Two government-sponsored enterprises—the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae)—have been the subject of much controversy of late. These institutions are government chartered but privately owned; both are charged with increasing the liquidity of mortgage markets by purchasing home loans from originating institutions. The source of the controversy is their rapid growth. Between 1992 and 1999, together Freddie Mac and Fannie Mae grew by nearly 300 percent—much faster than U.S. banking organizations of comparable size. Indeed, as a group, the top five U.S. bank holding companies grew by 165 percent over the same period.

Another government-sponsored enterprise with a similar mission, the Federal Home Loan Bank (FHLB) system, has also posted impressive growth but without attracting much attention. Congress established the FHLB in 1932 to make collateralized loans—called advances—to thrift institutions.1 In the late 1980s, Congress opened Home Loan Bank membership to other depository institutions in the mortgage business. Now, the FHLB offers thrifts, commercial banks and credit unions a wide range of products and services designed to help fund mortgage loans, manage interest rate risk and meet the other challenges of an increasingly competitive banking environment. Between 1992 and 1999, the total assets of the FHLB system grew by 260 percent. At year-end 1999, system assets totaled $583 billion—larger than Freddie Mac, Fannie Mae and all U.S. banking organizations except Citigroup and Bank of America.

The impact of the FHLB on the banking sector can be seen in the increase in the growth of membership and advances. As the table shows, between 1992 and 1999, the number of system members more than doubled, fueled by the opening of membership to commercial banks. Over the same period, advances outstanding to system members nearly quintupled. For community banks—the subset of commercial banks that concentrate on local loan and deposit markets—the increases were even more impressive: Membership increased four-fold and advances increased sixteen-fold.2 Once the Gramm-Leach-Bliley (GLB) act of 1999—which includes provisions governing FHLB membership and collateral requirements—takes effect, nearly all of the nation's thrifts and commercial banks could boast membership, and total outstanding advances could well top $500 billion.3

Table 1

The Amazing Growth of Federal Home Loan Bank Membership and Advances

1992 vs. 1999

The Financial Institutions Reform Recovery and Enforcement Act of 1989 opened FHLB membership to commercial banks that hold at least 10 percent of their assets in mortgage-related products. Between 1992 and 1999, system membership more than doubled, and advances outstanding nearly quintupled. During this time, the number of thrift members dropped by 30 percent, because of a steep decline in the number of thrift institutions. Meanwhile, the number of commercial bank members rose by 312 percent, because of the changes in the membership criteria.

Membership by Type of Financial Institution
	December 1992	December 1999	Percentage Change
Thrift Institutions
Number of members	2,291.0	1,611.0	-29.7%
Percent of all thrift institutions	95.9%	98.2%
Large Commercial Banks (>$500 million, 1999 dollars)
Number of members	113.0	521.0	361.1%
Percent of all large commercial banks	16.1%	76.5%
Community Banks (<$500 million, 1999 dollars)
Number of members	1,171.0	4,772.0	307.5%
Percent of all community banks	11.0%	60.9%
Total Members*	3,624.0	7,378.0	103.6%

Advances Outstanding by Member Type
	December 1992	December 1999	Percentage Change
Thrift Institutions
Advances ($ millions)	72,331.0	237,952.0	229.0%
Percent of Total Advances	91.8%	60.9%
Large Commercial Banks (>$500 million, 1999 dollars)
Advances ($ millions)	4,395.0	122,031.0	2,676.4%
Percent of Total Advances	5.6%	31.3%
Community Banks (<$500 million, 1999 dollars)
Advances ($ millions)	1,582.0	25,251.0	1,495.6%
Percent of Total Advances	2.0%	6.5%
Total Borrowers**	1,554.0	5,089.0	227.5%
Total Advances ($ millions)	78,780.0	390,025.0	395.0%

*The Gramm-Leach-Bliley Act of 1999 defines a community financial institution as a bank that holds less than $500 million in assets. This threshold was used to classify institutions as large commercial banks and community banks for 1999. For 1992, the threshold was adjusted to reflect the 14 percent change in the Gross Domestic Product Deflator between 1992 and 1999.

**This figure includes credit unions and insurance complanies.

SOURCE: Federal Housing Finance Board, Reports of Income and Condition for U.S. Commercial Banks

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Anatomy of the System

Congress created the FHLB system to address a perceived defect in the nation's capital markets. At the time, no secondary market was available for mortgages; therefore, any thrift making a home loan had to hold it until maturity. Because thrifts were often "loaned up," some good borrowers were denied mortgages. The FHLB system enabled thrifts to lend to all creditworthy applicants and use existing mortgage loans as collateral to obtain additional funding from a regional Home Loan Bank.4

The scope of FHLB lending has grown considerably since the system's creation. Originally, only thrift institutions—savings and loan associations and savings banks—and insurance companies could join the FHLB system and obtain advances. Over time, as the bulk of mortgage lending shifted from thrifts to other depository institutions, Congress broadened access to advances. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 opened the FHLB to commercial banks and credit unions that held at least 10 percent of their assets in mortgage-related products. The GLB act of 1999 widened access further by eliminating the 10 percent membership condition for community banks and enabling these banks to post small business, small farm and small agri-business loans as collateral for long-term advances. GLB also lifted the cap on the amount of other real-estate-related assets, such as commercial real estate loans, that FHLB members can post as collateral.5

In essence, the FHLB system is a financial intermediary, borrowing funds in world capital markets and lending to domestic member institutions. The system obtains funding by selling debt instruments, which are joint obligations of the regional Home Loan Banks. Buyers include mutual funds, commercial banks and government bodies—both in the U.S. and abroad. At the end of 1999, consolidated obligations summed to $525.4 billion or 94.8 percent of system liabilities. Proceeds from debt sales are used to make advances from system members. At year-end 1999, advances outstanding totaled $395.7 billion or 67.9 percent of system assets. During that year, the FHLB earned $26.5 billion in interest income and paid $24.0 billion in interest expenses, leaving roughly $2.5 billion in net interest income.6

FHLB debt instruments offer a yield just above the yield on Treasury securities. For example, in early October 2000, the yield on FHLB debt maturing in five years was 6.63 percent, 66 basis points above the yield on a comparable Treasury security but 51 basis points below the yield on a comparable Citigroup security. The FHLB can borrow at a low interest rate because financial markets believe that the U.S. government will not permit default. This belief probably rests on the recent bailouts of two other government-created enterprises: the Farm Credit System in the 1980s and the Financing Corporation in the 1990s.7 Another reason the FHLB can borrow at low rates is the system's collateral policy. Regional Home Loan Banks insist that borrowers pledge assets such as mortgage loans that are worth more than desired advances. That way, if the member bank runs into trouble, the Home Loan Bank can avoid losses by taking possession of the pledged assets.

Advances May Be a Godsend for Community Banking...

Community bankers find FHLB advances attractive because the growth of loans has outstripped the growth of core deposits—the checking and savings accounts that stay in the bank despite changing economic conditions. Between 1992 and 1999, loan growth at community banks averaged 10.7 percent a year while core deposit growth averaged 6.3 percent. In contrast, core deposit growth kept pace with loan growth in the 1980s. The pickup in loan growth in the 1990s reflects the length and strength of the current economic expansion.

Core deposits have lagged behind loans at community banks in recent years because of financial innovation. This innovation served up a menu of new products to smaller communities. In particular, many community bank customers have found money market mutual funds, which offer checking services as well as attractive interest rates, to be a cut above traditional checking accounts. These customers have also found stock and bond mutual funds to be superior to traditional savings accounts.

As the gap between loan and core deposit growth widened in the 1990s, community banks turned to other funding sources, such as certificates of deposit of $100,000 or more (jumbo CDs). On average, community banks funded 7.7 percent of their assets with jumbo CDs at year-end 1992. By the close of 1999, that figure was nearly 12 percent. Funding with jumbo CDs requires more planning than core deposits. Many holders of jumbo CDs care only about the interest rate offered and move their funds around constantly in search of better rates. Because such "hot" money can be here today and gone tomorrow, community banks relying on jumbo CDs must have plans for obtaining funding in a hurry.

As a funding source, FHLB advances are more dependable and convenient than jumbo CDs. Regional Home Loan Banks offer advances in a variety of maturities, from overnight to over 20 years. Moreover, regional Home Loan Banks customize the terms on advances to help their members manage interest rate risk. Best of all, members know that their regional Home Loan Banks will be there for them, providing funding as needed on a continuing basis. Between year-end 1992 and year-end 1999, community banks increased their reliance on FHLB funding from 0.2 percent of assets to 3.2 percent of assets. This number will undoubtedly increase now that the 10 percent mortgage test for community banks has been removed and the definition of eligible collateral for advances has been broadened.

…But Not Necessarily for the FDIC

Easy access to FHLB advances may end up costing the Federal Deposit Insurance Corp. (FDIC). Advances may cost the FDIC because they allow community banks to take more risks, and they give the FHLB first crack at the assets of failed community banks.

Easy access to advances allows community banks to increase risk. Absent the FHLB, these banks would have to limit loan growth to core deposit growth or incur the extra costs of funding with jumbo CDs. Access to FHLB advances enables bankers to evade constraints on growth. Moreover, the ability to turn to the FHLB in a pinch can create a more relaxed attitude about other risks as well. A particular source of comfort is the absence of risk premiums on FHLB advances. The FHLB does not increase the interest rate on advances to risky members because its debt is backed implicitly by the federal government and its advances are backed explicitly by good collateral. In short, access to FHLB funding enables community banks to take risk without paying a price. And an increase in risk today makes it more likely that the FDIC will have to close the bank tomorrow.

Advances may also cost the deposit insurance fund by weakening the FDIC's position in failure resolutions. As noted, advances are collateralized loans, and under bankruptcy law, collateralized claims are settled first during failure resolution. Should a community bank fail, the FHLB would be in line before the FDIC.8 All other things equal, fewer losses for the FHLB system imply greater losses for the FDIC. And, because of its collateral policy, the FHLB has not lost a penny on advances in its history. (See "How the FHLB Could Cost the FDIC" for an example of how funding with advances could increase losses to the FDIC.)

To be fair, the conditions needed to put the FDIC at serious risk are a long way from being met. At year-end 1999, the median leverage ratio at community banks was 10.8 percent, which is well above the 5 percent threshold that makes a bank well capitalized for regulatory purposes.9 Moreover, less than 5 percent of community banks posted capital ratios below this benchmark. Still, the losses from bank and thrift failures in the late 1980s and early 1990s dictate erring on the side of caution when assessing risks to the FDIC.

What Now?

A fair assessment of Home Loan Bank funding would have to go further than simply cataloguing threats to the FDIC. Another point to note is that revenue from FHLB advances promotes access to affordable housing and helps pay the costs for 1980s thrift failures.10 It is also important to ask if the original mission of the housing government-sponsored enterprises—to promote the liquidity of mortgage markets—has been accomplished.

That said, the implications of FHLB advances for the FDIC should not be ignored. Even with the rapid consolidation of the banking industry, more than 7,800 banks—holding roughly $800 billion in assets—fit the Gramm-Leach-Bliley definition of a community financial institution in December 1999. Before the recent explosion in advances, early warning models used in bank supervision showed that small banks were more at risk for failure than large banks. With potentially so much at stake, bank regulators should keep a watchful eye on the use of Federal Home Loan Bank advances.

How the FHLB Could Cost the FDIC

This sidebar demonstrates how the use of Federal Home Loan Bank (FHLB) advances by a fictional bank could impose losses to the Federal Deposit Insurance Corp (FDIC).

Initial Position

The First State Bank of Nowhere uses capital contributed by the owners ($60) and funds deposited by customers ($270) to make loans ($300). The bank holds some cash ($30) to meet routine withdrawal requests. The sum in each deposit account is less than $100,000, so the bank's deposits are fully insured by the FDIC. The bank boasts a capital-to-asset ratio of 18.2 percent, more than three times the regulatory standard for well capitalized.

Initial Balance Sheet for First State Bank of Nowhere
Assets	$	Liabilities and Capital	$
Cash	30	Insured Depostis	270
Loans	300	Capital	60
Total Assets	330	Total Liabilities and Capital	330

Consider two possible economic scenarios for the First State Bank of Nowhere and the FDIC.

Scenario 1

An economic shock hits First State's market, raising the unemployment rate and the loan default rate. Specifically, defaults reduce the value of First State's loan portfolio by 20 percent. The 20 percent loss translates into $60, which the bank deducts from the loan account and from the capital account. After the loss is recorded, First State's capital level is $0. The FDIC closes the bank, pays off the insured depositors ($270) and sells the bank's assets ($270). Because the value of First State's assets equals the payout to insured depositors, the FDIC suffers no loss.

Balance Sheet for First State Bank of Nowhere—Scenario 1
Assets	$	Liabilities and capital	$
Cash	30	Insured Deposits	270
Loans	300 240	Capital	60 0
Total Assets	330 270	Total Liabilities and Capital	330 270

Scenario 2—Panel A

No economic shock occurs, and good times continue. Because of the good economic climate, First State receives applications for $80 in new loans. The bank contacts its regional Home Loan Bank for funds. Specifically, First State arranges an $80 advance—pledging existing loans as collateral—and makes the new loans. As a result, bank assets grow by 24.2 percent, and the capital ratio falls to 14.6 percent.

Balance Sheet for First State Bank of Nowhere—Scenario 2, Panel A
Assets	$	Liabilities and capital	$
Cash	30	Insured Deposits	270
Loans	300 380	FHLB Advancs	80
		Capital	60
Total Assets	330 410	Total Liabilities and Capital	330 410

Scenario 2—Panel B

Not long after the new loans are booked, an economic shock hits First State's market, raising the unemployment rate and the loan default rate. As in Scenario 1, defaults reduce the value of First State's loan portfolio by 20 percent. The 20 percent loss translates into $76, which the bank deducts from the loan account
and from the capital account. After the loss is recorded, First State's capital level is –$16. The FDIC closes the bank, pays off the insured depositors ($270), and—because the advances were secured with collateral—mails a check to the FHLB ($80). The FDIC then sells First State's assets ($334). The FDIC suffers a loss of $16, a sum equal to the difference between the payout to insured depositors ($270) and net proceeds from the asset sale (total proceeds minus the payoff to FHLB, which equals $254).

Balance Sheet for First State Bank of Nowhere—Scenario 2, Panel B
Assets	$	Liabilities and capital	$
Cash	30	Insured Deposits	270
Loans	380 304	FHLB Advancs	80
		Capital	60 -6
Total Assets	410 334	Total Liabilities and Capital	410 334

Funding growth with advances rather than uninsured deposits increases losses to the FDIC. Suppose First State had used uninsured deposits to fund the new loans in Scenario 2. In this case, the FDIC would have closed the bank, paid off the insured depositors ($270) and sold the bank's assets ($334). The proceeds from the asset sale would have been divided among the uninsured depositors and the FDIC. The division of the proceeds would have reflected the percentage of total debt held by each debt holder. Uninsured depositors would have held 22.9 percent ($80/$350 = 22.9 percent) of the bank's debt, so they would have been entitled to 22.9 percent of the proceeds of the asset sale (0.229 x $334 =$76.49). Similarly, the FDIC, representing insured depositors, would have been entitled to 77.1 percent of the proceeds (0.771 x $334 = $257.51). In the end, the FDIC would have suffered a loss of only $12.49. This loss is equal to the difference between the payoff to insured depositors ($270) and the FDIC's share of proceeds from the asset sale ($257.51).

Access to advances allowed First State to grow without paying a premium for additional funding. Without FHLB funding, the bank could have grown only by attracting insured or uninsured deposits. Attracting insured deposits is costly because customers demand services and returns comparable to those offered by large banks and mutual funds. Attracting uninsured deposits is costly because depositors demand compensation for the risk of potential losses ($3.51 in the example above, which is the difference between the $80 claim and the $76.49 share of asset sale). Paying these extra costs to attract funding would have forced First State to think twice before booking the new loans.

Thomas A. Pollmann provided research assistance.

Endnotes

For a history of the FHLB system through the early 1990s, see GAO (1993). [back to text]
The Gramm-Leach-Bliley Act of 1999 defined a "community financial institution" as a bank with less than $500 million in assets. The same standard is used to define a community bank in this article. [back to text]
Feldman and Schmidt (2000) estimated the likely expansion of membership and borrowing among agricultural banks. The same approach was used here. [back to text]
The 12 regional banks are located in: Atlanta, Boston, Dallas, Des Moines, Chicago, Cincinnati, Indianapolis, New York, Pittsburgh, San Francisco, Seattle and Topeka. [back to text]
See CSBS (2000), pp. 38-39, for a list of all GLB Act provisions that deal with the FHLB system. [back to text]
Data obtained from FHLB (1999). [back to text]
See Leggett and Strand (1997) for a discussion of the impact of these bailouts on the perceived default risk of government-sponsored enterprises. [back to text]
For a broader discussion of the absence of credit risk on FHLB advances, see Congressional Budget Office (1993), pp. 18-19. [back to text]
The regulatory leverage ratio is Tier 1 capital to assets. Tier 1 capital is a bank's core capital, which consists mostly of common stockholders' equity. [back to text]
The FHLB maintains two programs to help low-income individuals gain access to housing: the Affordable Housing Program and the Community Investment Program. In addition, the thrift clean-up legislation in 1989 dictated that a portion of the system's retained earnings, along with an annual assessment on the system's net income for the following 40 years, be used to help defray the cost of resolving failed thrifts. General Accounting Office (1993) contains a detailed discussion of these obligations. [back to text]

References

Conference of State Bank Supervisors (CSBS). "The Gramm-Leach-Bliley Financial Modernization Act of 1999: A Guide for the State System," Washington, DC, 2000.

Congressional Budget Office (CBO). "The Federal Home Loan Banks in the Housing Finance System," (July 1993).

Federal Home Loan Bank System (FHLB). "Financial Report 1999," March 29, 2000.

Feldman, Ron J., and Jason E. Schmidt. "Agricultural Banks, Deposits and FHLB Funding: A Pre- and Post-Financial Modernization Analysis," Journal of Agricultural Lending (Winter 2000), pp. 45-52.

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

Leggett, Keith J., and Robert W. Strand. "The Financing Corporation, Government-Sponsored Enterprises, and Moral Hazard," Cato Journal (Fall 1997), pp. 179-87.