Federal Home Loan Bank System: Establishment of a New Capital	 
Structure (20-JUL-01, GAO-01-873).				 
								 
The Federal Home Loan Bank (FHLBank) System is currently	 
establishing a new capital structure that, if properly		 
implemented, is likely to be an improvement over the historic	 
structure. Capital will become more permanent and new risk-based 
and leverage capital requirements will also be implemented. The  
new capital structure has the potential to address the risks	 
associated with advances as well as the direct acquisition of	 
mortgages. However, it is too early to assess the overall	 
adequacy of the structure, because the capital plans and risk	 
management practices to be implemented by the FHLBanks and	 
capital supervision practices to be followed by the Federal	 
Housing FInance Board (FHFB) are not yet known. Based on activity
to date, direct acquisition appears to provide regional 	 
diversification of mortgage acquisitions and incentives to member
institutions for sound mortgage underwriting and servicing	 
through the sharing of credit risks. However, risks could be	 
affected if changes are made in the level of mortgage acquisition
activity and in the risk-sharing agreements that are currently	 
present between the FHLBanks and their member institutions. Such 
changes might also increase the importance of risk-based capital 
requirements compared to FHFB leverage requirements. Going	 
forward, risks in the FHLBank System will increase due to	 
expanded collateral provisions in the Gramm-Leach-Bliley Act and 
direct mortgage acquisition activity. Effective mitigation of	 
that risk will depend on risk management by the FHLBanks, the	 
adequacy of capital structure, and oversight by FHFB. In addition
to the FHLBanks, the acquisition activity could also generate	 
additional risks for the enterprises. Although currently the	 
FHLBank System and the enterprises primarily engage in different 
business activities, these differences may decrease if direct	 
mortgage acquisition activity grows dramatically. Having one	 
housing government sponsored enterprise (GSE) regulator for	 
safety and soundness and mission compliance would provide greater
independence and objectivity, greater prominence, improved	 
ability to assess the competitive impact of new initiatives on	 
all housing GSEs, and improved ability to ensure consistency of  
regulation of GSEs that operate in similar markets.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-01-873 					        
    ACCNO:   A01422						        
  TITLE:     Federal Home Loan Bank System: Establishment of a New    
             Capital Structure                                                
     DATE:   07/20/2001 
  SUBJECT:   Capital						 
	     Financial institutions				 
	     Risk management					 
	     Mortgage loans					 
	     Government sponsored enterprises			 

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GAO-01-873
     
Report to Congressional Committees

United States General Accounting Office

GAO

July 2001 FEDERAL HOME LOAN BANK SYSTEM

Establishment of a New Capital Structure

GAO- 01- 873

Page i GAO- 01- 873 Federal Home Loan Bank System Capital Letter 1

Results in Brief 2 Background 4 A More Permanent Capital Structure Is Being
Established for the

FHLBank System 6 Risk Management Policies and the New Capital Structure Can

Mitigate the Increased Risks Associated With Advances and Mortgage
Acquisitions 12 FHFB and OFHEO Approach Risk- Based Capital Regulations

Differently 31 Conclusions 38 Recommendations 39 Agency Comments 39

Appendix I Scope and Methodology 42

Appendix II Background Information on the FHLBank System, Fannie Mae,
Freddie Mac, and Their Regulators 44

Appendix III Financial Information on the FHLBank System, Fannie Mae, and
Freddie Mac 46

Appendix IV Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements
49

Appendix V Comments From the Federal Housing Finance Board 59

Related GAO Products 61 Contents

Page ii GAO- 01- 873 Federal Home Loan Bank System Capital Tables

Table 1: Regional Distribution of MPF Mortgage Loan Balances Outstanding as
of Dec. 31, 2000 19 Table 2: FHLBanks? Consolidated Summary Balance Sheet as
of

Dec. 31, 1996- 2000 46 Table 3: FHLBank Advances and Total Assets as of Dec.
31, 2000 47 Table 4: Fannie Mae Selected Financial Highlights as of Dec. 31,

1996- 2000 48 Table 5: Freddie Mac Selected Financial Highlights as of Dec.
31,

1996- 2000 48

Figures

Figure 1: The Farm Credit System?s Experience 11 Figure 2: Double leveraging
28 Figure 3: Simplified Illustration of FHFB?s Approach to Risk

Modeling and Capital Calculation 32 Figure 4: Simplified Illustration of
OFHEO?s Stress Test and Capital

Calculation 33 Figure 5: Interest- Rate Risk Stresses in OFHEO?s Risk- Based

Capital Regulation 57 Abbreviations FCS Farm Credit System FDIC Federal
Deposit Insurance Corporation FHFB Federal Housing Finance Board FHLBank
Federal Home Loan Bank FIRREA Financial Institutions Reform, Recovery, and
Enforcement

Act GLBA Gramm- Leach- Bliley Act GSE Government- Sponsored Enterprise HUD
Department of Housing and Urban Development MBS Mortgage- Backed Securities
MPF Mortgage Partnership Finance MPP Mortgage Partnership Program OFHEO
Office of Federal Housing Enterprise Oversight

Page 1 GAO- 01- 873 Federal Home Loan Bank System Capital

July 20, 2001 Congressional Committees: This report responds to a mandate in
the Consolidated Appropriations Act of 2001 that we analyze the adequacy of
the capital structure of the Federal Home Loan Bank (FHLBank) System. The
FHLBank System- which consists of 12 regional FHLBanks and the System?s
Office of Finance- is cooperatively owned by member financial institutions.
1 Currently, FHLBank capital lacks permanence compared to other firms?
capital because it is redeemable with only 6 months? notice. As such, its
usefulness as a cushion in times of stress is questionable. The existence of
joint and several liability within the System also means that a FHLBank?s
capital must be available to protect the System if one or more FHLBanks
suffer losses severe enough to erode their capital. 2 In addition, in part
because the FHLBank System is a government- sponsored enterprise (GSE) whose
failure could lead to government intervention and potential losses to the
taxpayer, there are regulatory capital requirements imposed by the Federal
Housing Finance Board (FHFB) in the form of minimum leverage and risk- based
capital levels. 3 The Gramm- Leach- Bliley Act (GLBA) of 1999 mandated a new
capital structure that would increase the permanence of FHLBank capital and
require that FHFB promulgate capital requirements related to the risk of
activities undertaken by FHLBanks. The FHLBanks have not yet completed their
plans to implement their new capital structures, which limited the scope of
our analysis.

As agreed with your offices, our objectives were to (1) describe the basic
characteristics of the capital structure being established for the
cooperative FHLBank System; (2) analyze how risk management policies and the
new capital structure address interest rate, credit, and operations risks
that are associated with advances and the direct acquisition of mortgages;
and (3) compare and contrast the risk- based capital standards proposed by
FHFB for the FHLBank System to the standards proposed by

1 For financial purposes, capital is generally defined as the long- term
funding for a firm that cushions it against unexpected losses. 2 The
imposition of joint and several liability means that each FHLBank is an
obligor on the consolidated debt obligations of the System. 3 Generally, a
leverage capital requirement is the minimum amount- usually expressed as a
percentage- of capital that must be held against total assets.

United States General Accounting Office Washington, DC 20548

Page 2 GAO- 01- 873 Federal Home Loan Bank System Capital

the Office of Federal Housing Enterprise Oversight (OFHEO) for Fannie Mae
and Freddie Mac (the enterprises).

FHFB and OFHEO have proposed new capital standards that are related to the
risks of unexpected losses, but these standards have not been implemented.
To date, FHFB and OFHEO have enforced leverage capital requirements that are
based on asset, debt, and/ or activity levels rather than the risks of
specific activities. The FHLBanks facilitate mortgage financing primarily by
making collateralized loans, called advances, to their members. These loans
are funded by issuing consolidated bonds, which are the joint and several
liability of the FHLBanks, through the System?s Office of Finance. In
contrast to the cooperatively owned FHLBank System, the enterprises are
private corporations with publicly traded stock.

To complete our work, we reviewed FHFB and OFHEO capital standards; analyzed
FHLBank proposals for the use of expanded collateral provisions and
permissible uses of advances under GLBA; analyzed FHLBank information on
direct mortgage acquisition programs; and interviewed financial institution
regulatory body and GSE officials. We did not verify the accuracy of data
provided by FHFB and the FHLBanks. We obtained and analyzed information the
FHLBanks considered to be proprietary. Therefore, we do not report specific
details of the various FHLBank products. In addition, although we made
observations of some elements of risk management that appear to be
implemented at the FHLBanks, we did not analyze risk management procedures
employed by the FHLBanks, FHFB?s oversight of risk management, nor the risks
associated with FHLBank investments. We also did not analyze the risks of
activities that have been or might be undertaken by either Fannie Mae or
Freddie Mac.

We conducted our work in Washington, D. C., between February 2001 and June
2001, in accordance with generally accepted government auditing standards.
Written comments on a draft of this report from FHFB appear in appendix V.
We also obtained technical comments from the FHLBanks, enterprises,
depository institution regulators, FHFB, and OFHEO that have been
incorporated where appropriate. A detailed description of our scope and
methodology is presented in appendix I. This report does not contain any
recommendations.

The FHLBank System is currently establishing a new capital structure that
will include new risk- based and leverage capital requirements and will also
make capital more permanent. Under this new structure, the FHLBank members-
generally depository institutions- will purchase new classes of Results in
Brief

Page 3 GAO- 01- 873 Federal Home Loan Bank System Capital

stock that will not be redeemable if a FHLBank fails to meet its minimum
capital requirements. 4 Greater permanence is especially important given
that the FHLBanks are jointly and severally liable for the System?s
outstanding debt securities. With such liability, all FHLBanks are at risk
due to the possibility that a FHLBank could become troubled and not be able
to meet its debt obligations. In addition, the troubled FHLBank would have
incentives to undertake risky activities because profits would accrue to the
FHLBank?s owners, whereas losses could fall on the other FHLBanks. Thus,
joint and several liability creates incentives for the FHLBanks to monitor
each other?s activities, which they do through a number of System- wide
bodies of representatives from the 12 FHLBanks. The unique characteristics
of FHLBank capital and the potential for risk taking within the System
heighten the importance of supervisory oversight by FHFB.

The new capital structure has the potential to better address the increased
risks associated with advances and the direct acquisition of mortgages,
because it offers greater capital permanence, and includes both leverage and
risk- based capital requirements. However, it is too early to assess capital
adequacy, because the capital plans and risk management practices to be
implemented by the FHLBanks and capital supervision practices to be followed
by FHFB are not yet known. Additionally, the overall amount of risk
introduced into the system will depend on the type and amount of advances
and direct mortgage acquisitions undertaken by the FHLBanks. Advances
utilizing small business and agricultural loan collateral are activities
that are inherently more risky than traditional advances secured by
residential mortgage collateral. 5 While officials from the FHLBanks told us
they currently anticipate a low level of advances utilizing small business
and agricultural collateral, the overall risk in the System could increase
if these advances became an important part of the System?s assets.

Direct acquisition of mortgages also creates additional risks, especially if
these purchased mortgages are not regionally diversified and if member
institutions do not have incentives to limit risks in mortgage origination.

4 Historically, the FHLBank System had mandatory and voluntary member
institutions. Voluntary members could redeem stock with 6 months? notice.
GLBA made membership all voluntary.

5 GLBA authorized the FHLBanks to provide funds to any member community
financial institution for small business and agricultural loans with
corresponding expansions in eligible collateral. Community financial
institutions are defined as FDIC- insured institutions that have less than
$500 million in total assets, adjusted for inflation.

Page 4 GAO- 01- 873 Federal Home Loan Bank System Capital

Based on activity to date, direct mortgage acquisition appears to provide
regional diversification and incentives to member institutions for sound
mortgage underwriting and servicing through the sharing of credit risks. 6
However, this activity is relatively new and its level is expected to grow,
thereby increasing risks. In addition, risks could be affected if changes
are made in the risk- sharing agreements between the FHLBanks and their
member institutions. Increased activity in direct mortgage acquisitions by
FHLBanks could also increase competition with the enterprises in the
secondary mortgage market. Such increased competition could provide benefits
to borrowers, but it could also generate additional risks for the FHLBanks,
the enterprises, depository institutions, and taxpayers.

Both FHFB and OFHEO are implementing new risk- based capital regulations.
Both risk- based capital regulations are intended to help ensure that the
level of capital the FHLBanks and the enterprises maintain is sufficient to
cover the risks that these GSEs undertake. Both regulations also address
credit risk, interest rate risk, and operations risk. The regulations differ
substantially due to the different business activities of the regulated
entities, statutory requirements faced by each regulator, and conceptual
approaches. In addition, the FHLBanks? leverage requirements differ from
those of the enterprises, which may affect the relative impacts of the two
proposed risk- based capital regulations.

The FHLBank System and the enterprises are GSEs. Congress created GSEs to
help make credit available to certain sectors of the economy, such as
housing and agriculture, in which the private market was perceived as not
effectively meeting credit needs. GSEs receive benefits from their federal
charters that help them fulfill their missions. The federal government?s
creation of and continued relationship with GSEs have created the perception
in the financial markets that the government would not allow a GSE to
default on its obligations, even though intervention is not required. As a
result, GSEs can borrow money in the capital markets at lower interest rates
than comparably creditworthy private corporations

6 The FHLBank of Chicago has accounted for a majority of the acquisition
activity to date. Background

Page 5 GAO- 01- 873 Federal Home Loan Bank System Capital

that do not enjoy federal sponsorship, and market discipline is reduced. 7
In fact, during the 1980s, the government did provide limited regulatory and
financial relief to Fannie Mae when it experienced significant financial
difficulties, and, in 1987, Congress authorized $4 billion to bail out the
Farm Credit System, another GSE. Additional background on the FHLBank
System, the enterprises, FHFB, OFHEO, and financial risks are presented in
appendix II.

Our mandate directs us to analyze interest rate, credit, and operations
risks. Interest rate risk is a component of what is commonly called market
risk. Market risk is the potential for financial losses due to the increase
or decrease in the value or price of an asset or liability resulting from
broad movements in prices, such as interest rates, commodity prices, stock
prices, or the relative value of foreign exchange. Credit risk is the
potential for financial loss because of the failure of a borrower or
counterparty 8 to perform on an obligation. Credit risk may arise from
either an inability or unwillingness to perform as required by a loan, a
bond, an interest rate swap, 9 or any other financial contract. Operations
risk is the potential for unexpected financial losses due to inadequate
information systems, operational problems, breaches in internal controls, or
fraud. It is associated with problems of accurately processing or settling
transactions and with breakdowns in controls and risk limits. Individual
operating problems are considered small- probability but potentially high-
cost events for well- run firms. Operations risk includes many risks that
are not easily quantified, but controlling these risks is crucial to a
firm?s successful operation.

7 The enterprises made six commitments in October 2000 regarding, among
other things, the issuance of subordinated debt, liquidity management, and
public disclosure of financial information. They stated that the commitments
would improve transparency and market discipline. While these commitments
may be beneficial to the public, Congress, and regulators, the perception of
an implied guarantee will continue to reduce funding costs and market
discipline.

8 In any financial transaction, each party is the counterparty to the other.
9 FHLBanks and the enterprises enter into swap agreements. A swap agreement
is an agreement between counterparties to make periodic payments to each
other for a specified period. In a simple interest rate swap, one party
makes payments based on a fixed interest rate, while the counterparty makes
payments based on a variable rate.

Page 6 GAO- 01- 873 Federal Home Loan Bank System Capital

The FHLBank System is establishing a new capital structure that will include
new risk- based and leverage capital requirements and will also make capital
more permanent. FHLBank capital will continue to differ from capital issued
by publicly traded corporations, however, because of the cooperative nature
of the FHLBank System. Additionally, each FHLBank?s capital is potentially
available throughout the System, because the FHLBanks are jointly and
severally liable for the System?s outstanding debt securities. The unique
characteristics of FHLBank capital and the potential for risk taking within
the System heighten the importance of supervisory oversight by FHFB.

The new capital structure being implemented by the FHLBank System will
include risk- based and leverage capital standards. In January 2001, FHFB
published a final rule to comply with the provisions of GLBA that required
regulations prescribing uniform capital standards applicable for all
FHLBanks. These new capital standards, when fully implemented, will replace
the current ?subscription? capital structure for the FHLBanks. Under the
current structure, the amount of capital that each FHLBank issued was
determined by a statutory formula that dictated how much FHLBank stock each
member had to purchase. 10 A principal shortcoming of the subscription
capital structure was that the amount of capital each FHLBank maintained
bore little relation to the risks inherent in the FHLBank?s assets and
liabilities. Under the new structure, FHLBanks will be required to maintain
longer- term permanent capital and total capital in amounts sufficient for
the FHLBanks to comply with the minimum riskbased and leverage capital
requirements established by GLBA.

We have consistently supported the concept of risk- based capital standards
applied in combination with a leverage ratio that requires a minimum
capital- to- asset ratio for the FHLBanks. 11 A risk- based capital standard
has a number of benefits. First, it gives the government a mechanism to
influence risk- taking without involving itself in the FHLBanks? daily
business. Second, it gives FHLBanks? shareholders an incentive to demand
that management not take undue risks, since

10 In accordance with that formula, each member was required to purchase
FHLBank stock in an amount equal to 1 percent of the member?s total mortgage
assets or 5 percent of the advances outstanding to the member, whichever was
greater.

11 See Capital Structure of the Federal Home Loan Bank System (GAO/ GGD- 99-
177R, Aug. 31, 1999). A More Permanent

Capital Structure Is Being Established for the FHLBank System

The FHLBank System?s New Capital Structure Will Include Risk- based and
Leverage Capital Standards

Page 7 GAO- 01- 873 Federal Home Loan Bank System Capital

increased risk taking would impose additional costs resulting from raising
additional capital. Third, it provides a buffer that should be adequate to
absorb unforeseen losses to FHLBanks and thus helps prevent or reduce
potential taxpayer losses.

The new capital structure the FHLBank System is implementing will also
result in more permanent capital. After the enactment of GLBA in 1999,
membership in the FHLBank System became all voluntary. Voluntary members can
generally redeem stock with 6 months? notice. 12 Capital redeemable on such
short notice does not provide a cushion against unexpected losses.
Therefore, the change to all voluntary members increased the need for more
permanent capital that could not necessarily be redeemed with 6 months
notice, and GLBA required implementation of a more permanent capital
structure.

Under the new capital structure, the FHLBanks are permitted to issue Class A
stock, which can be redeemed with 6 months? notice, and Class B stock, which
can be redeemed with 5 years? notice, or both. To help ensure that capital
does not dissipate due to redemption in time of stress, GLBA does not allow
a FHLBank to redeem or repurchase capital if following the redemption the
FHLBank would fail to satisfy any minimum capital requirement. Based on
discussions with FHFB officials and their review of draft capital plans, it
appears that a majority of FHLBanks might initially implement an exclusive
Class B stock structure, while other FHLBanks might implement a mixed
structure. The presence of 5- year capital, combined with the requirement
that member institutions lose benefits of membership in the System if they
withdraw capital, acts to create a financial interest that mirrors some,
though certainly not all, characteristics of publicly traded perpetual
equity stock.

12 If impairment of the FHLBank?s capital were likely, FHFB could withhold a
portion of a withdrawing member?s capital stock. In previous reports, we
raised the possibility that if pending losses threatened the value of a
FHLBank?s stock, the FHLBank?s voluntary members may try to withdraw their
stock before the losses impair its value. We also concluded that, as a
practical matter, the degree to which FHFB?s authority makes FHLBank stock a
buffer for absorbing losses depends on the extent to which FHFB exercises
its authority to withhold stock redemption. We stated that for FHFB to use
this authority in a way that makes capital stock a meaningful buffer, FHFB
would have to recognize potential future losses in a timely manner and be
willing to withhold proceeds from stock redemption requests. We have also
consistently supported a more permanent capital structure for the FHLBank
System. FHLBank System Capital

Will Become More Permanent

Page 8 GAO- 01- 873 Federal Home Loan Bank System Capital

Permanent capital is defined in GLBA as amounts paid in for Class B stock
plus the retained earnings. Class A stock plus permanent capital is to be at
least 4 percent of assets. Class A stock plus 1.5 times permanent capital is
to be at least 5 percent of assets. Therefore, a FHLBank meeting the 4
percent requirement will also meet the 5 percent requirement if its
permanent capital equals at least 2 percent of assets. In addition, only
permanent capital is included in the capital definition for the risk- based
capital component of the minimum capital standards.

Although the new capital structure will result in more permanent capital,
FHLBank capital will continue to differ from the capital issued by publicly
traded corporations such as the enterprises or banks. The voluntary,
cooperative nature of the FHLBank System means that capital in this system
has characteristics different from capital issued by publicly traded
corporations.

First, the FHLBank stock will not be perpetual equity stock like that issued
by publicly traded corporations. Stock issued by publicly traded
corporations can be bought and sold freely and publicly at a
marketdetermined price. In contrast, a FHLBank member institution can redeem
FHLBank stock at par value 13 as long as all restrictions are met. For
example, a member can withdraw capital with prior notice (i. e., of 6 months
or 5 years) if after redemption the FHLBank satisfies all minimum capital
requirements. However, FHLBank member institutions lose benefits of
membership in the System if they withdraw minimum capital required for
membership. 14 This lessens incentives to remove capital, if, for example,
FHLBank earnings declined.

Second, investors cannot be obligated to buy the stock of publicly traded
corporations. However, FHLBank members can be required to buy additional
FHLBank stock to ensure that the FHLBank meets its capital requirements.
Third, corporations with publicly traded stock have responsibilities to
maximize the value of their stock. In contrast, FHLBanks have incentives to
provide the best mix of services and dividend payments to their member-
owners.

13 With respect to FHLBanks, par value is the price at which the member
acquired the stock. 14 If an institution withdraws from the system, it
cannot rejoin for 5 years. FHLBank Capital Will

Continue to Differ From Capital Issued by Publicly Traded Corporations

Page 9 GAO- 01- 873 Federal Home Loan Bank System Capital

Under the new capital structure, the capital of each FHLBank will continue
to be available to other FHLBanks in the System because the FHLBanks are
jointly and severally liable for the System?s outstanding debt securities,
called consolidated obligations. Joint and several liability for the payment
of consolidated obligations gives investors confidence that System debt will
be paid. Another related characteristic of joint and several liability is
that it potentially creates a large pool of capital from all FHLBanks to
provide a cushion in the event of unexpected System losses. However, joint
and several liability also puts all FHLBanks at risk because of the
possibility that one FHLBank could become troubled and not be able to meet
its debt obligations. In such a situation, the troubled FHLBank would have
incentives to undertake risky activities because profits would accrue to the
FHLBank?s owners, whereas losses and erosion of capital could fall on
others. This scenario creates incentives for the FHLBanks to monitor each
other?s activities, which FHLBank officials told us they do through a number
of System- wide bodies of representatives from the 12 FHLBanks.

In theory, joint and several liability appears to make most System capital
available in the event of large, unexpected losses in the System. However,
concerns about how joint and several liability would operate in the event of
a default or delinquency on a consolidated obligation prompted FHFB to issue
regulations in 1999. 15 The regulations establish a process by which FHFB
will look first to the assets of a FHLBank that received the proceeds of the
consolidated obligation. The regulations also contain certification and
reporting requirements with which the FHLBanks must comply. For example, the
FHLBanks must certify before the end of the each calendar quarter that they
will remain in compliance with the liquidity requirements and will remain
capable of making full and timely payments on their consolidated
obligations. A FHLBank that is unable to provide the required certification
must provide additional notifications to FHFB, such as a payment plan
specifying the measures the FHLBank will take to make full and timely
payments of all its obligations. The regulations also specify that FHFB may
order any FHLBank to make principal and interest payments

15 The concerns arose out of the municipal bankruptcy and the resulting
receivership of the County of Orange, California, and the ensuing litigation
brought by the receiver for Orange County against the FHLBanks. The
litigation raised issues concerning liability allocation arising from
issuing and servicing consolidated obligations. In addition, the new
activities undertaken by the FHLBanks since GLBA prompted at least one
FHLBank to suggest that it would be beneficial to clarify how the joint and
several responsibility for the consolidated obligations would be allocated
if a FHLBank were to experience a payment problem. Each FHLBank?s Capital Is

Potentially Available Throughout the FHLBank System

Page 10 GAO- 01- 873 Federal Home Loan Bank System Capital

due on any consolidated obligation in the System. In this case, each
contributing FHLBank is entitled to reimbursement from the FHLBank that was
responsible for making the payment. Liability is to be allocated among the
other FHLBanks on a pro rata basis in proportion to each FHLBank?s
participation in all consolidated obligations.

Joint and several liability provides incentives for the FHLBanks to monitor
each other and appears to make most System capital available in the event of
large, unexpected losses in the System. However, joint and several liability
in a cooperative system has never been tested. The FHLBanks have never
defaulted on principal or interest payments due on a consolidated
obligation. Another cooperative GSE with joint and several liability, the
Farm Credit System (FCS), experienced severe economic stress in the middle-
1980s. To provide a broader perspective on joint and several liability, we
obtained information on the FCS experience during and following its
financial rescue by the federal government. Figure 1 describes the collapse
and bailout of FCS in the 1980s and describes the problems invoking joint
and several liability in FCS.

Page 11 GAO- 01- 873 Federal Home Loan Bank System Capital

Figure 1: The Farm Credit System?s Experience

FHFB supervisory oversight is a very important aspect of implementing a new
capital structure. The extent to which the new structure results in an
improvement over the old one depends on how the structure is implemented and
on FHFB?s oversight of the process. Many of the details of the new capital
structure will be contained in the capital plans the FHLBanks are currently
submitting to FHFB. The approach and criteria FHFB will use to review and
approve the capital plans are being determined.

We looked at the Basel Committee on Banking Supervision?s New Capital
Accord, which is based on three pillars: minimum capital requirements, a
supervisory review process, and effective use of market discipline. Although
the New Capital Accord is to be applied to banks and their holding
companies, its principles can be applied to GSEs as well. Safety and
Soundness

Oversight Is Important

Page 12 GAO- 01- 873 Federal Home Loan Bank System Capital

However, GSE status reduces market discipline, increasing the importance of
supervision.

Beyond the FHLBank System?s status as a GSE, the unique characteristics of
FHLBank capital and the potential for risk taking within the System heighten
the importance of supervisory oversight by FHFB. First, even after the new
capital structure is in place, FHLBank capital will be less permanent than
perpetual equity stock. Therefore, more so than other regulators, FHFB must
be prepared to act in case a FHLBank?s financial condition weakens. Second,
although joint and several liability creates incentives for the FHLBanks to
monitor each other?s activities, the FHLBanks do not have the authority to
direct a financially troubled FHLBank to take corrective actions. However,
FHFB does have authorities it can use to take enforcement actions in such a
situation. 16

We last examined FHFB?s supervisory oversight of the FHLBank System in 1998.
17 We concluded that FHFB?s safety and soundness regulation is increasingly
important to protect taxpayer interests due to the System?s expanding
activities and the changing business environment. We found deficiencies in
FHFB?s oversight of FHLBanks and made a number of recommendations to improve
it. FHFB officials told us they have made progress in implementing these
recommendations. However, we have not examined FHFB?s supervisory oversight
since completing our 1998 report, and therefore we have not verified the
completeness of these actions.

Expansion in the types of eligible collateral and increased direct mortgage
acquisition will increase interest rate, credit, and operations risks in the
FHLBank System. Interest rate risk, however, will remain unaffected by the
new forms of collateral. The overall amount of risk introduced will depend
on the type and amount of advances and mortgage acquisitions undertaken by
the FHLBanks, the implementation of risk management practices by the
FHLBanks, and oversight provided by FHFB. The new capital structure has the
potential to address the risks associated with advances and mortgage
acquisitions, because of greater capital permanence, leverage capital
requirements, and the development of risk

16 See Comparison of Financial Institution Regulators? Enforcement and
Prompt Corrective Action Authorities (GAO- 01- 322R, Jan. 31, 2001). 17
Federal Housing Finance Board: Actions Needed to Improve Regulatory
Oversight

(GAO/ GGD- 98- 203, Sept. 18, 1998). Risk Management

Policies and the New Capital Structure Can Mitigate the Increased Risks
Associated With Advances and Mortgage Acquisitions

Page 13 GAO- 01- 873 Federal Home Loan Bank System Capital

based capital standards. However, capital requirements will not be finalized
until FHFB approves capital plans developed by the FHLBanks.

GLBA authorizes advances to member community financial institutions that
utilize small business and agricultural loan collateral. 18 These advances
are inherently more risky than traditional advances backed by mortgages and
generate credit risk that is more difficult to evaluate. However, the
financial management policies of the FHLBanks, as reported to FHFB, that we
have reviewed reflect the perception that the new collateral will entail
greater credit risks than residential mortgage collateral, and the policies
call for higher collateral levels compared to traditional advances.

The FHLBanks have also begun implementation of direct mortgage acquisitions
with the program begun by the FHLBank of Chicago accounting for a majority
of the System?s acquisition activity to date. Based on existing direct
mortgage acquisition activity, direct acquisition appears to provide
regional diversification of mortgage acquisitions and incentives for sound
underwriting by member institutions from member exposure to credit risks.
However, this activity is relatively new, and its level is expected to grow,
thereby increasing risks. In addition, risks could be affected if changes
are made in the risk- sharing agreements between the FHLBanks and their
member institutions. Increased activity in direct mortgage acquisitions by
FHLBanks could also increase competition with the enterprises in the
secondary mortgage market. Such increased competition could provide benefits
to borrowers, but could also generate additional risks for the FHLBanks, the
enterprises, depository institutions, and taxpayers.

Credit and operations risks for traditional advances utilizing home loan and
related types of collateral are relatively low. However, GLBA authorized
advances to community financial institutions utilizing small business and
agricultural loan collateral that will likely introduce greater credit and
operations risk. Interest rate risk will not change, and FHLBanks will
continue to manage this risk as they have managed it for traditional
advances. The FHLBanks have extensive experience in

18 GLBA also authorized FHLBanks to expand the level of advances utilizing
what is called other real estate related collateral, which includes
commercial mortgages and home equity lines of credit. In this report, the
new collateral we focus on is small business and agricultural loan
collateral. New Forms of Collateral

for Advances Will Increase Credit and Operations Risks

Page 14 GAO- 01- 873 Federal Home Loan Bank System Capital

managing their traditional advance business and have developed financial
management policies for managing risks, as required by FHFB. 19 In addition,
according to FHFB, the FHLBanks typically require 10 to 25 percent more than
the value of an advance in collateral. Largely due to collateral protection
and the System?s lien status, FHLBanks have never experienced a credit loss
on their advance business.

In contrast to their traditional advance business, advances to community
financial institutions utilizing small business and agricultural loan
collateral are inherently riskier and generate credit risk that is more
difficult to evaluate. 20 First, small business and agricultural loans are
more heterogeneous than single- family residential mortgage loans. In
particular, small business loans finance businesses involved in a wide range
of economic activities. Unlike mortgage loans that have fairly homogeneous
characteristics, loans to a wide variety of sectors are more difficult to
analyze. In addition, the value of each business is determined largely by
the performance of those operating it. In contrast, appraising the value of
a housing unit providing collateral for a single- family residential
mortgage loan is more straightforward. Operations risk would also increase,
because FHLBanks have not fully developed the expertise, information
systems, and operational procedures necessary for these new activities.

Both FHFB and the FHLBanks recognize that the new collateral will entail
greater credit risks than residential mortgage collateral. FHFB requires a
FHLBank, prior to accepting the new collateral for the first time, to file a
notice to demonstrate that the FHLBank has the capacity to manage the risks
associated with the new types of collateral to be accepted. 21 According to
FHFB, the FHLBanks are requiring 65 to 150 percent more collateral over the
size of advances when the collateral is loans secured by small businesses or
farms. Consistent with the stringency of their financial management
policies, officials from the FHLBanks told us that they currently anticipate
a low level of funding utilizing small business and agricultural collateral.

19 FHFB officials told us that once FHFB accepts each FHLBank?s capital plan
and implements the new capital structure, FHFB?s financial management policy
regulations will be replaced with new regulations that address each
FHLBank?s financial management policies and take into consideration the new
capital requirements.

20 See Comments on Enterprise Resource Bank Act (GAO/ GGD- 96- 140R, June
27, 1996). 21 We reviewed these notifications, which include the relevant
credit and collateral policies to be implemented.

Page 15 GAO- 01- 873 Federal Home Loan Bank System Capital

The FHLBanks have tools to manage interest rate risk, and the introduction
of the new forms of collateral for advances will not change the way this
risk is managed. The principal source of funds for FHLBanks is the
consolidated debt obligations of the System. According to FHFB, each FHLBank
calculates various measures of its exposure to interest rate risk. One of
the measures is duration of equity. 22 This measures the sensitivity of
market value of equity to changes in interest rates. FHFB?s financial
management policy specifies duration of equity limits, and the FHLBanks are
to report the results of their duration of equity calculations to FHFB each
quarter. If interest rate risk is well hedged, the market value of equity
will change little as interest rates fluctuate.

The FHLBanks have lien status in which their rights to the collateral they
hold generally have priority over other security interests, including
insured deposits, in the assets of failed insured financial institutions.
Historically, all advances have been secured with collateral. More recently,
FHLBanks have also required collateral to secure member- provided credit
enhancements on mortgages FHLBanks acquire directly. By statute, FHLBank
security interests generally have priority over the claims and rights of any
party, including receivers, conservators, and trustees. This preference can
result in increased costs to the Federal Deposit Insurance Corporation
(FDIC) in resolving a possible bank or thrift failure. Potential expansion
in FHLBank System advances, collateral, and direct mortgage acquisition
activities could therefore also increase resolution costs to the FDIC.

Interest rate, credit, and operations risks will increase from the direct
mortgage acquisition programs implemented by the FHLBanks. Holding mortgage
assets exposes FHLBanks to interest rate risk, because the FHLBanks assume
the risk for any changes in the market value of the retained mortgage
assets. If interest rates increase at a time when new debt has to be issued,
borrowing costs will increase while returns from fixed- rate mortgage asset
holdings remain constant. Because borrowers tend to prepay and refinance
their mortgages when interest rates decline, falling interest rates carry
another form of interest rate risk called prepayment risk. To the extent
that FHLBanks rely on long- term debt that cannot be refinanced, returns
will fall without a corresponding decline in

22 Generally, duration describes the average time to each payment on a
financial liability (such as a bond) or a financial asset (such as an
advance). New Forms of Collateral Will

Not Change Interest Rate Risk Lien Status May Result in Increased Costs to
Federal Deposit Insurance Funds

Direct Mortgage Acquisitions Will Increase Interest Rate, Credit, and
Operations Risks

Page 16 GAO- 01- 873 Federal Home Loan Bank System Capital

debt costs. The prepayment risk associated with mortgage holdings differs
from that associated with advances, because the advances to member
institutions carry prepayment penalties. The FHLBanks, however, currently
have experience in managing prepayment risk because they have investment
holdings of mortgage- backed securities (MBS) and the associated prepayment
risk. The FHLBanks and the enterprises tend to use financial instruments
such as long- term, callable debt to limit their exposure to interest rate
risk from holdings of mortgage assets.

FHLBanks use derivatives and callable debt to hedge interest rate risk
resulting from direct investments in mortgage assets. To the extent that the
duration of mortgage assets differs from that of debt obligations, FHLBanks
often enter into a matching interest rate exchange agreement. This agreement
is one form of financial derivative called an interest rate swap, in which
the counterparty pays cash flows to the FHLBank designed to mirror, in
timing and amount, the cash outflows the FHLBank pays on the consolidated
obligation. The FHLBanks also use other financial arrangements to manage
interest rate risk. For example, callable debt allows the FHLBank as issuer
to buy (i. e., call) back issued debt when interest rates decline. Callable
debt is attractive as a source of funds for mortgage asset holdings, because
borrowers tend to prepay their mortgages and refinance when interest rates
decline. FHLBanks had $224.5 billion of callable debt outstanding as of
December 31, 2000, out of total consolidated obligations of about $592
billion.

Direct mortgage acquisitions expose the FHLBanks to credit risk. To qualify
for FHLBank purchase, as is true for purchase by the enterprises, mortgage
insurance is required for mortgage loans with loan to value ratios of over
80 percent. FHLBank purchases have included conventional mortgage loans with
private mortgage insurance as well as mortgage loans with federal guarantees
or insurance. The FHLBanks? credit risk management includes enforcement of
lender guidelines for member institutions participating in direct mortgage
acquisition. The FHLBanks have established stated actions they will take to
ensure that member institutions follow these guidelines. For example, the
FHLBanks are to collect quality control reports from participating members
and perform a quality control review on a sampling of the mortgages
purchased from each member. Participating members are also subject to audit
by the FHLBank or its designated agents. FHLBank establishment and
enforcement of guidelines for participating members help the FHLBanks
mitigate credit risk by increasing the degree of assurance that lenders meet
fundamental standards for originating and servicing mortgages. The FHLBanks
credit risk management also includes implementation of lender

Page 17 GAO- 01- 873 Federal Home Loan Bank System Capital

credit enhancement requirements that subject participating member
institutions to credit risk. For example, the FHLBank establishes an account
in which payments to member institutions are reduced in the event of
mortgage defaults. These credit enhancements further help the FHLBanks
mitigate credit risk by creating incentives for sound mortgage underwriting
and servicing by participating members. The FHLBanks also seek wide
geographic distribution of their mortgage acquisitions to limit their
exposure to any particular regional economic downturn.

Lenders who hold mortgages and member institutions use an infrastructure to
manage their credit risk that is different from the infrastructure used by
secondary market entities, such as the enterprises. These institutions can
benefit in their management of credit risk from their potential ability to
better understand their local markets and thereby the credit risk associated
with mortgages they fund or mortgages they sell in which they still take on
credit risk. In addition, institutions that take on credit risk from
mortgages they originate do not face the moral hazard problems 23 secondary
market entities have when they purchase mortgages and take on the associated
credit risks. To address the moral hazard problem, secondary market entities
develop infrastructures to oversee the lending and servicing practices of
lenders from whom they purchase mortgages.

Direct mortgage acquisitions expose the FHLBanks to operations risk, because
in the past the FHLBanks had not developed the expertise, information
systems, and operational procedures to approve and oversee lenders. Exposure
to operations risk is related to the FHLBanks? exposure to credit risk,
because new operating infrastructure and procedures are necessary to the
extent that member exposure to credit risk reduces the moral hazard problem
faced by the FHLBanks. If the FHLBanks have little exposure to credit risk
and moral hazard, then operations risk will be lower. The actions taken to
avoid moral hazard, including systems used to provide lender oversight,
entail operations risk. In contrast, credit and operations risks from
traditional advances have been minimal because of collateral requirements.

23 The term ?moral hazard? has been defined as ?a description of the
incentive created by insurance that induces those insured to undertake
greater risk than if they were uninsured because the negative consequences
are passed through to the insurer.? In a situation where a secondary market
entity purchases mortgages from a lender and takes on the associated credit
risk, the lender would have incentives to originate riskier mortgages
because profits would accrue to the lender whereas losses could fall on the
secondary market entity.

Page 18 GAO- 01- 873 Federal Home Loan Bank System Capital

As of December 31, 2000, the FHLBanks held slightly over $15 billion in
fixed, long- term, single- family mortgages compared to about $1.4 billion
as of year- end 1999. The FHLBank of Chicago held about half of total
mortgage loans in the System.

The majority of direct acquisition activity to date has been accounted for
by the program begun by the FHLBank of Chicago, which is named Mortgage
Partnership Finance (MPF). 24 MPF was initiated on a pilot basis beginning
in 1997. The 10 FHLBanks from Boston, New York, Pittsburgh, Atlanta,
Indianapolis, Chicago, Des Moines, Dallas, Topeka, and San Francisco,
currently participate in MPF.

Although MPF offers multiple products, they share some common
characteristics. First, mortgage purchases are limited to mortgage loans
below the conforming loan limit for the enterprises, which is currently
$275,000 for a single- family housing unit. Second, the FHLBank holds an
account with funds generated from transactions between the FHLBank and the
member bank. This account takes the first- loss position after primary
mortgage insurance payments; that is, costs due to borrower mortgage
defaults are taken from this account before other sources of funds are
utilized to cover credit losses. The funds are generated by providing the
FHLBank a price deduction at time of sale and/ or from an annual flow of
payments. The latter device is often called a spread account, because it
represents a spread between payments due to the member institution from the
FHLBank (e. g., to compensate the member for taking on credit risk) and
payments actually made by the FHLBank. 25 Third, for some MPF products the
member institution is required to supply additional credit enhancements in
the form of direct loss guarantees and/ or supplemental insurance to provide
a second- loss position before the FHLBank is exposed to credit losses. The
loss positions taken by the first- loss account and the second- loss
supplemental insurance and lender guarantees are lender provided credit
enhancements. By FHFB regulation, the FHLBank requires the member
institution to provide collateral to secure direct loss guarantees provided
by the lender. The collateral is

24 ?Mortgage Partnership Finance? and ?MPF? are registered trademarks of the
FHLBank of Chicago. 25 With MPF products, the FHLBank pays the member
institution a guarantee fee. For some MPF products, when defaults occur,
guarantee payments to the member institution are reduced. The FHLBank of
Chicago Has

Developed a Direct Acquisition Program

Page 19 GAO- 01- 873 Federal Home Loan Bank System Capital

protected by the lien status applicable to collateral used to secure
advances.

The FHLBank of Chicago has two primary means of achieving regional
diversification of its credit risk. First, it purchases mortgages from
member institutions that are affiliated with large, nationwide lenders, and
second, it invests in the mortgage acquisitions (called participations) made
by the nine other FHLBanks that participate in MPF. Table 1 presents the
geographic distribution of MPF mortgages as of year- end 2000. Based on all
MPF mortgage loans to date, it appears that regional diversification has
been achieved. 26 According to FHLBank of Chicago officials, MPF serves both
large and small FHLBank member institutions.

Table 1: Regional Distribution of MPF Mortgage Loan Balances Outstanding as
of Dec. 31, 2000

Region Share of MPF mortgage loans

Northeast 22% Southeast 15 Midwest 24 Southwest 16 West 22

Note: Regions are as follows: Northeast- Connecticut, Delaware, Washington
D. C., Massachusetts, Maine, Maryland, New Hampshire, New Jersey, New York,
Pennsylvania, Rhode Island, Vermont, Virginia, and West Virginia; Southeast-
Alabama, Florida, Georgia, Kentucky, Mississippi, North Carolina, Puerto
Rico, South Carolina, Tennessee, and Virgin Islands; Midwest- Illinois,
Indiana, Iowa, Michigan, Minnesota, North Dakota, Ohio, South Dakota, and
Wisconsin; Southwest- Arkansas, Colorado, Kansas, Louisiana, Missouri,
Nebraska, New Mexico, Oklahoma, Texas, and Wyoming; and West- Alaska,
Arizona, California, Guam, Hawaii, Idaho, Montana, Nevada, Oregon, Utah, and
Washington.

Source: FHLBank of Chicago.

The FHLBanks of Cincinnati, Indianapolis, and Seattle participate in the
other direct mortgage acquisition program, which is named the Mortgage
Partnership Program (MPP). MPP was initiated near year- end 2000. As of
year- end 2000, less than $500 million in mortgage loan holdings were
accounted for by the FHLBanks participating in MPP.

26 We did not analyze the regional diversification of individual loan pools
purchased by the FHLBanks through MPF. A lack of regional diversification of
individual loan pools could affect credit risk exposure to the FHLBank to
the extent that a member institution could not meet its contractual payment
obligations. Three FHLBanks Have Jointly

Developed a Direct Acquisition Program

Page 20 GAO- 01- 873 Federal Home Loan Bank System Capital

MPP is in its infancy compared to MPF. The products share some of the basic
characteristics of MPF. A notable difference between MPP and MPF is that to
date MPP participants have only been larger member institutions. Another
difference is that the FHLBank MPP participants generally do not expect to
enter into participations with the other MPP FHLBanks, even though the
program parameters allow for such participations. Without joint
participation among the three FHLBanks on individual mortgage pools,
geographic diversification of mortgage assets might be limited if small
member institutions, which are not diversified geographically, provide a
large share of MPP activity.

Two major FHFB regulatory requirements that limit the risks of MPF and MPP
are (1) the member institution is to assume the first- loss position in the
transaction as defined by FHFB and (2) each loan pool is to receive an
investment grade rating based on FHFB approved rating criteria and loan
pools with ratings below AA (i. e., double- A) must be supported by
additional retained earnings or reserves. 27

FHFB regulations require member institutions to be in the first- loss
position (i. e., after primary mortgage insurance). FHFB uses an economic
definition of first- loss position in implementing its regulation. In an
accounting sense, it may not be apparent that the member is in a first- loss
position, because the account that takes the first- loss might not be on the
balance sheet of the member institution. However, the member institution is
at risk because defaults reduce payments from the first- loss account to the
member institution. These payments represent a fee paid to members for
assuming credit risk. When losses from defaults occur, the account covers
the losses and payments to the member are subsequently reduced. Therefore,
this structure should help provide incentives to member institutions through
the sharing of credit risks for sound underwriting and loan servicing
practices.

Another FHFB regulatory requirement that limits the risks of MPF and MPP is
the requirement that each loan pool receive an investment grade rating based
on FHFB approved rating criteria, and loan pools with ratings below double-
A must be supported by additional retained earnings or

27 FHFB requires an investment grade rating at least equal to the fourth
highest rating. The four highest ratings are triple- A, double- A, A, and
triple- B. Risks Can Be Sensitive to

Changes in Risk- Sharing Arrangements

The Member Institution Assumes the First- Loss Position

Each Loan Pool Is Required to Receive an Investment Grade Rating to Mitigate
FHLBank Credit Risk

Page 21 GAO- 01- 873 Federal Home Loan Bank System Capital

reserves. 28 FHFB has approved rating criteria contained in the computer
package LEVELS, a product of the rating agency Standard & Poors. To date,
participating FHLBanks have required a double- A rating. A double- A rating
is the second highest rating attainable. LEVELS considers credit risk
characteristics for loans in a mortgage pool, such as loan- to- value ratio,
mortgage insurance coverage, economic conditions and expected house price
changes in the metropolitan area where the residence is located, and
borrower credit history. Based on these characteristics, LEVELS calculates
the credit support necessary from the first- loss account and, when
applicable, supplemental insurance to achieve the double- A rating. Standard
& Poors officials we interviewed stated that LEVELS provides a comprehensive
credit analysis of a mortgage pool. They also told us that LEVELS does not
consider some factors that could affect FHLBank risk exposure such as the
capacity of the member institution and the first- loss account to meet
continuing obligations.

FHFB?s required investment grade rating, especially if participating
FHLBanks require a double- A rating from LEVELS, should help to limit credit
risk faced by the FHLBanks based on a thorough credit analysis of each
mortgage pool. Participating FHLBanks can further limit credit risk and
thereby improve the performance of their acquired mortgage portfolios above
what the LEVELS? model predicts by achieving regional diversification of
their portfolios. 29 In addition, LEVELS does not consider factors such as
concentrations of FHLBank credit risk with individual member institutions
that may have limited capacity to meet their continuing obligations. Due in
part to strategies to limit credit risk that can be implemented by
participating FHLBanks and risk factors not considered by LEVELS, capital
supervision of direct mortgage acquisitions by FHFB is important to ensure
the safety and soundness of the System.

28 The latter requirement is effective until FHFB?s risk- based capital rule
becomes effective. 29 According to Standard & Poors officials, LEVELS
assumes a nationwide worst- case scenario, and regional diversification by a
FHLBank could result in improved economic performance in the event of a
regional economic downturn.

Page 22 GAO- 01- 873 Federal Home Loan Bank System Capital

FHFB published a risk- based capital regulation on January 30, 2001, that,
if properly implemented, can establish a capital structure with the
potential to address the increased risks of new activities. The capital
regulation establishes classes of capital with varying degrees of
permanence, leverage requirements, and risk- based capital requirements to
be implemented. Each FHLBank is expected to hold capital commensurate with
its credit, interest rate, and operations risk. FHFB?s risk- based capital
regulation requires credit risk to be calculated using four broad categories
based on an evaluation of the credit risk associated with different types of
assets and positions. This evaluation is based in part on the loss history
of relevant assets with particular ratings and maturities. FHFB directed
each FHLBank to develop its own internal risk- based model to estimate
interest rate exposures and calculate risk- based capital requirements for
interest rate risk. These internal models are to be approved by FHFB in
connection with the approval of each FHLBank?s capital plan, which is to be
submitted to FHFB by October 29, 2001. The internal models must meet FHFB?s
technical restrictions and use interest rate scenarios approved by FHFB.
FHFB?s regulation includes a risk- based capital requirement to cover
operations risk.

FHFB?s minimum leverage requirement establishes two activity- based minimum
capital ratios; both ratios must be met. The simplest measure is total
capital equal to 4 percent of assets. The second measure is total capital
equal to 5 percent of assets when permanent capital is weighted by 1.5 and
other capital is weighted by 1. Only permanent capital is included in the
capital definition for the risk- based capital component of the minimum
capital standards.

FHFB?s capital regulation included capital requirements for the credit risk
of assets in two categories: advances and rated mortgage assets. 30
According to the published regulation, the credit risk capital requirement
for advances was based on the highest estimated (proportional) loss by
rating category and maturity class observed over a 2- year period of actual
corporate bond data from the interval 1970 to 1999. FHFB also used its
judgment to establish capital requirements. FHFB officials told us that the
numeric capital requirements are subject to refinement based on FHFB?s
ongoing research.

30 FHFB?s capital regulation also included capital requirements for the
credit risk of other rated assets and unrated assets. The Capital Structure

Being Established Has the Potential to Address the Increased Risks of New
Activities

Page 23 GAO- 01- 873 Federal Home Loan Bank System Capital

FHFB?s risk- based capital requirement for advances assumes little credit
risk exists. Although FHLBanks have never incurred credit losses on advances
backed by traditional mortgage collateral or securities, FHFB decided to
impose capital requirements on advances. The capital requirement on long-
term advances is higher than on short- term advances. FHFB used its
judgement to set a capital requirement on all advances that includes some
credit risk. This capital requirement is intended to reflect the potential
credit risks created by new types of collateral. FHFB oversight of
collateral policies and other aspects of FHLBank risk management of new
collateral will be important, because all advances are included in the same
category, and the new collateral entails greater credit risk than
traditional advances collateral.

Credit risk percentage requirements for residential mortgage assets are
based on FHFB?s analysis of residential MBS and their ratings. In developing
the capital requirements for mortgage assets, FHFB also took into account
the requirements set by other regulators. 31 In general, the riskbased
capital requirements for mortgage assets, such as mortgages on both single-
family and multifamily units or MBS, vary with the creditworthiness of the
assets.

FHFB?s capital regulation, with its rating- based approach, allows capital
requirements to vary based on the credit risk of the mortgage assets. In the
case of MPF and MPP, participating FHLBanks have required a credit rating of
double- A on each mortgage pool acquired. As stated earlier in this report,
the double- A rating is to be based on a thorough credit analysis of each
mortgage pool acquired. MPF and MPP assets are expected to become an
increasing part of the assets held by the FHLBanks.

FHFB directed each FHLBank to create its own internal risk- based model to
estimate interest rate risk exposures and calculate risk- based capital
requirements for interest rate risk. The exposure to interest rate risk in
each model is to depend on the level of stress from interest rate movements
taking into account any hedges that affect the actual exposure to interest
rate movements. These internal models must meet FHFB?s technical
requirements and use interest rate scenarios approved by FHFB.

31 Commercial banks have a 400 basis point requirement on residential
mortgages, and 160 basis point requirement on mortgage- backed securities
issued by GSEs. In addition, the leverage ratio for the enterprises on their
own MBS held by other investors is 45 basis points.

Page 24 GAO- 01- 873 Federal Home Loan Bank System Capital

FHFB?s regulation contains a stated preference that the internal models
created by the FHLBanks be based on a value at risk approach. Using this
approach, the loss is estimated based on several possible interest rate
patterns in the future. FHFB must approve the interest rate scenarios used
in the internal models and has placed some technical requirements on the
models themselves. Each FHLBank is required to have sufficient permanent
capital to meet the value at risk level established by FHFB, as well as
other capital requirements.

FHFB?s regulation requires that the FHLBanks maintain sufficient riskbased
capital to cover operations risk, although GLBA did not stipulate such a
requirement. FHFB?s capital requirement for operations risk is 30 percent of
the total capital required to cover interest rate and credit risk, but it
may be reduced to no lower than 10 percent if a FHLBank can demonstrate to
the satisfaction of FHFB that it has insurance or some other means to
justify the reduction.

Appendix IV contains further discussion of FHFB?s capital regulation. As
alternatives to holding mortgages on their own balance sheet, depository
institutions have a number of ways to obtain GSE funding for mortgage assets
and thereby transfer some or all of the related risks. How these assets are
funded and how the risks are transferred or shared has important
implications for regulatory capital treatment at both the depository
institution and at the GSE. For example, when mortgages along with all the
attendant risks are sold outright to a GSE, the only relevant capital
requirement would be at the GSE level. Alternatively, when a depository
institution purchases an MBS issued by a GSE, there is a capital charge
imposed at the depository level that is to reflect the credit risk of GSE
obligations as well as a capital charge at the GSE level. For those funding
arrangements in which credit risk is maintained, in whole or in part, at the
depository institution level, the capital treatment by the depository
institution regulators and the GSE regulators interact. 32 From an
integrated perspective it is important that risks and capital requirements
are in proper relation to one another. Otherwise certain arrangements can be
disadvantaged if capital charges are too high or

32 A primary purpose of regulatory capital for depository institutions is to
protect the deposit insurance funds. The primary purpose of regulatory
capital for the GSEs is to reduce the probability that a financial emergency
leading to government intervention to rescue a GSE would occur. Business
With GSEs

Affects Members? Capital Requirements and Risks

Page 25 GAO- 01- 873 Federal Home Loan Bank System Capital

advantaged if they are too low. As such, supervision is particularly
important.

Depository institutions that engage in secondary market transactions with
GSEs must hold capital based on (1) the amount of GSE obligations in their
portfolios, (2) their capital investment in the GSEs, and (3) the risks
retained when selling or transferring mortgage assets to a GSE. The
depository regulators we interviewed told us that they generally assign
relatively low credit risk weights to depository institution holdings of GSE
obligations, because they take into account the perception of implied
federal backing of GSE obligations. The regulators told us that depository
institution holdings of FHLBank debt, enterprise debt, and enterprise MBS
are in the 20 percent risk category. 33 Thus, rather than the general
requirement of $8 in capital for each $100 of assets in the 100 percent risk
category, such as unsecured loan assets, $1.60 of capital is required (that
is, 8 percent of $20). Therefore, depository institutions that sold
mortgages in the secondary market and purchased an equivalent amount of GSE
backed MBS would lower their credit risk and their capital requirements. In
fact, the combined capital requirement, including the capital requirement at
the GSE level, would be lower possibly reflecting the GSEs? ability to
reduce overall credit risk through geographic diversification. Currently,
depository institutions are required to hold $4 in capital for each $100 in
mortgage loan holdings and $1.60 of capital for each $100 in enterprise MBS
holdings, and the enterprises are required to hold capital equal to 0.45
percent of MBS issued and held by outside investors. Thus, the transfer can
result in $2.05 of total capital required rather than $4 of capital required
without the transfer of assets.

The depository institution regulators have also established capital
requirements for the risk associated with depository institution investments
in GSE equity. The regulators told us that currently FHLBank capital is in
the 20 percent risk category although they are actively reviewing this
capital treatment and considering the new capital structure being
established for the FHLBank System. In addition, they told us that
enterprise equity is generally in the 100 percent risk category; the one
exception is the Office of the Comptroller of the Currency, the regulator of
national banks, which places enterprise equity in the 20 percent risk

33 Depository institution regulators have risk- based capital regulations
that place assets into risk buckets based on associated credit risks. For
example, unsecured loans are in the 100 percent risk bucket, whole mortgage
loans are in the 50 percent risk bucket, and Treasury securities are in the
zero percent risk bucket.

Page 26 GAO- 01- 873 Federal Home Loan Bank System Capital

weight category. The regulators stated that their supervision activities
address concentrations of pledged assets and risks at individual depository
institutions that could result from heavy reliance on FHLBanks as a funding
source.

The depository institution regulators have provided guidance on the
riskbased capital treatment of only one MPF program, MPF 100. Under this
program, the member institution acts as agent for the FHLBank, underwriting,
servicing and providing a credit enhancement for residential mortgage pools.
The member receives fees for the credit enhancement that it provides. The
FHLBank provides a first- dollar loss protection cushion equal to 100 basis
points of the total mortgage pool?s unpaid balance. As the FHLBank incurs
credit losses allocable to this protection, the credit enhancement fees paid
by the FHLBank to the member are reduced. However, the credit enhancement
fees are not recorded on the balance sheet of the member institution until
received. The second- loss credit enhancement provided by the member
institution is sized so that the senior piece held by the FHLBank would have
the credit quality equivalent to a double- A rating.

The depository institution regulators determined that since expected receipt
of the guarantee fees by the member institution is not a balance sheet
asset, and since the member institution is under no obligation to pay
anything to the FHLBank, there is no risk of loss to the member?s capital.
The only consequence to the member institution in the case of credit losses
is the receipt of a lower level of credit enhancement fees. Because expected
credit losses would not affect the member?s balance sheet, the depository
institution regulators determined that the FHLBank is in the first- loss
position. They determined that the member institution?s capital requirement
would be based on the face value of the second- loss credit enhancement.

In contrast, the FHFB analysis of the credit enhancement structure of MPF
100 leads to a different result. 34 According to the FHFB analysis, because
the member institution?s credit enhancement fees are reduced if the FHLBank
incurs losses from the first- loss cushion due to mortgage defaults, the
member?s fees are contingent upon the performance of the

34 FHFB regulations require the member institution to bear the direct
economic consequences of actual credit losses in an amount at least equal to
the expected credit losses and positioned in the credit enhancement
structure no later than immediately after expected losses.

Page 27 GAO- 01- 873 Federal Home Loan Bank System Capital

mortgage pools. FHFB determined that because the member bears the economic
responsibility of the expected credit losses from the first dollar of loss,
the member is effectively in the first- loss position.

While the depository institution regulators have provided guidance on one
particular mortgage participation product, they have yet to opine on others.
It is also likely that new products could arise with various combinations of
credit risk sharing arrangements. The depository institution regulators have
issued proposed regulations that would change the risk- based capital
treatment of credit enhancements. The rules currently in effect provide for
differing capital treatment for credit enhancements that have the same
economic effect, depending on whether the credit enhancement is retained in
a sale of assets or acquired in some other way. The regulators have proposed
a more consistent treatment of economically equivalent credit enhancements.
The cost of regulatory capital associated with credit enhancements could
change based on the content of final regulations.

During the course of this assignment, enterprise officials we interviewed
raised questions about the adequacy of the capital structure of the FHLBank
System as it relates to the risks posed by the direct acquisition of
mortgages. In particular, it was suggested that if you view the FHLBank
System, including its membership, as if it were a holding company then the
System, in certain cases, could be viewed as engaging in ?double

leveraging.? According to this view, the member financial institutions use
their own capital to directly support their own activities but finance their
purchases of FHLBank stock with deposits, debt, or other instruments not
acceptable as regulatory capital. Figure 2 provides more information on
double leveraging. 35

35 The enterprises, at times during the course of this assignment, provided
a different approach to leverage that resulted in higher levels of
calculated capital leverage. We focused on their suggested holding company
approach. The Enterprises Questioned the

Adequacy of the FHLBank System?s Capital Structure to Support Direct
Mortgage Acquisitions

Page 28 GAO- 01- 873 Federal Home Loan Bank System Capital

Figure 2: Double leveraging

Enterprise officials told us that FHLBank capital is not adequate to support
the risks of direct mortgage acquisition, because debt issued to finance the
investment is a liability on the balance sheet of the FHLBank, the
investment is an asset on the balance sheet of the FHLBank, and the capital
of the FHLBank is downstreamed noncapital proceeds from member institutions.

This approach appears to be an analogy based on accounting flows resulting
from on- balance sheet investments by the FHLBanks. Based on our analysis,
there appear to be countervailing factors that lessen the applicability of
the analogy as a way of analyzing the ability of capital to address the
risks of FHLBank mortgage acquisitions. First, the approach focuses on
leverage directly, rather than on the relationship between capital and
risks. The present risk sharing arrangements, which include the requirement
that the member institution be in the first- loss position, limit credit
risk to the FHLBank. At the member institution level, depository institution
regulators rely on supervisory tools to limit exposure to potential risks
resulting from FHLBank mortgage acquisitions.

As a second countervailing factor, MPF and MPP are not the only secondary
mortgage market programs that reduce total capital requirements. When the
enterprises purchase mortgages from depository institutions, capital
requirements for the depository institutions are reduced without a
corresponding increase in enterprise capital requirements. As stated above,
depository institution regulators generally assign relatively low credit
risk weights to depository institution holdings of GSE obligations. One
reason why the capital requirements at the enterprise level are lower is
that the enterprises can reduce credit risk through geographic
diversification of their mortgage servicing portfolios.

Page 29 GAO- 01- 873 Federal Home Loan Bank System Capital

However, the relationship between the credit risk reduction from geographic
diversification and the reduction in total capital required has not been
established. As in the case of FHLBank mortgage acquisitions, depository
institution regulators rely on regulatory oversight.

As a third countervailing factor, even if capital should be consolidated
between FHLBanks and member institutions in some manner, the holding company
analogy lacks sufficiency as a method of analysis. Consolidation of balance
sheets has the most merit in the case of a parent holding company that
controls a subsidiary in which the parent funds the closely controlled
subsidiary with instruments not acceptable as regulatory capital and in turn
uses the subsidiary as an investment vehicle. In the case of the FHLBank
System, a parent holding company does not exist. The FHLBank System is a
cooperative in which member institutions provide System capital, but no one
member appears to hold a controlling interest in the corporate governance
decisions of any one FHLBank. In addition, joint and several liability
combined with all voluntary membership motivates the FHLBanks to monitor
each other?s financial activities.

While we have treated the concept of double leveraging as a distinct issue,
the more fundamental concern raised by the enterprises appears to be
associated with the nature of FHLBank capital. While we agree that the
capital is not perpetual equity capital, it will become more permanent.
However, we have not addressed the issue as to whether 5- year capital
combined with statutory and regulatory restrictions on withdrawal of capital
will result in the optimal level of permanence.

MPF and MPP, while structured differently than the secondary market products
offered by the enterprises, can generate increased competition in the
secondary mortgage market. In a 1996 report, we addressed the implications
of authorizing another GSE to compete with the enterprises. 36 In that
report, we assumed that the newly authorized GSE would have a similar
charter and be subject to the same regulatory requirements to compete with
the enterprises. Therefore, the GSE would also operate in a similar manner
to the enterprises. We indicated that such authorization could

36 Housing Enterprises: Potential Impacts of Severing Government Sponsorship

(GAO/ GGD- 96- 120, May 13, 1996). Increased Secondary

Market Competition Can Generate Risks

Page 30 GAO- 01- 873 Federal Home Loan Bank System Capital

 increase the overall amount of GSE activity in the mortgage market and, as
a result, raise the potential amount at risk in case of a government
bailout;

 increase the level of GSE risk, because entities operating in new markets
often have greater managerial and operations risk than those operating in
established markets;

 increase credit risk if the new entity attempted to establish market share
by lowering underwriting standards; and

 increase competition and thereby reduce mortgage interest rates to
borrowers.

Risks in the FHLBank System will increase from its direct mortgage
acquisition activity. The acquisition activity could also generate benefits
to borrowers and potential risks for the enterprises. The degree to which
increased competition could affect risk- taking by the FHLBanks and the
enterprises is among the unknowns in this competitive process. However, such
developments also create potential risks for taxpayers and therefore
challenges for both FHFB and OFHEO.

The introduction of the mortgage acquisition programs by the FHLBank System
has implications for competition between and the regulatory oversight of the
System and the enterprises. The mortgage acquisition programs of the FHLBank
System increase competition between the System and the enterprises. In past
reports we have recommended, and we still support, combining the GSE
regulators into one agency and authorizing the agency to oversee both the
safety and soundness and mission compliance of the FHLBanks, Fannie Mae, and
Freddie Mac. 37 We have pointed out the advantages of combining oversight
responsibilities in one agency. Such an agency could be more independent and
objective than the separate regulatory bodies and could be more prominent
than either one alone. Although the GSEs operate differently, the risks they
manage and their missions are similar. The regulators? expertise in
evaluating GSE risk management could be shared more easily within one
agency. In addition, a single regulator would be better positioned to be
cognizant of specific mission requirements, such as special housing goals
and new programs or initiatives any of the GSEs might undertake, and should
be better able to assess the competitive effect on all three housing GSEs
and better ensure consistency of regulation for GSEs that operate in similar
markets. Having all staff in one regulatory agency should also

37 See Government- Sponsored Enterprises: Advantages and Disadvantages of
Creating a Single Housing GSE Regulator (GAO/ GGD- 97- 139) July 9, 1997.

Page 31 GAO- 01- 873 Federal Home Loan Bank System Capital

facilitate coordination and sharing of expertise among staff responsible for
safety and soundness and mission compliance. Given the introduction of
mortgage acquisition programs by the FHLBanks, the ability of a single
regulator to assess competitive effects among the three housing GSEs and to
better ensure consistency of regulation for the housing GSEs becomes
relatively more important.

FHFB and OFHEO risk- based capital regulations are meant to ensure that the
FHLBanks and enterprises maintain sufficient capital to weather stressful
economic conditions and address credit, interest rate, and operations risks.
However, we are unable to assess the relative stringency of each regulator?s
approach to risk- based capital, for two reasons. First, the final
specifications of the risk models for both OFHEO and FHFB are not yet
available. Second, even if the final specifications were available,
differences in the assets and liabilities held by the FHLBanks and the
enterprises create different risk patterns. These differences, in turn, led
to different modeling approaches, making comparisons difficult. Although we
cannot provide an overall assessment of the stringency of each regulator?s
approach, we can compare certain attributes of the modeling approaches and
their strategies and procedures for estimating credit, interest rate, and
operations risk. We also provide a comparison of the effects of the leverage
requirement on the FHLBanks and the enterprises.

GLBA gave FHFB discretion to establish credit and interest rate scenarios to
be covered by permanent capital. 38 In implementing GLBA, FHFB decided to
require FHLBanks to hold capital for operations risk. The amount of
permanent capital required under the risk- based capital regulation is the
sum of capital for credit risk, interest rate risk, and operations risk.
Figure 3 is a simplified illustration of FHFB?s approach to risk modeling
and calculating capital.

38 For consistency throughout this report, interest rate risk is the term
used to designate the effects of movements in market prices on the financial
condition of a firm. GLBA used the term market risk. Interest rate risk is
the dominant determinant of market risk for FHLBanks. FHFB and OFHEO

Approach Risk- Based Capital Regulations Differently

FHFB?s Risk- Based Capital Regulation

Page 32 GAO- 01- 873 Federal Home Loan Bank System Capital

Figure 3: Simplified Illustration of FHFB?s Approach to Risk Modeling and
Capital Calculation

Source: GAO analysis of FHFB information.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(the 1992 act) established OFHEO as an independent regulator within the
Department of Housing and Urban Development (HUD). OFHEO?s mission is to
ensure the enterprises? safety and soundness. The 1992 act also authorized
OFHEO to develop a risk- based capital regulation that addresses credit,
interest rate and operations risks. OFHEO began developing its regulation
upon its creation in 1993. OFHEO has developed its own cash flow model to
estimate risks and calculate the total capital needed to cover credit and
interest rate risk. 39 The 1992 act specified the stresses that the model
must address. The risk- based capital regulation also requires capital for
operations risk. For risk- based capital, total capital is the sum of a
general allowance for foreclosure losses, common stock, perpetual
noncumulative preferred stock, 40 paid- in capital, and retained earnings.

39 This discussion of OFHEO?s risk- based capital regulation is based on the
Second Notice of Proposed Rulemaking, published in the Federal Register on
April 13, 1999. Details may differ in the final rule.

40 Perpetual noncumulative preferred stock is stock that has a priority
claim to dividends over common equity stock. However, if a dividend is
missed on perpetual noncumulative stock, holders of that stock do not
receive payment for this missed dividend in future time periods, while
holders of perpetual cumulative preferred stock would receive payment for
missed dividends in the future. OFHEO?s Risk- Based

Capital Regulation

Page 33 GAO- 01- 873 Federal Home Loan Bank System Capital

OFHEO did its own modeling of the risks for both enterprises so that the
enterprises would face identical analytical measures of their risks based on
their own assets, liabilities, and off- balance sheet positions. However,
the model this approach uses does not reflect any business strategies that
are unique to either enterprise.

Figure 4 is a simplified illustration of OFHEO?s approach to risk modeling
and risk- based capital calculation. OFHEO runs a single model in which the
capital calculations for credit risk and interest rate risk are based on the
model?s estimates of how much capital each enterprise needs. This approach
ensures that both credit risk, which is based on benchmark 41 losses, and
interest rate risk are integrated in a cash flow model. Appendix IV provides
a more detailed description of FHFB?s and OFHEO?s riskbased capital
requirements.

Figure 4: Simplified Illustration of OFHEO?s Stress Test and Capital
Calculation

Source: GAO analysis of OFHEO information.

41 The benchmark losses are based on criteria established by the 1992 act.

Page 34 GAO- 01- 873 Federal Home Loan Bank System Capital

Generally, FHFB has not directly modeled risks in its risk- based capital
regulation. For credit risk, FHFB has depended on data on historic losses,
the loss history of relevant assets with particular ratings and maturities,
and its own judgments to determine appropriate levels of risk- based
capital. For interest rate risk, FHFB decided to establish a framework that
each FHLBank must adhere to when it models its own interest rate risk. This
approach made it possible for FHFB to publish its regulation within 15
months of GLBA. However, we have not been able to evaluate the interest rate
risk models that are yet to be developed by each FHLBank and subsequently
approved by FHFB.

In contrast, OFHEO used a complex modeling approach to determine risks and
calculate required capital. This approach permitted OFHEO to finetune
feedbacks between interest rate risk and credit risk and explicitly model
the factors that created losses associated with particular assets. However,
this approach was difficult to implement and created delays in the actual
implementation of risk- based capital regulations for the enterprises.

Under the 1992 act, Congress set criteria for OFHEO to use in establishing
the stress test for credit, interest rate, and operations risk in risk-
based capital regulation. In contrast, GLBA required FHFB to create risk-
based capital requirements for the FHLBanks taking due consideration of any
risk- based capital test established by OFHEO pursuant to the 1992 act. GLBA
allowed FHFB to choose the economic scenarios used in modeling credit and
interest rate risks. On its own initiative, FHFB added operations risk to
its version of risk- based capital regulation.

FHFB developed capital calculations based on balance sheet data, the market
value of the portfolio for interest rate risk, and expected losses for
credit risk. OFHEO developed capital calculations that begin with initial
balance sheet positions but then use a 10- year cash flow stress test based
on specified interest rate scenarios and credit stresses over the 10- year
period. In the 1992 act, OFHEO was directed to run its model assuming that
no new business would occur during the 10- year stress period except for
already committed business of the enterprises. Therefore, enterprise assets,
liabilities, and off- balance sheet positions decline over time in OFHEO?s
model. FHFB?s balance sheet approach estimates the market value of the
FHLBank?s portfolio at risk under the financial stress scenarios and thus
does not require an assumption about new business. FHFB?s test is to be
applied monthly while OFHEO?s test is to be applied quarterly. FHFB?s and
OFHEO?s

Modeling Approaches Differ

Page 35 GAO- 01- 873 Federal Home Loan Bank System Capital

FHFB and OFHEO have different strategies for calculating the capital needed
to cover risks. FHFB requires that the FHLBanks calculate the capital needed
to cover credit risk and interest rate risk separately. OFHEO jointly
calculates capital needed for credit risk and interest rate risk. FHFB
stated that in periods of stress, a positive correlation exists between
interest rate risk and credit risk. 42 Given this positive correlation, they
stated that a separate calculation of interest rate risk and credit risk is
a conservative approach to calculating required capital. In contrast, OFHEO
officials stated that their single calculation of the capital needed to
cover credit and interest rate risk permits the model to deal with realworld
feedbacks between interest rate movements and credit losses. FHFB and OFHEO
also calculate capital required for operations risk based on the amount of
capital required for credit and interest rate risk, although FHFB may reduce
the amount required if a FHLBank demonstrates that it qualifies for a lower
requirement.

FHFB?s and OFHEO?s actual procedures for estimating credit stresses and
calculating the capital required to cover credit risk differ. FHFB uses
asset and position credit risk categories and assigns credit risk capital
requirements for assets and positions in each category. In making these
determinations, FHFB uses its own judgment and available information on
factors such as default losses, credit ratings, and capital regulations for
other regulated firms. For mortgage assets acquired from members with credit
risk- sharing arrangements, FHFB depends on the results of a model from a
credit rating agency to estimate and limit credit risk. In contrast, OFHEO
uses a more granulated approach based on detailed econometric modeling. This
approach allows the agency to address the effects of numerous variables on
credit losses directly in its own model.

FHFB?s and OFHEO?s approaches to calculating the capital required to cover
interest rate risk differ. FHFB uses a value at risk model that estimates
changes in the value of capital based on hundreds of historical interest
rate scenarios that represent possible stresses on the FHLBanks. The
scenarios are to be applied to each FHLBank?s balance sheet and should
represent periods of significant economic stress. The interest rate
scenarios are based on actual interest rate changes during periods that last

42 As evidence of this correlation, FHFB cited work by Mark Carey in
Prudential Supervision: What Works and What Doesn?t, ed., Frederic S.
Mishkin, National Bureau of Economic Research, 2001. FHFB?s and OFHEO?s

Strategies and Procedures for Calculating Capital Requirements Differ

FHFB and OFHEO Take Different Approaches to Calculating Capital Requirements
for Credit Risk

FHFB and OFHEO Have Different Procedures to Calculating Capital Requirements
for Interest Rate Risk

Page 36 GAO- 01- 873 Federal Home Loan Bank System Capital

120 business days and cover historical interest rate movements since 1978.
The test requires the FHLBank to hold capital sufficient to cover all but
the worst 1 percent of potential losses. In contrast, OFHEO uses a 10- year
cash flow model and two interest rate scenarios- one for a rising rate and
the other for a falling rate. In each OFHEO interest rate scenario, the
interest rate adjusts during the first year and then remains at the new
level for the remainder of the 10- year period. According to OFHEO
officials, both interest rate changes are greater than what has been
observed historically over any 1- year period. The amount of capital
required to cover interest rate risk is the amount of capital needed to
cover the worst of the two mandated interest rate scenarios.

Although GLBA did not require FHFB to establish a risk- based capital
requirement to cover operations risk, FHFB decided such a requirement was
needed. FHFB?s capital requirement for operations risk is 30 percent of the
total capital required to cover interest rate and credit risk but may be
reduced to no lower than 10 percent if a FHLBank can demonstrate to the
satisfaction of FHFB that it has insurance or some other means to justify
the reduction. In contrast, the 1992 act that directed OFHEO to establish
risk- based capital requirements for operations risk specified that capital
for operations risk be equal to 30 percent of the total capital required for
credit and interest rate risks.

Minimum leverage requirements establish minimum capital levels a firm must
hold irrespective of the level of risk it assumes. The leverage ratios
required by statute differ for the FHLBanks and enterprises. The minimum
leverage ratio for FHLBanks is measured in two ways; both ratios must be
met. The simplest measure sets total capital at 4 percent of assets. The
second measure sets total capital at 5 percent of assets, with permanent
capital weighted by 1.5 and other capital weighted by 1. For the
enterprises, the minimum leverage requirement is based on both the onbalance
sheet and off- balance sheet positions. Off- balance sheet positions are
generally guaranteed mortgage- backed securities held by investors but
managed by the enterprises. Thus, the OFHEO rule includes more than just the
assets held by the enterprises. The required leverage ratio for onbalance
sheet assets is 250 basis points (2.5 percent), while the ratio for off-
balance sheet positions is generally 45 basis points (. 45 percent).

FHFB and OFHEO also define capital for the leverage ratios differently.
OFHEO uses core capital in the minimum leverage requirement. Core capital is
the sum of outstanding common stock, outstanding perpetual noncumulative
preferred stock, paid- in capital, and retained earnings. FHFB and OFHEO
Have

Different Procedures to Calculate Capital Requirements for Operations Risk

FHFB and OFHEO Minimum Leverage Requirements May Affect the Regulated
Entities Differently

Page 37 GAO- 01- 873 Federal Home Loan Bank System Capital

FHFB?s total capital for the leverage ratio includes shorter- term Class A
stock, longer- term Class B stock, and retained earnings. FHFB?s alternative
5- percent leverage ratio reflects the longer- term nature of Class B stock
and retained earnings by valuing Class B stock and retained earnings at 150
percent of par value when calculating capital for the 5- percent leverage
ratio. To the extent that FHLBanks develop a capital structure based on
Class B stock, they will be using more permanent capital. In contrast,
enterprise capital is never redeemable.

FHFB officials said they anticipate that when the capital plans are
implemented, the risk- based capital requirement for all FHLBanks will be
below the minimum leverage requirements under GLBA. This will be the case,
in part, because FHLBanks are expected to establish an exclusive Class B or
a mixed Class A and B capital structure. FHFB officials told us that based
on seven draft capital plans submitted to FHFB, six of the FHLBanks
indicated that they expect to establish an exclusively Class B structure
initially because of the adverse tax consequences associated with a multiple
class structure. However, three of these FHLBanks indicated that they
anticipate issuing Class A stock in the future. Over time, issuing Class A
stock and increasing mortgage acquisitions could cause a FHLBank?s risk-
based capital requirement to exceed its leverage requirement. However,
FHFB?s risk- based capital requirement is unlikely to constrain operations
initially, given the current business of the FHLBanks.

OFHEO?s risk- based capital requirement may limit the enterprises more than
the leverage requirement. In the Second Notice of Proposed Rulemaking, OFHEO
estimated that Fannie Mae would not have had sufficient capital to meet its
the risk- based capital requirement on either September 30, 1996, or June
30, 1997, although Freddie Mac would have been in compliance with its risk-
based capital requirement. However, both Fannie Mae and Freddie Mac had
sufficient capital to meet the leverage requirement.

In FHFB?s risk- based capital regulation, the capital structure plan of each
FHLBank is to specify the date on which the plan shall take effect and may
provide for a transition period of up to 3 years to allow the FHLBank to
come into compliance. During the transition period the FHLBanks are expected
to remain in compliance with the preexisting leverage based requirement.
FHFB officials told us that the implementation of the riskbased capital
requirements depends on the submission of capital plans, including internal
models for interest rate risk, from all FHLBanks by FHFB?s Leverage
Requirement

Will Initially Affect FHLBank Capital Levels More Than the Risk- Based
Capital Requirement

OFHEO?s Risk- Based Capital Requirement May Limit the Enterprises More Than
Its Leverage Requirement

FHFB?s and OFHEO?s RiskBased Capital Regulations Are Subject to Transition
Rules With Differing Effective Dates

Page 38 GAO- 01- 873 Federal Home Loan Bank System Capital

October 29, 2001. In addition, FHFB must approve the plans, including any
transition plans needed to ensure that the FHLBanks attain compliance with
risk- based capital requirements.

For the enterprises, the risk- based requirement becomes effective when the
final rule is published in the Federal Register and can be enforced 1 year
after it is published. The rule for the capital requirement was cleared by
the Office of Management and Budget on July 16, 2001.

The FHLBank System is currently establishing a new capital structure that,
if properly implemented, is likely to be an improvement over the historic
structure. Capital will become more permanent and new risk- based and
leverage capital requirements will also be implemented. The new capital
structure has the potential to address the risks associated with advances as
well as the direct acquisition of mortgages. However, it is too early to
assess the overall adequacy of the structure, because the capital plans and
risk management practices to be implemented by the FHLBanks and capital
supervision practices to be followed by FHFB are not yet known.

Based on activity to date, direct acquisition appears to provide regional
diversification of mortgage acquisitions and incentives to member
institutions for sound mortgage underwriting and servicing through the
sharing of credit risks. However, risks could be affected if changes are
made in the level of mortgage acquisition activity and in the risk- sharing
agreements that are currently present between the FHLBanks and their member
institutions. Such changes might also increase the importance of risk- based
capital requirements compared to FHFB leverage requirements.

Going forward, risks in the FHLBank System will increase due to expanded
collateral provisions in GLBA and direct mortgage acquisition activity.
Effective mitigation of that risk will depend on risk management by the
FHLBanks, the adequacy of the capital structure, and oversight by FHFB. In
addition to the FHLBanks, the acquisition activity could also generate
additional risks for the enterprises. Although currently the FHLBank System
and the enterprises primarily engage in different business activities, these
differences may decrease if direct mortgage acquisition activity grows
dramatically. Having one housing GSE regulator for safety and soundness and
mission compliance would provide greater independence and objectivity,
greater prominence, improved ability to Conclusions

Page 39 GAO- 01- 873 Federal Home Loan Bank System Capital

assess the competitive impact of new initiatives on all housing GSEs, and
improved ability to ensure consistency of regulation of GSEs that operate in
similar markets. 43

This report does not contain any new recommendations. The Chairman of FHFB
provided written comments on a draft of this report, and these comments are
reprinted in appendix V. FHFB and OFHEO provided technical comments on a
draft of this report. The FHLBanks, enterprises, and depository institution
regulators also provided technical comments on draft excerpts of this report
that we shared with them. We incorporated technical comments into this
report where appropriate.

The Chairman of FHFB stated that we did a commendable job of analyzing
important and complex FHLBank System issues. His letter drew attention to
some of our findings related to the potential of the new capital structure
for the FHLBanks to address risks and the MPP and MPF programs. His letter
also stated that our past recommendations, with regard to regulatory
oversight, have been well received with many having been implemented.

FHLBank of Chicago officials wanted us to characterize the MPF first- loss
account as an account established by the FHLBank, rather than as a lender
provided credit enhancement. Our characterization is based on the FHFB
requirement that the member institution bear the economic cost of expected
credit losses. For example, the MPF arrangement in which the FHLBank is
reimbursed by the member institution when defaults occur through the
reduction of fees paid to the member is a mechanism in which the lender?s
credit enhancement is used to improve the rating of the mortgage pool
acquired by the FHLBank.

A Freddie Mac official provided comments addressing Freddie Mac?s concern
about ?double leveraging.? 44 He stated that in addition to the risks posed
by the direct acquisition of mortgages, Freddie Mac also has a

43 See Government- Sponsored Enterprises: Advantages and Disadvantages of
Creating a Single Housing GSE Regulator (GAO/ GGD- 97- 139, July 9, 1997).
44 The draft report excerpt we shared with the enterprises was limited to
our characterization of their views related to double leveraging. Fannie Mae
officials thought that our characterization of their view was accurate.
Recommendations

Agency Comments

Page 40 GAO- 01- 873 Federal Home Loan Bank System Capital

broader concern that relates to the overall fragility of the FHLBank System.
He stated that the risk of member institutions withdrawing their capital in
response to FHLBank losses is a direct result of the nonpermanent nature of
the FHLBank System capital stock even after the GLBA reforms. He
specifically referred to the potential for a run on the FHLBank System if
member institutions had advanced knowledge of potential future financial
losses.

We have addressed the question of capital adequacy directly by analyzing the
relationship between capital and risks. We have treated the concept of
double leveraging as a separate issue. In our discussion of the double
leveraging concept, we made revisions to reflect the concern about the
nature of FHLBank capital.

We will send copies of this report to the Chairman of the Board of FHFB,
Director of OFHEO, Presidents of the FHLBanks, Chief Executive Officer of
Fannie Mae, and Chief Executive Officer of Freddie Mac. We will also make
copies available to others upon request.

Please contact me or William B. Shear at (202) 512- 8678 if you or your
staff have any questions concerning this report. Key contributors to this
report were Rachel DeMarcus, Kristi A. Peterson, and Mitchell B. Rachlis.

Thomas J. McCool Managing Director Financial Markets and Community
Investment

Page 41 GAO- 01- 873 Federal Home Loan Bank System Capital

List of Congressional Committees

The Honorable Paul S. Sarbanes Chairman The Honorable Phil Gramm Ranking
Minority Member Committee on Banking, Housing,

and Urban Affairs United States Senate

The Honorable Michael G. Oxley Chairman The Honorable John J. LaFalce
Ranking Minority Member Committee on Financial Services House of
Representatives

The Honorable Richard Baker Chairman The Honorable Paul Kanjorski Ranking
Minority Member Subcommittee on Capital Markets, Insurance,

and Government Sponsored Enterprises Committee on Financial Services House
of Representatives

Appendix I: Scope and Methodology Page 42 GAO- 01- 873 Federal Home Loan
Bank System Capital

To describe the capital structure of the Federal Home Loan Bank (FHLBank)
System, we reviewed Federal Housing Finance Board (FHFB) capital standards
and regulations; conducted research on the role of capital in government-
sponsored enterprises (GSE) with a cooperative system; reviewed our prior
work addressing risk- based capital and the FHLBank System; and interviewed
financial institution regulatory body and GSE officials. To analyze the
adequacy of the capital structure of the FHLBanks, we also reviewed relevant
literature on interest rate, credit, and operations? risks; analyzed FHLBank
proposals for the use of expanded collateral provisions and permissible uses
of advances under the Gramm- Leach- Bliley Act (GLBA) of 1999; and analyzed
FHLBank applications to FHFB and other information on FHLBank direct
mortgage acquisition programs.

During the course of this assignment, officials from Fannie Mae and Freddie
Mac made presentations to us and provided extensive information reflecting
their perspectives on the adequacy of the capital structure of the FHLBank
System. On May 17, 2001, Freddie Mac provided us a consultant?s report
addressing the adequacy of the capital structure of the FHLBank System. We
considered the information provided by the enterprises in conducting our
work.

We analyzed information the FHLBanks considered to be proprietary.
Therefore, we did not report specific details of the various FHLBank
products. For example, due to this limitation, we did not report data on the
Mortgage Partnership Program and provided general information on Mortgage
Partnership Finance. To compare and contrast the risk- based capital
standards proposed by FHFB to the standard proposed by OFHEO, we analyzed
the standards; reviewed information provided by and interviewed officials
from the enterprises, the FHLBanks, FHFB, and OFHEO; and reviewed comments
on the proposed standards. The FHLBanks are yet to complete their capital
plans implementing their new capital structures, which limited the scope of
our analysis. In addition, although we made observations of some elements of
risk management that appear to be present at the FHLBanks, we did not
analyze risk management procedures employed by the FHLBanks, FHFB?s
oversight of risk management, nor the risks associated with FHLBank
investments. Furthermore, we did not verify the accuracy of data provided by
FHFB and the FHLBanks. We also did not analyze the risks of activities that
have been or might be undertaken by either Fannie Mae or Freddie Mac. We
conducted our work in Washington, D. C., between February 2001 and June
2001, in accordance with generally accepted government auditing standards.
Written comments on a draft of this report from FHFB appear Appendix I:
Scope and Methodology

Appendix I: Scope and Methodology Page 43 GAO- 01- 873 Federal Home Loan
Bank System Capital

in appendix V. We also obtained technical comments from the FHLBanks,
enterprises, depository institution regulators, FHFB, and OFHEO that have
been incorporated where appropriate.

Appendix II: Background Information on the FHLBank System, Fannie Mae,
Freddie Mac, and Their Regulators

Page 44 GAO- 01- 873 Federal Home Loan Bank System Capital

The FHLBank System is a GSE consisting of 12 federally chartered FHLBanks
and the System?s Office of Finance that are privately and cooperatively
owned by member institutions. The FHLBanks are located in Boston, MA; New
York, NY; Pittsburgh, PA; Atlanta, GA; Cincinnati, OH; Indianapolis IN;
Chicago, IL; Des Moines, IA; Dallas, TX; Topeka, KS; San Francisco, CA; and
Seattle, WA; with each FHLBank serving a defined geographic region of the
country. The FHLBanks raise funds by issuing consolidated debt securities in
the capital markets. The System was set up in 1932 to extend mortgage credit
by making loans, called advances, to its member institutions, which in turn
lend to home buyers for mortgages. Home mortgage loans and other collateral
secure advances. These advances help member institutions, originally limited
to thrifts and insurance companies, by enhancing liquidity and providing
access to national capital markets. In 1989, as part of the Financial
Institutions Reform, Recovery, and Enforcement Act (FIRREA), Congress opened
membership to nonthrift federally insured depository institutions that offer
residential mortgage loans. Thrifts with federal charters remained in the
System as mandatory members while nonthrift institutions were voluntary
members. GLBA created all voluntary membership and expanded the purposes of
System advances with corresponding expansion in eligible collateral for
community financial institutions. As of December 31, 2000, the FHLBanks held
about $438 billion in advances to members; $186 billion in investments, $16
billion in directly acquired mortgage assets; and $31 billion in capital, of
which $728 million was in the form of retained earnings. In addition, the
System had 7, 777 members, which included 5,681 commercial banks, 1,547
thrifts, and 549 credit unions and insurance companies. Additional financial
information on the FHLBanks is presented in appendix III.

Congress chartered Fannie Mae and Freddie Mac as governmentsponsored,
privately owned and operated corporations to enhance the availability of
mortgage credit across the nation during both good and bad economic times.
Fannie Mae?s headquarters is located in Washington, D. C. and Freddie Mac?s
is in McLean, Virginia. The enterprises are to accomplish this mission by
purchasing mortgages from lenders (banks, thrifts, and mortgage bankers) who
can then use the proceeds to make additional mortgage loans to home buyers.
The enterprises issue debt to finance mortgage assets that they retain in
their portfolios. A majority of purchased mortgages, however, are pooled to
create mortgage- backed securities (MBS) that are sold to investors. The
enterprises collect fees for guaranteeing the timely payment of principal
and interest on MBS held by investors. At year- end 2000, the enterprises
had combined debt obligations of about $1.1 trillion and combined MBS
obligations to investors of about Appendix II: Background Information on the

FHLBank System, Fannie Mae, Freddie Mac, and Their Regulators

Appendix II: Background Information on the FHLBank System, Fannie Mae,
Freddie Mac, and Their Regulators

Page 45 GAO- 01- 873 Federal Home Loan Bank System Capital

$1.3 trillion (a total of about $2.4 trillion). Additional financial
information on the enterprises is presented in appendix III.

FIRREA created FHFB as an independent agency within the executive branch,
with a five- member board of directors. FHFB is organized into 6 offices and
had about 95 permanent employees as of December 31, 2000. FHFB?s annual
budget is about $24 million, which is financed with assessments on the
FHLBanks. The functions of three offices are most relevant to capital
supervision of the FHLBanks. The primary responsibility of the Office of
Supervision is to ensure the safety and soundness and mission- compliance of
the FHLBanks; it conducts the federally mandated annual examinations of all
FHLBanks. The Office of Policy and Office of General Counsel provide
assistance to and share oversight responsibility with the Office of
Supervision. These three offices have about 54 employees, of which 14 are in
the Office of Supervision.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(the 1992 act) established OFHEO as an independent regulator within the
Department of Housing and Urban Development (HUD) whose mission is to help
ensure the enterprises? safety and soundness. Under the 1992 act, OFHEO?s
director has independent authority pertaining to matters of safety and
soundness. OFHEO?s primary means for fulfilling its mission are establishing
capital standards for the enterprises and conducting onsite examinations to
assess their management practices and financial condition. OFHEO has about
87 full- time equivalent employees and an annual budget of about $20
million. OFHEO?s expenses are funded with assessments on the enterprises.
However, unlike FHFB, OFHEO is subject to the annual appropriations process.

Appendix III: Financial Information on the FHLBank System, Fannie Mae, and
Freddie Mac

Page 46 GAO- 01- 873 Federal Home Loan Bank System Capital

This appendix provides basic financial information on the FHLBank System,
Fannie Mae, and Freddie Mac. Table 2 is a consolidated summary balance sheet
of the FHLBank System. Table 3 presents information on the advances 45 and
total assets of each FHLBank as of December 31, 2000. Tables 4 and 5 provide
selected financial highlights for Fannie Mae and Freddie Mac.

As indicated in table 2, the FHLBank System has grown substantially over the
past 5 years. The total assets in the FHLBank System increased 124 percent
between December 31, 1996 and December 31, 2000; and advances increased 171
percent over the same time period. At the end of 2000, the assets in the
FHLBank System totaled nearly $654 billion. In comparison, the assets of
Fannie Mae and Freddie Mac totaled $675 billion and $459 billion,
respectively. (See tables 4 and 5.)

Table 2: FHLBanks? Consolidated Summary Balance Sheet as of Dec. 31, 1996-
2000 2000 1999 1998 1997 1996

Dollar amounts in millions

Assets

Advances $437,861 $395,747 $288,189 $202,265 $161,372 Mortgage Loans, net
16,149 2, 026 966 37 -

Investments 186,437 171,425 137,193 140,106 125,231 Other assets 13,240
14,014 7, 654 6,167 5,432

Total Assets $653,687 $583,212 $434,002 $348,575 $292,035 Liabilities

Consolidated obligations $591,606 $525,419 $376,715 $304,493 $251,316
Deposits and borrowings 17,100 17,624 25,805 18,445 18,257 Other liabilities
13,716 11,154 8, 730 6,463 5,586

Total Liabilities $622,422 $554,197 $411,250 $329,401 $275,159 Capital

Capital stock outstanding $30,537 $28,361 $22,287 $18,833 $16,540 Retained
earnings 728 654 465 341 336

Total Capital $31,265 $29,015 $22,752 $19,174 $16,876

Source: Federal Home Loan Banks 2000 Financial Report.

45 FHLBank advances are essentially collateralized loans to member
institutions- which include savings banks, commercial banks, savings and
loans, credit unions, and insurance companies. Appendix III: Financial
Information on the

FHLBank System, Fannie Mae, and Freddie Mac

Appendix III: Financial Information on the FHLBank System, Fannie Mae, and
Freddie Mac

Page 47 GAO- 01- 873 Federal Home Loan Bank System Capital

Table 3 presents the level of advances and total assets at each FHLBank at
the end of 2000. The FHLBanks vary significantly in size. Total assets
ranged from about $27 billion at the FHLBank of Topeka to $140 billion at
the FHLBank of San Francisco. The amount of advances outstanding ranged from
about $18 billion to $110 billion at the same FHLBanks. The percentage of
total assets made up of advances also varied among the FHLBanks. At the
FHLBank of Chicago, advances made up only 52 percent of total assets, while
at the FHLBank of San Francisco, advances made up 78 percent of assets.
Other assets at FHLBanks may include cash or investments such as U. S.
government- agency securities or high- quality, short- term investments like
federal funds sold, certificates of deposit, and commercial paper.

Table 3: FHLBank Advances and Total Assets as of Dec. 31, 2000 FHLBank
Advances

outstanding Total assets Advances as a

percentage of total assets

Dollars in millions Boston $21,594 $38,282 56% New York 52,396 76,600 68%
Pittsburgh 25,946 45,063 58% Atlanta 58,249 80,641 72% Cincinnati 31,935
55,615 57% Indianapolis 24,073 33,391 72% Chicago 18,462 35,389 52% Des
Moines 21,158 35,531 60% Dallas 30,195 43,843 69% Topeka 17,582 26,787 66%
San Francisco 110,031 140,190 78% Seattle 26,240 45,392 58%

Source: Federal Home Loan Banks 2000 Financial Report and GAO analysis of
data.

As shown in Tables 4 and 5, Fannie Mae and Freddie Mac have also grown
substantially over the past 5 years. Fannie Mae?s total assets increased 92
percent between December 31, 1996 and December 31, 2000; while Freddie Mac?s
assets increased 164 percent over the same time period. Their offbalance
sheet obligations also increased. 46 For example, Fannie Mae?s

46 Off- balance sheet obligations may include guaranteed mortgage- backed
securities (MBS), commitments to purchase mortgages or to issue and
guarantee MBS, credit enhancements, and certain hedge instruments.

Appendix III: Financial Information on the FHLBank System, Fannie Mae, and
Freddie Mac

Page 48 GAO- 01- 873 Federal Home Loan Bank System Capital

outstanding net MBSs increased 29 percent from $548 billion in 1996 to $706
billion at the end of 2000. Freddie Mac?s participation certificates (PC)
increased 22 percent from $473 billion to $576 billion.

Table 4: Fannie Mae Selected Financial Highlights as of Dec. 31, 1996- 2000
2000 1999 1998 1997 1996

Dollar amounts in millions Retained mortgage portfolio, net $607,399
$522,780 $415,223 $316,316 $286,259 Total assets 675,072 575,167 485,014
391,673 351,041 Debt securities, net 642,682 547,619 460,291 369,774 331,270
Total liabilities 654,234 557,538 469,561 377,880 338,268 Stockholders
equity 20,838 17,629 15,453 13,793 12,773 Total MBS, net 706,100 678,600
636,600 578,700 548,173

Source: Fannie Mae Annual Reports and OFHEO?s 2000 Report to Congress.

Table 5: Freddie Mac Selected Financial Highlights as of Dec. 31, 1996- 2000
2000 1999 1998 1997 1996

Dollar amounts in millions Retained mortgage portfolio, net $385,693
$324,443 $255,009 $164,421 $137,755 Total assets 459,297 386,684 321,421
194,597 173,866 Debt securities, net 426,754 360,581 287,234 172,321 156,491
Total liabilities 443,865 374,602 309,978 186,154 166,271 Stockholders?
equity 14,837 11,525 10,835 7, 521 6,731 Total PCs, net 576,101 537,883
478,351 475,985 473,065

Source: Freddie Mac Annual Reports and OFHEO?s 2000 Report to Congress..

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 49 GAO- 01- 873 Federal Home Loan Bank System Capital

This appendix summarizes FHFB?s and OFHEO?s risk- based capital requirements
for the FHLBanks and the enterprises, respectively.

FHFB?s risk- based capital requirements are meant to ensure that the
FHLBanks maintain sufficient capital to weather stressful economic
conditions. The requirements address credit, interest rate, and operations
risks.

FHFB?s capital requirements separate FHLBank assets and positions into four
credit risk categories and establish capital levels within these categories.
The four categories are (1) advances, (2) rated mortgage assets, (3) rated
assets and positions other than advances or mortgages, and (4) unrated
assets. For the first three categories, maturity and/ or a credit rating
from a nationally recognized credit rating agency are the factors
determining the capital charge for an asset or position. Longer terms to
maturity and lower credit ratings increase the capital requirement because
they tend to increase credit risk. All unrated items have an 8- percent
capital requirement, except for cash, which has a zero capital requirement.
The capital requirements extend to off- balance sheet items; also credit
enhancements such as guarantees can reduce the credit requirements, if the
providers have credit ratings superior to that of the FHLBank asset or
position.

Although FHLBanks have never incurred credit losses on advances backed by
traditional mortgage collateral or securities, FHFB decided to impose
capital requirements on all advances, including short- term advances. FHFB?s
requirement assumes that advances will exhibit the same losses as the
highest investment grade (triple- A) corporate bonds and that advances would
have a recovery rate of 90 percent. FHFB stated this recovery rate is
consistent with overcollateralization and other protections afforded
advances. Additionally, longer term advances have higher capital
requirements, because risks tend to increase with terms to maturity.

Even though traditional advances have little credit risk, FHFB recognized
that new expanded collateral available to support advances may have greater
credit risk. As a result, it set a capital requirement for advances that
includes some credit risk. The expanded collateral includes real estate
related collateral, such as commercial mortgages and home equity lines of
credit, as well as nonmortgage agricultural loans and small business loans.
Because of the unknown risk created by new types of collateral, FHFB used
its judgment to set the capital requirement on all advances. For Appendix
IV: Summary of FHFB?s and

OFHEO?s Risk- Based Capital Requirements FHFB?s Risk- Based Capital
Requirement

FHFB?s Capital Requirements for Credit Risk

Risk- Based Capital Required for Advances Assumes Little Credit Risk Exists

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 50 GAO- 01- 873 Federal Home Loan Bank System Capital

example, advances with less than 4 years maturity have a 7 basis point
capital requirement even though FHFB had calculated the appropriate capital
requirement to be 0 basis points. 47 This imposition of 7 basis points
reflects, in part, concerns about potential credit risks in the new types of
collateral. In contrast, when the term to maturity on advances exceeds 10
years, the capital requirement is 35 basis points.

To ensure sufficient collateral protection is available against advances,
the extent of overcollateralization for different assets varies.
Overcollateralization is the extent to which the book value of collateral
exceeds the book value of the advances it secures. Overcollateralization
increases for riskier assets. FHFB expects FHLBanks to determine the
appropriate level of overcollateralization to be imposed on nontraditional
collateral permitted by GLBA. During the regular examination of FHLBanks,
FHFB will examine the amount of overcollateralization required by the
FHLBanks for different assets, if they permit nontraditional collateral to
back advances. Based on FHFB?s supervision and examination approach to
collateral policies, the risk- based capital regulation assumes that credit
risk is equalized across all advances.

The credit risk requirements for residential mortgage assets was based on
credit ratings by major credit rating agencies. When developing the capital
requirements for mortgage assets, FHFB also took into account the
requirements set by other regulators. 48 In general, the risk- based capital
requirements for mortgage assets, such as mortgages on both single- family
and multifamily units or MBSs, vary with the creditworthiness of the assets.

The final rule is based on the assumption that the collateral underlying the
residential mortgage assets will typically consist of conforming, prime
quality loans with loan- to- value ratios below 80 percent as well as loans
with higher loan- to- value ratios with appropriate mortgage insurance. FHFB
also assumes that the performance of any credit enhancement is reasonably
ensured in all relevant economic stress scenarios and that the FHLBank?s
portfolios of residential mortgage assets will have appropriate

47 A basis point is one one- hundredth of a percentage point. 48 Commercial
banks have a 400 basis point capital requirement on residential mortgages,
and 160 basis point requirement on MBSs issued by GSEs. In addition, the
leverage ratio for the enterprises on their own MBSs held by other investors
is 45 basis points. Risk- Based Capital

Requirements for Residential Mortgage Assets Reflect Credit Ratings

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 51 GAO- 01- 873 Federal Home Loan Bank System Capital

diversification and that credit enhancements will take account of any
geographic or other concentrations that increase credit risk.

Based on the above constraints, FHFB assigned credit risk requirements. For
example, for unsubordinated 49 residential mortgage assets in the highest
investment grade- triple A- residential mortgage assets have a 37 basis
point capital requirement; unsubordinated mortgage assets in the second
investment grade- double A- have 60 basis points capital requirement, and
unsubordinated mortgage assets in the fourth highest investment grade-
triple B- have a 120 basis points capital requirement.

In contrast, subordinated residential mortgage assets with ratings below
triple- A can have higher capital requirements. For example, subordinated
residential mortgage assets with a triple- B rating have a 445 basis point
capital requirement.

Risk- based capital requirements are set on residential mortgages assets
acquired by the FHLBank, where the FHLBank and the member selling the
mortgage asset share credit risk as is the case in MPF and MPP. To date,
participating FHLBanks have required the equivalent of a double- A on each
residential mortgage asset acquired based on a model created by S& P. These
mortgage assets have a 60 basis points capital requirement- the requirement
for any double- A rated residential mortgage asset. Mortgage assets, where
credit- risk is shared with members, are expected to become an increasing
part of the assets held by the FHLBanks.

FHFB has established risk- based capital requirements for assets other than
advances or mortgages that are also rated. Risk- based capital requirements
for such assets increase with decreasing creditworthiness and increasing
terms to maturity. For example, U. S. securities of any maturity have 0
basis point capital requirement while for triple- A rated corporate assets
the requirement ranges from 15 basis points to 220 basis points, with the
requirement increasing with an increasing term to maturity. Lower rated
assets carry a 100- percent capital requirement.

49 Unsubordinated residential mortgage assets based on a given pool of
mortgages receive full payments of what is due to them before subordinated
residential mortgage assets of that pool receive any payments. FHFB Risk-
Based Capital

Requirements for Assets Other Than Advances and Mortgages

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 52 GAO- 01- 873 Federal Home Loan Bank System Capital

Capital requirements for unrated assets are set according to type of asset.
This category includes cash, premises and equipment, and investment assets
that have not received ratings from the major rating agencies. Cash has a
zero capital requirement, while premises and equipment have an 8percent
capital requirement. FHFB has assigned an 8- percent capital requirement to
all investment assets that are unrated. This is the same as the requirement
that the Basel Committee of Bank Supervisors assigns to unrated assets in
its proposed revision of the bank capital standards.

Risk- based capital requirements are also established for off- balance sheet
assets such as commitments to purchase loans and standby letters of credit.
50 The risk- based capital rule establishes credit conversion factors that
convert off- balance sheet positions into asset equivalents. Each position
is multiplied by its credit conversion factor, measured as a percent, to
obtain the nominal value needed to determine the credit risk capital
requirement.

Risk- based capital requirements for derivatives are based on their current
and potential risks and vary by type of derivative and term to maturity.
Potential future risk exposures can be determined from a table in the
regulation or a FHFB approved internal model. For example, in the table,
interest rate derivative contracts with a term less than 1 year have a
conversion factor of 0 percent, while for equities, the conversion factor is
6 percent. When the term exceeds 5 years, the conversion factor for interest
rate derivative contracts is 1.5 percent, and the conversion factor for
equities is 10 percent. The final regulation also establishes procedures to
address the effects of multiple derivatives between two parties.

The FHFB?s capital requirements can reflect credit enhancements such as
third- party guarantees of an asset held by a FHLBank. If the credit
enhancement or its provider has a rating from a major rating agency, the
capital requirement will accord with the enhancement, if the FHLBank asset
is lower rated or unrated.

50 A standby letter of credit is a commitment by a FHLBank to make a payment
if certain conditions are met. Such payments are made on behalf of a
customer. Unrated Items Are Given

Specific Risk- Based Capital Requirements

FHFB?s Capital Structure Encompasses Off- Balance Sheet Items and Credit
Enhancements

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 53 GAO- 01- 873 Federal Home Loan Bank System Capital

The risk- based capital regulation requires each FHLBank to hold capital for
interest rate risk equal to the sum of two calculations. One calculation
estimates the potential losses in the FHLBank?s portfolio under parameters
specified by FHFB. The other measure is the amount by which the market value
of total capital falls short of the adjusted book value of capital, in the
event that the market value of capital is below this accounting benchmark.

FHFB prefers that the internal models be based on a value at risk 51
approach, which estimates level of capital that will prove sufficient to
absorb losses in all but the worst 1 percent of the time. In a value at risk
approach, the loss is estimated based on alternative possible interest rate
patterns over the chosen time period. However, if approved by FHFB, a cash
flow model can be used by a FHLBank as an alternative to a value at risk
approach. When estimating interest rate risk and calculating capital
required, each FHLBank is required to have sufficient permanent capital to
meet the value at the risk level established by FHFB. The exposure to
interest rate risk in each model is to depend on the level of stress from
interest rate movements and any hedges used which affect the actual exposure
to interest rate movements. These internal models must meet FHFB?s technical
restrictions and use interest rate stress scenarios approved by FHFB.

Additionally, added permanent capital will be required if the FHLBank?s
current market value of total capital, based on the estimated market value
of assets minus market value of liabilities, at the time of the capital
requirement analysis, is less than 85 percent of the FHLBank?s book value of
capital. The added capital will be the difference between the market value
of the capital and 85 percent of the book value 52 of the FHLBank?s capital.
This requirement was implemented because FHFB was concerned that the book
value of capital might not adequately reflect the economic value of capital
in some cases. This requirement forces the capital

51 Value at risk is an estimate of the potential losses that might occur in
a portfolio due to changes in market rates, based on a specified period of
time during which the rates change, and at a specified probability level.
For example, a firm may generate a value at risk estimate for a 10- day
period at 99 percent probability and arrive at a figure of $1 million. This
means that 99 percent of the time it would expect its losses during a 10-
day move of rates to be less than $1 million.

52 The book value of capital is calculated under Generally Accepted
Accounting Principles and can differ from the market value of capital, which
is adjusted for changes in interest rates and other market prices. FHFB
Requires Each

FHLBank to Hold Capital for Interest Rate Risk Based on the FHLBanks?
Internal Models

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 54 GAO- 01- 873 Federal Home Loan Bank System Capital

available to cover interest rate risk to have a market or economic value of
at least 85 percent of the book capital value. This requirement is
consistent with a value at risk approach, which calculates the market value
of capital available under different economic stresses.

FHFB also established technical restrictions on how the internal value at
risk model was to be designed in its risk- based capital regulation. FHFB
required that the probability of a loss greater than the estimate of the
market value of the bank?s portfolio at risk shall not exceed 1 percent. 53
Thus, the estimated net market value of the portfolio will cover estimated
losses 99 percent of the time. In the regulation, FHFB directed each FHLBank
to assume a stress period of 120- business days, based on historic interest
rates from 1978 to 1 month before the capital requirement is calculated.
FHFB stated that the periods chosen should be representative of the periods
of greatest potential stress in the market given the FHLBank?s portfolio.
FHFB officials told us that the 120- day periods will overlap. A new period
will start at the first of each month since 1978. This provides about 270
periods for the analysis. In a value at risk analysis with a 1 percent
confidence interval, this means capital required for interest rate risk will
be sufficient to cover estimated losses in 267 out of a total of 270 stress
periods.

FHFB directed each FHLBank to develop a model that is comprehensive given
the FHLBank?s capabilities. In addition, FHFB stated that the internal
models may incorporate empirical correlations among interest rates or other
market prices. 54 Lastly, FHFB required that the model be independently
validated and satisfactory to FHFB.

Although GLBA did not require FHFB to establish a risk- based capital
requirement to cover operations risk, FHFB decided such a requirement

53 To the extent the FHLBanks appropriately hedge their positions in terms
of match funding or hedging instruments, there is less chance that movements
in interest rates will lead to large losses.

54 Another technical restriction is that FHLBank models should also address
nonlinearities where the value of certain positions may not change for small
changes in interest rates, even though larger changes in interest rates can
create significant changes in the value of those positions. Mortgage
prepayments can exhibit nonlinearity because borrowers may not prepay for a
small decline in market rates. However, if rates decline enough, prepayments
can accelerate as the market rate falls below the rate on a higher
percentage of existing mortgages. FHFB Requires Capital for

Operations Risk

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 55 GAO- 01- 873 Federal Home Loan Bank System Capital

was needed. FHFB?s capital requirement for operations risk is 30 percent of
the total capital required to cover interest rate and credit risk, but it
may be reduced to no lower than 10 percent if a FHLBank can demonstrate to
the satisfaction of FHFB that it has insurance or some other means to
justify the reduction.

OFHEO?s risk- based capital requirements are meant to ensure that the
enterprises maintain sufficient capital to weather stressful economic
conditions. These requirements also address credit, interest rate, and
operations risks.

OFHEO has developed its own cash flow model to estimate risks and calculate
total capital needed to cover credit and interest rate risk. OFHEO runs a
single model in which the capital calculations for credit risk and interest
rate risk are based on the model?s calculation of how much capital is needed
by each enterprise. To determine credit risks the model must include
information on housing prices, vacancies and credit enhancements, as well as
other variables that affect credit risk. To determine interest rate risk the
model must include information on interest rates, interest rate hedges and
other variables that affect interest rate risk.

The purpose of OFHEO?s stress test is to calculate whether sufficient
capital was set aside at the beginning of the 10- year stress test period to
cover all benchmark losses and interest rate stress losses and to leave the
enterprise with a positive capital amount in each accounting period and at
the end of the stress period. Once the capital needed for credit and
interest rate risk is calculated in the stress test, total required capital
is the sum of capital for interest rate risk and credit risk plus 30 percent
of this sum to cover operations risk.

The intent in integrating the stresses for credit risk and interest rate
risk is to permit the OFHEO model to better deal with feedbacks between
interest rate movements and losses due to credit risk. For example, when
interest rates fall, prepayments accelerate, and this leads to a decline in
the value of mortgages on the balance sheets of each enterprise. At the same
time, the level of credit risk in the remaining mortgages may increase if
borrowers with poorer credit ratings cannot prepay. In addition, other
factors such as the recent history of interest rates and the number of
mortgages at different interest rates may interact with declining rates to
affect prepayments. Consequently, the cash flow model can only calculate
OFHEO?s Risk- Based

Capital Requirement OFHEO Calculates RiskBased Capital Requirements for
Credit and Interest Rate Risk in an Integrated Model

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 56 GAO- 01- 873 Federal Home Loan Bank System Capital

credit risk changes due to prepayments, if the values of all variables that
affect prepayments and credit risk are fully specified in the model. To
fully understand how interest rate risk and credit risk interact, a modeler
would have to test different mixes of input variables, including interest
rate changes. However, the accuracy of any feedbacks found in the model
would depend on the quality of the model and how well it specified the
underlying economic relationships that create losses due to interest rate
movements and defaults.

The credit stress, during the stress period, is specified in the 1992 act.
The benchmark loss for credit risk is the ?worst cumulative credit losses
for 2 consecutive years in contiguous states encompassing at least 5 percent
of the U. S. population?. 55 The actual area chosen by OFHEO to create
benchmark credit losses is Arkansas, Louisiana, Mississippi, and Oklahoma,
in 1983 and 1984.

OFHEO determined the factors or input variables that affected losses and
prepayments due to credit stress. To identify the input variables, it
reviewed the available literature on defaults and modeled defaults
separately for single family and multifamily mortgages as well as other
assets held by the housing enterprises. To actually estimate potential
losses due to credit risk, OFHEO created numerous asset classifications
based on factors such as:

 single- family or multifamily;

 loan- to- value ratio;

 retained in portfolio or in MBS;

 type of recourse available;

 fixed or variable rate mortgage;

 conventional, FHA, or VA mortgages;

 interest rate at origination; and

 origination date. Given these characteristics, each loan is placed in a
loan group, which determines its expected default loss. Credit enhancements
can affect default losses in OFHEO?s model, but the credit risk of the
credit enhancer is also taken into account. Similar classification schemes
are developed for other assets. Given this level of detail, OFHEO was able
to create a

55 12 U. S. C. 4611 (a) (1). Congress Established Criteria

to Create Benchmark Losses for Credit Risk Stress in the 10- Year Stress
Test

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 57 GAO- 01- 873 Federal Home Loan Bank System Capital

finely granulated sense of what creates losses and what credit losses would
occur during the stress test.

The 1992 act, which created OFHEO, established criteria for the size of the
interest rate shocks the enterprises are required to withstand over the
10year stress period. The criteria was based on a 10- year stress period for
both an increasing rate and decreasing rate environment that could affect
losses for an enterprise. In both environments, the rates move during the
first year and stay constant for the rest of the 10- year period. The act
specifies that capital must be sufficient to cover the more stressful of the
two interest rate environments. (See fig. 5 for a detailed enumeration of
the interest rate environments that the 1992 act required OFHEO to use.)

Figure 5: Interest- Rate Risk Stresses in OFHEO?s Risk- Based Capital
Regulation

Congress Established Interest Rate Scenarios for the 10- Year Stress Test
for the Enterprises

Appendix IV: Summary of FHFB?s and OFHEO?s Risk- Based Capital Requirements

Page 58 GAO- 01- 873 Federal Home Loan Bank System Capital

According to the 1992 act, OFHEO must assume that the enterprises acquire no
new mortgages other than those deliverable under existing commitments at the
beginning of the 10- year stress period. 56 This approach focuses on the
risks embedded in the book of business that existed at the beginning of the
stress test period. This restriction on new business forces the model to act
as if the enterprises are winding down their business during the stress
period.

Operations risk is also specified in the 1992 act and is equal to 30 percent
of the sum of interest rate risk and credit risk. 57 Consequently, total
capital requirement for the enterprises for risk- based capital is always
equal to 130 percent of the sum of capital needed to cover interest rate and
credit risk.

56 12 U. S. C. 4611 (a)( 3). According to 12 U. S. C. 4611 (a) (3) (C),
within 1 year of the first issuance of the risk- based capital regulation
for the housing enterprises, the GAO and Congressional Budget Office will
submit studies to the appropriate Congressional committees addressing the
advisability and appropriate form of any new business assumptions for
OFHEO?s risk- based capital regulation.

57 12 U. S. C. 4611 (c)( 2). Congress Mandated That

OFHEO Assume a Limited Amount of New Business in 10- Year Stress Test Period
in the Stress Test

Congress Established the Stress for Operations Risk as 30 Percent of the Sum
of Capital for Interest Rate and Credit Risk

Appendix V: Comments From the Federal Housing Finance Board

Page 59 GAO- 01- 873 Federal Home Loan Bank System Capital

Appendix V: Comments From the Federal Housing Finance Board

Appendix V: Comments From the Federal Housing Finance Board

Page 60 GAO- 01- 873 Federal Home Loan Bank System Capital

Related GAO Products Page 61 GAO- 01- 873 Federal Home Loan Bank System
Capital

Comparison of Financial Institution Regulators? Enforcement and Prompt
Corrective Action Authorities (GAO- 01- 322R, Jan. 31, 2001).

Capital Structure of the Federal Home Loan Bank System (GAO/ GGD- 99177R,
Aug. 31, 1999).

Farmer Mac: Revised Charter Enhances Secondary Market Activity, but Growth
Depends on Various Factors (GAO/ GGD- 99- 85, May 21, 1999).

Federal Housing Finance Board: Actions Needed to Improve Regulatory
Oversight (GAO/ GGD- 98- 203, Sept. 18, 1998).

Federal Housing Enterprises: HUD?s Mission Oversight Needs to Be
Strengthened (GAO/ GGD- 98- 173, July 28, 1998).

Government- Sponsored Enterprises: Federal Oversight Needed for Nonmortgage
Investments (GAO/ GGD- 98- 48, Mar. 11, 1998).

Federal Housing Enterprises: OFHEO Faces Challenges in Implementing a
Comprehensive Oversight Program (GAO/ GGD- 98- 6, Oct. 22, 1997).

Government- Sponsored Enterprises: Advantages and Disadvantages of Creating
a Single Housing GSE Regulator (GAO/ GGD- 97- 139, July 9, 1997).

Housing Enterprises: Investment, Authority, Policies, and Practices

(GAO/ GGD- 97- 137R, June 27, 1997).

Comments on ?The Enterprise Resource Bank Act of 1996? (GAO/ GGD96- 140R,
June 27, 1996).

Housing Enterprises: Potential Impacts of Severing Government Sponsorship
(GAO/ GGD- 96- 120, May 13, 1996).

Letter from James L. Bothwell, Director, Financial Institutions and Markets
Issues, GAO, to the Honorable James A. Leach, Chairman, Committee on Banking
and Financial Services, U. S. House of Representatives, Re: GAO?s views on
the ?Federal Home Loan Bank System Modernization Act of 1995? (B- 260498,
Oct. 11, 1995).

FHLBank System: Reforms Needed to Promote Its Safety, Soundness, and
Effectiveness (GAO/ T- GGD- 95- 244, Sept. 27, 1995). Related GAO Products

Related GAO Products Page 62 GAO- 01- 873 Federal Home Loan Bank System
Capital

Housing Finance: Improving the Federal Home Loan Bank System?s Affordable
Housing Program (GAO/ RCED- 95- 82, June 9, 1995).

Government- Sponsored Enterprises: Development of the Federal Housing
Enterprise Financial Regulator (GAO/ GGD- 95- 123, May 30, 1995).

Farm Credit System: Repayment of Federal Assistance and Competitive Position
(GAO/ GGD- 94- 39, Mar. 10, 1994).

Farm Credit System: Farm Credit Administration Effectively Addresses
Identified Problems (GAO/ GGD- 94- 14, Jan. 7, 1994).

Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,
Soundness, and Effectiveness (GAO/ GGD- 94- 38, Dec. 8, 1993).

Improved Regulatory Structure and Minimum Capital Standards are Needed for
Government- Sponsored Enterprises (GAO/ T- GGD- 91- 41, June 11, 1991).

Government- Sponsored Enterprises: A Framework for Limiting the Government?s
Exposure to Risks (GAO/ GGD- 91- 90, May 22, 1991).

Government- Sponsored Enterprises: The Government?s Exposure to Risks (GAO/
GGD- 90- 97, Aug. 15, 1990).

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