In Defense of the Federal Home Loan Banks

We succumbed to some clickbait yesterday when we encountered a Risk.net article entitled “FHLBs: safe as houses?” The subheading ominously read, “Health of huge bank funder rests on home loans and money market funds.” It caught our attention because we are well acquainted with the Federal Home Loan Bank system—an affiliated group of government-sponsored enterprises, owned by their member institutions, that unassumingly go about their business of supplying capital to mortgage lenders in one of the least risky ways imaginable. Finding fault with the Federal Home Loan Banks because of what befell Fannie and Freddie a decade ago is a little like picking on the quiet kid who keeps to himself and gets good grades because you don’t like his big brothers.

While it is reasonable to posit that the fortunes of the Federal Home Loan Banks are linked to the health of the housing market (the Banks’ charter, after all, is to provide capital in support of home loans) the title of this article is unnecessarily alarming. In hindsight, it was clearly a mistake not to heed the warning sirens leading up to 2008. But it does not follow that our collective failure to heed one warning about mortgage risk that proved to be right means that we should be forever skeptical of all large mortgage-related holdings. And likening the FHLBanks’ balance sheets to those of Fannie and Freddie before the crisis, as the article implies, is a bridge too far.

Member advances, which account for a significant majority of the FHLBanks’ assets, are collateralized primarily by performing, high-credit-quality mortgage loans. The article hints at this in an understated way by admitting, “The FHLBs are extremely conservative lenders: as of September 30, each had rights to collateral with an estimated value greater than the related outstanding advances.” In reality, the estimated value of the collateral significantly exceeds the related advances. When pledged assets become impaired because of delinquency or other reasons, member banks are required to replace them with collateral that meets the FHLBanks’ exacting standards.

The FHLBanks apply significant discounts (haircuts) to the lending value of the mortgages pledged to them as collateral. The models used to compute these haircuts are conservative and regularly subjected to independent, third-party model validation.  The resulting model validation reports are subsequently subjected to additional reviews by the FHLBanks’ internal auditors as well as their regulator, the Federal Housing Finance Agency.

This “belt-and-suspenders” approach to member advances—requiring only the highest-quality collateral and then applying highly conservative lending-value haircuts—is essentially the polar opposite of how Fannie and Freddie (the FHLBanks’ big brothers) approached credit risk in the years leading up to the financial crisis. The FHLBanks’ ultra conservative approach to mortgage funding is likely the reason no FHLBank has ever suffered a loss on a member advance—not even during the housing crash of 2008-2009. It would take a housing crisis far larger in magnitude to the one experienced a decade ago before the FHLBanks would even break a sweat.

Further, the mortgage risk borne by the FHLBanks is indirect—none of the pledged mortgages to which the Banks are exposed are actually on their balance sheets. Rather, the FHLBanks’ collective risk is primarily counterparty risk—risk that their member institutions will fail—as opposed to the direct credit risk of individual loans. And the risk of member institutional failure is largely mitigated by the fact that the vast majority of the Banks’ members are FDIC insured. When one does fail, the FDIC typically takes responsibility for shutting it down, reimbursing any outstanding advances to covered creditors (including the FHLBanks) and then taking possession of the pledged collateral. The FHLBanks typically don’t even have to deal with it. And even if they did, because so much of the collateral is squeaky-clean mortgages, these would be among the last assets to go bad, even under the most extreme economic conditions.

Government-sponsored enterprises (Fannie, Freddie, and the Federal Home Loan Banks) are among the many curiosities of the American housing finance system designed to promote homeownership. Reasonable people can disagree about whether homeownership ought to be subsidized at all and whether the good these institutions do justifies the risks they pose. Certainly, the nature of the FHLBanks’ charter business subjects them to a fairly high degree of industry concentration risk. But experience has demonstrated that they do a pretty good job of managing it.