[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