FHLBs: Red Sea, Dead Sea or Both?

On April 2nd, in a post Putting Perfume on a Pig,  I compared Freddie Mac, Fannie Mae, and the Federal Home Loan Bank system to the Red Sea. Why? For the very simple reason that for the foreseeable future, these entities will accrue losses. How? Unlike commercial banks, Freddie, Fannie, and their 12 FHLBs have very little earnings power in this environment while faced with a steady stream of losses on their mortgage holdings given ongoing defaults and foreclosures.

In retrospect, would it have been more appropriate to compare the FHLB system to the Dead Sea than the Red Sea? I think it may. As the Wall Street Journal highlights, Directors Are Faulted at Home Loan Banks:

Financial troubles at some of the Federal Home Loan Banks are raising questions about how well directors of these institutions are supervising their executives.

A plunge in the value of mortgage securities bought by several of the regional home-loan banks has forced them to halt dividends and curtail funding for local housing projects. An annual report issued by the banks’ regulator this past week says some of them “paid insufficient attention” to credit risks and haven’t invested enough in information technology.

Unlike giant banks or government-backed mortgage companies Fannie Mae and Freddie Mac, the 12 regional home-loan banks draw little public scrutiny. (LD’s emphasis) Created by Congress in 1932 to support the housing market, they are cooperatives owned by more than 8,000 banks, thrifts, credit unions and insurers.

Why do these home loan banks draw such little public scrutiny? They are the wholesale entity (providing funds) to their retail network (banks, thrifts, credit unions, insurers) which deals with the public. With no interaction with the public, the media and market analysts have accorded them little coverage. Thus, I make the assertion that these banks truly are a combination of both the Red Sea (ongoing losses) and Dead Sea (no coverage).

Charles Bowsher, the former chair of FHLB’s Office of Finance sent a warning shot loud and clear about the “hidden and embedded” losses in this system when he resigned his position as chair of the FHLB Office of Finance in late March. As Bloomberg reported on April 2nd:

Bowsher, who was comptroller general of the U.S. from 1981 to 1996, had a simple reason for resigning last week as chairman of the Federal Home Loan Bank System’s Office of Finance. He didn’t want to put his name on the banks’ combined financial statements, because he was uncomfortable vouching for them. Bowsher, 77, had held the post since April 2007.

With so many top executives complaining they can’t figure out what their companies’ assets are worth, the real wonder is that more corporate directors haven’t quit rather than certify financial reports they don’t understand.

The job Bowsher left is a crucial one. The Office of Finance issues and services all the debt for the 12 regional Federal Home Loan Banks. That’s a lot of debt — $1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. (LD’s emphasis) The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies.

Given the current financial straits of these FHLBs, there is truly very little the government or management can do short of hoping that defaults and foreclosures do not come in as the market is forecasting. Well, actually there is one thing the boards can do and they are doing it–trash management. As the WSJ offers,

In some cases, the directors of home-loan banks are cracking down.

However, how are the boards constructed and who is really minding the store? The WSJ provides real insight on this point, and highlights:

the home-loan banks need more directors willing to ask tough questions of the executives. Most of the directors are representatives of small and midsize banks that rely on the home-loan banks for funding. Some other directors represent nonprofit groups that receive grants from the home-loan banks, which are required by law to devote 10% of their profits to housing projects benefiting poor people.

Make no mistake, the structure, systems, and mix of business within the FHLB system is a direct corollary of our two national wards, Freddie Mac and Fannie Mae. While board members may want to play defense or execute the backstroke, I view these signs as clearcut indications that the boards know where this situation is headed. Where’s that? Again, I defer to the WSJ:

If the home-loan banks ever stumble badly, U.S. taxpayers would be called on to “rescue yet another financial entity,” warns Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. These banks have about $1.26 trillion of debt outstanding, putting them among the world’s biggest borrowers.

In my opinion, it is not a question of if, but when. Without a relaxation in the FASB’s mark-to-market, we would have probably already been there. The FHLB system in totality is the size of a third housing finance agency. There is little doubt in my mind that at some point they too will become official wards of the state.

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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