally.
    Senator Bennett. Before I turn it over to Senator Sarbanes, 
does anybody have a comment on the conflicting stresses created 
by the two types of regulators that Mr. Hemingway has raised?
    Mr. Middleton. Senator, I support that. My company is an 
SEC-registered bank as well, but we registered with the SEC 
because it was in the best interest of our business plan, and I 
worry about the mission of the FHLB we have a statutory mission 
plan, if you will, by Congress.
    Senator Bennett. Did you have an option not to register 
with the SEC?
    Mr. Middleton. Yes, sir, but because of the number of 
shareholders, we registered. We could have restricted the 
number of stakeholders had we want to do so.
    Senator Bennett. I see.
    Mr. Middleton. That is a choice, and that is why it is a 
voluntary registration. I just worry, as a deep user of the 
Federal Home Loan Bank, is that the difficulties that have to 
be worked through can be worked through, and a disclosure, in 
SEC format is easy to obtain, and everybody has recognized that 
this is always good for a GSE, but we do need to have 
sustainable, written agreements that say, here is how we are 
going to interpret issues such as joint and several 
obligations. This is how we are going to interpret issues such 
as REFCORP. This is what happens if the mission requires 
specific action--how do we serve the mission if it conflicts 
with the SEC's decisions.
    So there are very difficult things to work through, and I 
can assure you--I am on the Audit Committee and I chair the 
Finance Committee of the Atlanta Bank--we have spent a lot of 
hours and a lot of resources making sure that we do this thing 
in an appropriate manner because, at the end of the day, 
corporate law prevails. The prudent business judgment decision 
provision of the duty of care prevails. So, when we vote for 
this, we must know that these critical issues are resolved so 
that we will not hurt and do no harm to the System.
    Senator Bennett. Okay.
    Mr. Middleton. Does that help you?
    Senator Bennett. That is helpful. Ms. Bair, do you want the 
last word on this?
    Ms. Bair. If I could just add, my sense is that the 
prospect of SEC registration was added impetus to the Freddie 
Mac board to get their house in order, so to speak.
    I would also say I worked with the SEC for many years as 
the head of Government Relations for the New York Stock 
Exchange. It is a disclosure-based regulatory regime. It is not 
a safety and soundness regulatory regime vis-a-vis publicly 
traded companies. So, even though there have been conflicts 
between the bank regulators on the loss reserves, that has been 
not a safety and soundness issue for the SEC so much as it has 
been a managed earnings issue, a disclosure issue.
    It is also ironic, you bringing it up, because I have heard 
another concern may be that the low-level retained earnings in 
the System, which goes counter to where you might think the 
conflict was with the SEC in the loss reserves.
    But my sense is they are not a safety and soundness 
regulator. They are a disclosure-based regime, and that is the 
approach they take.
    Senator Bennett. I see.
    Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman.
    I would like each of the panelists very succinctly, if they 
could, to state what they think is the proper regulatory 
structure for the Home Loan Banks.
    Senator Bennett. Mr. Rice, let us start with you and go on 
down.
    Mr. Rice. The proper regulatory structure is----
    Senator Bennett. Here, the buck always starts in the middle 
of the table.
    [Laughter.]
    Mr. Rice. You are right.
    The proper regulatory structure is the structure, as it 
exists in the Finance Board now. If it is to move, I would hope 
that you would preserve the structure that is there, which has 
mission and safety and soundness tied together, the notion of 
respect for the cooperative, which makes it different than the 
other housing GSE's, and to make sure that the return on the 
investments that are made in the system go to their members, 
rather than to shareholders. So, I see that structure as being 
a very solid structure.
    Mr. Middleton. Let us go to the users of the System, not 
the community banks, but the purchasers of the consolidated 
obligations. What do those users need? They need a very strong 
independent regulator of a GSE, and that establishes 
credibility that their investment is safe and sound.
    Ms. Bair. I would hope that there is, as I said in my 
written testimony and oral statement, I believe that the 
broader the constituent base of the regulator, the stronger or 
the better position a regulator is in to be independent and not 
captive of a particular point of view. I think it will be a 
stronger regulator if the Federal Home Loan Bank System, and 
perhaps all other GSE's, are included in this new regulatory 
entity that it looks like we are on track to create.
    I would hope that this new regulator, it is not worth 
doing, unless the quality and credibility of the regulatory 
regime is significantly enhanced. I would hope we would be 
designing a system that would parallel the supervisory quality 
and professionalism that you get with OCC and OGS, including 
accreditation standards for examiners, you know, the 
overwhelming bulk of the budget going to safety and soundness 
oversight, not mission promotion or housing promotion.
    I think those are the things that the market needs to be 
sure that these things that we have created that do perform, 
all three, perform extremely significant and important roles in 
the housing market are run in a safe and sound manner.
    Senator Sarbanes. What are the roles that they perform in a 
housing market?
    Ms. Bair. The traditional role has somewhat been debated 
because they are getting into each other's line of business 
right now. But the traditional role has been for Fannie and 
Freddie to purchase and either hold, in portfolio or 
securitized mortgages, mortgages that come within the 
conforming limits set by HUD.
    The Federal Home Loan Bank System's job has been to provide 
advances, loans to its members. Its focus is on the 
institutions, as opposed to direct purchase of loans, which are 
collateralized by mortgage assets provided by the members.
    They are two distinctly different, somewhat competing 
roles, and since that, you can go to two different places for 
your funding. You can sell your mortgage to Fannie and Freddie 
or you can get an advance from the Federal Home Loan Bank 
System, but now we have a situation----
    Senator Sarbanes. I understand that the majority of the 
loans held by the Bank System are jumbo loans, beyond the 
conforming limits; is that correct?
    Ms. Bair. For collateral?
    Mr. Rice. No, they are not.
    Mr. Hemingway. They do not buy jumbo loans.
    Senator Sarbanes. Are you telling me the Home----
    Ms. Bair. I think by regulation----
    Senator Sarbanes. --the Home Loan Bank system holds only 
conforming loans?
    Mr. Rice. Yes, that is correct.
    Mr. Hemingway. The Mortgage Purchase Program will not buy 
jumbo mortgages.
    I believe you are talking about the Mortgage Purchase 
Program----
    Ms. Bair. No, he is talking about----
    Senator Sarbanes. I am talking about the collateral for 
securing advances.
    Mr. Hemingway. Oh, excuse me.
    Senator Sarbanes. What is the answer to that?
    Mr. Hemingway. Whatever the bank pledges. I mean, jumbo 
mortgages qualify as collateral, as do conforming mortgages. It 
is whatever the Bank happens to have available to pledge. But 
in the Mortgage Purchase Program, you cannot, a bank cannot 
sell, a member cannot sell jumbo mortgages to the Home Loan 
Bank, only conforming mortgages.
    Senator Sarbanes. What about a regulator?
    Mr. Smith. I would just like to echo what we heard. I think 
the key point is a strong, credible, and independent regulator 
for the Home Loan Bank System.
    Mr. Hemingway. I would agree, a strong independent 
regulator.
    I would just add to it, in my banking back----
    Senator Sarbanes. Those of you who are saying that, is it 
your view that you now have such a regulator?
    Mr. Smith. Yes.
    Mr. Middleton. Yes.
    Senator Sarbanes. Ms. Bair is no.
    [Laughter.]
    Mr. Middleton. Does it vary by the volume of the 
affirmation?
    [Laughter.]
    Senator Sarbanes. What is your----
    Mr. Middleton. It is my understanding that the credit 
markets are very efficient, and they recognize that we have a 
very strong, safe, and sound----
    Senator Sarbanes. What is your view, expressed by some, 
that the exposure to risk that the Home Loan Bank System is 
engaged in is increasing and that poses a potentially 
significant public policy question?
    Mr. Rice. I believe----
    Senator Sarbanes. Do you think there is nothing to that?
    Mr. Rice. Oh, no, on the contrary. I believe that as we 
progress in this program, we are adding the resources, we are 
changing our models, to take into account this new business 
activity, and we will add the necessary resources to maintain a 
safe and sound operation.
    There are a different analytics that go with it, and we are 
recognizing what those are and investing in the people that are 
necessary.
    Senator Sarbanes. When we say ``we,'' who do you----
    Mr. Rice. Our bank, I am sorry.
    Senator Sarbanes. Your particular bank.
    Mr. Rice. My particular bank. I cannot speak for all of the 
others, but I think almost every bank that is looking at MPP 
are making those decisions.
    Senator Sarbanes. The fact that you just said you cannot 
speak for the others leads me to my next question. I am moving 
quickly here because we have limited time.
    One observer described a system with joint and several 
liability with different capital structure as akin to 12 people 
with their shoelaces all tied together, but running at 
different speeds, and concluded that one of them is bound to 
fall on his face. And, of course, this leads to a number of 
concerns about the problem of moral hazard, with respect to the 
Home Loan Bank System.
    In a system where the Banks are doing highly collateralized 
advances, the issue raised by joint and several liability is 
muted. That is at a lower order of concern, I think, because of 
the highly collateralized advances that you are operating with.
    But now the System is expanding into new areas. Proposals 
to restructure the System to allow multidistrict membership 
have emerged. I must say, in both instances, I, it is my own 
position, that the board cannot do this without coming back to 
Congress for a statutory change.
    Senator Bennett. If you had been here, Secretary Abernathy 
would have taken the same position.
    Senator Sarbanes. Yes. If banks are put into a position of 
competing with each other for members, for example, as they 
would be under multidistrict membership, or for business with 
each other's members, as in the Shared Funding Program, what 
danger do you see in the possibility that Banks would engage in 
a race to the bottom, relaxing collateral, capital standards, 
and others in order to attract or retain members?
    The GAO said, ``Under the joint and several structure, the 
potential for moral hazard exists; that is, Federal Home Loan 
Banks may have incentives to take financial risk, knowing that 
their losses would be covered by other Federal Home Loan Banks 
or ultimately by the Federal Government.''
    What is your view of that?
    Mr. Rice. That is a big question. I will take them in 
pieces.
    Number one, I really do believe that the way in which we 
are managing mortgage purchases, and the way in which the 
Finance Board reviews it, and through the examination of safety 
and soundness, I do not see that risk growing. And I think that 
the oversight that we have from our Board, and the way in which 
we direct profitability and the like, are well served in this 
process.
    Senator Sarbanes. When you say ``by our board,'' you mean 
the Seattle Board?
    Mr. Rice. Our board of directors of the Seattle Bank. But 
at the end of the day, all Banks are examined. All Banks' 
capital plans have to be approved by the Finance Board. There 
is oversight over all of the Banks, and I think that that 
oversight is the protection that you get in managing these 
programs.
    The second issue that you have on multidistrict, I believe 
that the degree of consolidation that has gone on in the System 
necessitates some direction about modernization and accepting 
what is there. Whether that is the Congress' job or not, I 
think that if Congress chooses to move in that area, then I 
think it can resolve that issue, but we are not moving for 
multidistrict. The chairman of the Finance board is not 
entertaining any notion, and I do not think there will be a 
proposal before the Finance board to do so.
    I forgot the last one, but I will defer to my colleagues.
    Senator Sarbanes. Mr. Middleton, do you want to address any 
of that?
    Mr. Middleton. May I just address components of it, 
Senator?
    [Laughter.]
    With respect to the multidistrict, the Atlanta Bank raises 
a concern that we think it might introduce unhealthy 
competition, but I think, in light of the reality of what is 
going on in the financial markets, perhaps it should be looked 
at by somebody in authority. So whatever mode that you choose 
is fine.
    The purchase of member assets, I can assure you that at the 
Atlanta Bank we just completed an exhaustive strategic plan 
that we have to do by regulation. And one of the directives 
that the board gave to management and ensured that we are 
properly allocating the budgeted resources that are sufficient 
to assure competent staffing in place prior to any significant 
growth or expansion of a new business product line. We would do 
in that measure normal banking circles, because we all have a 
day job at our banks.
    I can assure you that we devoted a tremendous amount of 
resources and discussion to the endeavor. We are not going to 
eliminate risk. Our job is to manage risk. We want to manage 
risk in the most prudent manner possible. So that is at the 
forefront of our directorate at the Atlanta Bank.
    Senator Sarbanes. Let me throw another factor into the mix 
as we proceed along. As I understand it, the bulk of Federal 
Home Loan Bank advances go to a small number of very large 
members. The System has over 8,000 members, but the largest 1 
percent of its members account for 50 percent of the advances. 
In some Federal Home Loan Banks, the concentration is even 
higher. In San Francisco Bank, 80 percent of the advances go to 
only five institutions.
    I guess that raises the question, you know, what is the 
purpose of the System and why should the Home Loan Banks be 
devoting or providing low-cost funding to such large 
institutions which have direct access to the capital markets 
themselves? Should we graduate them from the Federal Home Loan 
Bank System at some point?
    I mean, what is the purpose of this? I mean, from the point 
of view of the institution, it is a good deal, but what is the 
public purpose of it? And why are we, in effect, running 
perhaps a significant public risk in order to do this?
    Sheila, why do we not go to you here.
    Ms. Bair. Well, I am asking the same question, Senator. I 
do not understand. I believe Congress's most recent 
pronouncement on the System, in Gramm-Leach-Bliley, clearly put 
an emphasis on community-based smaller institutions. I do not 
begrudge the ability of a large institution to use the System. 
They do, they always have, and they should continue in the 
traditional line of business of advances.
    But to take on these new controversial business lines and 
new risk, for a service that is being more predominantly used 
for large mortgage originators, it does not, you know, they 
have a lot of sophistication on their own to manage interest 
rate risk associated with mortgage portfolios. Why do they need 
the Federal Home Loan Bank System to be stepping up to the 
plate and providing this service? I do not understand it 
either.
    I think that it is telling that even those large 
originators are starting to get a little worried, I think, 
because the regulatory structure that was set up assumed a 
system that would continue its traditional line of business of 
fully collateralized advances, which is a very low-risk 
business. The lines that they are getting into now are not low-
risk businesses. And if this is the direction the System is 
going to take, then they need dramatically enhanced regulatory 
scrutiny, which is I think why world savings are calling for 
concurrent action on the Federal Home Loan Bank System as it 
appears Congress moves toward the creation of a new enhanced 
regulator at Treasury for Fannie and Freddie.
    Do not forget, a lot of these large and small institutions 
hold a lot of system capital stock. And if the System gets in 
trouble, that stock is going to be in trouble, too, which could 
have systemic implications for the banking system.
    Senator Sarbanes. I might note, in that regard, we just 
received a letter from Washington Mutual:
    The housing GSE's should have a strong regulatory oversight 
structure that ensures both the safe and sound operation of the 
GSE's and the fulfillment of their housing missions. The best 
way to assure this goal would be for Fannie Mae, Freddie Mac, 
and the Federal Home Loan Banks to be regulated by an 
independent agency within the U.S. Treasury Department.
    The Agency should have a single director and should be 
funded through user fees, like the other bank regulatory 
agencies under Treasury, with appropriate recognition of the 
unique nature of the Federal Home Loan Banks as cooperatives, 
compared to the other housing GSE's, which are publicly traded 
companies.

    Mr. Chairman, I presume this letter is in the record, but, 
if not, I would like to put it in the record.
    Senator Bennett. It shall appear in the record.
    [The letter follows:]
    Mr. Smith. Back to, in terms of the large institutions, the 
first point here is to effect the housing market for consumers, 
and all consumers do not use small institutions to get their 
mortgages. Many consumers use large institutions. To the extent 
we are able to effect the cost of funds at those larger 
institutions, it then flows through to the same consumer base.
    The second thing, when you look at our concentrations, our 
member base mirrors the industry. If you look at the percentage 
of asset distribution in the banking industry and compare it to 
the Home Loan Banks, we mirror that. We are a little highly 
weighted to the community institutions, the very small ones, 
but essentially we mirror the industry, and the industry is 
highly concentrated in its asset holdings. So, as a result, 
those are the institutions that typically are going to borrow 
more money.
    And then, finally, in terms of our business model, the 
larger institutions provide us with scale, and that scale flows 
through to the small institutions. One thing you have to 
remember from my testimony is our boards are primarily 
controlled by elected directors from community and financial 
institutions.
    If there was a concern that the larger institutions were 
being treated in any way better or advantageously relative to 
those institutions, I think our boards would be more than happy 
to tell us to knock it off.
    Senator Sarbanes. Did you want to add anything, Mr. 
Hemingway?
    Mr. Hemingway. No.
    Senator Sarbanes. I am not pressing you to do so, but I 
have one other question I want to ask, Mr. Chairman.
    Senator Bennett. Sure.
    Senator Sarbanes. You have been very generous with the 
time.
    Senator Bennett. Well, this has been a worthwhile exchange.
    Senator Sarbanes. Thank you.
    Some time ago the Atlanta Bank issued a notice that it 
would not accept as collateral any loans that included single-
premium credit insurance. As far as I know, no other bank has 
yet followed suit, nor have other banks taken any of the other 
steps, such as reducing prepayment penalties that one or more 
of the other housing GSE's have taken, let alone some of the 
moves with respect to best practices that lenders of their own 
volition or perhaps because of prompting have also taken.
    Isn't this an area where the Home Loan Banks can make a 
real contribution to the reduction of predatory lending?
    Mr. Rice. Yes.
    Senator Sarbanes. Mr. Smith.
    Mr. Smith. Yes.
    Senator Sarbanes. Mr. Hemingway.
    Mr. Hemingway. It sounds like a good idea to me.
    Senator Sarbanes. Yes, well, why do you not at least do 
what the Atlanta Bank----
    Mr. Hemingway. I suspect it will be on the next agenda, 
Senator.
    [Laughter.]
    Ms. Bair. Let the record show we all agree on that one.
    [Laughter.]
    Senator Sarbanes. Thank you very much.
    Senator Bennett. Thank you, Senator.
    And, again, thanks to the panel. This has been most 
informative. We appreciate your patience and your persistence 
in responding to the questioning of the Subcommittee.
    The hearing is adjourned.
    [Whereupon, at 4:28 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional materials supplied follow:]

               PREPARED STATEMENT OF SENATOR JIM BUNNING

     Mr. Chairman, I would like to thank you for holding this important 
hearing and I would like to thank all of our witnesses for testifying 
today.
    The Federal Home Loan Bank System has brought the American Dream of 
homeownership to millions in this country. The Cincinnati Federal Home 
Loan Bank, which represents the Commonwealth of Kentucky, has helped 
many in my State achieve that same dream. But with the troubles 
recently experienced by Freddie Mac and given the changing world of the 
Federal Home Loan Banks, it is very timely that you are holding this 
hearing here today.
    There are many issues facing the Home Loan Banks, multidistrict 
membership, mortgage acquisition programs, SEC registration, and 
regulatory structure are all questions that are before the banks today. 
In the past, Members of this Committee have brought up questions about 
the salaries of the Home Loan Bank presidents. I intend to bring up 
some of these issues in the question and answer period.
    And I thank the Chairman for bringing in these witnesses. I think 
we have just about everyone connected to the Federal Home Loan Banks 
covered today.
    I look forward to all of your testimony and to talking about some 
of these issues during the question and answer period.
    Thank you, Mr. Chairman.

                               ----------

               PREPARED STATEMENT OF SENATOR WAYNE ALLARD

    I want to thank Chairman Bennett for holding this hearing to 
discuss the Federal Home Loan Bank System and the integral role it 
plays in providing liquidity to the U.S. housing markets. The Federal 
Home Loan Banks provide the largest private source of residential 
mortgage and community development credit in the United States. The 
Congress, the Federal Housing Finance Board, and the Banks themselves 
have the important task of assessing and updating the Federal Home Loan 
Bank System in order to make the changes necessary to ensure its 
continued success in fulfilling and executing its mission.
    As Chairman of the Housing and Transportation Subcommittee, I have 
particular interest in and appreciation for the crucial role that the 
Federal Home Loan Bank System plays in promoting affordable housing in 
our country. The Banks' Affordable Housing Program (AHP) is the largest 
privately funded grant program for housing in the country, and key in 
financing affordable housing efforts through each of the Banks. In 
2002, the Federal Home Loan Banks contributed $199 million toward low-
income housing through the AHP program. The Community Investment 
Program (CIP) is also instrumental in funding community and economic 
development projects throughout the country.
    The unique aspect of the Federal Home Loan Bank System that 
contributes to its success, is the ability of each Bank to develop its 
own programs in response to the needs of its membership. I am 
particularly appreciative of the Rural First Time Housing Program 
(RFHP), the Community Housing Program (CHP), the Rural Technical 
Assistance Program (RTAP) and the Community Development Program (CDP). 
These specific programs of the Federal Home Loan Bank of Topeka help 
aid homeownership and community development in Colorado. The Topeka 
Bank plays a vital role in providing liquidity to the independent 
community banks in Colorado so that they can, in turn, address the 
affordable housing andeconomic development needs of Colorado 
communities.
    I would like to thank each witness for appearing before the 
Subcommittee today to address the Federal Home Loan Bank System and its 
role in the U.S. economy. I look forward to your testimonies.

                               ----------

                PREARED STATEMENT OF WAYNE A. ABERNATHY
             Assistant Secretary for Financial Institutions
                    U.S. Department of the Treasury
                           September 9, 2003

    Thank you, Chairman Bennett, Ranking Member Johnson, and Members of 
the Subcommittee for this opportunity to testify today on the Federal 
Home Loan Bank (FHLBank) System. The Department of the Treasury is 
keenly interested in the operations of the Federal Home Loan Bank 
System because of the important responsibility that the Congress has 
placed with the Federal Home Loan Banks to enhance the liquidity of 
financial institutions, particularly as the Federal Home Loan Bank 
members meet such important community needs as promoting homeownership.
    The housing finance market in the United States is the broadest, 
deepest, and most successful housing finance market in the world. That 
market is supported by a complex financial services infrastructure, 
which includes depository institutions, mortgage brokers, mortgage 
bankers, mortgage insurers, and a variety of other capital market 
intermediaries. Prominent among capital market intermediaries that make 
up that infrastructure are the housing government sponsored enterprises 
(GSE's)--Fannie Mae, Freddie Mac, and the FHLBank System.
    The FHLBank System has had a long history of supporting housing 
finance in America. Congress created the FHLBank System in 1932 in 
response to a Depression-era liquidity crisis in housing finance. The 
FHLBank Act directs the FHLBanks to make loans--called advances--to 
eligible members. Advances traditionally served the role of providing 
thrifts access to reliable long-term funding for mortgage lending and 
as a source of liquidity to help thrifts finance deposit outflows 
without calling or selling their mortgages. Over time, Congress has 
expanded the System's membership base beyond thrifts, but the primary 
function of advances has remained relatively constant. Today, financial 
markets and our Nation's housing finance system bear little resemblance 
to the one that existed when the FHLBank System was created.
    It is in that light that I would like to focus on three topics this 
morning: The need for the FHLBanks to voluntarily register with the 
Securities and Exchange Commission (SEC) under the terms of the 
Securities Exchange Act of 1934; the FHLBank Act and the activities of 
the FHLBank System; and Treasury's current detailed review of the 
FHLBank System.

Voluntary Registration with the SEC under the 1934 Act
    The observance of good, fundamental practices of corporate 
governance is a high priority of this Administration. Foremost among 
such practices is regular, comparable, quality disclosure of corporate 
financial conditions. A key part of that commitment is improving the 
quality of corporate disclosure requirements by the GSE's, which is why 
for more than a year the Administration has been urging all GSE's to 
comply with the same corporate disclosure requirements of the 
Securities Exchange Act of 1934, as interpreted and applied by the SEC. 
Investors in GSE securities should have access to the same corporate 
disclosures as they have for other companies who publicly offer their 
securities for investment.
    We are pleased that Fannie Mae has complied with this request to 
voluntarily register and made its first disclosures under the 1934 Act 
in the first quarter of 2003. Freddie Mac has also agreed to register 
with the SEC, though we are disappointed to learn that Freddie Mac may 
not be registering until sometime in 2004. The sooner that they 
register with the SEC the better for them and their investors, though 
we fully concur with their intention that such registration and the 
financial disclosures that this step entails fully meet the high 
standards that are required.
    The Administration has continued to urge the FHLBanks to move 
forward with voluntary registration with the SEC under the 1934 Act. 
Some have argued that the structure of the FHLBank System and the 
unique characteristics of the FHLBanks in comparison to Fannie Mae and 
Freddie Mac lessen the need for registration under the 1934 Act. 
Certainly there are differences: When the FHLBank System was created in 
1932, it was created with geographically limited regional banks. Each 
regional Home Loan Bank is cooperatively owned by its members, and its 
capital stock is not publicly traded. The 12 FHLBanks raise funds in 
the capital markets by issuing consolidated obligations for which they 
are jointly and severally liable. All of these facts are important and 
must be--and I believe can be--taken into account.
    However, the differences between the FHLBanks and the other GSE's 
do not change the fundamental fact that the FHLBanks are significant 
participants in our capital markets by any measure, and that investors 
should have the same information regarding the condition of the Home 
Loan Banks as they have for other significant capital market 
participants. The facts make this case dramatically:

        At the end of June, the FHLBanks had outstanding consolidated 
        obligations of $712 billion, of which bonds with original 
        maturity of 1 year or longer constituted $556 billion of the 
        total.
        The individual FHLBanks are each large financial institutions. 
        As of year-end 2002, the largest Home Loan Bank (the FHLBank of 
        San Francisco) had $135 billion in total assets, the smallest 
        (the FHLBank of Topeka) had $33 billion in total assets, while 
        the average among the 12 banks was $58 billion in total assets. 
        Even the smallest Federal Home Loan Bank would rank among the 
        top 40 commercial banks in the United States.

    Federal Home Loan Bank registration under the Securities Exchange 
Act of 1934 is an important step in increasing the transparency of the 
FHLBanks' financial information to investors. The recent problems of 
Freddie Mac and a credit rating agency's revision of its outlook for 
one of the Federal Home Loan Banks from stable to negative illustrate 
the need for investors to have a more accurate picture of the GSE's' 
financial operations. Following Federal Home Loan Bank registration 
under the 1934 Act, investors would have access to the FHLBanks' 
financial information through the same forms and methods as those that 
apply to other companies that sell publicly traded securities. 
Investors would benefit from the added oversight of the SEC, both in 
terms of reviewing the Federal Home Loan Banks' financial disclosures 
and through the uniform enforcement of current standards. And investors 
would have the basis for making comparable evaluations of the financial 
conditions of the variety of institutions competing for their 
investment dollars. Our system of securities regulation should offer 
investors nothing short of that standard.
    The continued operation of the FHLBanks outside of the SEC-
administered corporate disclosure regime is inconsistent with our 
objective of a sound and resilient financial system. We understand that 
the FHLBanks have some remaining concerns with how certain aspects of 
their business operation would be treated if they registered under the 
1934 Act. I would remind them and all concerned that the Federal Home 
Loan Banks are not the only corporate institutions in America that have 
unique characteristics. It was specifically in order to deal with the 
variety of corporations in the Nation--while still preserving a high 
standard of comparable disclosures--that the SEC was given its exemptive authority under the securities statutes. Given the flexibilities that 
the SEC has to address the individual circumstances of the various 
registrants under the 1934 Act, we are confident that the Federal Home 
Loan Banks' concerns can be worked out with the SEC.
    We appreciate the discussions that several of the Banks have had 
with the SEC earlier in the year, and we look forward to those 
discussions being renewed in the immediate future, within a context of 
acceptance of the public interest that would be served by the Federal 
Home Loan Banks registering under the terms of the Securities Exchange 
Act of 1934. We understand that the Board of Directors of the Federal 
Home Loan Bank of Cincinnati recently announced the Bank will be taking 
the next step in the process of voluntary registration with the SEC. In 
a recent letter to Secretary Snow, Housing and Urban Development 
Secretary Martinez, and Federal Housing Finance Board Chairman Korsmo, 
the Board of Directors of the Federal Home Loan Bank of San Francisco 
expressed their goal ``to enable the Federal Home Loan Banks to become 
role models for corporate transparency.'' That is our goal as well, to 
which Federal Home Loan Bank registration under the Securities Exchange 
Act of 1934 is essential.

Multidistrict Membership, In Context
    In chartering each of the housing GSE's, Congress described the 
markets to be served by these GSE's, the financial activities these 
GSE's should undertake, and created a regulatory structure to oversee 
the GSE's and their activities. While there have been and continue to 
be debates over a number of Home Loan Bank activities and how these 
activities fit within the statutory confines of the Federal Home Loan 
Bank Act, one current issue--the question of multidistrict membership--
raises particular concern. The Federal Housing Finance Board (Finance 
Board) has received a number of petitions requesting that Federal Home 
Loan Bank members be permitted to join more than one Federal Home Loan 
Bank. The Finance Board has analyzed this issue, obtained outside legal 
counsel on its authority to authorize multidistrict membership, and 
solicited views from interested parties.
    All of that is well and good and appropriate. A lively discussion 
of policies and programs is healthy. But the appropriate forum for the 
resolution of these issues must be kept in mind. As the Treasury 
Department has written in a comment letter to the Finance Board, 
regardless of whether allowing multidistrict membership is wise, a 
plain reading of the statute finds little room to conclude that the 
Finance Board has the legal authority to approve it. It provides:

        An institution eligible to become a member under this Section 
        may become a member only of, or secure advances from, the 
        Federal Home Loan Bank of the district in which is located the 
        institution's principal place of business, or of the bank of a 
        district adjoining such district, if demanded by convenience 
        and then only with the approval of the Board.\1\
---------------------------------------------------------------------------
    \1\ 12 U.S.C. Sec. 1424(b).

    This view is reinforced by the comments of Assistant Legislative 
Counsel Mr. John O'Brien (a principal drafter of the Federal Home Loan 
Bank Act) in response to questions regarding the Federal Home Loan Act 
---------------------------------------------------------------------------
at a Senate hearing in 1932.

        [I]t was not the desire, say, for members in South Carolina to 
        borrow of a New York bank, because it would mean too great a 
        concentration at the New York bank. If the New York bank 
        happened to do better than a South Carolina bank, all members 
        would go there. There is the opportunity in the bill for a 
        member whose principal place of business is in one district to 
        belong to a bank in the adjoining district, but outside of that 
        there is no provision. It is impossible under the terms of the 
        bill for a company doing business in New York to belong to a 
        South Carolina bank.\2\
---------------------------------------------------------------------------
    \2\ Id. (citing Hearings on S. 2959 concerning creation of the 
FHLBank System), 72nd Cong., 1st Sess (1932), at 199.

    To say this is not to render a policy point of view. There are 
compelling arguments on both sides of the question with regard to the 
advisability of multidistrict membership. Clearly our financial system 
has changed dramatically since the System was established in 1932 and 
the predecessor to the current regulator created the 12 banks, and 
determined their locations and boundaries. In the intervening years, 
however, Congress has revised the governing statutes on several 
occasions. It is to the Congress that these arguments should be offered 
and where any change in the statute will have to be made.
    To some, multidistrict membership represents a natural progression 
in the modernization of the FHLBank System. We would only add our view 
that if multidistrict membership is considered, it should be done 
within the general context of evaluating the Federal Home Loan Bank 
System's charter.

Treasury's Review of the FHLBank System
    Perhaps the time for such a review is near. Earlier this year, I 
requested the 
Office of Financial Institutions Policy at the Treasury Department to 
conduct an in-house review of the Federal Home Loan Bank System, with 
particular--but not exclusive--consideration of the effect of the 
changes enacted as part of the Gramm-Leach-Bliley Act of 1999 (GLBA). 
As I announced at that time, the review would consider:

 how these changes have affected the ability of the Federal 
    Home Loan Banks to meet their statutory mission;
 implications for the financial strength of the Banks 
    individually and the System in general;
 how the business operations of the Banks contribute to 
    accomplishing their statutory mission;
 issues regarding governance structure and management, 
    including executive compensation;
 effect of new capital structures on operations; and
 other issues regarding the strength of the System and the 
    structure of Federal oversight.

    We are now about 4 months into that process, nearing completion of 
the first phase. In the first phase, the staff conducted a general 
review of the literature, discussions, debates, and developments to put 
a sharper focus to the questions to be examined. Now they are preparing 
to go into greater detail. The initial step in the second phase will be 
to discuss specific topics with the Finance Board.
    Some of the issues we will be looking at in greater detail include:

Capital Structure
    GLBA significantly changed the capital structure of the Federal 
Home Loan Banks and provided greater flexibility in the development of 
capital plans. What are the similarities and differences among the 
various capital plans? How have the risk-based capital requirements 
been implemented? How will new capital plans impact the Banks' 
investment portfolios?

Membership
    GLBA eliminated mandatory membership requirements for Federal 
savings associations and permitted broader access to FHLBank membership 
for community financial institutions (insured depository institutions 
with less than $500 million in total assets). What has been the impact 
of these changes in membership participation? Have those changes 
affected governance of the Home Loan Banks?

Advances and Collateral
    The GLBA provided community financial institutions with a broader 
range of eligible collateral for FHLBank advances. The Finance Board 
reports that as of June 30, 2003, expanded collateral from community 
financial institutions represents approximately $10.6 billion of the 
$486 billion in outstanding advances. How has this provision been 
implemented by the FHLBanks and what factors impact community financial 
institutions use of the broader range of eligible collateral?

    In addition to evaluating these specific legislative changes, over 
the last decade the activities of the Federal Home Loan Banks have 
evolved in many ways. Some specific activities that we will be focusing 
on include:

Balance Sheet Developments
    How have key activities (advances, investments, and mortgage 
purchases) of the System and the individual Home Loan Banks evolved 
over the last decade, and what does this imply for the future of the 
System?

Advance Usage
    What are the characteristics of FHLBank advance users? What types 
of advances are most commonly used by System members? What impact is it 
having on the activities of the members and their ability to serve 
their customers?

    Again, I would like to emphasize that Treasury's review of the 
Federal Home Loan Bank System is part of what we normally do at 
Treasury, and what I envision for our current review is a more specific 
look at how the changes made to the FHLBank System as part of GLBA have 
been implemented. Treasury is not primarily a regulatory agency. We see 
as part of our important function, however, providing executive branch 
oversight of the activities of the independent financial regulators, 
and this study is part of meeting that responsibility.
    And before I leave this subject, with regard to regulatory 
oversight of the FHLBank System, I would like to commend Finance Board 
Chairman Korsmo for the increased emphasis he has placed on safety and 
soundness oversight, in particular the emphasis he has placed on the 
supervision and examination function. In recent years, many observers 
have pointed to weaknesses in the Finance Board's supervision of the 
Federal Home Loan Banks. Chairman Korsmo has given major focus to 
strengthening the examination process, doubling examination staff on 
the way to tripling it. I have no doubt that even further increases 
will be made as necessary.
    As another related aside, I would like to raise a point about a 
legislative proposal regarding the membership of privately insured 
credit unions in Federal Home Loan Banks. As part of that proposal, 
private insurers of credit union deposits would be required to submit 
annual audit reports to the National Credit Union Administration 
(NCUA). In addition, upon the NCUA's request, the appropriate State 
supervisory agency would be required to provide the NCUA with 
examination reports of private deposit insurers. We are concerned that 
the provisions related to the NCUA could give the false impression that 
the NCUA has oversight authority over the private deposit insurers of 
credit unions and that the Federal Government somehow stands behind the 
private insurers. Not only would that be a terribly false impression 
potentially harmful to depositors, but it would also remove some of the 
market discipline that is so essential to the successful functioning of 
any private insurance program.

Conclusion
    The Federal Home Loan Bank System presents policymakers with issues 
that deserve continued attention. The System has historically played an 
important role in our Nation's housing finance markets. We must 
continue to evaluate the System to ensure that it is achieving the 
objectives set forth by Congress, meeting the needs of our communities 
that might not otherwise be met.
    Thank you again for providing me with the opportunity to discuss 
these important issues with the Subcommittee today.

                               ----------

                  PREPARED STATEMENT OF JOHN T. KORSMO
                Chairman, Federal Housing Finance Board
                           September 9, 2003

    Thank you, Chairman Bennett, Ranking Member Johnson, and 
distinguished Members of the Subcommittee on Financial Institutions. I 
appreciate the opportunity to speak with you today about the Federal 
Housing Finance Board (Finance Board) and the Federal Home Loan Bank 
System.
    Many important issues are facing the Nation's Government Sponsored 
Enterprises (GSE's), including, certainly, the Federal Home Loan Banks 
(Banks). I highlight today the aggressive steps we have taken at the 
Federal Housing Finance Board, the System's regulator, first, to 
strengthen the Agency's oversight capabilities; and second, to improve 
financial disclosures by the Federal Home Loan Banks through voluntary 
registration with the Securities and Exchange Commission (SEC).
    These initiatives will benefit not just the Federal Home Loan Banks 
and their member institutions, but also the investors that purchase the 
Banks' debt, the taxpayers, and ultimately, the homebuying public who 
are served by the housing finance mission of the Banks.
    As requested in Chairman Bennett's invitation to this oversight 
hearing, I will also address the issues of multidistrict memberships in 
Federal Home Loan Banks and the Banks' various Acquired Member Asset 
programs (AMA).
    Allow me to begin by providing a brief overview of both the Federal 
Housing Finance Board and the entities we regulate, the 12 Federal Home 
Loan Banks and the Office of Finance.
    The Federal Housing Finance Board is an independent agency in the 
executive branch of the U.S. Government, with a five-member Board of 
Directors, four appointed by the President and one ex-officio member, 
the Secretary of Housing and Urban Development. Created to take over 
certain duties of the Federal Home Loan Bank Board by the Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 
the Finance Board's primary duty is to ensure that the 12 Federal Home 
Loan Banks and the Office of Finance operate in a financially safe and 
sound manner.
    In addition, the Finance Board ensures that the Federal Home Loan 
Banks carry out their housing finance and community lending mission and 
remain adequately capitalized and able to raise funds in the capital 
markets. The Federal Home Loan Bank Act requires the Finance Board to 
examine and report on the condition of each Federal Home Loan Bank at 
least annually. Finally, the Finance Board is a nonappropriated agency 
that enacts its own budget; it assesses the Banks for the costs of its 
operation.
    The 12 Federal Home Loan Banks and their joint office, the Office 
of Finance, serve the public by promoting the availability of housing 
finance, including community lending credit, through 8,000-plus member 
institutions. The 12 Banks provide a readily available, low-cost source 
of funds to members and a secondary market facility for home mortgages 
originated or acquired by their members. The Banks are cooperatives; 
only members may own the stock of each Federal Home Loan Bank, and the 
members receive dividends on their investment. Insured banks, thrifts, 
and credit unions and insurance companies engaged in housing finance 
can apply for membership.
    The Federal Home Loan Banks play a unique role in housing finance. 
They make loans, called advances, to their members and eligible housing 
associates (principally State housing finance agencies) on the security 
of mortgages and other collateral pledged by those members and housing 
associates. Advances generally support mortgage originations, provide 
term funding for portfolio lending, and may be used to provide funds to 
any member ``community financial institution'' (an FDIC-insured 
institution with assets of $538 million or less) for loans to small 
business, small farms, and small agribusiness. Because portfolio 
lenders may originate loans they are unwilling or unable to sell in the 
secondary mortgage market, Federal Home Loan Bank advances serve as a 
funding source for a variety of mortgages. This flexibility allows 
these advances to support important housing markets, including those 
focused on low- and moderate-income households.
    Federal Home Loan Bank advances can provide funding to smaller 
lenders that lack diverse funding sources. Smaller community lenders 
often do not have access to funding alternatives available to larger 
financial entities, including repurchase agreements, commercial paper, 
and brokered deposits. The Federal Home Loan Banks give these lenders 
access to competitively priced wholesale funding.
    The Federal Home Loan Banks principally fund themselves by issuing 
consolidated obligations, which are the primary obligation of a 
sponsoring Bank or Banks, backed by a joint-and-several liability 
guarantee of all Banks. Consolidated obligations outstanding at June 
30, 2003, totaled $712.4 billion. This includes bonds (original 
maturity of 1 year or longer) of $556.2 billion and discount notes 
(original maturity of less than 1 year) of $156.2 billion.
    Finally, a few more key figures: Total assets of the Federal Home 
Loan Banks stood at $812 billion as of June 30, 2003. Advances totaled 
$506.3 billion, which is 7.6 percent greater than 1 year ago. Viewed 
collectively, the Federal Home Loan Banks represent the third largest 
domestic banking organization.
    Institutions of this size and importance to the Nation's housing 
market and economy in general clearly require a robust and capable 
regulator, and since President Bush named me Chairman in December 2001, 
I have sought to establish the Finance Board as just that.
Improvements in Safety and Soundness Oversight
    Soon after I became Chairman, my Finance Board colleagues and I 
determined that the Finance Board lacked the necessary resources to 
effectively carry out its primary responsibility, that of overseeing 
the Federal Home Loan Banks and the Office of Finance for safety and 
soundness. Just one example demonstrates this point: The Finance Board 
had only eight bank examiners on staff to review and supervise a dozen 
financial institutions with, at the time, more than $700 billion in 
assets, more than $30 billion in capital, and some $650 billion in 
outstanding debt. Yet, the Agency also had an Office of Public Affairs 
with the same number of staff, eight. The relative allocation of 
resources simply did not meet the Agency's statutory mandates.
    In addition to being understaffed, the examination function was 
also insufficiently focused on the Banks' risk assessment processes and 
the Banks' internal control systems. Such shortcomings had been 
identified in a 1998 General Accounting Office (GAO) report of the 
Finance Board's examination program, but had not by that time been 
addressed and corrected.
    I immediately set out to respond to these problems, beginning with 
the recruitment of new leadership for the Agency's Office of 
Supervision. After a national search, the Finance Board hired a new 
director and a new deputy director of supervision, who between them 
have 40 years of regulatory experience with the Office of the 
Comptroller of the Currency and the Federal Deposit Insurance 
Corporation (FDIC).
    My Finance Board colleagues and I increased the resources available 
for supervision, expanding the Agency's examination staff to 17 full-
time bank examiners. Our goal is to have 24 in place by the end of this 
calendar year, and 30 by the end of the next budget year.
    The Finance Board is now conducting more thorough, risk-focused 
examinations, and communicating the results of those examinations more 
effectively to the Banks.
    Examinations now recognize that banking--including AAA-rated, GSE 
banking--is a business of managing risks, and the responsibility of 
bank supervisors is to ensure that the institutions they regulate 
understand those risks and monitor and control them through prudent 
risk management practices.
    To enhance analysis and oversight in the risk management area, we 
have established two risk units--a Risk Modeling Division and a Risk 
Monitoring Division. The Risk Modeling Division is responsible for the 
development of our asset/liability modeling and for monitoring the 
Bank's internal interest rate risk models. The Risk Monitoring Division 
pulls together all our data and the Banks' own financial reporting into 
a risk-monitoring framework.
    We have hired an Associate Director for Examinations who oversees 
all our safety and soundness examiners. She has more than 15 years of 
bank regulatory experience with the FDIC. We also have hired a Senior 
Advisor to the Director of Supervision to provide support to the Risk 
Modeling and Risk Monitoring Divisions. That Senior Advisor possesses 
some 30 years of bank supervision, capital markets, and capital 
regulation experience with the Board of Governors of the Federal 
Reserve System and the Office of Thrift Supervision.
    While on-site examinations remain the primary tool of supervisors, 
the Agency now complements exams with off-site monitoring and regular 
communication with the Banks. Our new ``Bank Analyst Program'' charges 
a member of our Office of Supervision with following an individual Bank 
and reviewing monthly and quarterly financial reports for trends and 
changes, while also keeping abreast of issues in the financial and 
housing industries to determine their effect on each Bank.
    Our Office of General Counsel has also assigned attorneys who serve 
as points of contact for the examiners on particular Bank issues.
    In short, the Finance Board's safety-and-soundness oversight of the 
Federal Home Loan Banks has improved dramatically. We have more work 
ahead of us, to be sure, but the Finance Board is a much stronger and 
more capable regulatory agency than it was as recently as 12 months 
ago.
    The 1998 GAO report also found that Finance Board examinations 
neglected the critical area of board governance at the Federal Home 
Loan Banks. To address this shortcoming, and as another element of our 
safety and soundness supervision, the Finance Board has undertaken a 
thorough assessment of corporate governance at each of the Banks. This 
effort included the first-ever horizontal review--that is, a systemwide 
supervisory review of a single issue at each of the 12 Banks--which 
addressed the Banks' effectiveness relative to eight indicators of 
effective board governance.
    Those indicators are:

 Engaged Board of Directors;
 Skilled Senior Management;
 Thorough Strategic Planning;
 Sound Risk Management;
 Robust Internal Control;
 Effective Audit Program;
 Strong Ethical Culture;
 Timely, Accurate, and Complete Communications.

    The Finance Board's final report on this review includes a variety 
of general recommendations for improving corporate governance. The 
Agency also provided specific, confidential feedback to each of the 12 
Banks.
    The next step with respect to bank governance is a public hearing, 
tentatively scheduled for October 15. The Finance Board will solicit 
from the Banks, their member institutions, experts, and interested 
members of the public any ideas for reform in this important area. 
Input generated may be used in the design of proposals aimed at making 
the Federal Home Loan Banks role models in corporate governance.
    Earlier this year, the Finance Board undertook a second systemwide 
horizontal review--that of the Federal Home Loan Banks' implementation 
of the statutorily mandated Affordable Housing Program (AHP). The AHP 
is a highly successful program that warrants a separate discussion and 
some background.

The Affordable Housing Program (AHP)
    The Federal Home Loan Bank Act requires each Bank to establish and 
fund an Affordable Housing Program. Under the AHP, each Bank must 
annually contribute the greater of 10 percent of its net earnings for 
the previous year, or such prorated sums as may be required to ensure 
that the aggregate contribution of the Banks is at least $100 million. 
Actual contributions to the program were $199 million for 2002, and the 
contributions have exceeded $100 million each year since 1994.
    AHP subsidies must be used to fund the purchase, construction, or 
rehabilitation of:

 Owner-occupied housing for very low-income, or low- or 
    moderate-income (no greater than 80 percent of area median income) 
    households; or
 Rental housing in which at least 20 percent of the units will 
    be occupied by and affordable for very low-income (no greater than 
    50 percent of area median income) households.

    In 2002, the Finance Board adopted a regulation enabling Banks to 
allocate annually the greater of $4.5 million or 35 percent of each 
Bank's AHP contribution to homeownership set-asides. Part of this 
increased funding authority helps Banks combine AHP subsidies with HUD 
initiatives benefiting minority, immigrant, and other first-time 
homebuyer families.
    Since the inception of the AHP in 1990, the Federal Home Loan Banks 
have contributed $1.7 billion to the program, funding 236,596 rental 
units and 122,126 owner-occupied units. In 2002, the Banks committed 
$286 million to AHP projects.
    The Finance Board appropriately devolved operation of the AHP to 
the individual Banks in the late 1990's, a valuable development because 
the Banks are best equipped to assess local affordable housing needs 
and build partnerships with local community groups and housing 
agencies.
    Correspondingly, the Finance Board's oversight responsibility has 
grown with respect to the AHP to ensure proper and effective program 
operation. As such, we are following up the horizontal review with a 
new practice of examining each Bank's AHP once a year. These exams are 
performed by examiners and analysts whose specialized training has 
specifically equipped them for this task.
    We are also preparing regulatory language intended to enhance the 
effectiveness of the AHP by permitting Banks more latitude in 
establishing the criteria to score applications. The goal is for Banks 
to be more responsive to local housing conditions. We also plan to 
streamline the application process to permit projects to proceed more 
quickly and with lower administrative costs.
    AHP is truly one of the Federal Home Loan Banks' great success 
stories, and with rigorous oversight at the Federal Housing Finance 
Board, I am confident it will be even more successful in the years 
ahead.

Enhanced Disclosures
    The other key initiative I wish to discuss today is enhancing the 
quarterly and annual corporate disclosures of the Federal Home Loan 
Banks.
    In July 2002, the administration called on all Government Sponsored 
Enterprises to comply with the corporate disclosure requirements of the 
Securities Exchange Act of 1934, as interpreted and enforced by the 
SEC.
    Fannie Mae and Freddie Mac, the other two housing-related GSE's, 
answered this call. Fannie Mae has already filed its first disclosures 
under the new SEC regime.
    As Chairman of the Federal Housing Finance Board, I too am 
determined to hold the Federal Home Loan Banks to the highest standard 
of disclosure. Accordingly, I formed a working group from the Finance 
Board and the Federal Home Loan Banks to review the implications of 
acceding to the Administration's request.
    Early this year, I concluded that voluntary registration with the 
SEC was indeed the best approach to providing enhanced public 
disclosure of the operations and finances of the Federal Home Loan 
Banks. I reached this conclusion based on two premises.
    First, the Banks' long-term access to global capital markets will 
be enhanced by providing investors in consolidated obligations with 
maximum reliable transparency into the finances and governance of each 
of the 12 Banks. Markets function best, especially in times of stress, 
when needed information is readily available and reliable.
    Second, as public trusts, these 12 GSE's have a duty to contribute 
both to the smooth functioning of capital and mortgage finance markets 
and to public confidence that the benefits of GSE status are used 
wisely.
    At my urging, Federal Home Loan Banks and the staff of the SEC have 
held numerous meetings to address the process for voluntary 
registration, including methods for resolving several key disclosure 
and accounting questions.
    The Board of Directors of the Federal Home Loan Bank of Cincinnati 
actively embraced the disclosure initiative as in the best interest of 
its members, voting in February to pursue voluntary registration. Last 
month, the Cincinnati board resolved to ``actively engage, effective 
immediately, in the process of voluntary registration with the SEC of 
its member-held stock.''
    This summer, too, the boards of the Federal Home Loan Bank of San 
Francisco and the Federal Home Loan Bank of Atlanta resolved that if 
SEC registration was the determined course of action, it is their 
request that the Finance Board adopt a regulation requiring it.
    In response to those requests, at its regularly scheduled meeting 
tomorrow the Finance Board will consider a proposed regulation 
requiring each Bank to register a class of securities with the SEC 
under Section 12(g) of the Securities Exchange Act of 1934.
    The proposed rule provides for a lengthy, 120-day comment period, 
during which, I hope, the Banks will each meet with the SEC to work out 
the necessary details to effectuate registration and begin meeting the 
periodic financial reporting requirements of the 1934 Act.
    The focus of the enhanced disclosure effort from the start has been 
to ensure that the Federal Home Loan Banks play their part, as 
Government Sponsored Enterprises, in contributing to the smooth 
functioning of the capital and mortgage finance markets. In the end, 
consistent and full disclosures of these institutions' finances and 
corporate governance also serve the public, who stand behind their 
charters as Government Sponsored Enterprises.

Acquired Member Assets (AMA)
    I have been asked to address two other issues in my testimony 
today. The first of these concerns regulations governing the Acquired 
Member Assets programs, or AMA, of the Federal Home Loan Banks.
    The 12 Federal Home Loan Banks are authorized to purchase single-
family mortgages that do not exceed the conforming loan limit 
applicable to Fannie Mae and Freddie Mac, currently $322,700. The 
authority granted under the current rule (12 CFR Part 955) is an 
expansion and refinement of previous authority that had been granted to 
the Banks by a Finance Board resolution in 1996. That authority was 
challenged in 1997, a challenge rejected by a U.S. District Court in 
1998. The U.S. Court of Appeals for the Fifth Circuit upheld the 
District Court's ruling in 2000, affirming the Finance Board's 
authority in this area.
    There are currently two AMA programs--Mortgage Partnership Finance 
(MPF) and Mortgage Purchase Program (MPP). MPF is the older and larger 
program. Under the current AMA programs, a Bank may purchase mortgage 
assets from a member institution. The programs, like advances, provide 
member institutions liquidity for mortgage lending. In AMA programs, 
the member manages and bears a material portion of the credit risk. 
Since the programs' inception in 1996, the Banks have purchased more 
than 600,000 loans. Approximately 75 percent of those loans were 
purchased under MPF and 25 percent under MPP. More than 95 percent of 
the total loan acquisition has occurred since 2000, the current AMA 
regulation having become effective on July 17, 2000.
    On July 1 of this year, the Finance Board unanimously adopted and 
published for comment a proposed revision to the current AMA 
regulation. The Finance Board's intent is clearly stated in the 
preamble to the regulation, that is, to make the regulation more 
``effective and efficient in regulating the Banks' mortgage purchase 
programs.'' In the rule, the Finance Board also seeks to clarify and 
simplify the language of the current rule. The proposed regulation does 
not expand or alter the fundamental structure of the AMA programs.
    The proposed regulatory changes also maintain or strengthen many 
appropriate safety and soundness provisions of the current rule, again 
reflecting the Finance Board's continued emphasis on improving its 
safety and soundness oversight of the Federal Home Loan Banks.
    Safety and soundness provisions maintained or strengthened under 
the proposed rule include requirements that:

 All AMA must be at least investment grade when acquired by the 
    Bank.
 The Bank must have in place a process and methodology to 
    determine the required credit enhancement prior to acquisition of 
    any asset and throughout the life of the asset on the Bank's books.
 The Bank must take remedial action by requiring the member to 
    provide additional credit enhancement or hold additional capital if 
    the estimated credit rating of the asset declines to below the 
    rating required at time of acquisition.
 Insurers must be rated AA or better to provide a portion of 
    the credit enhancement to the member institution selling assets to 
    the Bank.
 Banks without risk-based capital structures in place must hold 
    retained earnings for losses as support for the credit risk 
    associated with any AMA estimated to be rated below AA.

    In addition, the proposed regulation incorporates Finance Board 
criteria previously set forth in the preamble of the July 2000 final 
AMA rule outlining the circumstances under which Banks are permitted to 
acquire from members highly rated interests in pools of mortgages as an 
alternative to acquiring whole loans. Among the criteria is a 
requirement that all loans backing such interests must themselves be 
eligible for purchase by the Bank as AMA. As with any new AMA product, 
a Bank is only allowed to acquire such interests after its proposed 
program has been reviewed and approved under the Finance Board's New 
Business Activity regulation.
    The proposal further seeks comment on whether the Finance Board 
should take measures to prevent a Bank from acquiring loans or assets 
backed by loans, through its AMA program, where the loans have features 
or were made under circumstances that may be considered predatory or 
abusive. The proposal also asks for comment on whether and how to limit 
Banks' authority to acquire such loans or assets backed by such loans.
    The text of the proposed regulation maintains the current 
prohibition on purchases directly from affiliates of member 
institutions. In response to numerous 
requests from members using affiliates and subsidiaries for mortgage 
origination activities, the preamble does invite comment on changing 
current policy to allow affiliates owned and controlled by members to 
directly sell assets to Federal Home Loan Banks.
    The importance of revising Finance Board regulations to better 
reflect the Agency's supervision approach argues for a constructive 
exchange among the interested public, Federal Home Loan Banks, and the 
Finance Board. It appears, however, that some may have misunderstood 
the intention of this proposed regulation.
    As a result, in agreement with my fellow Directors, I will ask the 
Finance Board to vote at its regular Board meeting tomorrow to withdraw 
the present rulemaking. The proposed text will be revised and clarified 
to more clearly enunciate the principles I listed above, and the 
resulting proposed regulation will be voted on in a subsequent meeting. 
If approved by the Finance Board, the revised proposed regulation will 
be published for a 90-day comment period.

Multidistrict Membership
    When I became Chairman of the Finance Board in December 2001, the 
multidistrict membership debate was already over a year old, having 
been prompted by regulatory requests filed in 2000 and 2001 by four 
Federal Home Loan Banks that had lost large members to mergers with 
institutions headquartered in other Federal Home Loan Bank districts. A 
Solicitation for Comments on the issue was pending and remained open 
until March 2002.
    When Congress created the 12 Federal Home Loan Banks 71 years ago, 
it anticipated that each member thrift institution would operate where 
its collateral was located, and at that time, that meant in its home 
State alone. The financial world, of course, has fundamentally changed 
since 1932, as has the membership base of the Federal Home Loan Banks 
now that membership is voluntary for all and open to commercial banks 
and credit unions, as well as thrifts and insurance companies.
    With the advent of interstate banking and national holding 
companies, the Federal Home Loan Banks are operating in a different 
competitive environment than existed through most of their history. For 
Bank member institutions organized under certain holding company 
structures, multidistrict membership already exists. One hundred three 
holding companies, doing business in more than one Federal Home Loan 
Bank district through separately chartered subsidiaries, currently 
account for 451 distinct Bank memberships. Institutions that operate in 
multiple regions through a single charter, however, are precluded by 
Finance Board regulations from establishing similar operating 
arrangements with more than one Federal Home Loan Bank.
    Let me make clear that, while it is my view that the Federal Home 
Loan Bank Act both empowers and obligates the Finance Board to continue 
regulating the terms of Bank membership to the extent necessary to 
ensure safe and sound operation of Banks, access by Banks to capital 
markets, and achievement of the Banks' housing finance mission, I am 
neither an advocate nor an opponent of expanding multidistrict 
membership in the Federal Home Loan Bank System.
    When I became Chairman, I asked the four Banks seeking regulatory 
approval for multidistrict membership to withdraw their requests to 
permit a thorough, comprehensive review of the changed financial 
services industry and mortgage market circumstances that give rise to 
the multidistrict issue. That review has occurred without producing any 
compelling reason for the Finance Board to address the question of 
expanded multidistrict membership on its own initiative.
    My commitment to those Banks that withdrew their pending regulatory 
requests, however, was that, when the review was complete, any Bank 
seeking authority to admit as a full member an institution doing 
business in that Bank's district but maintaining a charter and 
membership in another Federal Home Loan Bank district would be afforded 
an opportunity to make its case to the Finance Board and present its 
recommended solutions to the various operational challenges its 
proposal would raise. In June, in fulfillment of my commitment to those 
Banks, I requested the Office of Supervision and the Office of General 
Counsel to draft a proposed regulation establishing a process by which 
the Finance Board could receive, review, and accept or reject such 
applications, should any Bank choose to make one. No Bank, however, has 
made any request to the Finance Board to proceed on multidistrict 
membership, the draft proposal was never completed, and no further 
Finance Board action establishing a procedure is planned.

Conclusion
    Chairman Bennett, distinguished Members of the Subcommittee, I 
close by returning to the very reason the Federal Housing Finance Board 
exists: to ensure that Federal Home Loan Banks operate in a financially 
safe and sound manner, carry out their housing-finance mission, and 
remain adequately capitalized and able to raise funds in the capital 
markets.
    Since 2002, the Finance Board has dramatically improved its ability 
to perform these statutorily mandated responsibilities. The Agency's 
supervision function is stronger, more thorough, and more effective. 
Taken in conjunction with the initiative to enhance the financial 
disclosures filed by the Federal Home Loan Banks, I believe the Finance 
Board is capably representing the interests of the public and taxpayers 
who stand behind the Federal Home Loan Banks and who benefit from the 
successful performance of the Federal Home Loan Banks' important role 
in housing finance.

                               ----------

                  PREPARED STATEMENT OF NORMAN B. RICE
   President and Chief Executive Officer, Federal Home Loan Bank of 
                                Seattle
                           September 9, 2003

    Good afternoon Chairman, Ranking Member Johnson, and Members of the 
Subcommittee. I am Norman B. Rice, President and Chief Executive 
Officer of the Federal Home Loan Bank of Seattle.
    I would like to thank Chairman Bennett and the Subcommittee for the 
opportunity to provide my perspective on the unique and vital role the 
Federal Home Loan Banks play in building strong communities and healthy 
economies across America.
    The 12 Federal Home Loan Banks have a long history of service and 
accountability to the more than 8,000 financial institutions we serve, 
to the millions of individuals and families we help realize the 
American Dream of homeownership, and to the regulators and Congress who 
oversee our system.
    But it is not the history of our banks that I want to talk with you 
about this afternoon. Where we have been and what we have accomplished 
as a Bank System is significant and well documented. But my focus is on 
the relevance of the Bank System today--and in the future--and the 
critically important role we play on behalf of our financial 
institution members, and the economic health of our country.
    I will start with what I consider to be the most important element 
of the Federal Home Loan Banks--we are a cooperative. Our members own 
the Bank System, and we are accountable to them.
    We are truly unique in that sense. By constructing the Home Loan 
Banks as a cooperative, Congress ensured that all value and benefits 
from the System are passed directly back to the member financial 
institutions that are the lifeblood of small business, agriculture, and 
neighborhood revitalization in this country.
    These are the banks, credit unions, thrifts, and other institutions 
that give communities critically needed access to credit; these are the 
risk-takers whose leadership and resources build stronger towns, 
cities, and, to a very real extent, a stronger Nation.
    You can do that in a cooperative that provides each one of its 
members--small and large--the same access to a stable, low-cost, and 
reliable source of wholesale funding. In turn, you cannot do what we do 
in a publicly traded company where your primary focus is building 
investor value for tens of thousands of individual stockholders.
    It works much differently in the Federal Home Loan Bank System. We 
have a business relationship with each of our members--they are both 
our owners and our customers. We know them by name. We understand their 
individual market needs and the needs of their communities. They are 
represented on our boards and provide the leadership of our 12 banks.
    No other housing GSE or financial institution can replicate this 
partnership of bank, member, and community.
    At the Seattle Bank, we like to use the term ``rock solid'' to 
characterize our organization and the business relationship we have 
with our members. It conveys a sense of accountability and commitment 
to our cooperative, and the unwavering belief that a member's 
investment is being managed for the long-term, not just quarter to 
quarter. That is how our member financial institutions see us--as a 
safe, sound partner they can use to more effectively manage their 
balance sheets--in good economic times and bad--for the purpose of 
better serving their local customers and communities.
    Within the cooperative structure of the Bank System, it is also 
important to understand the profile of our membership. The overwhelming 
majority of our member financial institutions are smaller, community-
based companies. Our typical member has about $110 million in assets, 
almost half of our members are located in rural areas, and most are 
independently owned.
    We also serve the Nation's largest lenders. Our Congressionally 
mandated mission is to make bank credit available for our local 
communities. Given the realities of the financial services industry, 
which has consolidated enormously, it would simply be impossible to 
fulfill our mission unless we also supported the largest lenders who 
now account for a vast amount of lending activity. For example, the top 
three U.S. lenders now account for 37 percent of all home mortgage 
originations. The top 30 originators account for 60 percent of all loan 
originations.
    As you can see, the Bank System cooperative is a place where 
financial institutions of all sizes share mutual interests and share 
mutually in the benefits of their joint enterprise.
    As I sit before you today, the Federal Home Loan Banks and the 
housing GSE's are facing significant challenges and changes regarding 
their business practices, regulatory structure and mission-based 
programs and activities.
    There is much to discuss and determine in the coming months, and 
potentially much at stake for financial institutions, businesses, 
homebuyers, and the American economy.
    As this Subcommittee and other Members of Congress consider the 
future of the Federal Home Loan Banks and the housing GSE's, you will 
no doubt be inundated with recommendations and solutions from many 
people representing many of the constituencies that have come before 
you today.
    As a former public policymaker, I remember that process all too 
well. But in place of recommendations and solutions, I would like to 
offer you two things today: Some baseline questions and principles to 
consider in your discussions in the weeks and months ahead, and clear 
evidence of the powerful impact the Bank System has on our country's 
financial services industry, our communities, and our economy.
    First, two questions that I believe appropriately frame the issues 
now before Congress regarding our Bank System and housing GSE's.

 What are the benefits and risks that the housing GSE's present 
    to taxpayers?
 How are the risks best managed?

    Over the course of any week in my job, I am asked by a number of 
people what the Federal Home Loan Bank of Seattle is, and what it does. 
For those not involved in the banking and financial services industry, 
our system is, for the most part, unknown. So, I am always pleased to 
provide some quick education, and pleased because of the answer I am 
able to give: We help ensure that Americans have homes and healthy 
local economies.
    How do we do that? By connecting financial institutions of all 
sizes to the capital markets. This provides our member banks with a 
stable source of lower-cost funds that they use in their own 
communities to support homebuyers, businesses, and farmers.
    But perhaps an even better way to illustrate the benefits of the 
Bank System is to imagine our country without the 12 Home Loan Banks. 
Consider the following:

 In 2002, the Bank System extended nearly a half trillion 
    dollars in advances (what we call loans) to our member financial 
    institutions, strengthening local economies, and increasing 
    homeownership. Imagine those dollars gone.
 Since 1991, the Federal Home Loan Banks have awarded $1.6 
    billion in Affordable Housing Program grants, helping to create 
    360,000 low-income housing units across the country. Each of our 12 
    Banks annually provides 10 percent of their net income for 
    affordable housing. Last year, that totaled about $200 million. 
    Imagine those dollars gone.
 In 2002, the Bank System provided nearly $9 billion in 
    reduced-rate, long-term Community Investment Program (CIP) 
    advances, used by our member financial institutions to finance 
    commercial and economic development initiatives that benefit low- 
    to moderate-income families and neighborhoods. Since CIP began in 
    1990, our Banks have issued nearly $36 billion in reduced-rate 
    loans. Imagine those dollars gone.

    Now imagine the collective impact on our national economy, not to 
mention individual business owners, homebuyers, and farmers.
    Ask yourselves who would provide the bank credit to support your 
local economies? How would your local bank compete if they did not have 
access, through their regional Home Loan Bank, to the capital markets? 
Where would these institutions turn, in good times and bad, to meet 
loan demand despite the outflow of consumer deposits from the banking 
system? Where would your constituents go to get loans to buy homes and 
run their businesses?
    Now go one step further: If the housing GSE's did not exist today, 
what would Congress put in their place? I believe you would come back 
to something that looked a lot like the Federal Home Loan Bank System.
    Here's why:

 The Bank System is funded entirely through private capital. 
    The cooperative is built by private owners who have put more than 
    $36 billion of their own money at risk to capitalize the Bank 
    System.
 The Bank System is cooperatively owned to support--rather than 
    compete with--the private marketplace. Our stock is not publicly 
    traded. We are not driven by an imperative for double-digit growth 
    to meet expectations of the stock market. We do not have third-
    party investors pulling value out. Every dollar of value created by 
    the Bank System is poured back into the housing finance system, 
    ultimately benefiting your constituents, the consumers of bank 
    credit. Those are bank owners, business owners, farmers, 
    homebuyers, nonprofit housing corporations, neighborhood social 
    service organizations, municipalities, and many, many others.
 The Bank System has the capacity to innovate and keep pace 
    with an evolving financial services industry. This is why the Bank 
    System offers mortgage purchase programs. Our members have told us 
    they can better serve homebuyers and local markets if there is more 
    competition in the secondary mortgage markets. It is no accident 
    that our System's program volume has accelerated from zero to 
    almost $100 billion. Without question, there is a private-market 
    demand for competition, and we believe that competition is 
    healthy--it is good public policy. And it is equally important to 
    remember that when programs such as these boost earnings and 
    profitability in our banks, that provides more funding for 
    affordable housing and economic development in our communities. At 
    the Seattle Bank last year alone, our Mortgage Purchase Program 
    generated $1.75 million in additional AHP subsidies. My point here 
    is, you cannot disconnect profitability and mission with the Bank 
    System.
 The Bank System is organized by region, ensuring that each 
    bank is connected and responsive to local markets. Twelve Home Loan 
    Banks were created to focus on local markets, to know their local 
    member financial institutions and create products and services that 
    meet their customers' needs and the affordable housing and economic 
    development needs of their communities.
 The Bank System pays its fair share of taxes. The Home Loan 
    Banks carry a special tax burden that cannot be sheltered and is 
    equivalent to a Federal corporate tax rate. The Bank System has 
    been required, since 1989, to pay off the REFCORP debt and provide 
    10 percent of its net income in support of low-income housing. This 
    is the single-largest private source of housing subsidy in the 
    United States.
 The Bank System is a reliable source of liquidity through all 
    parts of the economic cycle. This is the primary reason why 
    financial institutions join the Bank System. They rely on our 
    capacity to access the capital markets on their behalf. That is 
    why, even in a down economy, demand for advances across all of our 
    banks has reached nearly a half trillion dollars.

    As you can see, it is not a difficult task for me to list the 
benefits provided by the Bank System. Over the last 70 years, the 12 
Home Loan Banks have consistently proven their relevance to our members 
and their communities.
    The harder question--especially in today's environment--is whether 
or not the risks are being managed appropriately. While it is one thing 
to say our advance and mortgage purchase programs drive profitability 
and support mission-based programs and activities--which they do--it is 
quite another to ensure that the risks inherent in those programs are 
being managed appropriately.
    My colleagues testifying on this panel today will address other key 
issues regarding the Bank System, including risks associated with 
financial management, governance, and regulatory oversight.
    Just as I have noted some attributes and principles that should 
underlie a modern housing GSE, I would like to also articulate some 
basic principles as you consider GSE oversight going forward.
    First of all, it would be disingenuous of me or anyone else to 
state that the Home Loans Banks and other housing GSE's are far bigger 
and more complex, and therefore should be held to different risk 
standards. Clearly, the bar has been raised across the financial 
services industry in this regard.
    While history proves that we have done a great job for a long 
time--not a single credit loss against advances since the inception of 
the Bank System in 1932--I also understand this is 2003, not 1932, and 
much more must be done. Your constituents and ours are demanding the 
highest levels of accountability, and we must deliver on that.
    On the matter of consolidation of the GSE regulators: Whether or 
not Congress determines that a single GSE regulator is the appropriate 
direction or not, all three housing GSE's must have strong regulatory 
oversight to ensure both safety and soundness and mission achievement. 
There can be no debate on that point.
    The fact is that the three housing GSE's must manage many of the 
same risks, and we share a common mission--to support homeownership by 
providing the funding and the tools the Nation's housing lenders need 
to be successful. That means it is time to straighten out the 
hodgepodge of inconsistent requirements and oversight of the housing 
GSE's.
    For example, why do two housing GSE's have lower capital 
requirements than the Home Loan Banks that demonstrably carry less 
credit risk? Why is there inconsistent mission oversight--with the Home 
Loan Banks delivering cash grants, while the other housing GSE's hit a 
different set of affordable housing goals?
    What public policy goal is advanced when roadblocks are put in 
front of our Bank System when we respond to our members' stated desire 
to have greater competition in the secondary mortgage market? And when, 
in fact, those roadblocks actually hinder our ability to drive more 
funding to our member financial institutions and their communities? I 
have heard it called ``mission creep.'' From my point of view, it is 
more like ``mission leap''--it allows us to take more significant steps 
toward fulfilling our mission, not walking away from it.
    While it is often frustrating to me that the Bank System's mission 
and impact is understood by so few, I think it is apparent that this 
Nation and your constituencies--our financial institutions and local 
communities--would struggle mightily if we failed to do our job.
    Today, as one of 12 presidents within the Federal Home Loan Bank 
System, I stand committed to work with you to find better ways to serve 
the ever-changing needs of the financial services industry and our 
communities.
    I want to be clear that I believe the onus for strengthening our 
system lies not only with Congress and regulators, but with the Home 
Loan Banks themselves. We must further step up and accept the risks in 
our system and industry, and accept that more intense public oversight 
is inevitable. We welcome that public oversight because, if done 
smartly, it will strengthen our Bank System and, ultimately, the 
economy of this country.
    In closing, I would like to leave you with some principles that I 
believe should inform your discussions and decisions in the months to 
come:

 Private capital is the most effective cushion to guard the 
    public against the risks inherent in our enterprises. As 
    cooperatives, the Home Loan Banks are capitalized by their 
    customers, who are risk-averse, and who monitor risk-taking in a 
    way that third-party shareholders cannot.
 Insist on competition among housing GSE's rather than 
    competition with the private financial services industry.
 Demand that more of the value created by the housing GSE's be 
    delivered to the housing finance system and consumers rather than 
    private investors.
 Demand consistent, strong and smart regulatory oversight for 
    all housing GSE's--and recognize the critical differences between 
    the Bank System and publicly traded housing GSE's.
 Demand an intense focus on our mission, hold us accountable, 
    and keep in mind what America would look like if the Home Loan 
    Banks did not exist.

    Mr. Chairman, this concludes my written remarks. Thank you, again, 
for allowing me the opportunity to speak with you today. I would be 
happy to answer any questions you or other Members of the Subcommittee 
may have.

                               ----------

                PREPARED STATEMENT OF MICHAEL MIDDLETON
             Vice-Chairman, Federal Home Loan Bank Atlanta
      Chairman and CEO, Community Bank of Tri-County, Waldorf, MD
                           September 9, 2003

    Good afternoon Chairman Bennett, Senator Johnson, and Members of 
the Subcommittee. Thank you for the opportunity to appear before you 
today to discuss something that is very important to my business and to 
my community--the Federal Home Loan Bank System. I am Michael 
Middleton, Chairman and CEO of Community Bank of Tri-County, in 
Waldorf, Maryland. I serve as Maryland's elected Director on the 
Federal Home Loan Bank of Atlanta's Board of Directors and am honored 
to serve as the Vice-Chairman of that Board. I am also a Member of the 
Board of the Council of Federal Home Loan Banks.
    I am pleased to testify today on behalf of the Atlanta Bank. I am 
Chairman and CEO of a bank that is a member and long-time user of 
Federal Home Loan Bank advances, as well as other products, 
particularly in the community investment area. I believe this 
experience, together with my 5 years of service on the board of the 
Federal Home Loan Bank of Atlanta, gives me a broad perspective on the 
Federal Home Loan Bank System that I hope can provide helpful insight 
to the Subcommittee.
    Community Bank of Tri-County has over $300 million in assets and is 
a true community bank serving southern Maryland. Our customer base 
draws from a broad economic range and includes rural, agricultural, 
small business owners, and the families employed by high tech companies 
that support three naval facilities. We try to tailor our services and 
products to meet the needs of our communities while competing with 
large regional and national financial institutions.
    At my bank, we take our Community Reinvestment Act responsibilities 
very seriously. Moderate to smaller-sized community banks are 
increasingly challenged in meeting their CRA requirements. The 
FHLBank's programs, explained in greater detail below, provide us with 
the tools and skills to fulfill this statutory and community 
responsibility. The FHLBank System helps level the competitive playing 
field in many ways, enabling Community Bank to continue to be part of 
the economic foundation of southern Maryland.

Background
    As you may be aware, the 12 Federal Home Loan Banks are Government 
Sponsored Enterprises that were created and organized under the 
authority of the Federal Home Loan Bank Act of 1932. Congress created 
the Federal Home Loan Banks to stabilize and improve the availability 
of funds to support homeownership. Although initially capitalized with 
Government funds, member banks, like mine, have contributed all the 
Federal Home Loan Banks' capital for over 50 years. The Federal Home 
Loan Banks have provided over 70 years of innovation and service to the 
U.S. housing market, and currently have over 8,000 member institutions.
    The Federal Home Loan Banks and their members (federally insured 
savings associations, commercial banks, credit unions, and some 
insurance companies) are the largest source of residential mortgage and 
community development credit in the United States. Federal Home Loan 
Banks increase the lending power of local financial institutions. 
Thanks in large part to the work of Senators Hagel, Johnson, and Bayh 
to include Federal Home Loan Bank modernization in the Gramm-Leach-
Bliley Act, the Federal Home Loan Banks help community financial 
institutions provide critical small business, community development, 
rural and agricultural loans, as well as residential mortgages. I 
believe it is important to note, Senators, that the Federal Home Loan 
Bank System is the only institution in the United States that fulfills 
this mission.
    The Federal Home Loan Banks are very different from the other 
housing GSE's. They are unique in that they are cooperatives that are 
jointly and severally liable for the consolidated debt issued through 
the Office of Finance as their agent. As cooperatives, only member 
institutions own the capital of each Federal Home Loan Bank. There is 
no publicly traded stock and no established marketplace for the Federal 
Home Loan Banks' capital. Further, there is no market pressure on the 
price of the capital stock; it is always bought and sold at par. While 
the Federal Home Loan Banks are not the only cooperatives, nor are they 
the only institutions that operate with joint-and-several liability, no 
other housing GSE or private sector financial institution plays the 
same economic role or operates under the same overall structure as the 
Federal Home Loan Banks.
    It is the task of the Federal Home Loan Banks to maintain a balance 
between their public policy mission and their obligation to provide 
adequate returns on the capital supplied by their members. They do this 
by providing a stable, low-cost, and reliable source of short- and 
long-term funding. For many Federal Home Loan Bank members that are 
small- or medium-sized community banks, direct borrowing in the capital 
markets is not a viable option. With the disintermediation of our 
deposits to Wall Street during the 1990's, a gap in funding during the 
last economic expansion proved the value of the FHLBanks in assisting 
us in meeting the credit needs of our local market. By providing a 
necessary source of wholesale funding to help members manage liquidity, 
loan demand, and interest rate risk, the Federal Home Loan Banks enable 
us to remain independent and continue as an economic engine in our 
community. Between 1994 and 1999, approximately 30 percent of all 
wholesale funding used by banks came from the Federal Home Loan Bank 
System.
    As regional institutions, each Federal Home Loan Bank develops its 
programs in response to the needs of its membership. For example, in 
response to member demand, the Federal Home Loan Bank of Atlanta 
provides its members a competitive alternative to the traditional 
residential secondary mortgage market through two acquired member asset 
(AMA) programs, Mortgage Partnership Finance,' and Mortgage 
Purchase Program. These AMA programs provide medium- and smaller-sized 
institutions with another financial tool in delivering competitive 
credit products. Like the advance programs, the AMA programs help level 
the competitive playing field.
    Reflecting the Federal Home Loan Banks' cooperative nature, the 
financial strategies of the Federal Home Loan Banks are designed to 
enable them to expand and contract in response to their members' credit 
needs.

Federal Home Loan Bank Programs--How They Meet Their Mission Locally
    My bank relies on the Federal Home Loan Bank of Atlanta and its 
programs to deliver financial services to our communities. Like much of 
the country, our area needs more affordable housing. The price of 
housing continues to rise and demands for land limit the availability 
of workforce housing throughout our local market. Our major population 
centers are growing, resulting in greater need for improved medical, 
school, and volunteer fire/rescue support facilities. The Federal Home 
Loan Banks are often an invisible, but vital, partner in fulfilling 
these needs. We use the FHLBank to provide the critical first layer of 
support upon which many layers of private and public support are built 
to bring about new affordable housing and/or community growth.
    Community Bank has partnered with a number of nonprofit Community 
Development Corporations to support affordable housing and 
infrastructure development projects through programs offered by the 
Federal Home Loan Bank of Atlanta. These include the Affordable Housing 
Program (AHP) and the Economic Development and Growth Enhancement 
(EDGE) Program. By using AHP, EDGE, and other similar programs, 
community banks like mine can make affordable housing and community 
development projects economically feasible.
    A good example of this is the Yardley Hills project in Calvert 
County, Maryland. That project utilized over $2.7 million in complex 
layered funding made available by participation in the Federal Home 
Loan Bank of Atlanta's Affordable Housing Program. In another project, 
we used the EDGE loan program to provide the Jarboe Family Head Start 
Center in St. Mary's County, Maryland with permanent funding when other 
traditional banking sources of large regional banks became unavailable.
    Federal Home Loan Bank Community Investment Programs have allowed 
us to partner with the USDA to provide single-family homeownership to 
very low-income families with structured funding and first time 
homebuyer funds.
    Finally, for one of our community's volunteer fire/rescue needs, we 
obtained a $2,000,000 Economic Development Program advance to provide 
permanent financing for a new firehouse located in a low-income 
community in La Plata, Maryland.
    Senators, these projects and hundreds of others like them would not 
have been economically feasible without the programs of the Federal 
Home Loan Bank. They enable community banks to meet those credit needs 
that often would go unmet by larger nonlocal banks. It is also 
important to point out that the Federal Home Loan Banks provide the 
training and technical assistance that teach smaller institutions to 
use these programs--training that would otherwise be too expensive for 
or unavailable to community banks.
    The examples I have given with respect to my bank describe in part 
the distinctive role played by the Federal Home Loan Banks in housing 
finance. They make loans, called advances, to their members on the 
security of mortgages and other eligible collateral. Federal Home Loan 
Bank advances directly support our housing markets, including those 
focused on low- and moderate-income households, as well as all aspects 
of community development critical to the creation of jobs.
    Federal Home Loan Banks also help their members provide other 
needed forms of community development credit. Since the passage of the 
Gramm-Leach-Bliley Act, Federal Home Loan Banks may now allow 
``community financial institutions'' to pledge as collateral for 
advances small business, small farm, and small agribusiness loans. 
Expanding the types of eligible collateral that smaller financial 
institutions may pledge serves a number of purposes. Many smaller 
institutions, particularly in rural areas, have faced funding needs but 
have not had sufficient residential mortgage collateral to secure 
FHLBank advances. Expanding the eligible forms of collateral for these 
institutions will help them meet these funding needs. With the help of 
the Federal Home Loan Banks, small local financial institutions may now 
better serve the community development credit needs of their areas.
    As I indicated earlier in my testimony, the Federal Home Loan Banks 
also help members meet their Community Reinvestment Act (CRA) 
responsibilities. They do this through programs such as the Affordable 
Housing Program (AHP), the Community Investment Program (CIP), EDGE, 
and others. These programs give members access to subsidized and other 
low-cost funding for affordable housing and community development 
projects that benefit low- and moderate-income neighborhoods.
    By supporting their member institutions, the Federal Home Loan 
Banks also strengthen their communities. Each Federal Home Loan Bank is 
required, by law, to allocate 10 percent of its net income to 
affordable housing programs. The funds provided under this program are 
grants and loans. Last year, the Federal Home Loan Banks contributed 
$199 million to the AHP. Since the program's beginning in 1990, the 
Federal Home Loan Banks have set aside approximately $1.7 billion in 
AHP subsidies, helping to create 360,000 units for low-income families. 
The Federal Home Loan Banks collectively are the largest source in the 
Nation of private funding for affordable housing.
    The Federal Home Loan Banks also have established a number of other 
housing and economic development initiatives for their members. These 
programs are funded voluntarily by the Federal Home Loan Banks separate 
from AHP. The Federal Home Loan Bank of Atlanta has established a 
predevelopment fund that offers recoverable grants to help finance 
predevelopment expenses associated with affordable housing and economic 
development projects. The Atlanta Bank also offers a training and 
technical assistance initiative for community development corporations 
serving the neighborhoods surrounding Historically Black Colleges and 
Universities, as well as a subsidized loan program called EDGE, 
mentioned earlier in this testimony, to finance targeted community 
economic development projects. In addition, FHLBank Atlanta also offers 
both an at-cost advance program to help members finance loans for 
economic development activity, and a fund to provide matching equity 
investments for members investing in New Market Tax Credits.
    In addition to examples cited earlier involving my bank, EDGE loans 
have helped finance a childcare center serving low-income families in 
Tuscaloosa, Alabama. Training and technical assistance supported by the 
Federal Home Loan Bank of Atlanta in North Carolina enabled Elizabeth 
City State University, a Historically Black University, to obtain 
financing through the Bank's Affordable Housing Program for the 
rehabilitation of owner-occupied units damaged by Hurricane Floyd. 
Other Federal Home Loan Banks have customized programs as well--
programs like assistance to potential minority-homebuyers; first-time 
low-income homebuyer programs; various predevelopment and affordable 
housing capacity initiatives; flood 
relief assistance programs; and rural technical assistance programs to 
help communities address unmet affordable housing needs by establishing 
rural housing partnerships.
    I strongly believe that the Federal Home Loan Bank System is able 
to provide the important benefits it does because of its dynamic 
membership of large and small institutions and its regional, 
decentralized, cooperative structure. And, I can say 
unequivocally that without the Federal Home Loan Banks and the programs 
they provide, it would be far more difficult for my bank, and the 
thousands of other community banks to remain independent, competitive, 
and capable of extending important housing and community development 
credit.

FHLBank and Director Responsibility
    I have discussed the role of the Federal Home Loan Banks in meeting 
their mission of providing competitive funding to their member 
financial institutions to increase the availability of funds for 
residential and community development lending. I have given you 
examples of why the Federal Home Loan Bank System is so vital for 
community banks like mine. As I stated earlier, I am also an elected 
Member of the Board of Directors of the Federal Home Loan Bank of 
Atlanta, and that role imposes additional important responsibilities.
    As a director, I know that the Federal Home Loan Banks have 
obligations in addition to the mission of being a creative funding 
source for the extension of residential and community development 
credit. The Federal Home Loan Banks, although being exempt from 
Federal, State, and local taxation, are required to make payments to 
the Resolution Funding Corporation (REFCORP) and the Affordable Housing 
program (AHP). Those mandatory contributions are equivalent to a 26.5 
percent effective income tax rate.
    The Federal Home Loan Bank of Atlanta and its board of directors 
support the Administration's position that the housing GSE's should 
provide complete and transparent financial disclosures that constitute 
``best of class.'' That is why we, along with the other FHLBanks, have 
been working on these issues with all relevant parties to resolve the 
specific issues presented by the FHLBanks' statutory mission, 
cooperative structure, and joint and several liability.
    As a director, I want the Atlanta Bank to meet the highest 
standards of disclosure. At the same time, as a director, I have an 
obligation to all the other member/owners to be certain that such 
disclosures are not administered in a manner that could impair the 
mission, operations, or increase the cost of funds of the Bank. If, as 
a director, I agree to voluntarily register the Bank's equity with the 
SEC, not only do I assume additional personal civil and criminal 
liabilities under the relevant statutes, but I also assume liability 
for my decision to voluntarily register. In conducting my fiduciary 
duty as a corporate director consistent with the Business Judgment 
Rule, I must believe that all critical issues have been satisfactorily 
resolved and sustainable agreements reached before I, as a director 
representing the shareholders of the Bank, am permitted to agree to 
such action.
    Just one example of the outstanding issues is how joint and several 
liability will be handled. The Federal Home Loan Banks have always been 
jointly and severally liable for each other's debt. Under SEC 
registration, it is possible that each Federal Home Loan Bank could 
have to create an additional on balance sheet liability reflecting the 
``fair value'' of such liability for the combined debt of all the 
FHLBanks. Critical accounting issues like this and others must be 
effectively resolved in a manner that all the Federal Home Loan Banks 
can rely on going forward without the threat of quarter-to-quarter or 
year-to-year reconsideration upon each SEC filing.
    Contrary to popular misconceptions, the Federal Home Loan Banks are 
privately capitalized by their members and do not receive any taxpayer 
assistance to operate. The Federal Home Loan Bank System debt is not 
guaranteed by the Federal Government, and does not constitute an 
obligation of the United States. The Federal Home Loan Banks have 
operated since 1932 to help bring needed credit to the members and 
communities they serve. And they have done so in a safe and sound 
manner. The Federal Home Loan Banks are required by statute to obtain 
sufficient collateral on advances to protect against losses, and to 
accept only certain collateral on their advances. Consequently, no 
Federal Home Loan Bank has ever experienced a credit loss on an 
advance. At the end of 2002, for example, the Federal Home Loan Banks 
had rights to collateral, either loans or securities, on a member-by-
member basis, with an estimated fair market value in excess of 
outstanding advances.
    The resources and services provided by the Federal Home Loan Banks 
to their member institutions play a key role in the continued success 
of our Nation's housing market. They play a key role in serving the 
financial needs of our local communities. Without the Federal Home Loan 
Banks, it would be far more difficult for our Nation to achieve these 
objectives.
    Thank you for the opportunity to appear before you this afternoon. 
I would be pleased to answer any questions that you may have.

                               ----------

                  PREPARED STATEMENT OF SHEILA C. BAIR
            Dean's Professor of FinanciaL Regulatory Policy
       Isenberg School of Management, University of Massachusetts
                           September 9, 2003

     Chairman Bennett, Senator Johnson, Members of the Subcommittee, it 
is a pleasure to appear before you today to assist you in your 
oversight of the Federal Home Loan Bank System. A strong housing market 
is among the Nation's top economic priorities, and the Federal Home 
Loan Bank System is an indispensable component of that market. When the 
Hoover Administration developed the blueprint for the System in the 
throes of the Great Depression, it was based on the premise that this 
cooperative was needed to assure a constant flow of funding when 
deposits proved inadequate due to national or regional economic 
conditions. Seventy years later, with over $500 billion in FHLB 
advances outstanding, the underlying premise for the System remains 
valid. The Federal Home Loan Banks play a vital role in mortgage 
finance and deserve to be continued and strengthened.

Challenges Confronting the System
     It is in the spirit of System supporter that I come to you this 
morning to raise three issues that I believe warrant your attention: 
Multidistrict membership, expansion of the System's mortgage 
acquisition programs, and lack of SEC registration of FHLB securities. 
These issues are important because their resolution will help determine 
the future of the system and its long-term stability. They were 
examined in detail in a paper I recently completed that was funded by a 
grant to the School of Management from the Fannie Mae Corporation, 
which I would like to submit for the record. The conclusions reached in 
the paper are my own, and do not reflect the views of the research 
sponsor. After discussing my paper, I will make some general 
observations about the FHLB System's regulatory structure in relation 
to efforts underway to improve safety and soundness regulation of 
Fannie Mae and Freddie Mac.

Multidistrict Membership
    Recent industry consolidations have prompted some to call for 
allowing members to belong to more than one district FHLBank. 
Throughout the System's history, no single institution has ever been a 
member of more than one district bank and the System's authorizing 
statute leaves little doubt that this is what Congress intended. The 
Federal Housing Finance Board's (FHFB) efforts to allow multidistrict 
membership by regulation have been highly controversial, supported by 
only 5 of the System's 12 district banks. Four of the FHLBanks are 
strongly opposed, with the remaining three undecided and expressing 
serious reservations.
    My primary objection to multidistrict membership is that Congress--
not the FHFB--should decide whether such a fundamental change should be 
made to the System's historic regional and cooperative structure. I am 
also concerned that multidistrict membership could have a destabilizing 
influence on the System. Multidistrict membership would allow large 
institutions to ``shop'' their advance activity among multiple 
FHLBanks, but because all the FHLBanks raise funds in the same way, 
their ability to compete based on price will be limited. As a 
consequence, they will likely compete on collateral and credit 
standards. In addition to diminution of credit quality, allowing one 
member to have multiple relationships with FHLBanks would increase 
operational risk since the System lacks safeguards to obviate the 
multiple pledging of collateral or the prospect of competing blanket 
liens. Moreover, allowing multiple memberships could increase large 
borrower activity in the System as a whole, thus exacerbating large 
borrower concentrations. Nearly 24 percent of all advance activity is 
already concentrated in the System's 10 top borrowers.
    Multidistrict membership would, by definition, help only 
institutions large enough to take advantage of it, and fundamentally 
alter the basic concept of the System--a cooperative of regional banks 
existing to serve the funding needs of institutions headquartered in 
their districts. Moreover, given the seismic consolidation activity 
that occurred in the 1980's--which the System weathered quite well--it 
is difficult to see why current consolidation activity should provide 
the impetus for such a dramatic restructuring. Under a holding company 
structure, separately chartered subsidiaries have been able to hold 
memberships in different banks--the same arrangement commercial banks 
have with the Federal Reserve Banks--which maintains consistency with 
the Federal Home Loan Bank Act and the regional character of the 
System.

The Mortgage Acquisition Programs
    The second issue I examined--expansion of the System's mortgage 
acquisition programs--also primarily benefits the System's largest 
members. Begun in 1997 as a small pilot capped at $750 million, these 
programs have grown exponentially. The System now holds $90 billion 
worth of mortgages in portfolio, representing over 10 percent of its 
assets. One FHLBank now has half its assets invested in mortgages and 
only one-third of its assets in advances, the business activity that 
Congress assigned it.
    There is nothing in the System's legislative history or authorizing 
statute that grants authority for direct mortgage purchases, and the 
other two major housing GSE's, that is, Fannie Mae and Freddie Mac were 
established and chartered by Congress expressly for that purpose. 
Congress, not the individual FHLBanks or the FHFB, should decide 
whether it wants the System to be a major player in the secondary 
mortgage market, and if so, the terms and limitations that should 
apply.\1\
---------------------------------------------------------------------------
    \1\ Congress placed specific limitations on Fannie Mae and Freddie 
Mac regarding capital, safety and soundness, and mission requirements. 
However, since Congress never authorized the FHLB System to enter the 
secondary mortgage market, it did not specify the limitations that 
should apply.
---------------------------------------------------------------------------
    The risks associated with mortgage acquisition are distinctly 
different from those associated with the System's traditional role of 
making fully collateralized advances. Advances have prepayment 
penalties and call features that allow the FHLBanks to effectively 
manage their interest rate risks. Different, more complex tools are 
needed for the interest rate/prepayment risk presented by mortgages 
held in portfolio. Operational risk is also significant--there is a 
serious question as to whether the System has sufficient numbers of 
qualified staff or infrastructure needed to manage even the day-to-day 
risk associated with secondary mortgage market participation. The 
staffs of each FHLBank and the Office of Finance are relatively small, 
and they are trained in the traditional business of advances, not 
mortgage acquisition and portfolio management. Regarding credit risk, 
the mortgage acquisition programs' proponents boast that the 
originators--not the FHLBanks--retain the credit risk. In truth, the 
originators provide credit enhancements that are only as good as the 
FHLBanks require them to be based on their own interpretation of 
historical default data, which again, is outside their traditional 
mission and expertise. It is also telling that a recent FHFB proposed 
rulemaking--now withdrawn--would have eliminated one of these programs 
most important tools in managing credit risk--the 
requirement that pools of purchased mortgage assets achieve an 
investment grade rating from an independent ratings agency.
    No adequate public policy basis has been advanced for the System's 
foray into this new, riskier line of business. Though promotional 
materials for the programs claim that they are designed to help smaller 
institutions, available data suggests that they are being run 
overwhelmingly for the benefit of large originators. According to trade 
journal reports, the top five mortgage originators sold $42.7 billion 
in mortgages to the FHLBanks in 2002.\2\ Assuming the accuracy of this 
report, these five institutions would account for almost all of the 
$45.7 billion dollars in FHLBank mortgage acquisitions in 2002. If 
Congress wishes to authorize yet another GSE entry into the secondary 
mortgage market, it should assure itself there is a valid public policy 
basis to do so. Meeting legitimate market needs of smaller, community-
based institutions might be one justification. Enriching large mortgage 
originators is not.
---------------------------------------------------------------------------
    \2\ Inside the GSE's (April 2, 2003), at p.6; 2002 FHLBank System 
Annual Report at p.22.
---------------------------------------------------------------------------
SEC Registration
    In my paper, I also concluded that voluntary SEC registration would 
be in the best interests of the System and its debtholders. I will not 
belabor the arguments, because Assistant Secretary Abernathy has 
already eloquently stated them in his testimony. Suffice it to say, 
voluntary SEC registration would enhance the image of the System and 
demonstrate that the FHLBanks are committed to a policy of full 
disclosure.

Thoughts on Regulatory Structure
    Questions about the capability of the System to manage new risks 
associated with multidistrict membership and mortgage acquisition 
programs are heightened by longstanding weaknesses in the FHFB 
examination process, identified by the Government Accounting Office 
(GAO) in 1998 and again in 2002. Though the FHFB has taken a number of 
steps to address these weaknesses, including increasing the number of 
examiners and putting greater focus on major risks and the quality of 
controls at FHLBanks, the GAO found in a report released last February 
that it is still too soon to evaluate the effectiveness of these 
measures. As of February 2003, the FHFB had only 14 examiners, with 
plans to increase the total number of examiners to 24 by the end of 
2004. According to its fiscal year 2003 budget, only $9.7 million of 
its $27 million budget was allocated for the Office of Supervision. By 
way of comparison, Treasury's two bank regulatory bureaus--the Office 
of the Comptroller of the Currency (OCC) and the Office of Thrift 
Supervision (OTS) will typically assign teams of 20-30 examiners to 
each of its largest institutions, and will spend 70-80 percent of their 
budgets in direct support of supervision.
    More fundamentally, the structure of the FHFB suffers from many of 
the same defects now being scrutinized at the Office of Federal Housing 
Enterprise Oversight. It is a small, low-profile agency that simply 
cannot attract and retain the quality of staff that it needs. It exists 
outside the financial regulatory mainstream, and thus does not benefit 
from the, routine day-to-day interaction that occurs among the major 
bank regulatory agencies. It is responsible for only 12 Banks, plus the 
Office of Finance--a narrow constituent base that creates the 
perception of ``captive regulator.'' Other major financial regulators 
have a much broader regulatory base, and their actions are generally 
reflective of the views and interests of diverse and competing 
constituencies. For instance, bank regulators are constantly mediating 
differences between large and small banks, those with different 
business lines, geographic concentrations, or customer bases. This in 
turn enhances the credibility and quality of regulatory decisionmaking. 
When a regulator's jurisdiction is confined to a small group of closely 
aligned institutions, the pressure and input it receives can become 
narrowly focused and one-sided. It becomes difficult for the regulator 
to stay objective and ``above the fray.''
    Should a new agency be created at the Treasury Department for 
oversight of Fannie Mae and Freddie Mac, I believe it would be a 
stronger agency if it also included oversight of the FHLB System. The 
new regulator would have a bigger, better view of the housing finance 
market and would be in a better position to evaluate the advantages--
and dangers--of the major housing GSE's competing directly with each 
other in the same lines of business. From the standpoint of systemic 
risk and taxpayer exposure, it is just as important to the Government 
for the FHLB System to have quality safety and soundness oversight as 
it is for Fannie and Freddie. At year-end 2002, the System had $668 
billion in outstanding debt, compared to Fannie's $884 billion and 
Freddie's $644 billion. It enjoys the same implied government 
guarantee, with an even more generous line of credit from the U.S. 
Treasury. Though unlikely, a widespread failure in the System could 
have staggering ramifications for U.S. taxpayers and the housing 
market.
    Some have argued that the FHLBanks would be overwhelmed by the 
other two politically powerful GSE's if their oversight were to be 
housed in the same agency. I do not believe it. With their longstanding 
community bank ties, and extensive grass roots, I have no doubt the 
FHLBanks can hold their own. I have also heard it argued that the 
Treasury Department would be hostile to the System, which I can say 
from first hand experience is not the case. On the contrary, I believe 
the Treasury respects the role of the System in the housing finance 
market and would not do anything to disrupt it.
    The competitive impact on FHLB funding costs should also be weighed 
in the balance when considering whether to merge the FHFB into the new 
agency. The creation of a credible, high quality GSE regulator within 
the Treasury will likely 
receive a positive reaction in the capital markets, which could reduce 
Fannie and Freddie's funding costs. If the FHLB System is left out, 
that could widen spreads between FHLBank securities and those issued by 
the Enterprises. Wider spreads would in turn mean a higher cost of 
funds for the FHLBanks, which would adversely impact the price of 
advances and other FHLBank services.

Conclusion
    Strong momentum is building for the creation of a credible, high 
quality regulator within the Treasury Department to replace OFHEO. Now 
would be a propitious time for the Congress to consider whether 
oversight of the FHLB System should also be placed under this new 
regulator. To be sure there are important policy determinations that 
Congress needs to make regarding the FHLB System's mission and future, 
and it is important not to impede the momentum behind the transfer of 
OFHEO's safety and soundness functions. However, concurrent action 
could assure quality regulation of all three major housing GSE's, and 
prevent a widening of spreads, which could further weaken the System.
    Thank you Mr. Chairman. I will now be happy to answer any questions 
you may have.

                               ----------

                   PREPARED STATEMENT OF TERRY SMITH
          President and CEO, Federal Home Loan Bank of Dallas
                           September 9, 2003

    Mr. Chairman, Ranking Member Johnson, and Members of the 
Subcommittee, I appreciate the opportunity to speak to you today about 
the Federal Home Loan Banks. My name is Terry Smith, and I am President 
and CEO of the Federal Home Loan Bank of Dallas. I am also the current 
Chairman of the Bank Presidents Conference of the Federal Home Loan 
Banks (FHLBanks). Along with my colleagues, I am pleased to provide an 
update on the FHLBanks' activities and our progress implementing the 
FHLBank provisions of the Gramm-Leach-Bliley Act (GLB Act).

Overview of the FHLBanks
    The FHLBanks were created in 1932 to support America's housing 
finance system. It was largely the FHLBanks' ability to raise long-term 
debt in the capital markets and pass that funding along to their member 
financial institutions that encouraged the development of the 30-year 
fixed-rate mortgage that is the predominant financing tool in the U.S. 
mortgage finance system today.
    The FHLBanks continue to play a vital role in the Nation's housing 
finance and community lending system. Our member institutions, 
primarily community banks and thrifts, use the FHLBanks' advances 
program to meet the mortgage and community lending needs of their local 
markets, and use our Affordable Housing Programs to make housing more 
affordable for thousands of low-income families in those communities. 
These are our primary purposes, and we are proud of our accomplishments 
in carrying them out.
    The FHLBank System, as it is sometimes called, is comprised of 12 
individual FHLBanks, their 8,080 member institutions, and the Office of 
Finance which issues debt on behalf of the FHLBanks. Each FHLBank is a 
separate and distinct corporate entity with its own stockholder/member 
institutions and its own board of directors. While the FHLBanks issue 
debt collectively and are jointly and severally liable for the 
repayment of those debt obligations, there is no single controlling 
corporate entity with responsibility for or authority over the 
FHLBanks. The 12 FHLBanks operate independently under the authority 
granted by Congress through the Federal Home Loan Bank Act (Bank Act), 
as amended, and in accordance with the regulations established by and 
under the regulatory oversight of the Federal Housing Finance Board 
(Finance Board).
    The FHLBanks are cooperative institutions that operate within 
districts originally established by the Federal Home Loan Bank Board, 
the predecessor to the Finance Board. Each FHLBank's capital stock is 
owned only by its member institutions, and only a FHLBank's members 
(plus certain nonmember housing associates such as state housing 
authorities) may conduct business with an individual FHLBank.
    FHLBank members must meet certain statutory eligibility criteria. 
Each member must purchase the FHLBank's capital stock in order to 
become a member, and must maintain capital stock holdings sufficient to 
support its business activity with the FHLBank, either in accordance 
with the statutory formula or, for FHLBanks that have already 
implemented the capital plans required by the GLB Act, in accordance 
with the individual FHLBank's capital plan.
    A FHLBank's capital stock cannot be issued to or held individually 
by members of a FHLBank's board of directors, its management, its 
employees or the public, and is not publicly traded. There is no market 
for FHLBank capital stock other than among FHLBank members. The price 
of a FHLBank's capital stock cannot fluctuate, and all FHLBank capital 
stock must be purchased, repurchased, or transferred only at its par 
value. There are no stock options or other forms of stock-based 
compensation for FHLBank management, directors, or employees.
    Prior to the passage of the Financial Institutions Reform, Recovery 
and Enforcement Act (FIRREA) in 1989, the FHLBanks' membership was 
generally limited to thrift institutions (building and loan 
associations, savings and loan associations, savings banks, homestead 
associations, etc.) and a handful of insurance companies. FIRREA 
expanded eligibility for membership to include commercial banks and 
credit unions with a demonstrated commitment to housing finance. The 
GLB Act further refined FHLBank membership rules by making federally 
chartered thrifts voluntary members for the first time and eliminating 
the remaining statutory differences in the terms of access between 
thrift institutions and commercial banks and credit unions.
    The combination of the FIRREA and GLB Act statutory changes, along 
with changes in the mortgage lending market, have caused FHLBank 
membership to expand exponentially in the last decade. As of June 30, 
2003, the 12 FHLBanks had a total of 8,080 member institutions, which 
included 6,037 commercial banks, 1,273 thrift institutions, 693 credit 
unions, and 77 insurance companies.
    As an indication of the role the FHLBanks play in today's financial 
system, the FHLBanks' 7,310 commercial bank and thrift institution 
members represent approximately 79 percent of all FDIC-insured 
institutions in the country. Reflecting the structure of the depository 
institutions industry, approximately 6,519 (or 89 percent) of those 
FDIC-insured members are Community Financial Institutions (CFI's), as 
defined by the GLB Act. (CFI's are FDIC-insured institutions with 
average total assets for the 3 years ended December 31, 2002 of $538 
million or less.) Altogether, approximately 7,493 member institutions 
(93 percent of all members) as of June 30, 2003 were community lenders 
with total assets less than $1.0 billion.
    As noted previously, every member institution has made a voluntary 
decision to belong to a FHLBank. Among other things, that means that 
the FHLBanks must offer, and continue to provide, a membership value 
proposition that members perceive as adding value to their 
institutions. The value the FHLBanks provide our members is a blend of 
the modest dividends we pay on members' capital stock investment, the 
value of access to stand-by liquidity from the FHLBanks, availability 
of short- and long-term funds at attractive rates, and access to other 
products that make a community lending institution better able to 
profitably serve the credit needs of its community.
    The FHLBanks' primary product offerings include traditional 
advances (fully secured loans to member institutions) and the more 
recently introduced Acquired Member Asset (AMA) programs. Advances 
represent the core of the FHLBanks' business, providing a source of 
funds members can use to support mortgage lending and, for CFI's, other 
community banking assets. The AMA programs, through which the FHLBanks 
acquire mortgage loans originated by member institutions under risk-
sharing rules and other parameters established by Finance Board 
regulations, provide a secondary market alternative for those loans. In 
addition, the FHLBanks offer favorably priced advances for members' 
special community lending activities under their Community Investment 
Cash Advances (CICA) programs, and competitive grant programs that 
provide funds for housing for low-income families under Affordable 
Housing Programs (AHP) established following FIRREA.

Implementation of Gramm-Leach-Bliley Legislative Changes
    Since the enactment of the GLB Act in November 1999, a principal 
focus of the FHLBanks has been the implementation of the FHLBank 
provisions contained in Title VI of that Act. The modifications to the 
Bank Act made by the GLB Act represented the culmination of many years 
of effort to reform the FHLBanks, particularly the membership rules and 
capital structure. The main purposes of the FHLBank provisions were to 
establish a system of universal voluntary membership, provide for a 
more permanent capital structure to accommodate voluntary membership, 
equalize the terms of access to the FHLBanks for all types of 
institutions eligible for membership, and to expand the types of 
collateral that community banks can pledge to secure advances. I am 
pleased to report that the FHLBanks are in the last stages of 
implementing those changes and fulfilling that purpose.
    Before FIRREA, the membership of the FHLBanks was comprised almost 
entirely of thrifts that were required to be members by terms of their 
charter or deposit insurance. FIRREA authorized commercial banks to 
become voluntary members, but most thrifts continued as mandatory 
members. In addition, the terms of access to the FHLBanks for newly 
eligible institutions, including capital stock purchase requirements, 
differed from the requirements for thrift institutions. It quickly 
became evident that this disparate treatment was inconsistent with the 
cooperative structure of the FHLBanks and was not needed to ensure that 
thrift institution members had adequate access to the FHLBanks. As a 
result, the FHLBanks and their members urged Congress to amend the Bank 
Act to provide for universal voluntary membership and equal terms of 
access.
    The System of total voluntary membership has been successfully 
implemented. All members now have the same rights to access FHLBank 
products and services. In particular, the higher capital stock purchase 
requirements for advances to commercial banks and credit unions based 
on their different asset mix have been eliminated, which has enabled 
community bank members better access to advances and, in turn, to 
better serve the credit needs of their customers. And, although FHLBank 
membership is now voluntary for all, only a handful of institutions 
whose business model did not benefit from FHLBank membership have taken 
the opportunity to withdraw from membership.
     Community banks historically have had a somewhat different 
customer base than thrift institutions, often spreading their lending 
activity among the various types of loans needed in the community, such 
as mortgage, small business, and small farm loans. In recognition of 
this fact and in order to allow the FHLBanks to better serve their 
members' needs, the GLB Act authorized the FHLBanks to make advances to 
CFI's secured by small business and small farm loan collateral. The 
FHLBanks have successfully and responsibly implemented this new 
authority, acting prudently as secured lenders to assign appropriate 
lending values to the new collateral and maintain their record of never 
having suffered a credit loss on an advance to a member. As a result, 
the new collateral authority has enabled community bank members to 
better serve their communities.
    In order to implement universal voluntary membership, while at the 
same time providing for capital with more permanence, the GLB Act 
outlined a new capital structure for the FHLBanks. The major 
differences include authorization to issue two classes of capital 
stock--Class A stock redeemable with 6 months notice and Class B stock 
redeemable with 5 years notice--and implementation of new leverage, 
risk-based and total capital requirements. This new framework adds 
permanence to the FHLBanks' capital structure by requiring them to 
maintain sufficient Class B stock plus retained earnings to meet the 
new risk-based capital requirements.
    The GLB Act created a series of statutory deadlines for adoption of 
new capital regulations by the Finance Board and adoption and 
implementation of new capital plans by the individual FHLBanks. All of 
the relevant deadlines have been met and the FHLBanks are well on their 
way to implementing their new capital plans. In fact, six FHLBanks have 
already implemented their new capital plans, I believe another FHLBank 
will implement its plan later this year, and the remaining five 
FHLBanks will implement their plans by mid-2005. Each FHLBank has 
developed its capital plan in consultation with its members and in 
accordance with the Finance Board's regulations. The plans have been 
well received thus far, with only a very few members exercising their 
right to withdraw from membership before implementation.
    In general, the provisions of the GLB Act have been very positive 
for the FHLBanks and their members. These changes have had, and will 
continue to have, a positive impact on the Banks' ongoing ability to 
fulfill their statutory role, and to do so safely and soundly.

Federal Home Loan Banks Financial Profile
    Reflecting the expansion of their membership base, the overall 
growth in the banking industry, and increased usage of FHLBank advances 
and AMA programs, the 12 FHLBanks have grown considerably in the last 
decade. As of June 30, 2003, the FHLBanks had combined total assets of 
$809 billion. The FHLBanks' balance sheets were supported by nearly $38 
billion of capital, of which more than $36 billion represented capital 
stock contributed by member institutions. The FHLBanks' aggregate 
capital-to-assets ratio was 4.7 percent at June 30, with capital ratios 
for individual FHLBanks ranging from 4.2 to 5.6 percent.
    Of the FHLBanks' total assets, $596 billion (74 percent) 
represented direct funding of member assets through advances and AMA. 
The FHLBanks' aggregate advances were $506 billion at June 30, representing 
63 percent of their combined balance sheets, and AMA were $90 billion, accounting for about 11 percent of the FHLBanks' aggregate assets. The remaining $209 billion (26 percent) of the FHLBanks' balance sheets were comprised primarily of various highly rated investments that the FHLBanks 
hold to maintain a ready supply of liquidity to satisfy member demand for 
advances and AMA, and to supplement earnings to keep advances rates low 
and maintain adequate returns on members' capital stock investment. 
Approximately $78 billion of the FHLBanks' investments were in short-
term instruments such as Federal funds sold or commercial paper used by 
the FHLBanks to warehouse liquidity to meet members' credit needs and 
the FHLBanks' other day-to-day obligations.
    The FHLBanks also maintain longer-term investment portfolios that 
provide a source of standby liquidity and supplement earnings so the 
FHLBanks can provide advances and other credit products at attractive 
rates. At June 30, 2003, the FHLBanks' longer-term investment portfolio 
represented about 16 percent of their total assets and included $23 
billion in securities issued by the U.S. Government or U.S. agencies, 
approximately $6 billion of securities issued by state or local housing 
agencies to support their housing finance activities, and approximately 
$98 billion of mortgage-backed securities. The FHLBanks' mortgage-
backed securities have been purchased in accordance with Finance Board 
guidelines not to exceed three times an individual FHLBank's total 
capital. These securities are all issued by the U.S. Government or U.S. 
agencies, or rated triple-A when they are purchased by the FHLBanks.
    After weathering the storm of the thrift crisis of the late 1980's 
and its aftermath, the FHLBanks have been consistently profitable 
throughout the past decade. Although actual earnings and rates of 
return have fallen with the decline in interest rates over the last 3 
years, this reduction in earnings is a natural and expected result of 
the way the FHLBanks are structured and how they operate. Because the 
FHLBanks are wholesale institutions investing primarily in fully 
secured advances, high credit quality mortgage loans or highly rated 
investment securities, they operate on very narrow interest spreads 
between their cost of funds and the yields on their assets. It is 
typical for a FHLBank to have a net interest spread (the difference 
between the cost of its liabilities and the yield on its assets) of 
about 20 basis points (0.20 percent). By way of comparison, a 
commercial bank might have an interest spread closer to 400 basis 
points (4.0 percent). Given the FHLBanks' small interest spreads, a 
much greater proportion of the FHLBanks' earnings are derived from the 
investment of capital than is the case for commercial banks.
    Before paying dividends to members, the FHLBanks' earnings from 
these and other sources must cover the FHLBanks' operating expenses and 
assessments. These assessments include the expenses of the Finance 
Board and the FHLBanks' obligations to contribute 20 percent of their 
earnings toward the payment of interest on REFCORP bonds issued in the 
early 1990's to help finance the cost of resolving the thrift 
institution crisis, and an additional 10 percent to fund their own 
regional AHP.
    As interest rates have fallen (particularly short-term interest 
rates such as the Federal funds rate which is now at 1.0 percent), the 
return on a FHLBank's investment of its capital has necessarily fallen 
as well. If a FHLBank could completely insulate itself from interest 
rate risk by perfectly match funding all of its assets and maintaining 
a constant interest spread as interest rates fall, it would expect its 
rate of return on invested capital to fall about 75 basis points (0.75 
percent) for every 100 basis point (1.0 percent) reduction in interest 
rates.
    Because of this dynamic, the FHLBanks' earnings and rates of return 
generally rise and fall with the level of interest rates, and our 
dividend rates follow suit. In the case of the Dallas Bank, we paid 
dividends at an average rate of 6.36 percent in 2000 when the average 
Federal funds rate was about 6.25 percent, while we expect to pay 
dividends at an annual rate of 2.0 percent in the third quarter of this 
year, with the Federal funds rate at 1.0 percent.
    Our experience indicates that this result fits very well with our 
members' investment expectations. Members do not invest in FHLBank 
capital stock with the expectation of earning equity investment 
returns. Rather, members' investment in FHLBank capital stock 
represents a very low-risk asset with explicit returns in the form of 
dividend payments that fluctuate with market interest rates, and 
overall benefits that include the value of access to FHLBank funding. 
The FHLBanks do not attempt and are not expected to produce rates of 
return comparable to other equity investments.

Corporate Governance of the FHLBanks: The Role of the Board
of Directors
    Congress established a unique ownership and governance structure 
for the FHLBanks, which has served the FHLBanks well in the past and 
continues to do so. The most critical feature of this structure is that 
the FHLBanks are wholly owned by their members/customers. In addition, 
the boards of directors of the FHLBanks are truly independent of 
management. No member of management may serve as a director of a 
FHLBank, and management is precluded by regulation from recruiting 
directors or participating in the election of directors.
    The Bank Act provides that a majority of each FHLBank's directors 
be elected by its member institutions from among officers and directors 
of those institutions. Members vote for directors representing member 
institutions from their States. The FHLBanks' members currently elect 
approximately 57 percent of the FHLBanks' directors in this way, with 
the remaining directors being appointed by the Finance Board.
    Not only are members assured of the ability to elect the majority 
of their FHLBank's directors, but the Bank Act also provides that no 
member may cast a number of votes greater than the average number of 
shares all the members in its specific state are required to hold. This 
prevents large members holding relatively large amounts of a FHLBank's 
capital stock from dominating director elections and, in practice, 
means that the majority of each FHLBank's elected directors generally 
represent the small institutions that make up the great majority of all 
members.
    The statutory framework that controls the composition of the 
FHLBanks' boards of directors ensures that each FHLBank's board of 
directors will have a balance of interests represented. With no members 
of management on the board of directors, directors are in a position to 
independently oversee management actions. The members that contribute 
capital and benefit from the FHLBank's products and services are 
assured a majority of the directors. The director election voting 
preferences for small members ensure that larger members cannot 
dominate the board of directors and that a FHLBank's policies will not 
be detrimental to small members. Finally, the large contingent of 
appointed directors ensures that the FHLBanks will appropriately 
consider their public policy obligations.
    Finance Board regulations require that the FHLBanks' boards of 
directors not only fulfill the typical corporate director duties of 
care and loyalty, but that they also carry out specific 
responsibilities. These duties include, but are not limited to, the 
responsibility to select and oversee management, the responsibility to 
ensure the establishment and maintenance of an adequate internal 
control system, the responsibility to adopt a risk management policy, a 
strategic business plan, and a member products policy that details the 
Bank's credit and pricing policies, and the responsibility to approve 
the FHLBank's annual operating budget and quarterly dividends.
    In carrying out their responsibilities, the boards of directors 
typically establish and act through committees. Finance Board 
regulations require each FHLBank's board of directors to have an audit 
committee with very specific regulatory responsibilities, including 
direct oversight of the FHLBank's internal and external audit 
functions. The boards of directors also typically establish other 
committees to facilitate their oversight of management. Committees vary 
from FHLBank to FHLBank, but typically include risk management, human 
resources, and housing oversight functions. The various elements of the 
FHLBanks' corporate governance structure combine to provide boards of 
directors that are active, knowledgeable, and engaged, and that are 
fully aware of their responsibilities and take them seriously.

Regulatory Oversight of the FHLBanks
    The combination of this governance structure and the regulatory 
oversight provided by the Finance Board make the FHLBanks among the 
most intensively audited entities in the country. As noted above, each 
FHLBank has its own independent internal auditor, who actively and regularly audits all FHLBank operations and reports directly to the board of directors. In addition, each FHLBank's financial statements are reviewed by an 
outside accounting firm (currently PricewaterhouseCoopers). Finally, 
the Finance Board's ``primary duty'' under the Bank Act is ``to ensure 
that the Federal Home Loan Banks operate in a financially safe and 
sound manner.''
    The Finance Board is not limited by funding constraints in carrying 
out its declared focus of ensuring the FHLBanks' safety and soundness 
because its funding is provided by assessments on the FHLBanks that are 
not subject to review or challenge by the FHLBanks. The Finance Board 
not only has regulatory authority over the FHLBanks that extends beyond 
that which is typically afforded a safety and soundness regulator--the 
GLB Act extended to the Finance Board the regulatory enforcement powers 
of both the Federal banking regulatory agencies and the Office of 
Federal Housing Enterprise Oversight (OFHEO) and--but also has wide-
ranging authority over many aspects of FHLBanks' operations.
    Finance Board regulations govern every facet of the FHLBanks' 
operations, from advances pricing to eligible collateral to risk 
management to capital plans to directors' responsibilities to new 
business activities. The Finance Board also collects and monitors 
financial and risk management data from the FHLBanks each month, 
performs ongoing reviews of all aspects of the FHLBanks' operations and 
conducts annual on-site examinations of all 12 FHLBanks. While the 
FHLBanks do not always enjoy being subjected to regulatory scrutiny, 
all believe that it is essential that the FHLBanks have a strong, 
independent regulator with the resources to ensure the FHLBanks' safety 
and soundness.

Risk Management of the FHLBanks
    As 12 independent institutions, all the FHLBanks are responsible 
for their own risk management activities. Each FHLBank has its own risk 
profile and approaches management of its risks in a slightly different 
way. However, there are a number of factors that are held in common 
across the FHLBanks that enable each FHLBank individually, as well as 
the Consolidated Obligations (CO's) issued by the 12 FHLBanks 
collectively in the capital markets, to be rated triple-A.
    The cooperative structure of the FHLBanks eliminates many of the 
incentives a publicly traded company might have to raise its risk 
profile, and in fact discourages FHLBanks from taking excessive risk. 
Just as FHLBank members do not expect equity investment returns on 
their capital stock investment in a FHLBank, they also do not expect 
equity investment risk in that investment. Members purchase FHLBank 
capital stock in order to obtain access to FHLBank funding products, 
and must maintain capital stock investments in the FHLBank as long as 
they maintain advances outstanding. That is, members provide the 
capital that supports their 
advances transactions with the FHLBanks. In that environment, members 
expect stability, reliability, and consistency of returns and credit 
product pricing. These member expectations are reflected in the 
oversight provided by each FHLBank's board of directors, a majority of 
which is comprised of directors representing and elected by member 
institutions.
    In large part due to the incentives created by the FHLBanks' 
cooperative structure, risk aversion and conservative risk management 
practices are ingrained in the corporate culture. That same 
conservative approach to risk management is also reflected in both the 
legal restrictions and the Finance Board's regulatory regime. For 
instance, the Bank Act and the Finance Board's implementing regulations 
clearly describe and mandate the various limitations on the types of 
collateral the FHLBanks may accept to secure advances. Regulations 
limit the types, amounts, and required credit ratings on both short and 
long term investments the FHLBanks make with surplus funds. Finance 
Board regulations include separate additional restrictions on the 
aggregate amount, ratings, and characteristics of mortgage-backed 
securities the FHLBanks may purchase and hold.
    In addition, Finance Board regulations require that each FHLBank 
maintain a Risk Management Policy, reviewed at least annually and 
readopted at least every 3 years by its board of directors, which 
identifies specific risk management practices and limits for the 
individual FHLBank. These practices and limits are monitored by the 
FHLBanks' internal audit departments, which report their findings 
directly to the FHLBanks' boards of directors. The Finance Board also 
monitors FHLBank compliance with these and other regulatory 
requirements through monthly call reports, constant off-site 
monitoring, and annual on-site examinations. The FHLBanks are also 
subject to very conservative capital requirements imposed by statute in 
the GLB Act and by Finance Board regulations implementing those 
statutory requirements. These requirements specify that FHLBanks must 
have total capital equal to at least 4.0 percent of their total assets, 
and must have sufficient permanent capital (as defined by the GLB Act) 
to meet a risk-based capital regime established by Finance Board 
regulation.
    The FHLBanks minimize credit risk by ensuring that advances are 
fully secured, that their investments are limited to issuers or 
securities that are highly rated at the time the investments are made, 
and that their AMA have appropriate risk-sharing features. No FHLBank 
has ever suffered a credit loss on an advance to a member in the 
FHLBanks' 71 year history. As of June 30, 98 percent of the FHLBanks' 
investment securities have long-term ratings of triple-A or the 
corresponding highest short-term ratings. In addition, due in large 
part to the risk sharing structure of the AMA programs, the FHLBanks' 
loss experience on AMA assets has been very favorable.
    Since each FHLBank's primary activity is to serve as a financial 
intermediary, the FHLBanks are also subject to market (or interest 
rate) risk. To the extent the individual maturities of a FHLBank's 
assets are not exactly matched by the individual maturities of its 
liabilities, the FHLBank's future earnings stream is subject to 
fluctuation due to changes in the relationship between yields on its 
assets and the cost of its liabilities. Complicating the picture is the 
fact that the FHLBanks hold assets (such as mortgage loans and 
securities) or have issued liabilities (such as callable debt) that can 
be repaid prior to their stated maturities. Further complicating the 
issue is the fact that the FHLBanks' narrow interest spreads do not 
provide a large margin of error.
    To manage these risks, each FHLBank uses sophisticated financial 
models to continually assess the magnitude of the risk to the FHLBank's 
estimated market value or earnings from various changes in interest 
rates. This information is reported to the FHLBank's board of directors 
on a regular basis and to the Finance Board as often as monthly, and is 
summarized in the FHLBanks' combined financial statements.
    Reflecting the FHLBanks' conservative approach to interest rate 
risk management, the 12 FHLBanks' ``duration gaps,'' or (generally) the 
difference between the estimated average maturity of a FHLBank's assets 
and the estimated average maturity of its liabilities, ranged from 
negative 1.4 months to positive 1.6 months as of June 30, 2003. A 
duration gap of 1.6 months generally means that the weighted average 
expected maturity of a FHLBank's assets is 1.6 months longer than the 
weighted average expected maturity of its liabilities.
    The FHLBanks use interest rate derivatives extensively to maintain 
their conservative interest rate risk profile. While much has been 
written about the potential risks that can be created by the improper 
use of derivatives, the manner in which the FHLBanks use derivatives is 
a key component of their risk management activities. A couple of facts 
are germane to an understanding of the FHLBanks' use of derivatives.
    First, Finance Board regulations prohibit the use of derivatives 
for speculative purposes. That means that every derivative instrument 
entered into by a FHLBank is designed to hedge (that is, reduce) an 
identified risk. Second, a majority of the FHLBanks' interest rate 
derivative transactions are structured to exactly offset another 
specific transaction. For instance, a FHLBank may use an interest rate 
swap to convert the interest payments on a particular fixed rate 
advance to a floating rate, so that the net payment stream will float 
in a manner that matches the debt the FHLBank has issued to fund the 
advance. Similarly, much of the debt the FHLBanks issue is long term, 
fixed rate, and often callable. The FHLBanks typically convert a large 
portion of this fixed rate debt to floating rates by executing exactly 
offsetting interest rate swaps simultaneously with the issuance of the 
debt. Approximately 82 percent of the FHLBanks' outstanding derivatives 
as of June 30, 2003 represented these two types of transactions.
    While the use of interest rate derivatives is critical to managing 
the FHLBanks' interest rate risk, derivatives can cause problems if not 
managed appropriately. The FHLBanks mitigate these risks in several 
ways. The appropriateness of the FHLBanks' derivatives activities for 
risk management purposes are validated internally by the use of 
internal valuation models, by internal audits that often employ 
external experts to validate a FHLBank's valuation model and hedging 
practices, by external audits of the FHLBank's derivative valuations, 
and through the Finance Board's annual on-site examination process.
    The use of derivatives can also increase credit and operational 
risks that must be managed carefully. For instance, derivatives pose 
credit risk created by the potential for default by derivative 
counterparties. The FHLBanks mitigate this risk by engaging in 
derivatives transactions only with highly rated counterparties, and 
maintaining bilateral collateral agreements with each counterparty that 
require that the net fair value of derivatives positions be calculated 
periodically and collateral exchanged to the extent that the FHLBank is 
exposed to risk of default beyond some small threshold.
    It should be noted that the magnitude of the potential counterparty 
credit risk of a derivatives portfolio has little to do with the 
aggregate notional amount of the derivatives. The potential credit risk 
is represented by the net fair value of the portfolio of derivatives 
between a FHLBank and a particular counterparty. For instance, the 
aggregate notional amount of the FHLBanks' interest rate derivatives as 
of June 30, 2003, was $694 billion. However, the net fair value of 
those derivatives represented a fair value loss to the FHLBanks (not 
including offsetting fair value gains on hedged instruments) of $16 
billion.
    Each FHLBank's credit exposure created by its derivatives portfolio 
is determined by netting the current fair value of the derivatives by 
counterparty, as provided in the FHLBanks' bilateral collateral 
agreements. After taking that step, the FHLBanks' total aggregate 
counterparty credit exposure was $2.2 billion before taking into 
consideration collateral held to offset that exposure. After taking 
collateral into consideration, the FHLBanks' aggregate net exposure was 
$435 million, about one-third of the FHLBanks' aggregate retained 
earnings. Of the FHLBanks' aggregate net exposure, $125 million of the 
exposure was to triple-A rated counterparties, $228 million to double-A 
rated counterparties, and $82 million to single-A rated counterparties.
    One of the primary operational risks related to derivatives is the 
risk of inaccurate accounting for those instruments, particularly since 
the implementation of Statement of Financial Accounting Standard 133, 
Accounting for Derivatives and Certain Hedging Transactions (SFAS 133) 
in 2001. That statement requires generally that derivatives be carried 
on the balance sheet at fair value, prescribes the appropriate income 
recognition for changes in fair value of derivatives, and specifies 
criteria that must be met in order for hedged instruments to qualify 
for hedge accounting.
    The FHLBanks have gone to great lengths to apply SFAS 133 
appropriately and ensure that all derivatives accounting complies with 
generally accepted accounting practices (GAAP). Prior to implementation 
of the accounting standard, the FHLBanks' controllers formed an inter-
FHLBank task force, which included representatives from the FHLBanks' 
external audit firm, to catalogue the various types of derivatives 
transactions on the books of the FHLBanks, identify the appropriate 
accounting treatment for each, and develop an accounting guide used 
across the 12 FHLBanks to ensure consistency. This task force has 
remained in place since the implementation of the standard to ensure 
ongoing accounting consistency and compliance with GAAP. In addition, 
the FHLBanks' external audit firm reviews each FHLBanks' derivatives 
accounting as part of its quarterly reviews and annual audits of their 
financial statements.

FHLBank Financial Reporting and Disclosure
    There has been much discussion recently about the appropriate forum 
for the FHLBanks' financial reporting and disclosure. We believe that 
it is most important to focus carefully on the precise nature of the 
issue under consideration. All 12 FHLBanks are fundamentally committed 
to provide complete and state of the art disclosure consistent with the 
unique characteristics of the FHLBanks as established by Congress.
    Under the FHLBanks' current financial reporting and disclosure 
regime, the FHLBanks' combined financial statements are required by 
Finance Board regulation to comply with most Securities and Exchange 
Commission (SEC) reporting requirements, except those specifically 
excluded by the regulation. The individual FHLBanks' financial 
statements are required to be consistent in form and content with the 
combined financial statements. Both the FHLBanks' combined statements 
and their individual financial statements comply with GAAP as certified 
by the FHLBanks' external auditor. In addition, all 12 FHLBanks are 
evaluating ways to enhance their financial reporting and disclosure in 
accordance with evolving best practices. As part of that consideration, 
for instance, it is my understanding that all 12 FHLBanks are currently 
preparing to voluntarily comply with the requirement for attestation of 
internal controls as set forth in Section 404 of the Sarbanes-Oxley 
Act, and evaluating the applicability of other aspects of that 
legislation.
    The matter under discussion is not disclosure, but rather the 
request by the Chairman of the Finance Board and others within the 
Administration that the FHLBanks voluntarily register with the SEC. The 
FHLBanks take these requests very seriously and have devoted a great 
deal of time and resources to considering the appropriate application 
of SEC standards--designed for publicly traded companies--to 
cooperatives whose capital stock is not traded, has a fixed value and 
is only held by member financial institutions. In order for our boards 
of directors to carry out their legal fiduciary duty, they must 
carefully consider the potential effects of voluntary registration on 
the FHLBanks, their members and the fulfillment of the FHLBanks' 
mission.
    We are involved in ongoing discussions with SEC staff on how 
voluntary registration of the FHLBanks would be implemented. While some 
key threshold issues appear to have been resolved in a workable way, 
other important issues remain to be resolved, as does the form of the 
agreement between the FHLBanks and the SEC that would memorialize the 
resolution of those issues.

Conclusion
    Over its long history, the Federal Home Loan Banks have played a 
vitally important role in supporting their member financial 
institutions' ability to meet the housing finance and credit needs of 
their local communities. The FHLBanks remain 
economically strong today and continue to serve a vital function for 
their financial institution members and the communities they serve.

                PREPARED STATEMENT OF DAVID W. HEMINGWAY

              Director, Federal Home Loan Bank of Seattle
          Executive Vice President, Zions First National Bank
                           September 9, 2003

    Good afternoon Chairman Bennett, Ranking Member Johnson, and 
Members of the Subcommittee. I am David Hemingway, Executive Vice 
President of Zions First National Bank, based in Salt Lake City, Utah, 
and a Member of the Board of Directors of the Federal Home Loan Bank of 
Seattle.
    I would like to thank Chairman Bennett and the Subcommittee for the 
opportunity to speak this morning on behalf of the Federal Home Loan 
Banks and 
address the critically important issue of corporate governance and 
responsibility within the Bank System.
    As both a community banker for the better part of three decades, 
and an elected member of the board of directors of the Federal Home 
Loan Bank of Seattle, the issue--and practical application--of board 
governance is of paramount importance to the financial institutions and 
communities we serve every day, and to me, personally. Simply put, I am 
accountable for the safety and soundness of the Seattle Bank.
    While I am not alone in that role--I share it with 17 other 
directors and the management team of the company--I consider it my job 
to ensure that the financial management of this $47 billion bank is 
effective over the long-term, including proper stewardship of our 
shareholders' capital.
    That is a staggering responsibility when you consider that the 
funding provided within the Seattle Bank district fuels housing 
finance, affordable housing initiatives and economic development in 
communities from Pago Pago to Walla Walla, Washington. Our nearly 400 
member institutions rely on the Federal Home Loan Bank of Seattle to be 
their partner in helping their communities and local economies not only 
survive, but thrive.
    Across the Federal Home Loan Bank System, we partner with nearly 
8,000 community financial institutions in extending affordable credit 
to communities in every region of the United States. The Federal Home 
Loan Banks hold nearly $800 billion in assets, provide nearly a half 
trillion dollars in advances annually, issue about $200 million in 
affordable housing grants yearly, and hold nearly $100 billion in 
mortgage assets.
    So when elected to serve as a director of the Federal Home Loan 
Bank of Seattle, I understood the critical importance of my role and 
what I needed to bring to the board--namely, my personal integrity and 
accountability, and my financial services and community banking 
expertise.
    Over the last several years, we have witnessed corporate failures 
of historic proportions--financial disasters brought on by a 
combination of inept business practices, poor leadership and financial 
oversight, and fraudulent and unethical behavior. We are all well aware 
that a quantum shift has occurred in how American corporations--large 
and small, privately held or publicly traded--will be run. Must be run.
    The term used most these days is ``corporate governance.'' It is 
now in our business vernacular; it makes headlines in The Wall Street 
Journal; it comes out of the mouths of network anchors on a frequent 
basis. But I believe there is another way to state it, and it goes 
something like this: Those who get to exercise the power must be 
accountable to those who are affected by it.
    We share with our regulator, the Federal Housing Finance Board, the 
Treasury, and Congress the sense of urgency that is so pervasive today 
regarding the need for increased accountability and responsibility. And 
we have worked hard over the last several years to significantly 
strengthen the leadership and oversight of our banks.
    While we fully understand that corporate governance is a process; a 
discipline that can--and must be--constantly improved, I am personally 
and professionally encouraged by the intensity of our efforts and the 
progress being made.
    Over the course of the last year, the Seattle Bank board has 
created, adopted, and publicly disclosed a set of Core Principles and 
Guidelines relating to board governance, realigned our board committee 
structure to more effectively oversee all facets of the bank's 
operations, upgraded our education and training program for directors, 
and established a website that provides directors with faster access to 
a wider range of information critical to their board roles.
    Our Core Principles and Guidelines provide us with a corporate 
governance roadmap, if you will, keeping us focused on:

 Assuring that policies, risk assessments, internal controls 
    and decisions are effective in managing risk and are administered 
    fairly.
 Operating in an independent and active manner.
 Setting the strategic direction of the bank and managing 
    progress against goals.
 Determining if management is capable and if the business is 
    being properly managed.
 Evaluating our own board effectiveness.

    Our regulator, the Federal Housing Finance Board, is also diligent 
in overseeing and supporting sound corporate governance practices 
across the Bank System. The Finance Board just recently completed a 
horizontal review designed to assist the Agency in directing and 
developing its supervisory and regulatory initiatives. The 
comprehensive review provided all 12 banks with a valuable resource for 
identifying practices that contribute to effective governance programs. 
The Finance Board interviewed management and board members, and 
reviewed a wide range of bank documents with respect to board policies, 
practices, and decisions.
    I offer these comments to underscore the ongoing value of having 
boards and bank management teams focused on enhancing corporate 
governance standards, and a regulator performing its supervisory duty 
in a way that provides additional information and resources that 
further enhance the safety and soundness of the Bank System. As we all 
know, it is one thing to say your house is in order and quite another 
to prove it. As a director--and a member and owner of the Seattle 
Bank--it is my job to prove it.
    Does your board audit committee provide effective oversight of the 
internal and external audit functions? Is the audit function 
independent, reporting only to the board, and is it supported 
appropriately by directors? Does the board ensure that material risks 
are accurately and consistently assessed by management and reported to 
the board in compliance with regulation and prudent business practice? 
Are all directors working responsibly in carrying out their duties? Are 
board and management actively involved in strategic planning?
    I am pleased to say the Seattle Bank has ``yes'' answers to these 
questions posed by the Finance Board in its recent horizontal review. 
But that is today. Our job is to ensure that we have ``yes'' answers 
tomorrow, the next day, and the day after that. Which is a much tougher 
proposition. But that is our job.
    We are fortunate within the Federal Home Loan Bank System when it 
comes to corporate governance and responsibility. We were never 
starting from scratch. We have had the advantage of enhancing practices 
and standards that have, for more than 70 years, protected the Bank 
System against even a single member credit loss.
    But I would emphasize again that we are fully aware that a new era 
has dawned in American business--one that looks on corporate governance 
as an ongoing, rigorous discipline that demands, at all times, review 
and accountability.
    As one of 216 directors of the Bank System cooperative, I wouldn't 
have it any other way.
    Mr. Chairman, this concludes my written testimony. Thank you, 
again, for allowing me the opportunity to speak with you today. I would 
be happy to answer any questions you or other Members of the 
Subcommittee may have.

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES AND SENATOR 
                   CARPER FROM JOHN T. KORSMO

Q.1.a. I would just like to ask several questions regarding 
your examination and supervision of the Federal Home Loan 
Banks. What has been your total budget for the last 5 years? Of 
that amount, what percentage has been spent on safety and 
soundness supervision? Of the amount spent on safety and 
soundness, please specify what percentage is spent on: 
Examination personnel; Examiner travel; Examiner training; and 
Systems support? For each of the last 5 years, what has been 
the total number of examiners? What is the average examiner's 
pay? The range of examiner's pay?

A.1.a. The following tables provide answers to the questions 
listed above.



Q.1.b. For each examiner currently employed by the FHFB, 
specify education level, years of examination experience, and 
whether or not they are accredited.

A.1.b. The examination staff, including the Deputy Director of 
the Office of Supervision, averages more than 17 years of 
professional experience in banking, mortgage finance, and bank 
examinations. All examiners are commissioned examiners or have 
a professional accreditation, and many have both.



Q.1.c. How many safety and soundness examinations have you 
conducted in the last 12 months? How many examiners were 
assigned to each examination? How often do you conduct safety 
and soundness examinations of each bank? How many on-site 
examinations did you conduct during the last 12 months? How 
often do you conduct on-site examinations of each bank? What 
was the length of time spent on each on-site examination? How 
many examination staff conducted each on-site examination?

A.1.c. The Finance Board has a statutory requirement to examine 
each FHLBank at least annually as set forth in Section 1440 of 
the Federal Home Loan Bank Act. Accordingly, the Finance Board 
conducts annual on-site examinations of each FHLBank and the 
Office of Finance.
    The Finance Board's Office of Supervision has a 
comprehensive program to supervise, monitor, and examine the 
FHLBanks. Each FHLBank is assigned an examiner-in-charge who 
oversees the implementation of a supervisory strategy and 
monitors that FHLBank on a regular basis. In addition to 
examination staff, accountants, financial analysts, and 
economists monitor trends that have the potential to affect all 
FHLBanks. Further, an analyst designated for each FHLBank 
analyzes the FHLBank's quarterly and annual financial results 
and monitors developments at the FHLBank. The Office of 
Supervision also has a risk modeling division that is charged 
with evaluating and validating the FHLBanks' risk modeling 
results and assumptions. Finally, the Office of Supervision has 
a risk monitoring division that, among other duties, is charged 
with monitoring the quality of data submitted by each of the 
FHLBanks.
    Finance Board supervision of the FHLBanks is predicated on 
the principle that banking is a business of managing risks. 
Indeed, FHLBanks must continually manage risks in selling debt, 
underwriting advances, evaluating collateral, acquiring 
mortgages and mortgage backed securities, setting dividend and 
retained earnings policies, managing liquidity positions, 
swapping cashflows, and using derivatives to hedge market 
risks. Decisions in each of those areas are made separately by 
each FHLBank pursuant to the 
policy direction and risk limits established by the FHLBank's 
Board of Directors.
    It has not always been this way. Until the passage of the 
Gramm-Leach-Bliley Act (GLBA) in 1999, the Finance Board was 
actively involved in a number of key operating decisions for 
the FHLBanks--such as setting dividend payouts and preparing 
the FHLBanks' combined quarterly and annual financial 
statements. Finance Board examinations were little more than 
checklists designed to assess the FHLBanks' compliance with 
Finance Board regulations.
    Today, day-to-day operating decisions are properly the 
responsibility of the individual FHLBank, pursuant to the 
policy direction established by its Board of Directors. Our 
examiners do not substitute their judgment, on individual 
business decisions, for the decisions made by the FHLBank's 
management or board. However, our examiners review the 
framework within which those decisions are made. In particular, 
our examiners evaluate the risk management policies and 
controls established by the FHLBank's Board of Directors and 
assess the adequacy and effectiveness of the FHLBank's policies 
and practices in identifying, measuring, monitoring, and 
controlling risks.
    FHLBank examinations are typically conducted over an 8-week 
period, with the on-site portion of the examination lasting 4 
weeks. During the period prior to the on-site portion of the 
examination, Finance Board examiners spend several weeks 
conducting preliminary analyses and reviews of FHLBank records, 
and defining the scope of the on-site portion of the 
examination. During the on-site portion of an FHLBank 
examination, a team typically consisting of 6 to 10 staff 
members from the Finance Board travel to the FHLBank to conduct 
the examination.
    In the period following the on-site portion of the 
examination, Office of Supervision staff prepares and presents 
examination findings to the FHLBank's Board of Directors. The 
FHLBank's Board of Directors is responsible for reporting back 
to the Finance Board its actions taken in response to the 
findings in the examination report. Finance Board staff conduct 
quarterly follow up reviews to monitor the progress of the 
FHLBank in addressing the findings of the report of 
examination.
    Over the past year, both the number of examination staff 
on-site and the length of examinations have generally 
increased. Our efforts to hire well-qualified examiners are 
beginning to realize results, as measured by the number of 
examiners we are able to devote to each examination, and by the 
quality of the examinations. Examination statistics over the 
year are as follows:

 The length of an FHLBank examination is typically 8 
    weeks, including 4 weeks on-site. As warranted, the on-site 
    period is extended. In one 2003 examination, for example, 
    the on-site portion lasted 6 weeks.
 During 2003, the number of staff on-site at the 
    FHLBanks during an examination normally ranged from 6 to 
    10. The Office of Supervision devotes more staff to an 
    examination as conditions warrant.
 During 2002, all 12 FHLBanks and the Office of Finance 
    were examined.
 During 2003, all 12 FHLBanks and the Office of Finance 
    will be examined. To date, 10 FHLBanks have been examined 
    during 2003.
 During 2003, we installed a ``resident examiner'' (an 
    examiner operating full-time on-site) for 6 weeks prior to 
    the scheduled examination for one FHLBank.
 During 2003, the Finance Board also conducted System-
    wide (or ``horizontal'') reviews of the effectiveness of 
    board governance and of the operations of the Affordable 
    Housing Program (AHP) at the 12 FHLBanks.

Q.1.d. Without revealing the names of individual institutions, 
how many examinations identified ``problem'' areas? What were 
these problem areas?

A.1.d. All FHLBank examinations in 2002 and 2003 identified 
matters that required the attention of the management and Board 
of the FHLBank. Not all of these matters would necessarily be 
``problems.'' There were instances, however, where the 
seriousness of the examination ``findings'' resulted in the 
Finance Board seeking specific action by an FHLBank's Board of 
Directors.
    There are eight ``findings'' categories defined in the 
endnotes of each safety and soundness report of examination. 
They are identified in such a way as to convey the seriousness 
or nature of the ``finding.''
    All examinations conducted in 2002 and 2003 identified 
matters that resulted in ``recommendations'' from the Finance 
Board to the FHLBank. ``Recommendations'' represent the mildest 
``findings'' included in a report of examination. Most 
examinations also resulted in ``findings'' that included 
``weaknesses,'' ``exceptions,'' ``resolved violations,'' and 
``violations.'' In six FHLBanks, the examination ``findings'' 
or related supervisory activities resulted in the Finance Board 
seeking specific corrective or preventative action by the 
FHLBank's Board of Directors. In those cases, the FHLBank was 
required to address deficiencies in:

 Risk assessment and controls programs;
 Board and management oversight;
 Affordable Housing Program oversight;
 Risk modeling;
 Credit analysis;
 Strategic planning; or
 Documentation of hedging activities.

Q.1.e. Over the past 5 years, how many enforcement actions has 
the FHFB taken against the FHLBanks? Please list each action.

A.1.e. Prior to the passage of the Gramm-Leach-Bliley Act in 
1999 (GLBA), the Finance Board's statutory enforcement 
authorities were limited to suspension and removal powers over 
any director, officer, employee, or agent of any FHLBank or 
joint office, for example, the Office of Finance. GLBA gave to 
the Finance Board enforcement powers similar, but not 
identical, to those of the banking agencies. In particular, the 
Finance Board was granted statutory cease and desist authority.
    As is typical of any banking regulator/supervisor, the 
Board enforces regulations and the safe and sound conduct of 
its regulated entities in three ways. In the majority of cases 
we detail statutory or regulatory violations and operating 
deficiencies in an examination report or, if the violation or 
deficiency is noted through our off-site monitoring of the 
FHLBank, by formal notification to the FHLBank. Our examination 
reports are sent to each board member of the FHLBank, and 
presented in detail at a meeting of the full board of directors 
shortly after the completion of the on-site examination. Where 
appropriate, we require the FHLBank to take remedial actions. 
We check the sufficiency of those actions by requiring a 
response from the FHLBank and by following up during the on-
site portion of the next examination of the FHLBank. In 
virtually every case where such operating deficiencies or 
violations have been cited, the FHLBank board and management 
have corrected the deficiencies or violations in the normal 
course of business.
    If an unsafe or unsound condition or practice that 
threatens the safety of an FHLBank were to be noted, the Office 
of Supervision would take a formal enforcement action to 
correct and/or reverse the condition or practice. Over the past 
5 years, there have been numerous occasions when our examiners 
or analysts have noted operating deficiencies at the FHLBanks. 
Less frequently, they have noted situations where the FHLBanks 
have violated statutes or regulations. There have not been 
occasions where our examiners have cited violations or 
deficiencies that have risen to a level that would threaten the 
safe and sound operation of an FHLBank. Consequently, no formal 
enforcement actions have needed to be taken against any 
FHLBanks.
    Between those situations where normal course-of-business 
operating deficiencies and/or violations have been cited, and 
where unsafe or unsound conditions or practices have been 
noted, we employ ``preemptive'' supervisory strategies. 
Specifically, we strongly encourage an FHLBank's Board of 
Directors to exercise its fiduciary responsibilities by taking 
action to assure the safe and sound operation of the FHLBank. 
Where we believe it necessary, we communicate to the board of 
directors our view that it needs to intercede more actively. 
That exercise of responsibility and authority by an FHLBank's 
board normally takes the form of a board resolution and follow-
up action plan, together with regular reporting by management 
to the board or to an appropriate committee thereof. It is also 
customary for us to receive, as part of our supervisory 
activities, copies of those resolutions and copies of status 
reports regarding progress. In addition, we offer comments on 
the sufficiency of those actions plans and/or progress reports.
    Over the past 5 years, and particularly over the past 12 
months, we have worked with the boards of directors of the 
FHLBanks to improve their operations or to correct ongoing 
deficiencies. In most cases, particularly in the past 12 
months, our efforts have been aimed at enlisting the boards of 
directors to improve the risk management practices of their 
institutions. A brief description of those actions is provided 
below. In several cases, our actions took the form of notifying 
an FHLBank's board that the implementation of its approved 
capital plan should not move forward until noted and cited 
deficiencies had been corrected.

 In one case, the Board of Directors of an FHLBank 
    postponed the scheduled conversion to its new capital 
    structure until the examination-cited deficiencies in the 
    FHLBank's planning and risk management practices were 
    addressed to our satisfaction.
 In response to our supervisory concerns, an FHLBank's 
    Board of Directors postponed conversion to its new capital 
    structure until the FHLBank had enhanced its risk 
    assessment and risk management practices.
 At our behest, an FHLBank postponed its capital 
    conversion and suspended dividends in light of operating 
    losses and risk management deficiencies.
 Based on discussions with the Office of Supervision, 
    the Board of Directors of an FHLBank agreed to analyze and 
    revise its retained earnings and dividend policies before 
    declaring or paying dividends.
 Based on examination-cited deficiencies in risk 
    assessment and risk management practices, two FHLBanks' 
    boards of directors have limited growth and committed to 
    maintaining their capital positions until those 
    deficiencies have been corrected. One of those FHLBanks has 
    also committed to suspend requests for new business 
    activities.
 Based on examination-cited deficiencies in the 
    administration of its Affordable Housing Program, the Board 
    of Directors of an FHLBank contracted for an independent 
    third-party review of its program.

    Again, these actions, while not specifically characterized 
as formal enforcement actions, are examples of recent instances 
where the Finance Board has used its available supervisory 
tools to promote the safe and sound operation of the FHLBanks. 
As is normal for any bank regulator, the actions taken by 
boards of directors as a result of discussions with us are part 
of a supervisory effort aimed at preventing, rather than 
reacting to, unsafe and unsound conditions.

Q.2.a. The Pittsburgh FHLBank suffered a very bad second 
quarter. Based on its most-recent financial reports, its 
annualized return on assets is 0.02 percent. Its capital stands 
at $2.25 billion, or 4.2 percent of assets, barely above the 
regulatory minimum. Its second-quarter dividend was subsidized 
with $10 million from retained earnings. How do you explain the 
Pittsburgh FHLBank's poor performance?

A.2.a. After reporting net income of $15.3 million for the 
first quarter of the year, Pittsburgh's net income fell to $2.4 
million for the second quarter. Three principal factors 
depressed the FHLBank of Pittsburgh's earnings in the second 
quarter.
    First, low market rates adversely affected the Pittsburgh 
FHLBank's net income. To the extent that an FHLBank invests 
member capital primarily in short- or intermediate-term 
instruments, the rate of return on these investments, and thus 
the return on its equity, will move in tandem with short-term 
interest rates.
    Second, as assets prepaid faster than debt was retired, 
compressed interest margins reduced net income. The Pittsburgh 
FHLBank experienced higher than expected prepayment on 
mortgages and securities backed by mortgages in the second 
quarter. The Pittsburgh FHLBank was using previously issued 
long-term debt to support its operations. That debt, issued 
principally in 1994 and 2000, carries relatively high interest 
rates, ranging from approximately 4.0 to 6.3 percent, 
reflecting market rates at the time of issuance. In the lower 
interest-rate environment during the second quarter, margins 
were compressed and earnings declined. Margins will continue to 
be squeezed until that debt is retired or asset yields rise. 
The Pittsburgh FHLBank has reported that the higher cost debt 
will begin to roll off in July 2004.
    Third, during the second quarter, the recognition of 
substantial premium amortization expenses associated with the 
prepayment of mortgage loans significantly reduced the 
Pittsburgh FHLBank's net income.\3\
---------------------------------------------------------------------------
    \3\  If a mortgage with a coupon rate that matches the current 
market rate sells for $100, then a mortgage with a coupon rate above 
the current market rate will sell for more than $100, since it offers 
higher cashflows. The amount in excess of $100 is the ``premium'' 
associated with that mortgage.
---------------------------------------------------------------------------
    There are three components to mortgage premium 
amortization.

 When a loan is purchased at a premium (normally due to 
    an interest rate on the loan that is above the current 
    market level), accounting rules require the holder to 
    amortize the premium over the loan's expected life. This 
    represents regular amortization of the premium.
 When a loan is prepaid, any unamortized premium 
    associated with that particular loan must be written off 
    immediately because that that loan is no longer on the 
    institution's books and the mortgage's cashflow ceases.
 The amortization of the premium associated with loans 
    remaining in portfolio must be adjusted to reflect current 
    prepayment speeds. When interest rates fall and prepayment 
    rates rise, amortization rates increase. This is normally 
    referred to as ``catch-up'' amortization.\4\
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    \4\ Statement of Financial Accounting Standards No. 91, Non-
Refundable Fees and Costs Associated with Originating or Acquiring 
Loans and Initial Direct Costs of Leases (SFAS 91), governs the 
accounting for mortgage premiums and discounts.

    The Pittsburgh FHLBank currently limits its exposure to 
accelerated premium amortization by using interest-rate 
floors.\5\ The Pittsburgh FHLBank has reported to the Finance 
Board that it is reevaluating the most effective hedge vehicles 
available and is limiting growth in its net premium exposure.
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    \5\ As employed by the FHLBanks, a floor is an interest-rate 
exchange agreement where the FHLBank pays a fixed fee up front and the 
counterparty pays the FHLBank the difference between 3-month LIBOR and 
some specified interest rate if 3-month LIBOR falls below that 
specified rate. Thus, the FHLBank buying a floor expects the gains from 
the floor to offset premium amortization when interest rates fall.

Q.2.b. Why did FHFB supervisors allow the Bank to pay a 
---------------------------------------------------------------------------
subsidized dividend given its poor performance?

A.2.b. Prior to the passage of GLBA, the Finance Board approved 
dividends paid by the FHLBanks. GLBA devolved the 
responsibility to set dividends to the FHLBank boards of 
directors. One focus of the Finance Board's supervision of the 
FHLBanks has been to ensure that the FHLBanks' boards of 
directors exercise this authority appropriately and in 
compliance with Finance Board regulations.
    Finance Board regulations prohibit an FHLBank from paying a 
dividend if it would result in the FHLBank failing to meet any 
of its capital requirements (See 12 CFR Sec. 931.4). The 
FHLBank of Pittsburgh met all of its capital requirements after 
the payment of the second-quarter dividend. However, we have 
communicated our concerns to the Pittsburgh FHLBank about their 
paying a dividend in excess of their quarterly net income.
    In August 2003, the Office of Supervision issued Advisory 
Bulletin 03-08 instructing each FHLBank to adopt a retained 
earnings policy that specifically assesses the adequacy of 
retained earnings in light of alternative future financial and 
economic scenarios, and prioritizes retained earnings over 
dividends. On October 8, 2003, the Finance Board, during an 
open board meeting, took the position that an FHLBank should 
not use retained earnings to pay a dividend to its members 
unless and until that FHLBank meets the standards set in 
Advisory Bulletin 03-08.
    We monitor dividends and retained earnings in our 
supervisory program. The Finance Board has expressed to the 
FHLBanks its concern about the relatively low levels of 
retained earnings at a number of the FHLBanks. Advisory 
Bulletin 03-08, mentioned above, requires:

 Each FHLBank to assess the adequacy of its retained 
    earnings in an analytically rigorous fashion using a 
    variety of truly stressful scenarios;
 The Board of Directors of each FHLBank to review the 
    analysis of retained earnings of that FHLBank, and
 Each FHLBank to establish a formal retained earnings 
    policy.

    We will review those analyses and retained earnings 
policies during our 2004 examinations.

Q.2.c. What will happen if bank regulators mark down the 
Pittsburgh Bank stock?

A.2.c. A write-down of the Pittsburgh FHLBank's capital would 
occur only if the capital stock were impaired and this 
impairment were viewed as other than temporary. The Pittsburgh 
FHLBank's stock is not impaired. Members can purchase and 
redeem stock in the FHLBank of Pittsburgh at par.

Q.2.d. Please describe the supervisory steps you will take when 
an FHLBank's capital falls below required levels. At what point 
do you take supervisory action? Do you wait until the minimum 
capital requirement is violated?

A.2.d. As a practical matter, because of their portfolio 
composition, FHLBanks should not fall out of compliance with 
the minimum capital requirements. An FHLBank that approaches 
its regulatory capital minimum should be able to sell assets 
(or not roll over short-term asset positions) to remain in 
capital compliance.
    In addition, Finance Board regulations prohibit the payment 
of any dividend by any FHLBank if the payment would result in 
that FHLBank failing to meet any of its minimum capital 
requirements (See 12 CFR Sec. 931.4). Finance Board regulations 
also prohibit any FHLBank from redeeming or repurchasing any 
capital stock if the FHLBank would fail to meet any minimum 
capital requirement after the redemption (See 12 CFR 
Sec. 931.7(c)). Furthermore, an FHLBank may not redeem or 
repurchase any capital stock without the prior written approval 
of the Finance Board if the Finance Board or the Board of 
Directors of the FHLBank has determined that the FHLBank has 
incurred or is likely to incur losses that result in or are 
likely to result in charges against the capital stock of the 
FHLBank (capital impairment) (See 12 CFR Sec. 931.8(a)).
    The Finance Board also has in place a comprehensive 
regulatory structure to facilitate prompt supervisory action 
before any FHLBank would violate the minimum capital 
requirements. First, the FHLBanks must submit monthly, as well 
as more extensive quarterly, call reports to the Finance 
Board.\6\ Second, the Finance Board has designated an examiner-
in-charge (EIC) for each FHLBank. The EIC assignment is for a 
multiyear period to provide continuity of supervision of each 
FHLBank.\7\ EIC's have formal contact with their designated 
FHLBank no less frequently than quarterly, and more frequently 
if conditions warrant. Third, the Finance Board has designated 
12 financial analysts, each to serve as the principal analyst 
for one FHLBank. The analysts can alert the EIC, senior 
management, or the Board of Directors of the Finance Board 
about deteriorating trends at any FHLBank.
---------------------------------------------------------------------------
    \6\ The call report is the principal way an FHLBank reports 
financial information to the Finance Board. There are both monthly and 
quarterly reporting requirements. Balance sheet, investments, income 
statement, advances, leverage, derivatives, capital compliance, and 
credit concentration information is required monthly.
    \7\ Those appointed to EIC positions are senior bank examiners, all 
of whom had extensive experience at other financial institution 
regulatory agencies before joining the Finance Board.
---------------------------------------------------------------------------
    If, despite these regulatory and supervisory protections, 
an FHLBank's capital were to fall below required levels, the 
Finance Board would take formal enforcement actions with 
provisions to address the capital deficiency.

Q.3.a. Looking at System financial statements for the second 
quarter of this year, several FHLBanks had losses attributable 
to ``derivatives and hedging operations.'' For example, Boston 
and Pittsburgh each had $14 million in losses, Atlanta had $72 
million, and Chicago and Topeka each had $23 million. Of these 
Banks, several had reduced net income from the prior quarter--
for example, Boston went from $22 million in the first quarter 
of 2003 to $19 million, Pittsburgh from $15 million to $3 
million, and Topeka from $17 million to $11 million. Atlanta 
had a slight dip and Chicago had a slight increase in income. 
My understanding is that the average Return on Assets for the 
FHLBank System is generally around 1 percent, but for the last 
quarter it was only 0.2 percent, with one Bank earning only 
0.02 percent. Are derivative losses responsible for the overall 
drop in earnings?

A.3.a. Net realized and unrealized losses on derivatives and 
hedging activities were approximately $138 million in the 
second quarter of 2003, $111 million higher than in the first 
quarter of 2003. Because those losses flow through the income 
statement, they affect the level of reported net income. Those 
losses, therefore, contributed to the overall drop in reported 
FHLBank earnings in the second quarter. However, two points 
warrant elaboration. First, the drop in overall earnings to 
approximately 0.2 percent of assets was not as steep as the 
question suggests. The return on average assets for the 
FHLBanks ranged from 0.25 percent to 0.47 percent for the 1988-
2002 period. It is not ``generally around 1 percent.'' Second, 
in isolation, the realized and unrealized gain or loss on 
derivatives and hedging activities offers an incomplete picture 
of an institution's hedging activities.
    When a financial institution reports a ``loss'' on 
derivatives and hedging activities, the loss often arises 
because accounting rules prohibit the recognition in income of 
simultaneous gains on the balance sheet items being hedged. For 
example, losses or gains on derivatives used to hedge the risks 
associated with held-to-maturity securities flow through the 
income statement. Under generally accepted accounting practices 
(GAAP), however, fluctuations in the value of the held-to-
maturity assets being hedged with those derivatives are not 
recognized in income unless the fluctuation in value is deemed 
to reflect ``other than temporary'' impairment. In other words, 
an institution's GAAP income may be affected by the asymmetry 
of accounting rules that require the marking to market of the 
derivative, but not the held-to-maturity assets being hedged.
    In the case of ``securities held at fair value,'' changes 
in their market value appear on the income statement as an 
``unrecognized gain or loss on securities held at fair value.'' 
To the extent derivatives are used to hedge against changes in 
the market value of 
securities held at fair value, the income-statement categories 
``unrealized gain or loss on securities held at fair value'' 
and realized or unrealized ``gains or losses on derivatives and 
hedging activities'' tend to move in opposite directions.
    Consequently, a given change in interest rates will tend to 
generate gains on one set of instrument and losses on the 
other. To gauge the overall effect, one must consider the net 
effect of the change in value of the derivatives and of the 
securities held at fair value. The following table provides 
that information for the FHLBanks during the second quarter and 
the first half of 2003. 



     For the second quarter of 2003, the combined effect of 
gains/losses on derivatives and the unrealized gain/loss on 
securities held at fair value was to contribute $16 million to 
income before REFCORP and AHP assessments of $613 million. For 
the first half of 2003, the combined effect of gains/losses on 
derivatives and the unrealized gain/loss on securities held at 
fair value was to decrease income before REFCORP and AHP 
assessments by $31 million resulting in a total of $1.2 
billion. In each case, the net effect was less than 3 percent 
of income before assessments for REFCORP and AHP.
    Thus, in isolation, the gain or loss on derivatives and 
hedging activities offer an incomplete picture of the 
effectiveness of an institution's hedging strategies. As bank 
supervisors, we are principally concerned with whether an 
FHLBank has a well conceived, properly documented, and 
prudently implemented hedging program that is designed to limit 
or reduce risk and that is subject to rigorous internal 
controls and oversight.

Q.3.b. How can we be sure that the Home Loan Banks are using 
derivatives to hedge risk instead of to speculate?

A.3.b. At June 30, 2003, the FHLBanks had notional derivatives 
of $693.8 billion. The total net exposure at fair value was 
$2.2 billion.
    A focus of our supervisory policy, on-site examinations, 
and off-site monitoring is to review FHLBank derivatives 
activities for compliance with our rule prohibiting their use 
for speculative purposes. The following factors mitigate 
against the speculative use of derivatives by the FHLBanks.

 Finance Board rules specifically require that all 
    derivative transactions must either qualify as hedging 
    instruments pursuant to generally accepted accounting 
    principles in the United States (GAAP) or the FHLBank must 
    demonstrate the nonspeculative use (See 12 CFR Sec. 956.6).
 All derivative contracts with a single counterparty 
    must be governed by a single master agreement to facilitate 
    the netting of obligations, such as International Swaps and 
    Derivatives Association (ISDA) agreements.
 Finance Board rules require that all derivative 
    contracts be marked to market and subsequent collateral 
    adjustments occur no less frequently than monthly.
 The Finance Board receives information on the 
    derivatives of the FHLBanks through monthly and quarterly 
    sections of the call report.
 A critical element of the on-site examination of each 
    FHLBank is a review of the policies and procedures dealing 
    with derivatives, as well as a review of the internal 
    controls, documentation, accounting, board of director 
    oversight, and segregation of duties dealing with 
    derivatives transactions.
 Each year as part of its annual audit, each FHLBank 
    undergoes a review of the accounting for its derivative 
    instruments by the FHLBank's independent external auditor.

    Appropriate risk limits at the individual FHLBanks are a 
critical factor in controlling the use of derivatives for 
speculative purposes. Some of these limits are regulatory, for 
example, limits on duration of equity contained in the Finance 
Board's Financial Management Policy. Other limits are properly 
adopted and monitored by the FHLBank itself, subject to asset-
liability committee and board of director approval. Duration of 
equity and value at risk, as well as other measures, such as 
market-value sensitivity to a variety of risk measures, are 
effective ways to assess the extent to which derivatives hedge 
risk exposure. The Finance Board regularly reviews compliance 
with both regulatory and internal risk limits as part of 
annual, on-site examinations.
    The Finance Board examiners also assess whether the 
FHLBanks have appropriate policies, procedures, and controls in 
place regarding their use of derivatives at the instrument 
level. Key elements of such policies, procedures, and controls 
include a process for developing and approving hedging 
strategies and controls over implementation of those 
strategies. We expect those controls to include risk limits, 
identification of individuals within the FHLBank approved to 
conduct a trade, requirements for documenting hedge 
transactions, including risk analytics showing the specific 
risk exposure(s) reduced by the trade, and procedures to be 
followed if ever risk limits are violated.
    The aforementioned steps limit the likelihood of 
unauthorized use of derivatives by any FHLBank. Nevertheless, a 
number of Finance Board initiatives should provide additional 
transparency and enhance oversight of FHLBank derivative 
activity. For example, the Finance Board has requested 
proposals for purposes of acquiring an Enterprise Risk 
Management system to enhance further our supervision of the 
FHLBanks. This sophisticated computerized asset-liability 
management software should enable the Finance Board to generate 
a ``second opinion'' of risk exposure calculations generated by 
the FHLBanks, to compare risk exposures of the FHLBanks using a 
common set of methodologies and assumptions, and to measure 
additional risk exposures as the need arises. In the coming 
months, the Finance Board also expects to issue further 
guidance regarding market-risk management information that will 
be reported to the Finance Board for supervisory and monitoring 
purposes, providing additional information on the risk 
implications of derivative investments in a whole-portfolio 
context.

Q.4. It is my understanding that the Chicago and Pittsburgh 
FHLBanks impose a zero percent capital charge against mortgages 
acquired under their mortgage acquisition programs. However, 
they are required to maintain a minimum 4 percent total capital 
against assets. Given the fact that the Chicago FHLBank holds 
over $39 billion in mortgage assets, and only $25 billion in 
advances, can you please explain how the Chicago FHLBank is 
meeting its minimum capital requirements? Similarly, Pittsburgh 
holds $9.8 billion, nearly 20 percent, of its assets in 
mortgages. How does it meet its minimum capital requirements?

A.4. Prior to the passage of the Gramm-Leach-Bliley Act of 1999 
(GLBA), member stock purchase requirements were uniform across 
the FHLBanks. Each member had to purchase subscription stock in 
its FHLBank that was at least as great as the larger of either 
(1) $500; (2) 1 percent of the member's aggregate unpaid loan 
principal; \8\ or (3) 5 percent of the member's aggregate 
amount of outstanding advances.
---------------------------------------------------------------------------
    \8\ ``Aggregate unpaid loan principal'' means the aggregate unpaid 
principal of a subscriber's or member's home mortgage loans, home-
purchase contracts and similar obligations. (See 12 CFR Sec. 925.1).
---------------------------------------------------------------------------
    With the passage of GLBA and its requirement that the 
FHLBanks convert to a risk-based, permanent capital structure, 
the FHLBanks were granted authority, subject to Finance Board 
approval, to develop their own stock purchase requirements for 
their members. Irrespective of how stock purchases requirements 
are defined, the FHLBanks are required to maintain a minimum of 
4 percent total capital against assets.
    The Finance Board approved all of the FHLBanks' new capital 
plans in 2002. To date, 6 of the 12 FHLBanks have implemented 
their revised capital plans (Seattle, Indianapolis, Pittsburgh, 
Cincinnati, Dallas, and Des Moines). The remaining 6 FHLBanks 
are expected to implement their new capital plans by the end of 
2005.
    Under the new capital plans, the FHLBanks impose on their 
members stock purchase requirements that are dependent on 
either the member's size, for example, measured by total 
assets, mortgage assets, or borrowing capacity, or on the level 
of business activity that member has with the FHLBank. In fact, 
all FHLBanks use member-based stock purchase requirements; all 
also use activity-based requirements for at least one or more 
activities. In cases where the FHLBanks impose a zero percent 
stock purchase requirement for a given activity, capital to 
support the assets acquired by the FHLBank because of that 
activity must come either from the membership stock purchase 
requirement, or other outstanding stock, such as stock 
dividends or member voluntary stock purchases.\9\
---------------------------------------------------------------------------
    \9\ The Home Loan Bank Act allows members to voluntarily acquire 
``excess stock,'' for example, stock that is not required to be 
purchased by membership requirements or activity-based requirements.
---------------------------------------------------------------------------
    All capital stock held by members, regardless of how it is 
obtained, is subject to the same waiting period once it 
notifies the FHLBank of its desire to redeem stock:

 6 months after a member has given notice of its 
    intention to redeem stock under the pre-GLBA capital plans, 
    and for Class A stock under the GLBA capital plans;
 5 years after a member has given notice of its 
    intention to redeem stock for Class B stock issued under 
    the GLBA capital plans.

    Stock supporting a member activity may not be redeemed 
until that activity has been completed. Further, no FHLBank may 

redeem capital stock if doing so would result in that FHLBank's 
failure to meet minimum capital standards. Thus, it makes 
little difference whether the FHLBank is using membership, 
activity-based, or voluntary stock to meet its capital 
requirement supporting its assets, since the degree of 
permanence is not related to how the stock is acquired.
    As the accompanying table indicates, the FHLBank of Chicago 
had total capital stock of $3.3 billion as of December 31, 
2002. Of this amount, capital stock requirements assessed on 
the members of the FHLBank accounted for 45.2 percent of total 
capital, while voluntary stock holdings accounted for 49.1 
percent. Retained earnings were 5.8 percent of the FHLBank's 
total capital.
    The table similarly illustrates how the FHLBank of 
Pittsburgh capitalized its operations. As of December 31, 2002, 
total capital stock was $1.9 billion. Of this, 91.1 percent 
came from stock requirements assessed on members, 5.4 percent 
came from voluntary stock holdings, and 3.5 percent came from 
retained earnings.



Q.5. As I understand it, one result of treating Shared Funding 
interests as ``acquired member assets'' under the AMA rule is 
that such assets are not subject to the FHFB's requirement that 
MBS investments not exceed 300 percent of capital. Please 
indicate to what extent the Chicago FHLBank's investments in 
Shared Funding interests, combined with its other MBS 
investments, exceed this [three times capital] cap?

A.5. The Chicago FHLBank has not exceeded the three times 
capital limit on MBS investments.
    As of August 31, 2003, the FHLBank of Chicago had $4.2 
billion in mortgage-backed securities, $682 million in Shared 
Funding assets, and capital of $4.3 billion. As such, the total 
of mortgage backed securities and Shared Funding assets was 
approximately 112 percent of capital.
    As a general matter, the FHLBank of Chicago has not 
substantially increased its investment in mortgage-backed 
securities over the last few years even though capital has 
increased substantially. The quarterly average of mortgage-
backed securities reached its highest dollar amount in the 
fourth quarter of 2002 at $4.8 billion when average capital was 
$3.3 billion. The ratio of mortgage-backed securities to 
capital, based on annual averages from 2000 to 2002, fell from 
271 percent in 2000, to 206 percent in 2001 and to 150 percent 
in 2002.

Q.6. Was the Finance Board aware of the problems in the 
manufactured housing portfolio at the New York Home Loan Bank 
before Standard & Poor's raised the alarm? Are you concerned 
about the potential for similar problems at other Banks?

A.6. During his regular monitoring of the FHLBank of New York 
in the first quarter of 2003, our examiner-in-charge (EIC) 
noted that the FHLBank had a concentration of securities backed 
by manufactured housing loans. The EIC, who, as an FDIC 
examiner had examined a large originator of manufactured 
housing loans, recognized the potential risk posed by the New 
York FHLBank's concentration of investment securities backed by 
manufactured housing loans and home equity lines of credit. 
Because of that concern, the EIC alerted the FHLBank in March 
2003 that this portfolio would be a specific area of review at 
the 2003 examination of the FHLBank. In particular, the EIC 
notified the FHLBank that we would be reviewing the assumptions 
of values, and potential for credit losses in manufactured 
housing-backed securities.
    Standard & Poor's reduced the outlook for the FHLBank of 
New York to negative from stable in August 2003, well after the 
EIC had first alerted the FHLBank of his concerns.
    While we are monitoring the investment portfolios of all of 
the FHLBanks, we are not concerned about the potential for 
similar problems with respect to manufactured housing 
securities at other FHLBanks. According to our quarterly call 
report data, no other FHLBank has any significant holdings of 
these securities.

Q.7. Earlier this year, Fannie Mae and Freddie Mac agreed to 
provide MBS investors with additional information about their 
mortgage backed securities, including such things as original 
loan-to-value ratios, credit scores, property types, and 
others. What disclosures are made to investors in the 
certificates issued under the Shared Funding Program?

A.7. The three investors in the certificates of the initial 
shared funding transaction are the FHLBanks of Des Moines, 
Pittsburgh, and Chicago. Under Securities and Exchange 
Commission (SEC) rules, they are qualified investors.
    Under the Shared Funding Program, the underwriters of the 
securities provide the disclosures to investors in the 
certificates of the mortgage-backed securities in a 
confidential Private Placement Memorandum and a Private 
Placement Supplement (collectively, the ``Memorandum''). These 
disclosures are governed by standards for private placement 
securities as established by the SEC.
    During an examination of an FHLBank, we reviewed that 
Memorandum, which the FHLBank had received as an investor in 
those securities. The Memorandum includes detailed information 
on the mortgage pool. For example, information is provided on 
credit score distribution, loan-to-value ratios, geographic 
distribution of the mortgaged properties, loan purposes, 
property types, and documentation types. In addition, 
information is provided on the risks associated with investing 
in these securities, for example, risk of loss. Without opining 
as to the legal sufficiency of the Memorandum, our examiners 
concluded that the Memorandum was comprehensive both as to the 
characteristics of the underlying assets and the risks to an 
investor.

Q.8. Dow Jones reported last month that total Federal Home Loan 
Bank operating expenses for the second quarter of 2003 were 
17.5 percent higher than operating expenses for the same period 
last year (``FHLBanks Report Significant Boost in Operating 
Expenses,'' August 15, 2003). Can you explain why operating 
expenses have increased so dramatically?

A.8. The increase in operating expenses from the second quarter 
of 2002 to the second quarter 2003 reflects the 13.3 percent 
growth in System assets during this same period. Assuming that 
operating expenses represent a constant proportion of assets, 
this growth would account for more than three-quarters of the 
increase in operating expenses noted in the question above.
    During this period, however, the FHLBanks also began to 
acquire significant holdings of mortgages under the Mortgage 
Purchase and Mortgage Partnership Finance' programs, 
with the value of combined program assets increasing by 135 
percent between the second quarter of 2002 and the second 
quarter of 2003. This growth pushed the value of such assets to 
more than 11 percent of total System assets from 5.4 percent at 
the beginning of the period. Because this represents a 
relatively new line of business for FHLBanks and because the 
risks posed by this business are more complex than those posed 
by the Banks' traditional advance products, the Finance Board 
expects that FHLBank operating expenses will increase at a 
faster rate than aggregate assets until the appropriate risk-
management programs emerge.
    A comparison between publicly available Fannie Mae and 
Freddie Mac data underscores this expectation. While FHLBank 
System annualized administrative operating expenses represent 
5.7 basis points of combined assets, Fannie Mae (2002) and 
Freddie Mac (2001 is the most recent data available) reported 
administrative operating expenses of 13.7 basis points of 
assets. Furthermore, both these institutions reported year-on-
year growth in operating expenses approaching 20 percent, a 
result of expenses related to development of updated IT 
infrastructures and salaries.
    Past levels of FHLBank funding for risk management have not 
been sufficient to manage their increasingly complex balance 
sheets. FHLBank operating expenses can be expected to increase 
at a faster rate than aggregate assets until enhanced risk-
management programs are in place. The Finance Board has been 
recommending that the FHLBanks bolster their investments in 
risk management infrastructures and their expenditures on 
resources to create and maintain these investments. To measure 
their success in doing so, Finance Board examinations and off-
site monitoring will look closely at whether FHLBank outlays 
are sufficient for, and sufficiently directed toward, the 
creation and maintenance of sound risk-management 
infrastructures.

Q.9. Does the Finance Board collect information on the Home 
Loan Banks' affordable lending and community development 
activities? Is that information considered in your review of 
the Banks' compliance with their mission?

A.9. The Finance Board collects information on the Banks' 
affordable lending and community development activities for 
four different mission-related activities of the FHLBanks:

 The Affordable Housing Program (AHP);
 The Community Investment Program (CIP);
 Community Investment Cash Advances (CICA); and
 Acquired Member Assets (AMA).

     Congress established the AHP and CIP in 1989 as mission-
specific programs to assist in the financing of affordable 
housing and community development projects for targeted income 
levels. The AHP provides funding solely for affordable housing 
for very low, and low- and moderate-income households. The CIP 
is used for advances to members to fund both affordable housing 
for targeted households and community development benefiting 
low- and moderate-income households. All 12 FHLBanks are 
required to provide funding through them. CICA is a regulatory 
program, implemented in 1999, for financing community 
development for which CIP is not well-suited and is targeted 
according to household income, geographic areas, such as 
brownfields or small business eligibility. FHLBank 
participation in CICA programs is voluntary. The AMA program, 
as adopted by the Finance Board in July 2000, allows an FHLBank 
to acquire eligible whole residential mortgage loans, or 
interests in such loans, from its members. The Finance Board 
collects loan level data on all mortgages acquired by the 
FHLBanks under the AMA program, including data on property 
location and borrower characteristics.
    These four programs--AHP, CIP, CICA and AMA--are important, 
but not exclusive, components of the FHLBanks' overall 
activities and operations designed to meet their public policy 
mission. The AHP, CIP, and CICA programs are targeted programs 
that complement the FHLBanks significantly larger advances 
operations that support their financial institution members in 
meeting the housing and community development needs of their 
service areas.
    The Finance Board uses the data collected for AHP, CIP, and 
CICA to monitor and evaluate the activity levels of these 
programs at individual FHLBanks and for the entire System; to 
assess the FHLBanks' compliance with the statutory and 
regulatory requirements of these programs; and to evaluate and 
develop policies affecting the operation of these programs. The 
Finance Board also uses the AHP data specifically to ensure 
that all the FHLBanks contribute the full amount of the 
required AHP contributions (ten percent of net earnings each 
year) and that these amounts are distributed to eligible 
projects. The Finance Board also uses CICA data to evaluate the 
distribution of community development funding among the various 
targeted purposes.
    The Finance Board uses AMA data primarily for the 
assessment of the safety and soundness of the FHLBanks mortgage 
portfolios and to determine compliance with regulatory 
requirements.
    Since 1990, the FHLBanks have made more than $1.8 billion 
available for affordable housing through the AHP; $27.9 billion 
for affordable housing through the CIP; and $4.5 billion for 
targeted community development projects through the CIP and 
CICA.
    During the past year, the Office of Supervision implemented 
a horizontal review of all 12 FHLBanks' Affordable Housing 
Programs. This review was comprised of a series of on-site 
interviews with the FHLBanks' community investment staff, 
senior managers, and directors, along with an examination of 
the documents supporting the program. We are currently 
analyzing the results of this review. Our analysis will result 
in a report to be presented to the FHLBanks.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 
                      FROM SHELIA C. BAIR

Q.1. What is your assessment of the quality of the FHFB's 
safety and soundness supervisory program as compared to the 
major bank regulatory agencies? As compared to OFHEO? What do 
you view as the primary weaknesses in the FHFB's safety and 
soundness regulatory regime?

A.1. The FHFB does not publicly disclose as detailed 
information about its safety and soundness supervisory program 
as do the major bank regulators. Thus, comparisons are 
difficult to make. A 1998 Report by the GAO \1\ identified 
several deficiencies in the FHFB's examination program which 
FHFB officials then attributed, at least in part, to a shortage 
of qualified examination staff. At the time of that GAO report, 
the FHFB had only 10 examiners. By late July 2002, the FHFB 
still had only 10 examiners.\2\ The current FHFB has placed 
greater emphasis on safety and soundness, and according to 
recent public statements by Chairman John Korsmo, the number of 
examiners has been increased to 17. The FHFB hopes to increase 
that number to 24 by the end of this calendar year and 30 by 
the end of the next fiscal year.\3\
---------------------------------------------------------------------------
    \1\ General Accounting Office. 1998. Federal Housing Finance Board: 
Actions Needed to Improve Regulatory Oversight. September. (GAO/GGD-98-
203).
    \2\ General Accounting Office. 2003. Financial Regulation: Review 
of Selected Operations of the Federal Housing Finance Board. February. 
(GAO-03-364).
    \3\ Testimony of John Korsmo before the Subcommittee on Financial 
Institutions, Senate Banking Committee (September 9, 2003).
---------------------------------------------------------------------------
    The number of examiners employed by the FHFB--though on the 
rise--still pales in comparison to the large, experienced 
examination staffs of the major bank regulatory agencies. For 
instance, OCC will have 20 to 30 examiners assigned in 
residence to each of its largest institutions, in addition to 
special teams that may visit the institution as part of the 
annual examination process. Similarly, the FDIC and OTS--while 
not utilizing in-residence examiners--will assign teams of 20 
to 30 examiners for extended periods to review their larger 
institutions. For an institution the size of Washington Mutual, 
for instance, the size of the team can go as high as 50 
examiners. OFHEO also has significantly more examiners, a total 
of 40, who conduct annual examinations and ongoing monitoring 
of Fannie Mae and Freddie Mac.
    The FHFB and OFHEO do not disclose detailed operating 
budgets. Thus, it is difficult to compare the amount of 
resources they devote to their supervisory programs. OFHEO's 
2002 annual report to Congress indicated that it spent just 16 
percent of its budget on examinations. However, because OFHEO 
conducts capital adequacy reviews separately from the 
examination process, that number may understate the resources 
it commits to supervision. An additional 13 percent of the 
Agency's budget is reportedly devoted to capital adequacy.
    According to the 2003 GAO report $9.7 million of FHFB's $27 
million budget was devoted to the Office of Supervision 
(OS),\4\ or 36 percent. However, that figure may overstate the 
amount actually spent on examinations because the OS is also 
responsible for providing policy advice and analysis and 
reporting on general economic, housing, finance, community 
investment, and competitive environments for the FHLBanks.
---------------------------------------------------------------------------
    \4\ Ibid. pgs.10 and 28.
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    In contrast, the Office ofthe Comptroller of the Currency 
(OCC) spends 85 percent of its budget on its supervision 
program, the bulk of which goes to salary and benefits for its 
1,882 examiners. Similarly, the Office of Thrift Supervision 
(OTS) spends 77 percent of its budget on its supervision 
program, mostly supporting its 526 safety and soundness 
exammers.
    Both OFHEO and the FHFB lack formal training and 
accreditation programs for their examiners. In contrast, all 
the major bank regulators have training and accreditation 
programs, and the overwhelming majority of their examiners are 
either accredited or in training to become accredited.
    It should be emphasized that the FHFB and OFHEO have a 
number of experienced, knowledgeable examiners dedicated to 
conducting rigorous oversight of institutions under their 
authority. However, the size and the depth of experience of 
these agencies' examination staffs do not compare favorably to 
that of the bank regulators. Both agencies are no doubt impeded 
in their ability to attract highly qualified staff given their 
small size and narrow regulatory base, which in turn, limits 
the opportunities for promotion and career advancement.

Q.2. How would the FHFB's recently withdrawn proposed AMA 
rulemaking have affected safety and soundness oversight of the 
FHLBanks? In your view, is the Chicago FHLBank's Shared Funding 
Program consistent with the current AMA rule?

A.2. Chairman Korsmo's stated intent behind the recently 
withdrawn AMA rulemaking was to ``to clarify and simplify the 
current rule, while improving oversight.'' I have no doubt that 
the Chairman and FHFB members believed the proposed changes 
were consistent with safety and soundness. However, the impact 
of many of the proposed changes would have been to ease 
important safety and soundness restrictions currently in place 
over the FHLBanks mortgage acquisition programs. The most 
dangerous of the proposals was to eliminate the requirement 
that acquired mortgage assets receive an investment grade 
rating from an independent agency such as Moody's or Standard & 
Poor's, instead allowing the FHLBanks to use their own 
``estimated credit ratings.'' Another would have eased credit 
enhancement requirements, and diluted restrictions on the types 
of collateral that a member must post to secure its credit 
obligations under AMA. The proposed changes would also have 
allowed FHLBanks to purchase ``interests'' in whole loans, for 
example, securitizations, in contrast to the current 
requirement that they must purchase whole loans. Finally, the 
proposed rulemaking would have opened the door to allowing 
System members to act as conduits for participation in AMA by 
nonmember finance companies and mortgage bankers.
    It does not appear that Chicago's Shared Funding Program is 
consistent with the current AMA rule, which, as mentioned 
above, is restricted to purchases in ``whole loans.'' The FHFB 
staff quietly approved the Shared Funding Program last 
December, with no public discussion or input. Under the 
program, Mortgage Partnership Finance (MPF) loans are sold to a 
member of the Chicago FHLBank, which issues its own ``private 
label'' securities backed by these loans. Two tranches of 
securities are created, with the senior tier being sold to the 
Chicago FHLBank or other FHLBanks, which may in turn, sell some 
or all of the securities to System members. The member 
securitizing the loans may sell the securities or 
``certificates'' anywhere in the capital markets or hold them 
in portfolio. Shared funding provides a vehicle for the Chicago 
FHLBank to circumvent charter limitations on its own issuance 
of MBS by partnering with one of its member institutions.
    As previously mentioned, the FHFB' s current AMA rule 
authorizes the FHLBanks to purchase from members only ``whole 
loans'' based on the rationale that such purchases are the 
``functional equivalent of an advance'' to such members. 
However, Shared Funding Certificates are clearly ``interests'' 
in whole loans. Presumably, one of the reasons the FHFB sought 
to extend the AMA to ``interests'' in whole loans was to 
reconcile the current inconsistency between the Shared Funding 
Program and FHFB regulatory requirements.
    The FHFB has also exempted Shared Funding Certificates from 
the limit FHLBanks otherwise must observe for investing in 
mortgage-backed securities: Three times capital. The Treasury 
Department has previously expressed the view that MBS 
investments are a way for the FHLBanks to generate arbitrage 
income, though they provide little public benefit. Similarly, 
MBS acquired through the Shared Funding Program, while adding 
interest rate and credit risk to the books of the FHLBanks, 
would appear to add no new value.
    These issues and others are discussed in more detail in a 
comment letter Greg Baer and I filed on the proposed AMA 
rulemaking, which is attached. Mr. Baer preceded me as the 
Assistant Secretary for Financial Institutions in the Clinton 
Administration.

Q.3. The Pittsburgh FHLBank suffered a very bad second quarter. 
Based on its most recent financial reports, its annualized 
return on assets is .02 percent. Its capital stands at $2.25 
billion, or 4.2 percent of assets, barely above the regulatory 
minimum. Its second quarter dividend was subsidized with $10 
million from retained earnings. In your opinion, would a bank 
regulator allow a bank to pay a dividend if the bank's core 
operating results were so poor? What types of supervisory 
action might be taken by a bank regulator when confronted with 
a bank in this type of financial condition? Based on your 
research, when will a bank regulator intervene based on a 
bank's deteriorating capital position? Does the regulator wait 
until the minimum requirement is breached before taking 
supervisory steps?

A.3. Federally regulated banks and thrifts generally hold on 
average at least 50 percent more capital than the regulatory 
minimum. If they fall below a sufficient capital level, or if 
there are other indicators of financial deterioration, Federal 
examiners will carefully scrutinize their financial position, 
request a capital restoration plan and direct corrective action 
if there are indications of further financial deterioration. 
Federal bank regulators try to identify early ``red flags'' of 
financial troubles and institute corrective action long before 
there is a threat that minimum capital will be breached.
    Federal bank regulators look at several factors when 
determining the appropriate supervisory action to take. In 
determining a bank's financial condition, they perform an in 
depth analysis of earnings to assess their quality, level, and 
trends. They will seek to identify the source and cause of 
earnings issues before making a determination of their severity 
and the degree of supervisory concern 
warranted. In determining the adequacy of a bank's capital, 
bank regulators will evaluate the quality of the bank's assets, 
interest rate sensitivity, and risk management practices. 
Before a final determination concerning the bank's capital 
level could be fully implemented, they would want to know the 
bank's availability of other capital sources and if there were 
any plans to use those sources. They would also evaluate the 
possible adverse impacts of the bank not paying a dividend 
before taking action to prohibit such payment.
    If the Pittsburgh FHLBank had been regulated by one of the 
Federal bank regulators, I believe it very likely that bank 
examiners would have taken action to restrict or prohibit 
dividend payments, and most certainly would not have permitted 
a dividend payment that had to be subsidized with retained 
earnings. (For example, Federal law 12 U.S.C. 56 and 60 
restricts the payment of dividends by national banks; other 
bank charter types are subject to similar restrictions.) 
Rather, Federal bank examiners likely would have acted to 
restrict asset growth, while protecting capital to cushion 
against further losses, and taken action to address any 
underlying unsafe and unsound practices that caused or 
contributed to the bank's undercapitalized condition, including 
restricting the bank's ability to enter into new contracts or 
engaging in new business lines. This would be particularly true 
if the earnings problems were associated with exponential 
growth in a new, higher-risk activity and were expected to 
persist, which is the case in Pittsburgh. The Pittsburgh 
FHLBank grew MPF loans from about $2 billion at June 30, 2002 
to over $9 billion at June 30, 2003 and is predicting 
protracted constraints on earnings arising from losses 
associated with prepayments on its mortgage portfolio. And of 
course, the Pittsburgh Bank just announced that it is now 
estimating a third quarter GAAP net loss of $6.5 million.



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