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Viewpoint: FHLBs' Critical Role in Restoring Liquidity

American Banker | Friday, October 19, 2007
By John R. Price

The third quarter was one of the most tumultuous in years, and it should not have been surprising that the contagion of delinquency and defaults on subprime loans spread rapidly with brutal results.

The shifting structure of the market for mortgages echoes the transformation of financing for emerging markets. Though once largely confined to bank portfolio lending, emerging markets have shifted heavily toward capital markets, with extensive internationalization and a proliferation of debtholders.
Massive expansion of the mortgage securities markets meant the nexus of borrower and lender has been attenuated. Many originators were more lax in approving credits than they would have been if loans had stayed on their balance sheets — a situation compounded by financial engineering that made the credit reality of loan pools supporting complex instruments more opaque.

The seizing up of investors' willingness to take on more mortgage-backed securities had several consequences. First, confidence in the interbank market dwindled, driving up fund rates and often reducing tolerance to only overnight lending. Second, large poolers, which warehouse mortgages until they are securitized, faced a buildup in holdings and an evaporation of funding.
It was a liquidity crisis thrust suddenly upon us.

In stepped the Federal Reserve Board and the European Central Bank. In two major dollops, the Fed rapidly injected $70 billion of additional liquidity, hoping to break the fever. This injection and the reduction of the discount rate were widely heralded.

Less noticed was the role of the Federal Home Loan Banks. These triple-A government-sponsored enterprises — organized as a cooperative for banks, thrifts, insurance companies, and credit unions — played their intended role as a provider of liquidity.

As the Fed acted, the 12 Home Loan banks injected an additional $163 billion of liquidity to calm the markets, in the form of loans to members ranging from small community banks to large commodity players. All told, 8,100 financial institutions own and can borrow from the Home Loan banks.

The Federal Home Loan Bank System's office of finance issued overnight and term debt on demand. The banks in the system — one of the world's largest debt issuers, with more than $1.14 trillion of outstanding consolidated obligations — enjoy the broadest receptivity in the capital markets, passing on the proceeds of attractively priced, triple-A agency debt to members.

The Home Loan banks were a major pacifying influence. They provided on-request funding of varying durations as other sources of liquidity dried up or became prohibitively expensive.

They opened their doors 75 years ago this week, and it is appropriate to remember the circumstances surrounding their creation.

By December 1931, President Herbert Hoover was presiding over the failure of over 4,000 U.S. banks, foreclosures on a large percentage of homes and farms, and the unemployment of a quarter of the nation's work force. (Keep in mind that this was all prior to Social Security and other government safety nets, when most households relied on one spouse as the breadwinner.) Make no mistake — the situation was catastrophic.

President Hoover proposed the creation of the Home Loan banks and the Reconstruction Finance Corp. (the latter to offer liquidity to commercial banks and local governments, whose finances were also strained).

On Oct. 15, 1932, the Home Loan banks opened their doors and began jump-starting the financial sector with nontaxpayer liquidity. Providing ready, low-cost liquidity to local lenders in all economic cycles was, and still is, their core mission.

With passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, that mission was sharpened to include an obligation to assist with affordable housing. The Affordable Housing Program has served members and their low- and moderate-income communities well. The program is widely regarded as a model of cooperation among depository institutions, local developers, nonprofits, and government. With more than $3 billion of collective funding, the program is one of the largest housing foundations in the country.

More recently, the collateral Home Loan banks can lend against was expanded to include small-business, agribusiness, and commercial real estate loans, reflecting a new statutory emphasis on community and economic development.

The Home Loan banks will continue to support members during rough seas in the mortgage markets. But crisis or not, they will also try, through means such as the Home Loan Bank of Pittsburgh's introduction of free software, to enable members to manage risk and make more effective decisions about utilizing the system's credit products.

They also hope to broaden the ways in which they can help communities meet their need for infrastructure. Modifying the Internal Revenue Code to allow Home Loan banks to wrap triple-A letters of credit around tax-exempt obligations of smaller issuers — municipalities, colleges, and health-care entities — is entirely consistent with their mission.

To remain relevant, the Home Loan banks must define the most important ways in which they can help their members address new needs, through their special status, access to global financial markets, and as steady, reliable friends.

Mr. Price is the president and chief executive of the Federal Home Loan Bank of Pittsburgh