[Federal Register Volume 63, Number 64 (Friday, April 3, 1998)]
[Notices]
[Pages 16505-16537]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-8508]


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FEDERAL HOUSING FINANCE BOARD


Hearing on FHLBank Investment Practices and an Approach for 
Limiting Certain Non-Housing-Related Investments

AGENCY: Federal Housing Finance Board.

ACTION: Notice of public hearing.

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SUMMARY: The Federal Housing Finance Board (Finance Board) is hereby 
announcing a public hearing on Federal Home Loan Bank (FHLBank) 
investment practices and an approach for limiting certain non-housing-
related investments.

DATES: The public hearing will be held on May 11, 1998 beginning at 
9:00 a.m.. Written requests to participate in the hearing must be 
received no later than Monday, April 13, 1998.

ADDRESSES: The hearing will be held at the Office of Thrift Supervision 
Amphitheater, 1700 G Street, N.W., Washington, D.C. 20552. Send 
requests to participate in the hearing, written statements, or other 
written comments to Elaine Baker, Executive Secretariat, Federal 
Housing Finance Board, 1777 F Street N.W., Washington, D.C. 20006. The 
submission may be mailed, hand delivered, or sent by facsimile 
transmission to (202) 408-2895. Submissions must be received by 5:00 
p.m. on the day they are due in order to be considered by the Finance 
Board. Late, misaddressed, or misidentified submissions may affect 
eligibility to participate in the hearing.

FOR FURTHER INFORMATION CONTACT: Kerrie Ann Sullivan, External Affairs 
Specialist, at (202) 408-2515, or Christine M. Freidel, Associate 
Director, Office of Policy at (202) 408-2976, Federal Housing Finance 
Board, 1777 F Street, N.W., Washington, D.C. 20006

SUPPLEMENTARY INFORMATION: The Finance Board is interested in the views 
of System members, community groups, trade associations, federal or 
state agencies and departments, elected officials, and others on the 
implications of FHLBank investment practices for Finance Board 
investment policy. Specific questions that the Finance Board would like 
hearing participants to address and a Finance Board staff discussion 
paper follow:

Questions

    (Question 1) Should the Finance Board limit FHLBank purchase of 
money market investments (MMI) beyond the level necessary for liquidity 
and cash management?
    (Question 2) Should any limits on MMI apply to each FHLBank or to 
the FHLBank System? If a limit were applied to the System, should there 
be a mechanism allowing FHLBanks to trade the right to hold MMI beyond 
their pro-rata share of the System limit?
    (Question 3) Could mission limits on FHLBank MMI affect the safe 
and sound operation of the FHLBanks? If so, how could such effects be 
mitigated?
    (Question 4) The Finance Board is considering a definition of MMI 
that is total investments less mortgage and asset-backed securities and 
investments that support housing and targeted economic development. 
This definition includes fed funds, resale agreements, deposits, 
commercial paper, bank and thrift notes, bankers' acceptances, and U.S. 
government, U.S. government-guaranteed, and agency non-mortgage-backed 
securities (MBS) and asset-backed securities. Should all these assets 
be included in the definition of MMI?
    (Question 5) What is the appropriate level of liquidity for the 
FHLBanks, taking into account their access to the government-sponsored 
enterprise (GSE) capital markets? Are the liquidity requirements in the 
Finance Board's Financial Management Policy (FMP) adequate? 
1 If not, why not?
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    \1\ The Federal Home Loan Bank Act requires each Bank to 
maintain an amount equal to the total deposits received from its 
members invested in: obligations of the United States; deposits in 
banks or trust companies (as defined in Finance Board regulation) 
which are eligible financial institutions; and advances that mature 
in 5 years or less to members. In addition, each Bank is required to 
maintain a daily average liquidity level each month in an amount not 
less than 20 percent of the sum of its daily average demand and 
overnight deposits and other overnight borrowings during the month, 
plus 10 percent of the sum of its daily average term deposits, COs 
and other borrowings that mature within one year. Certain money 
market investments authorized under the FMP may be used to satisfy 
the liquidity requirements.
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    (Question 6) Are there circumstances where it is appropriate for 
the FHLBanks to hold MMI in levels greater than their liquidity and 
cash management needs?
    (Question 7) What is the minimum appropriate level of advances as a 
percent of consolidated obligations (COs) and the maximum appropriate 
level of MMI funded with COs? Are there other approaches for limiting 
Bank MMI?
    (Question 8) What should be the assumed spreads on MMI and MBS?
    (Question 9) To what extent do MBS investments further the FHLBank 
System's housing finance mission? Should the FHLBanks be subject to 
additional MBS investment limitations?
    (Question 10) How much of a decline in dividends would trigger a 
reassessment by voluntary members of

[[Page 16506]]

the benefits of FHLBank System membership. How do institutions 
determine the minimum required return on FHLBank stock? What is an 
appropriate benchmark for FHLBank dividends and what is the minimum 
required spread over the benchmark?
    (Question 11) Would FHLBank borrowing costs fall if CO issuance 
declined?
    (Question 12) What is an appropriate transition rule for: (1) 
implementation of any new limits on FHLBank investment activity; and 
(2) FHLBanks that fall out of compliance due to situations such as 
merger activity and regional and cyclical downturns in advance demand?
    (Question 13) What changes in interest rates and advances should be 
assumed to simulate the effects of investment limits during a cyclical 
economic downturn?
    (Question 14) Should the FHLBank System's $300 million annual 
REFCorp payment be changed to a percentage of net income and should the 
Finance Board defer establishing limits on FHLBank money market 
investments until Congress has made such a change?
    (Question 15) Should the FHLBanks be permitted to make a small 
amount of narrowly targeted investments in people and communities left 
behind, that would have credit quality significantly below the double-A 
level, and that might be more heavily weighted in evaluating the 
mission-related character of the overall portfolio?

Staff Analysis

Background

    Prior to the thrift crisis and enactment of the Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) 
(Pub. L. 101-73, 103 Stat. 183 (1989)), the assets on the Federal Home 
Loan Banks' (FHLBanks or Banks) balance sheets were predominantly 
advances. The Banks maintained relatively small investment portfolios, 
primarily for liquidity purposes.2 For the period 1980 
through 1988, Bank System advances represented, on average, about 84 
percent of System assets, while total investments represented about 14 
percent of assets.
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    \2\ The Federal Home Loan Bank Board's (FHLBB) Investment Policy 
and the subsequent Funds Management Policy, adopted in 1988, set 
forth authorized investments for the FHLBanks. This list of eligible 
investments was similar to the current list of eligible investments 
in the Financial Management Policy (FMP). Currently, permissible 
Bank investments include overnight and term fed funds, overnight and 
term resale agreements, deposits, commercial paper, bank and thrift 
notes, bankers' acceptances, securities issued or guaranteed by the 
U.S., agency securities, mortgage-backed securities (MBS), and 
certain other assets that support housing and community development. 
Bank investments in MBS, prior to adoption of the FMP, were limited 
to 50 percent of a Bank's capital; such investments, along with 
investments in other eligible asset-backed securities, are currently 
limited to 300 percent of a Bank's capital.
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    Significant and rapid changes in the structure of the FHLBank 
System's balance sheet and its profitability occurred following the 
enactment of FIRREA in 1989. The legislation, among other things, 
required: (1) closure of failing thrift institutions that resulted in 
advance prepayments and stock redemptions; (2) new, higher statutory 
capital requirements for thrifts that caused many Bank System thrift 
members during the early 1990s to either reduce their asset size and 
prepay advances or to stop growing and reduce their demand for new 
advances; (3) transfer of $2.5 billion in FHLBank retained earnings to 
the Resolution Funding Corporation (REFCorp) to help pay for the cost 
of thrift resolutions; 3 (4) a $300 million annual payment 
toward interest on the REFCorp bonds; and (5) a payment, beginning in 
1990, of the greater of five percent of net income or $50 million and 
increasing by steps to the greater of ten percent of net income or $100 
million in 1995 and thereafter, to fund the newly-required Affordable 
Housing Program (AHP). One other important provision in FIRREA also 
allowed federally insured commercial banks with at least 10 percent of 
their assets in residential mortgage loans to join the Bank System. The 
changes that occurred in the Banks' assets, liabilities, net income and 
membership in the post-FIRREA period are shown in the attached graphs.
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    \3\ This payment was in addition to the FHLBanks' payment of 
$0.7 billion in retained earnings to defease the Financing 
Corporation bonds as required under the Competitive Equality Banking 
Act of 1987. (Pub.L. 100-86, 101 Stat. 552 (1987)).
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    After growing steadily during the 1980s, Bank System advances 
peaked at $166.7 billion in April 1989 and then declined 15 percent to 
$142 billion at year-end 1989. The shrinkage continued for two years, 
with advances declining 18 percent in 1990 to $117 billion and then an 
additional 32 percent to $79 billion at year-end 1991. Beginning in 
1989, the Banks began to replace repaid and prepaid advances with 
generally lower-yielding investments.4 Investments doubled 
from 1988 to 1989 from $17 billion to $34 billion and more than 
quadrupled between 1988 and 1991 to $72 billion. By year-end 1991, 
advances comprised about 51 percent of the System assets, down from 78 
percent at year-end 1989. In addition, for the reasons discussed above, 
Bank capital levels fell by 25 percent between 1989 to 1991. Lower 
capital levels resulted in lowered Bank net earnings because a greater 
amount of Bank assets were funded with the proceeds from the issuance 
of consolidated obligations (COs) instead of by FHLBank capital.
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    \4\ The Banks had funded these advances largely with the 
proceeds from non-callable consolidated obligations (COs). The Banks 
repurchased and retired some of this debt to the extent it was 
economically feasible, but a large portion remained outstanding 
after the advances were prepaid. The Banks reinvested these CO 
proceeds in allowable investments.
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    Reduced spreads on earning assets, lower capital levels, and a 
lower interest rate environment all contributed to a marked decline in 
Bank System net income during the early 1990s. Net income peaked at 
$1.78 billion in 1989 and fell almost 18 percent to $1.47 billion in 
1990. Net income fell an additional 21 percent in 1991 to $1.16 
billion, and then 27 percent in 1992 bottoming out at $850 million. Net 
interest margin (net interest income divided by earning assets) fell by 
more than half from 1989 to 1992, from 1.13 percent to 0.47 percent, 
although the decline in net interest income was partially offset by 
advance prepayment fee income. Return on assets (ROA) declined from 95 
basis points in 1989 to 53 basis points in 1992.
    Declining System net income and weak demand for advances raised 
questions about the Banks' future ability to pay their statutorily 
mandated REFCorp and AHP obligations, and pay an adequate return to 
shareholders. The $300 million REFCorp payment as a percentage of Bank 
System net income increased from about 20 percent in 1990, to 26 
percent in 1991, and to 35 percent in 1992.
    Concerns about income pressures on the Bank System led the Finance 
Board to increase the FHLBanks' mortgage-backed security (MBS) 
investment authority from 50 percent to 200 percent of capital when it 
adopted the Financial Management Policy (FMP) in June 1991.5 
The Finance Board attached a two-year sunset to the expanded authority, 
although it removed the sunset before it would have become effective. 
In December 1992, the Finance Board changed the Bank System's 
regulatory leverage limit and the components of the leverage ratio. 
Prior to this time, Finance Board regulations had limited FHLBank 
System COs to 12 times the total paid-in capital stock of the FHLBanks; 
the amended regulation

[[Page 16507]]

raised the leverage limit to 20 times total capital and included COs 
and unsecured senior liabilities (e.g., deposits) in the leverage 
ratio. The expanded leverage ratio became effective September 22, 1993.
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    \5\ The FMP consolidated into one document the policy guidelines 
governing much of the FHLBanks' non-advance financial activity and 
also established limits on unsecured credit risk and interest rate 
risk. The FMP restated the eligible investments in the Funds 
Management Policy and expanded the list of authorized investment to 
include private triple-A rated MBS and commercial paper.
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    In December 1993, the Finance Board again increased the Banks' 
authority to invest in MBS, raising the limit from 200 to 300 percent 
of capital. Financial projections indicated that the Banks would have 
adequate earnings to meet their financial obligations in 1994. However, 
prepayment income, which represented nearly 25 percent of 1993 net 
earnings was declining (down from 46 percent of earnings in 1992), and 
the Finance Board was concerned that interest income from advances 
might be insufficient to offset the earnings decline. In addition, the 
Finance Board believed an absence of a quorum to be imminent and felt 
obliged to provide the Banks with sufficient investment capacity to 
adjust to near-term structural changes in their balance sheets.
    Another major change in the Bank System was the growth of 
commercial bank membership. Until 1989, actual membership consisted 
almost exclusively of thrift institutions. (Prior to 1989, insurance 
companies were also eligible to become members, but very few actually 
joined and there was minimal borrowing activity.) System membership 
declined from 1989 to 1990 due to the closing of failed institutions, 
but rose rapidly thereafter as significant numbers of commercial banks 
joined the System. Total Bank System membership increased from 2,855 at 
year-end 1990 to 6,504 at year-end 1997. The greatest growth occurred 
at the FHLBanks of Des Moines, Atlanta, and Dallas. The volume of 
residential mortgage loans held by members increased from $905 billion 
in 1989 to $1.24 trillion in 1997.6
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    \6\ Residential mortgage loans include housing construction 
loans, mortgage loans for single- and multi-family housing, and MBS.
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    At year-end 1997, commercial bank members comprised 69 percent of 
System members and held 44 percent of Bank System capital stock. About 
55 percent of commercial bank members had advances outstanding. 
Commercial banks borrow relatively less than thrifts. However, 
commercial bank share of outstanding advances has increased steadily 
over the last five years, from 8 percent ($6.4 billion) of outstanding 
advances in 1992 to 29 percent ($57.4 billion) of outstanding advances 
at year-end 1997. At year-end 1997, commercial bank members 
collectively held $578 billion in residential mortgage loans, 
indicating a sizable pool of collateral eligible to secure advances.
    After bottoming out in 1992, advance levels ended the year at 
slightly higher levels relative to 1991 and then increased 
significantly each year thereafter except for 1995. Advances increased 
by 154 percent between 1992 and 1997--from $80 billion to $203 billion. 
In second quarter 1997, advance levels surpassed the previous all-time 
high of $166.7 billion. Although the Banks initially grew investments 
as a substitute for advances, FHLBank investments have generally 
increased over the past five years along with advances. Investments 
increased by 88 percent between 1992 and 1997--from $79 billion to $149 
billion. At year-end 1997, advances represented about 57 percent of 
balance sheet assets, compared to about 79 percent in 1989.
    As a result of the increases in advances and investments, the Bank 
System's balance sheet assets more than doubled between 1992 and 1997, 
increasing from $162 billion in 1992 to $359 billion at year-end 1997. 
An increase in capital due to new members joining the System and the 
decision by the Finance Board to expand the regulatory leverage limit 
allowed the Banks to grow their balance sheets. Between 1992 and 1997, 
capital levels almost doubled, from just under $11 billion to over $19 
billion, and the Bank System's ratio of capital to assets declined from 
6.5 percent to 5.4 percent.
    Bank System liabilities increased to fund the expanded investments 
and advances. Between 1992 and 1997, COs (bonds and discount notes) 
outstanding increased by 174 percent--from $115 billion to $314 
billion. Due to the short-term of the discount notes, discount note 
issuance increased many times more than outstandings. From 1992 to 
1997, discount note issuance increased 20 times--from $97 billion to 
just under $2 trillion. As a result of the rapid increase in discount 
notes and their shortening maturity, the Finance Board in 1994 changed 
the limit in the Office of Finance's 1995 debt authorization from one 
based on obligations issued to one based on obligations outstanding.\7\ 
The debt authorizations for 1996 and 1997 limited the level of COs 
outstanding and senior, unsecured obligations to 20 times total 
capital, the regulatory leverage limit.
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    \7\ The Office of Finance (OF) is a joint office of the FHLBanks 
and serves as the FHLBanks' fiscal agent. The OF also acts as agent 
of the Finance Board in issuing consolidated obligations.
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    Bank System net income bottomed out at $850 million in 1992 and 
increased 79 percent to $1.5 billion in 1997. Spreads on advances have 
generally narrowed over the last several years and much of the income 
growth has been due to greater levels of earning assets. The Bank 
System's net interest margin recovered somewhat from its low in 1992 
but remains lower than the levels in the 1980s. The lower net interest 
margin is largely due to reduced spreads on advances and significantly 
larger volumes of lower-yielding investments on the balance sheet. Bank 
System return on assets declined slightly from 1992 to 1997, from 53 
basis points to 47 basis points.
    Given the large increase in voluntary members since 1989, 
maintaining a dividend adequate to retain voluntary members has been 
considered necessary for ensuring a stable System.8 Dividend 
payments to shareholders have varied by Bank. From third quarter 1992 
through fourth quarter 1997, the Bank System average dividend was 6.5 
percent; eight Banks paid average dividends above the System average 
dividend.
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    \8\ With the exception of federally-chartered savings 
associations, all of the Bank System's members are now voluntary. 
(The Office of Thrift Supervision in April 1995 ceased requiring 
state-chartered thrifts to maintain Bank System membership.) At 
year-end 1997, voluntary members represented 85 percent (5,502) of 
the System's membership base and held 57 percent ($10.4 billion) of 
total System capital stock.
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    Each Bank establishes its own dividend target and dividend 
benchmarks vary. Since at any point in time a voluntary member can 
withdraw from the System with six-month notice, one dividend benchmark 
may be the return on a six-month maturity CO, with a spread to 
compensate members for the relative illiquidity of the stock investment 
and the additional risk associated with holding equity relative to 
debt. With the exception of one FHLBank, all the FHLBanks paid 
dividends with returns above the six-month CO coupon between 1992 and 
1997. The average spread was 157 basis points, ranging from a low of 27 
basis points to a high of 409 basis points. Some members may view their 
cost of funds as a floor on Bank dividends. From third quarter 1992 to 
fourth quarter 1997, Bank dividends on average exceeded System members' 
average cost of funds by 214 basis points. Variation among the Banks 
ranged from a low of 23 basis points to a high of 461 basis points.
    Member perceptions of an adequate dividend clearly vary across the 
districts.9 One of the Banks that has paid one of the lowest 
dividends in the System has been very successful at attracting new 
members. The on-going

[[Page 16508]]

adequacy of Bank System dividends is suggested by the fact that large 
numbers of voluntary members have joined the System while only a few 
have exited, and that as of year-end 1996 members collectively held 
$2.3 billion in capital stock beyond the amount they were required by 
law to hold. Of course, the benefit of System membership exceeds the 
return on stock. Besides receiving a dividend, System members maintain 
on-going access to liquidity, long-term funding, and access to FHLBank 
programs, products, and services.
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    \9\ The Furash Group is currently surveying members about their 
views of an adequate dividend and the other benefits of FHLBank 
membership.
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Issue

    The FHLBanks, as governmentally sponsored enterprises (GSEs), can 
be viewed as representing a social compact between the Banks and their 
members and the federal government. The federal government bestows upon 
the Banks certain benefits through their GSE status, including: (1) an 
ability to borrow at rates only slightly above Treasury borrowing rates 
due to the perception of an implicit federal guarantee of GSE debt, as 
well as the ability to issue large amounts of debt, including debt with 
complex structures; (2) exemption from Securities and Exchange 
Commission registration and reporting requirements and fees; and (3) 
exemption from state and local income taxes. In exchange for these 
benefits, the Banks have a responsibility to serve the public by 
enhancing the availability of residential mortgage and targeted 
community development credit through their member institutions. As 
such, the federal benefits, most importantly the funding advantage, 
should be used to fund activities that safely and soundly further the 
Banks' public purpose.
    During the period of rapidly declining advances and shrinking 
thrift membership in the early 1990s, the Finance Board took rational 
steps to alleviate earnings pressures by expanding the Banks' 
investment authority and increasing the leverage limit. However, 
despite the remarkable recovery that has since occurred in advances and 
System membership, Bank investments continue to increase. While 
advances at year-end 1997 were a record $202.7 billion, the System's 
advances to assets ratio of 56.6 percent was still slightly lower than 
the advances to assets ratio of 57.6 percent at year-end 1993 when 
advances were $103 billion.
    Many of the assets in the Banks' investment portfolios--Treasury 
and agency securities, fed funds, resale agreements, commercial paper, 
bank and thrift notes, bankers' acceptances and deposits--bear little 
if any relationship to the Banks' mission of enhancing the provision of 
credit through members for housing and community development. Such 
investments, beyond those required for liquidity, can thus be 
considered non-mission related.10
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    \10\ It is important to note that several of the FHLBanks have 
recently taken action to reduce their money market investments.
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    The principal purpose of these primarily short-term money market 
investments has been to generate income to help the Banks satisfy their 
REFCorp and AHP obligations and pay a dividend sufficient to attract 
and retain voluntary members and offer competitively priced products. A 
large volume of money markets investments may have been justified 
during a temporary period of contracting advances, declining 
membership, and severe income pressures. However, now that membership 
and advances are at record levels and System income exceeds $1.5 
billion, the need to maintain such investments--which averaged $98 
billion during 1997--should be examined in light of the Banks' public 
mission as GSEs.
    The Banks also hold substantial MBS investments--System-wide MBS 
investments averaged $47 billion in 1997. Although MBS are housing-
related, the extent to which these investments support the Banks' 
housing finance mission is debatable. MBS generally are traded in 
large, well-established and liquid markets. The FHLBanks' presence in 
these markets may not result in increased availability of funds for 
housing, or in lower cost funds. Bank investment in MBS, therefore, 
could be considered as providing less ``value'' to housing than 
advances or other investments that provide financing that is not 
generally available or is available at lower levels or under less 
attractive terms.
    However, absent any legislative reforms to the fixed $300 million 
REFCorp obligation and the Banks' capital structure, or any substantial 
and sustained increase in advances demand or other high yielding 
mission assets, a substantial reduction in the Banks' MBS authority 
would have a significant adverse impact on the Banks' net income and 
dividends. The Bank System's capital level is based on ``subscription 
capital,'' i.e., statutory member stock purchase requirements, rather 
than the risk of its operations.11 As a result, the System 
holds more capital than it can adequately leverage in advances business 
with members. Capital not supporting advances must be leveraged with 
other assets (e.g., money market assets, MBS subject to the 300 percent 
of capital limit, and other investments supporting housing and targeted 
community development) in order to generate earnings for dividends.
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    \11\ By law, each member is required to hold capital stock equal 
to the greater of one percent of residential mortgage loans, 0.3 
percent of total assets, or five percent of advance. Members that do 
not meet the definition of qualified thrift lender are required to 
hold stock against advances equal to five percent divided by their 
actual thrift investment percentage.
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    Assuming a 60 basis point spread on MBS, elimination of the Banks' 
$47 billion in MBS would reduce System income by $282 million. Other 
things being equal, and assuming 1997 average capital stock balances, 
this would reduce the average dividend by 161 basis points. With the 
decline in income, the $300 million REFCorp payment would represent a 
larger share of System net income. On the other hand, and as discussed 
in more detail below, significant volumes of low yielding money market 
assets can be rolled-off with a much smaller reduction in income. For 
example, assuming a 10 basis point spread on money market assets, the 
Banks could reduce these assets by $50 billion and net income would 
fall by $50 million. Other things being equal, this would result in an 
average decline in dividends of approximately 29 basis points assuming 
1997 average capital stock balances.

Possible Approaches to Limiting Money Market Investments

    There are several possible approaches to limiting Bank money market 
investments. One approach would be simply to restore the more 
restrictive leverage limit that existed before 1993. However, while 
such an approach could require the Banks to shrink their balance 
sheets, there would be no guarantee that the shrinkage would occur in 
money market investments rather than in investments that add more value 
in terms of advancing the System's public purpose.
    Another approach would be to place restrictions on the composition 
of the liability side of the Banks' balance sheets. After the Finance 
Board ceased placing limits on debt issuance effective with the 1995 
debt authorization, there were substantial, contemporaneous increases 
in the volumes of both discount notes and short-term money market 
investments. In December 1997, the Finance Board authorized a three-
month extension of the Office of Finance's debt issuance authority so 
that staff could examine the relationship between discount notes and 
money market investments. As discussed in the debt authorization issues 
paper, staff concluded that the Banks could respond

[[Page 16509]]

to any limitations placed on the discount note issuance by funding 
short term money market investments with longer term COs or by creating 
synthetic short-term funding instruments with possibly increased risk 
and cost.\12\
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    \13\ The Finance Board on March 13, 1998, authorized the Office 
of Finance to issue debt through year-end 1998. The debt 
authorization does not contain any limits on System debt issuance.
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    A more direct approach to limiting the holding of money market 
assets would be to place constraints on the Banks' holdings of such 
investments. If the policy objective is to ensure that the System's 
principal federal benefit-- its GSE funding advantage--is being used to 
meet the System's public purpose, there is some logic to tying 
allowable levels of money market investments to the levels of COs 
outstanding. Such an approach would constrain the use of the GSE 
funding advantage to finance assets, beyond reasonable liquidity needs, 
not related to the Banks' housing and community investment mission. 
Money market investments funded with deposits and capital would not be 
subject to these limits because these sources of funds are not raised 
in the GSE debt market.
    Implementing limits on Bank money market investments obviously 
requires making a distinction between non-mission related, money market 
investments and other types of assets, and could be an additional step 
toward evaluating on a systematic basis the degree to which Bank assets 
and products further System mission fulfillment. Bank System assets and 
products can be viewed on a continuum from those that are most mission-
related, that is provide the greatest benefit to users of residential 
and community development credit, to those that are not mission-related 
and held solely for purposes of liquidity and income generation. 
Presumably, FHLBank products and services that are not readily 
available in the capital markets, such as long-term advances, could be 
considered the most mission-related. As part of its study, the Furash 
group will be attempting to develop a methodology for measuring System 
mission achievement, which could be helpful in making further 
distinctions among System assets and products.
    Working within this conceptual approach, staff evaluated three 
options that placed limits on the allowable levels of money market 
investments. For simplicity of exposition, System assets were 
classified into three categories: Advances, MBS, and money market 
investments (MMI).\13\ The three options were as follows:
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    \13\ Money market investments are defined as fed funds, resale 
agreements, deposits, commercial paper, bank and thrift notes, 
bankers' acceptances, and Treasury and agency non-MBS securities. As 
the Banks develop investments to support housing and community 
development, the classifications could be refined. For example, the 
Finance Board recently authorized the FHLBanks to invest in 
federally insured deposits of all members to enhance the Banks' 
ability to provide liquidity to members, particularly smaller 
members that do not have sufficient capital or the required rating 
to be deemed an eligible financial institution as set forth in the 
FMP. To the extent it is deemed appropriate, future refinements 
could allow these investments to be reclassified as mission related.
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    (1) Advances required to be a minimum of 65 percent of COs, with 
MBS limited to the maximum of either the existing 300 percent of 
capital limit or 20 percent of COs;
    (2) Advances required to be a minimum of 70 percent of COs, with 
MBS limited to the maximum of the existing 300 percent of capital limit 
or 20 percent of COs; and
    (3) Advances required to be a minimum of 80 percent of COs, with 
MBS limited to the maximum of the existing 300 percent of capital limit 
or 20 percent of COs.
    The change in the MBS limit from one based solely on capital to one 
based on COs represents a change in how the limit should be viewed. The 
Finance Board initially limited MBS investments to a multiple of 
capital in part because it was concerned about the Banks' ability to 
manage the interest rate and options risk associated with these assets. 
However, now that the Banks have developed more effective techniques 
for hedging these risks, and there are policy limits in place 
constraining the Banks' interest rate risk exposure, the MBS limit 
could be viewed as more of a mission than a safety and soundness 
constraint. Accordingly, under this approach, MBS investments would be 
limited to a percentage of COs outstanding. However, to the extent that 
the existing 300 percent of capital limit is less restrictive, it 
should also be retained so that the Banks would not be required to 
shrink their MBS portfolios.
    Under this approach, the Banks could fund MMI through capital and 
deposits. Assuming MBS investments equal at least 20 percent of 
liabilities, allowable amounts of MMI funded by COs would be no more 
than 15 percent of COs in option one and no more than 10 percent of COs 
in option two. In option three, MMI could only be funded with deposits 
and capital to the extent a Bank maximizes its use of the MBS 
authority.14
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    \14\ From 1980 through 1988, advances averaged 118 percent of 
COs, indicating that the Banks funded advances with deposits and 
capital, as well as COs.
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    At year-end 1997, advance to CO ratios at the individual FHLBanks 
ranged from a low of 45 percent to a high of 89 percent. The System 
average was 65 percent, with seven Banks below the average. The ratio 
of advances and MBS to COs ranged from 62 percent to 99 percent. The 
System average was 81 percent. The ratio of MBS to COs ranged from 10 
percent to 23 percent, with a System average of 16 percent. MMI to CO 
ratios (excluding MMI funded with deposits and capital) ranged from one 
percent to 39 percent. The System average was about 20 percent.

Simulations

    Staff generated simulations applying the limitations under each of 
the options to each Bank's 1997 average balance sheet. The simulations 
assume that Banks not meeting the minimum requirement for advances 
would reduce their levels of COs and money market investments until the 
minimum advance to CO requirement was satisfied. Advance and capital 
levels were fixed at 1997 average balances. As money market investments 
are reduced, therefore, Bank leverage decreases and capital-to-asset 
ratios increase.
    Because these simulations assume no behavioral responses on the 
part of the Banks, the results should not be considered predictions of 
what would have happened had these investment restrictions actually 
been in place in 1997. Rather, they should be considered an indication 
of the magnitude of the Banks' required balance sheet adjustments, and 
the potential impact on net income and dividends. The simulations 
assume that all adjustments occur instantaneously, while in reality 
there would be a transition period.
    Based on analysis of empirical data and discussions with FHLBank 
staff, the simulations assume that money market investments generate a 
spread of 10 basis points and MBS have a spread of 60 basis points. The 
low return on MMI should generally allow the Banks to roll-off 
substantial amounts of MMI without significantly reducing net income.
    Overall, Bank System MMI would fall by 50 percent or $49 billion 
under option two. The effects of the approach vary by Bank and are 
related to a Bank's advances to CO ratio. The Banks with the lowest 
advances to CO ratios, and correspondingly the highest ratios of MMI to 
COs, would be required to roll-

[[Page 16510]]

off the greatest volume of MMI. Reductions in MMI at the individual 
Banks would range from no change to an 80 percent decline.15
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    \15\ Discussion centers on option two since it is the middle 
option.the magnitude of effects should be less for option one and 
greater for option three.
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    Total System assets would decline by 14 percent or $47 billion 
under option two. Reductions in assets at the individual Banks would 
range from no change to a 36 percent decline. With the exception of one 
FHLBank, leverage at all the Banks would decrease in option two due to 
the reduction in assets. The average System capital to asset ratio 
would increase from 5.6 percent in the base case to 6.6 percent. 
Capital to asset ratios at the Banks would range from 5.8 percent to 
8.1 percent.
    The approach allows the Banks to hold MBS equal to the greater of 
300 percent of capital or 20 percent of COs. In most cases, the 300 
percent of capital limit would be more permissive than the 20 percent 
of COs constraint. In option one, two Banks would hold MBS in levels 
greater than 300 percent of capital; in option two, only one Bank would 
have MBS greater than 300 percent of capital; and in option three, no 
FHLBank would have MBS greater than 300 percent of capital. In general, 
MBS would represent a greater percentage of COs at those Banks with the 
least leverage.
    System-wide, MBS would average 21 percent of COs, compared to 17 
percent in the base case. The ratio of MBS to COs would range from a 
low of 11 percent to a high of about 29 percent. System MBS levels 
would grow modestly, $2.6 billion or 5 percent, under the three options 
because the model assumes that each Bank maximizes its MBS holdings 
subject to Finance Board or Bank board requirements.16 The 
growth in MBS mitigates the reduction in earnings resulting from the 
roll-off in MMI. System-wide, MMI (less MMI funded with deposits and 
capital) would decline from 23 percent of COs in the base case to about 
six percent in option two.
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    \16\ In the base case, each Bank's average MBS balance was less 
than either 300 percentof capital or, with one exception, 20 percent 
of COs.
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    Under option two, System net income would fall by $30 million, or 
two percent, to $1.49 billion. Declines in net income would range from 
no change to a reduction of seven percent. Under option two, the 
average System dividend would drop by 17 basis points. As a result of 
the decline in System income, funding for the AHP program would fall by 
approximately $3 million, slightly less than three percent.
    Dividend reductions would range from no change to a 54 basis point 
decline. System-wide, the average dividend under option two would have 
a spread of 106 basis points over the six-month CO rate. This spread is 
17 basis points lower than the 123 basis point spread in the base case. 
Spreads over the six-month CO rate would range from 16 basis points to 
216 basis points. Dividend spreads over member cost of funds under 
option two would range from 124 basis points to 309 basis points. 
System-wide, the average spread would be 228 basis points.
    This analysis suggests that reducing MMI would generally result in 
modest declines in net income, with the magnitude of the effects 
varying across the Banks. To the extent the resulting return on equity 
(ROE) at a Bank is below its target ROE, the Bank could attempt to 
increase its return by taking greater risk. The Finance Board's FMP 
contains limits on the FHLBanks' interest rate risk and unsecured 
credit risk exposure. These limits, as well as regular on-site 
examination of the FHLBanks, should constrain incentives to increase 
risk. Another option would be to increase the spreads on advances to 
generate additional income. However, increased spreads would likely 
reduce demand for advances, and the Banks would be limited in their 
ability to replace advances with MMI.

Issues Requiring Further Analysis

    This preliminary analysis suggests that the investment restrictions 
in option two, when applied to the 1997 average balance sheet, would 
achieve a 50 percent reduction in MMI--$49 billion--without 
significantly affecting Bank System net income and dividends. It seems 
unlikely that the relatively small reductions in dividends would 
trigger widespread withdrawal by voluntary members given that dividend 
spreads over comparable benchmarks generally would not be significantly 
lower than the spreads in the base case. Transition rules would be 
needed to facilitate Bank adjustment to any new investment limitations, 
particularly for those Banks requiring the greatest reduction in MMI. 
Transitional rules would also be needed for Banks that fall out of 
compliance due to situations such as merger activity and regional and 
cyclical downturns in advance demand.
    This analysis assumed constant levels of advances and capital. The 
impact of limits on Bank MMI in a period of declining advances and 
interest rates should be analyzed, as well as the implications of 
declining capital levels due to the redemption of stock held in excess 
of the minimum statutory requirements. Another issue involves the 
payment of stock dividends by the FHLBanks. Stock dividends involve a 
greater taxpayer subsidy because taxes are deferred, and the Banks 
currently may leverage the stock in investments that do not support 
their public purpose.
    It is also important that any Finance Board limits on Bank MMI do 
not result in inadequate levels of liquidity at the FHLBanks. The Banks 
are currently subject to statutory liquidity requirements and 
additional liquidity requirements set forth in the FMP.17 
Preliminary analysis indicates that all the Banks would have met their 
requirements at year-end 1997 under options one and two. One Bank would 
not have met its requirements under option three. Finance Board staff 
will be examining the adequacy of these liquidity requirements as part 
of its review of the FMP.
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    \17\ The Bank Act requires each bank to maintain an amount equal 
to the total deposits received from its members invested in: 
obligations of the United States; deposits in banks or trust 
companies (as defined in Finance Board regualtion) which are 
eligible financial institutions; and advances that mature in 5 years 
or less to members. In addition, each Bank is required to maintain a 
daily average liquidity level each month in an amount not less than 
20 percent of the sum of its daily average demand and overnight 
deposits and other overnight borrowings during the month, plus 10 
percent of the sum of its daily average term deposits, COs and other 
borrowings that mature within one year. Certain money market 
investments authorized under the FMP may be used to satisfy the 
liquidity requirements.
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    This analysis also made no assumptions about changes in FHLBank 
funding costs. It has been suggested that Bank borrowing costs could 
fall if CO issuance declined. Staff could review the existing research 
that has been done is this area and incorporate expected changes, if 
any, into the simulations.

Conclusions

    The FHLBanks, as GSEs, can be viewed as representing a social 
compact between the Banks and their members and the federal government. 
The federal government bestows upon the Banks certain benefits through 
their GSE status, and such federal benefits should be used to fund 
activities that safely and soundly further the Banks' public purpose. 
The System acted rationally during the transition period following the 
resolution of the thrift crisis when it replaced declining advance 
balances with increasing levels of investments. However, now that the 
demand for advances has rebounded and reached record levels, and System 
membership is at record levels as well, the on-going maintenance of 
large balances of MMI

[[Page 16511]]

appears to be inconsistent with the Banks' mission.
    With the goal that the System's principal federal benefit--its GSE 
funding advantage--be used to meet the System's public purpose, staff 
evaluated three options that tied allowable levels of money market 
investments to the levels of consolidated obligations outstanding. Such 
an approach would constrain the use of the GSE funding advantage to 
finance money market assets. Preliminary analysis suggests that 
reducing low-yielding MMI by 50 percent, while holding advances and 
capital constant, would generally result in relatively small reductions 
in dividends. In most cases, FHLBank dividend spreads over comparable 
benchmarks would be only modestly lower than historical averages. It 
appears unlikely that these dividend reductions would result in a 
reassessment by voluntary members of the benefits of System membership.
    Setting limits on Bank MMI could be viewed as another near-term 
step in restructuring the Banks' balance sheets. Longer-term efforts 
could involve Finance Board consideration of additional limits on Bank 
MBS investments, as well as the Banks' continued development of new and 
innovative investments that support housing and targeted community 
development.
    Persons wishing to participate in the hearing should send a written 
request to the address listed in the ADDRESSES portion of this notice, 
to be received no later than Monday April 13, 1998. A request to 
participate in the hearing must include the following information:
    (A) The name, title, address, business telephone and fax number of 
the participant; and
    (B) The entity or entities that the participant will be 
representing.
    Depending on the number of requests received, participants may be 
limited in the length of their oral presentations. All submissions will 
be included as part of the record, including written testimony not 
presented orally, although extraneous material may be deleted from the 
printed record to reduce printing costs. The Finance Board will notify 
those selected to make oral presentations if more requests are received 
for participation than may be accommodated in the time available.
    Participants will be required to submit 100 copies of their written 
statements in advance of the hearing date. These written statements 
should incorporate the major points to be presented at the hearing and 
should be accompanied by an executive summary of no more than two 
pages. Written statements must be received no later than Friday, May 1, 
1998, and should be sent to the address listed in the ADDRESSES portion 
of this notice. Anyone selected for an oral presentation whose 
testimony has not been received by Friday, May 1, 1998 may not testify 
except by special permission of the Finance Board.

    By the Federal Housing Finance Board.
Bruce A. Morrison,
Chairman.

BILLING CODE 6725-01-P

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[FR Doc. 98-8508 Filed 4-2-98; 8:45 am]
BILLING CODE 6725-01-C