THE FEDERAL HOME LOAN BANKS AND RISK DISTRIBUTION IN U.S. HOUSING FINANCE

1
THE FEDERAL HOME LOAN BANKSAND RISK DISTRIBUTION
INU.S. HOUSING FINANCE

• ALEX J. POLLOCK
• March 11, 2003

157843
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OUTLINE

1. Overview of the Federal Home Loan Banks
2. Risk Distribution Perspective
3. Historical Development of the FHLBs
4. Postulates of Housing Finance

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ESSENCE OF FHLBs

• FHLBs efficiently link
• long-term residential mortgages
• with the bond markets.

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FEDERAL HOME LOAN BANKSOverview

• AAA/Aaa rated government-sponsored enterprise
  (GSE) created by Congress to provide economical
  housing finance.
• FHLB debt raised in the global capital markets
  provides financing for 7,900 member financial
  institutions.
• Over 75 of U.S. banks and thrifts are members.
• Each FHLB has own board and management.
• 70 years of profitability.
• No losses on advances to members.

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FHLBs HAVE SIGNIFICANT SIZE U.S. Banking
Companies Housing GSEs As of 12/31/02, in
Billions
Rank Organization Assets 1
Citigroup 1,097 2 Fannie Mae 887
3 Federal Home Loan Banks 766 4 J.P
Morgan Chase 759 5 Freddie Mac
722 6 Bank of America 660 7 Wells
Fargo 349 8 Wachovia 342 9
Bank One 277 10 Washington Mutual
271 11 MetLife 268 12 Taunus
254
Source Bloomberg Professional, National
Information Center (Federal Reserve System),
FHLB 2nd Quarter 2002 Financial report 3Q
2002 Financial Information
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FHLBs COMBINED BALANCE SHEETAs of 12/31/02, in
millions
Advances 489,598 Mortgage loans
60,553 Investments 215,723 TOTAL
ASSETS 765,874 Bonds and discount
notes 674,841 Deposits
27,679 TOTAL LIABILITIES
729,570 Capital stock 35,188 Retained
earnings 1,191 TOTAL
CAPITAL 36,304
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FHLB MEMBERSHIPAs of Sept. 30, 2002

• of Industry
• Banks 5,873 74
• Thrifts 1,408 95
• Ins. Cos. / CUs 711
• TOTAL 7,992

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THE FUNDAMENTAL RISK DISTRIBUTION PERSPECTIVE

• Who has which risk?
• Who should have which risk?
• Mortgage Finance Systems
• Different patterns of risk distribution

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• CREDIT RISK

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CREDIT QUALITY AND GEOGRAPHIC CONCENTRATION
Distribution of One-Year Net Charge-Off
RatiosFHLB Chicago Thrift Members by Institution
1994-1998
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INTEREST RATE RISKANDPREPAYMENT RISK
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WHO HAS THE INTEREST RATE / PREPAYMENT RISK?

• Variable Rate Mortgages
• Mark-to-Market Prepayment Fees
• Bond-Based Systems
• Pass-Through MBS
• GSE Balance Sheets
• Deposit Insurance

Borrower

Capital Market Participants

Government Support
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STRUCTURAL MODELS FOR PROVISION OF HOUSING
FINANCE

• Banking Model
• Deposit financed, portfolio lenders
• European Mortgage Model
• Bond financed, specialized portfolio lenders
• Contract Savings Model
• Deposit financed, specialized institutions
  offering loan-linked savings contracts
• Secondary Market Model
• Bond financed, securitizing loans from primary
  lenders

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STRENGTHS OF EUROPEAN MORTGAGE BANK SYSTEM

• Specialized Institutions Viewed as Lower Risk
• More transparent
• Separate and specialized regulatory focus
• Focus on Pure Mortgage Finance
• Ability to tap Capital Market Funding
• Source for longer term fixed rate funds
• Tested Model
• 200 years in Denmark, 100 years in Germany, 70
  years in the U.S.

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FHLBs LINK MEMBER LENDERSTO THE GLOBAL BOND
MARKETS

• The U.S. mortgage finance system must distribute
  the risks inherent in long-term, fixed-rate
  mortgages.
• Private credit institutions require an efficient
  link to the bond markets in order to prudently
  make long-term fixed-rate mortgages.
• The Federal Home Loan Banks are such an effective
  link for member lenders.

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AMERICAN HOMEOWNERSHIP RATES

• 1900 47
• 1940 43
• 1980 65
• 1995 65
• 2000 67.7

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HOMEOWNERSHIP RATES INTERNATIONAL PERSPECTIVE

• Ireland 80
• Spain 78
• Italy 78
• Norway 76
• Luxembourg 72
• New Zealand 71
• Australia 70
• U.S. 67.7
• U.K. 67
• Finland 67
• Belgium 65
• Canada 64

Source International Housing Finance Sourcebook
2000. (International Union for Housing Finance,
2001)
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FEDERAL HOME LOAN BANKS

• 1932 ? 2002

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FHLB OWNERSHIP

• 1932 U.S. Treasury purchases initial
  capital
• 1933 1951 Transition to private
  ownership
• 1951 Present 100 private ownership by
  member institutions

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FHLB MEMBERSHIP

• 1932 1933 Voluntary
• 1933 1989 Primarily Mandatory
• 1989 1999 Federal Thrifts Mandatory
• All Others Voluntary
• 1999 Present Entirely Voluntary

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FHLB GOVERNANCE

• Mixed Boards of Directors 1932
  Present
• Stockholder majority 9 10
• Govt appointed minority 2 6
• 11 16
• Chairmen of FHLB Boards
• 1932-1999 Appointed by government
• 2000-Present Elected by Board of Directors

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FHLB GOVERNANCE

• Government oversight of the FHLBs has changed
• 1932-1989 Federal Home Loan Bank Board
  Manager / Regulator / Cheerleader
  of FHLBs and thrift industry
• 1989-1999 Federal Housing Finance Board
  Manager / Regulator / Cheerleader of
  only FHLBs
• 1999-Present Federal Housing Finance Board
  Regulator of FHLBs

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• TRADITIONAL FHLB PRODUCTS
• Loans (advances) -- fully collateralized,
  low-cost, short and long-term, fixed and
  floating-rate
• Affordable housing and community development
  funding (AHP and CIP)
• Deposits
• Off balance sheet / risk management products
• (Letters of credit, interest rate swaps, caps,
  floors)
• Operating services

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MORTGAGE PARTNERSHIP FINANCE A new line of
business for the FHLBs

• An alternative for financial institutions to fund
  fixed-rate, conventional mortgages.
• Creates a partnership between the FHLB and its
  members to manage the risks of mortgages
• Each handles what it does best
• Adds needed competition to secondary market
• FHLB members and their customers benefit
• Credit risk is dispersed, not concentrated in
  GSEs

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MPF A BETTER METHOD OF FUNDING HOME MORTGAGE
LOANS

• Management of credit risk is not the problem.
• Financial institutions should be rewarded for
  creating high-quality loans.
• Financial institutions should receive fees for
  managing the credit risks of the loans they
  originate, rather than paying GSEs to manage
  those risks.

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MPF KEY CONCEPT MORTGAGES ARE BUNDLES OF RISKS
Natural Competitive Advantage

• Marketing Risk
• Credit Risk
• Servicing/Operations Risk
• Funding Risk
• Interest Rate Risk
• Options/Prepayment Risk

Financial Institution

GSE
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EVOLUTION OF RISK DISTRIBUTION
Traditional Lending Lender Lender
Allocation by Mortgage Program Interest Rate
and Options Risk Credit Risk
Secondary Market GSE GSE
MPF Program FHLB Lender
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• BASIC POSTULATES OF HOUSING FINANCE
• Homeownership is important for every society, as
  it promotes individual progress and social
  stability.
• A robust mortgage financing system is needed to
  achieve widespread homeownership.
• Robust mortgage finance requires private credit
  institutions, with market incentives to balance
  risk and return, innovate, allocate resources and
  increase productivity.
• For lenders to offer long-term fixed-rate
  mortgages, an effective link to the bond markets
  is required.

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• As a people we need at all times the
  encouragement of home ownership.
• -- President Herbert Hoover,
  proposing the Federal Home
• Loan Bank Act in 1932

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THE FEDERAL HOME LOAN BANKSAND RISK DISTRIBUTION
INU.S. HOUSING FINANCE

• ALEX J. POLLOCK
• March 11, 2003

157843