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Impact of Excess Stock Rule on the Affordable Housing Program' which 
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June 22, 2007: 

The Honorable Christopher Bond: 
Ranking Member: 
Subcommittee on Transportation, Housing and Urban Development, and 
Related Agencies: 
Committee on Appropriations: 
United States Senate: 

Subject: Federal Home Loan Banks: Too Soon to Tell the Potential Impact 
of Excess Stock Rule on the Affordable Housing Program: 

Dear Senator Bond: 

Affordable housing organizations and Federal Home Loan Bank (FHLBank) 
members have raised concerns that a Federal Housing Finance Board 
(FHFB) rule limiting excess stock could adversely impact FHLBank 
earnings.[Footnote 1] In particular, concerns have been raised 
regarding the FHLBanks' Affordable Housing Program (AHP), which 
subsidizes the cost of affordable housing with funds from the 12 
FHLBanks, all of whom are required to contribute a minimum of 10 
percent of their prior year's net earnings to the program, subject to a 
minimum annual combined contribution of $100 million.[Footnote 2] You 
asked us to examine the impact of FHFB's rule making on AHP. 
Specifically, this report describes (1) the results of FHFB's rule 
making and the provisions of the final rule on excess stock, and (2) 
the potential impact of the final rule on AHP. On May 22, 2007, we 
provided your staff with a briefing on the results of our work. 
Enclosure I is an updated version of the briefing we provided. 

Background: 

In March 2006, FHFB issued a proposed rule that would require each 
FHLBank to (1) maintain a minimum level of retained earnings, (2) limit 
the amount of excess stock it could have outstanding, and (3) cease 
payments of dividends in the form of stock (referred to as stock 
dividends). However, in the final rule issued in December 2006, FHFB 
did not include a retained earnings requirement but did include limits 
on FHLBanks issuing excess stock and paying stock dividends. 

The FHLBank System was created by the Federal Home Loan Bank Act of 
1932 as a government-sponsored enterprise (GSE) to support mortgage 
lending and related community investment. Through AHP, the 12 FHLBanks 
subsidize the cost of affordable owner-occupied and rental housing 
targeted to individuals and families with very low, low, and moderate 
incomes.[Footnote 3] From 1990 through 2006, FHLBanks awarded a total 
of nearly $3 billion in AHP funds through member institutions, such as 
community banks, for a wide range of affordable housing projects. For 
2006 specifically, FHLBanks awarded a total of about $315 million in 
AHP funds. 

Final Rule Places Limit on FHLBanks Issuing Excess Stock and Paying 
Stock Dividends: 

The FHFB adopted a final rule in December 2006 limiting the ability of 
FHLBanks to create member excess stock under certain circumstances. The 
key features of the proposed rule were a limit on excess stock at each 
bank to one percent of its total assets, an absolute ban on the payment 
of stock dividends and sales of excess stock to members, and a 
requirement that banks with outstanding excess stock greater than one 
percent of assets develop a plan to reduce their excess stock to one 
percent. The effect of the final rule is that it limits the ability of 
FHLBanks to issue new shares of excess stock and pay stock dividends 
once the amount of outstanding excess stock reaches a threshold of 1 
percent of a FHLBank's total assets. 

The final rule addresses FHFB concerns about how excess stock could 
affect the FHLBanks System's mission. FHFB officials stated that 
FHLBanks have used cash from the sale of member excess stock to support 
capital market investments. They also noted that while some level of 
such investment is appropriate for liquidity and other purposes, high 
levels of excess stock can create an incentive for FHLBanks to create 
large portfolios of investments that are meant to provide a return on 
the excess stock, but which do not necessarily further the FHLBank 
System's public purpose of supporting mortgage lending and related 
community investment. 

The FHFB also addressed safety and soundness concerns in its rule 
making. Since FHLBanks have generally redeemed excess stock upon the 
request of a member, FHFB officials do not believe that member excess 
stock is a stable source of capitalization, particularly when it is 
used to capitalize long-term assets, and because FHLBanks could 
experience large-scale repurchase (stock redemption) requests in a 
short period of time. FHFB officials also stated that while investments 
funded through the issuance of excess stock are intended to generate 
bank income, they add risk to a bank's balance sheet and must be 
managed appropriately in order to be profitable. Further, other 
factors, such as the type of investment and degree of leveraging, also 
affect the level of earnings generated by each FHLBank's investments 
through excess stock. 

Too Soon to Tell Potential Impact of Excess Stock Final Rule: 

The final rule may have an impact on the FHLBanks' AHP, but FHLBank and 
trade group officials stated it is too early to tell. Officials at two 
FHLBanks told us that the final rule could limit the ability of 
FHLBanks to increase capital over time since FHLBanks can no longer pay 
stock dividends or issue excess stock once they reach the 1 percent 
threshold. Paying cash dividends in place of stock dividends lowers the 
amount of funds available to generate income through FHLBank 
investments. Since FHLBanks are required to contribute 10 percent of 
the prior year's net earnings to AHP, lower levels of FHLBank 
investments could lower net earnings, which in turn reduce FHLBank 
contributions to AHP. As of the end of September 2006, four FHLBanks 
had excess stock with a value greater than 1 percent of total assets, 
and one of these was paying stock dividends. This FHLBank paid a total 
of $205 million in stock dividends to members during 2006. According to 
the FHLBank's officials, if this amount had been paid in cash 
dividends, the resulting reduction in annual AHP funding would have 
been about $1.2 million since the bank would have had lower levels of 
investments to generate income. Overall, FHLBank and trade group 
officials we interviewed said it is too early to tell what the exact 
impact of the final rule on AHP will be. FHLBank officials stated that 
it is too early to make an accurate assessment whether FHLBank capital 
growth may decrease, by how much, and to what extent this could affect 
earnings and contributions to AHP. Trade group officials stated there 
has not been a noticeable impact on AHP subsidies for projects, but the 
situation could change based on what happens to the banks over time. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Chairman of FHFB for his 
review and comment. We received informal comments that are summarized 
in this section. We also received technical comments that we 
incorporated into the report where appropriate. In its comments, FHFB 
stated that our description in the report that it's too soon to tell 
the potential impact of the excess stock rule repeats, without 
independent analysis, arguments made by certain FHLBank officials and 
trade group representatives. Further, FHFB stated that the estimate 
presented in the report of the potential reduction in AHP contributions 
at one FHLBank depends on a number of assumptions, including a fixed 
leverage ratio, the pricing of products, and the types of investments 
the FHLBank makes. FHFB also noted that this estimate amounts to less 
than 1 percent of AHP funding by all the banks in 2006. In the absence 
of a rule in place over a period of time that limits the issuing of 
excess stock to members, we lack a basis for determining to what extent 
the rule may affect each FHLBanks' use of excess stock in financing 
investments, and to what extent earnings could be affected by those 
investments. While the final rule places limits on excess stock, we 
believe that the impact of actions taken by FHLBanks to date based on 
the rule cannot be determined given that the rule has been in effect 
only since the end of January 2007. Further, in our report, we note 
that various factors, including the degree of leveraging and type of 
investment, affect the level of earnings generated by investments made 
through the sale of excess stock. Finally, the estimate of the 
potential reduction in AHP contributions we report is for one FHLBank. 
Rather than making a direct comparison to either system-wide or FHLBank 
specific AHP funding, we provided the 2006 level of system-wide AHP 
funding in the background section of our report. 

FHFB also noted that two FHLBanks had income problems arising from 
mortgage loans capitalized by excess stock and were operating under 
written agreements in 2006, and that this capitalization of long-term 
assets was one of the concerns it addressed in restricting excess 
stock. We inserted in our report that one of the primary concerns FHFB 
had in its formulation of the rule is the capitalization of long-term 
assets. 

Scope and Methodology: 

To describe the results of the FHFB's rule making and the provisions of 
the final rule on excess stock, we obtained and analyzed information on 
FHFB's rule making for the proposed and final rule. We also reviewed 
comment letters submitted by FHLBanks and trade associations addressing 
the proposed rule and interviewed FHFB officials. To describe the 
potential impact of the final rule on the FHLBanks' AHP, we reviewed 
documentation on the possible impact of the final rule on the AHP. We 
also interviewed officials from two FHLBanks, one of which was the most 
affected by the rule, and officials from three trade associations--the 
Council of FHLBanks, the Mortgage Bankers Association, and the National 
Low-Income Housing Coalition. We conducted our work from February 2007 
through June 2007 in accordance with generally accepted government 
auditing standards. 

We are sending copies of this report to the Chairman of the 
Subcommittee on Transportation, Housing and Urban Development, and 
Related Agencies, Senate Committee on Appropriations; the Chairman and 
Ranking Member of the Subcommittee on Transportation, Housing and Urban 
Development, and Related Agencies, House Committee on Appropriations; 
and the Chairman of the FHFB. We will also make copies available to 
others upon request. In addition, the report will be available at no 
charge on the GAO Website at http://www.gao.gov. 

If you or your staff have any questions about this report, please 
contact me at (202) 512-8678 or shearw@gao.gov. Contact points for our 
Offices of Congressional Relations and Public Affairs can be found on 
the last page of this report. Major contributors to this report were 
John Wanska, Assistant Director; Tarek Mahmassani; Barbara Roesmann, 
and Paul Thompson. 

Sincerely yours, 

Signed by: 

William B. Shear, 
Director, Financial Markets and Community Investment: 

Enclosure: 

Enclosure I: Potential Impact of Excess Stock Rule on the Federal Home 
Loan Banks' Affordable Housing Program: 

Potential Impact of Excess Stock Rule on the Federal Home Loan Banks' 
Affordable Housing Program: 

Briefing for: 

The Honorable Christopher Bond: 
Ranking Member, Subcommittee on Transportation, Housing and Urban 
Development, and Related Agencies: 
Committee on Appropriations: 
United States Senate: 

May 22, 2007: 

Overview: 

* Introduction: 
* Objectives: 
* Scope and Methodology: 
* Background: 
* Discussion of Objectives: 

Introduction: 

Through the Affordable Housing Program (AHP), the 12 Federal Home Loan 
Banks (FHLBanks) subsidize the cost of affordable owner-occupied and 
rental housing targeting individuals and families with very low, low, 
and moderate incomes.[Footnote 4]  

From 1990 through 2006, FHLBanks awarded a total of nearly $3 billion 
in AHP funds through member institutions for a wide range of affordable 
housing projects. 

By statute, each of the 12 FHLBanks is required to contribute at least 
10 percent of its previous year's net earnings to AHP, subject to a 
minimum annual combined contribution by the 12 banks of $100 
million.[Footnote 5] 

Affordable housing organizations and FHLBank members have raised 
concerns that a Federal Housing Finance Board (FHFB) rule limiting 
FHLBank member excess stock (stock that is held by a member that 
exceeds that member's minimum investment in FHLBank capital stock) 
could adversely impact FHLBank earnings, and consequently funding for 
the FHLBanks' AHP. 

The FHFB issued a proposed rule in March 2006 that would have required 
each FHLBank to maintain a minimum level of retained earnings, limit 
the amount of outstanding excess stock it could have, and prohibit 
FHLBanks from paying dividends in the form of stock (referred to as 
stock dividends). 

The December 2006 final rule did not include a retained earnings 
requirement; the rule primarily focused on limiting the ability of 
FHLBanks to issue new shares of excess stock and pay stock dividends. 

Objectives: 

1. Describe the results of FHFB's rulemaking process and the provisions 
of the final rule on excess stock. 

2. Describe the potential impact of the final rule on the AHP. 

Scope and Methodology: 

Obtained and analyzed information on the proposed and final rule, the 
AHP, and the potential impact of the final rule on the AHP. 

Reviewed comment letters submitted by FHLBanks and trade associations 
about the proposed rule. 

Interviewed officials from FHFB and two FHLBanks, one of which was the 
most affected by FHFB's final rule. 

Interviewed officials from three trade associations: 

* Council of FHLBanks: 

* Mortgage Bankers Association: 

* National Low Income Housing Coalition: 

We conducted our work from February 2007 through June 2007 in 
accordance with generally accepted government auditing standards. 

Background: 

The FHLBank System (the System) was created by the Federal Home Loan 
Bank Act of 1932 as a government-sponsored enterprise (GSE) to support 
mortgage lending and related community investment. 

* The System comprises 12 FHLBanks with more than 8,000 member 
financial institutions, and the Office of Finance, which issues debt on 
behalf of the FHLBanks. 

* Each FHLBank is a separate, government-chartered, member-owned 
corporation. 

* As GSEs, FHLBanks are able to borrow in capital markets at favorable 
rates and provide secured loans, known as advances, at favorable rates 
to their members. 

FHFB is the regulator for the FHLBank System. 

FHFB ensures that the 12 FHLBanks: 

* Operate in a safe and sound manner; 

* Carry out their housing and community development finance mission; 

* Remain adequately capitalized; and: 

* Are able to raise funds in the capital markets. 

The Financial Institutions Reform, Recovery, and Enforcement Act 
(FIRREA) of 1989 established AHP and expanded the FHLBank System's 
mission to include affordable housing and community development 
lending. 

AHP requires each FHLBank to subsidize the financing of eligible low- 
and moderate-income housing and FIRREA sets priorities for use of these 
advances among eligible projects. 

Over the years, AHP has provided assistance to groups such as: 

* Low-and moderate-income homeowners and first-time homebuyers; 

* Very low-income residents of rental housing; 

* Residents in rural communities; and: 

* Residents in n urban areas. 

AHP funds are awarded through FHLBank members under two programs. 

* AHP competitive program: 

- Members submit applications on behalf of sponsors and developers of 
affordable housing projects. 

- Projects must meet certain eligibility requirements and those that 
achieve the highest scores on their applications obtain funding. 

* AHP homeownership set-aside program: 

- Each FHLBank may set aside up to the greater of $4.5 million or 35 
percent of its AHP funds each year to assist low-and moderate income- 
households in purchasing homes, provided that at least one-third of 
each FHLBanks set-aside allocation is made available to assist first- 
time homebuyers. 

- The FHLBanks allocate funds to members that in turn use them to make 
grants to eligible households. 

- Set-aside funds may be used for down payment, closing cost, 
counseling, or rehabilitation assistance. 

In 2006, FHLBanks awarded a total of about $315 million through both 
programs, with the competitive program accounting for about $265 
million. 

Excess Stock Rulemaking: 

Excess stock defined: 

* The members of each FHLBank must buy stock in the FHLBank, usually 
redeemable at par or face value, as a prerequisite for obtaining 
advances and other FHLBank services. 

* Excess stock is any FHLBank stock held by a member that exceeds that 
member's required minimum investment in capital stock. 

In the past, FHLBanks have issued excess stock and paid stock dividends 
to members. 

* Members may receive tax benefits from stock dividends versus cash 
dividends. 

* FHLBanks are able to use cash from the sale of excess stock and from 
paying stock instead of cash dividends to finance investments that 
provide another source of income. 

Rationale for rule (mission concerns): 

* FHFB had concerns about FHLBanks using member excess stock to support 
capital market investments, such as mortgage backed securities and 
other investments, that; 

- Exceeded the level of such investments required for liquidity and 
other purposes; and: 

- Did not necessarily further the FHLBank System's mission. 

Rationale for rule (safety and soundness concerns): 

* FHLBanks have generally redeemed excess stock upon the request of a 
member, and therefore FHFB did not believe that member excess stock was 
a sufficiently stable source of capitalization for FHLBanks, 
particularly because FHLBanks could experience large-scale repurchase 
(stock redemption) requests in a short period of time. 

* FHFB also believed that while FHLBanks have a 5-year statutory 
redemption period for Class B stock (6 months for Class A stock), 
waiting the entire 5-year period to honor the redemption request could 
be interpreted by members as a sign of a weak financial position, which 
could precipitate more redemption requests. 

* FHLBanks that use excess stock to capitalize long-term investments 
with significant market risk may not be able to sell the investment, in 
response to a redemption request prior to the 5-year waiting period, 
without realizing a loss in market value. 

* FHFB officials also explained that while FHLBanks may expect 
investments through excess stock to generate Bank income, these 
investments bear risk, and consequently excess stock has to be invested 
appropriately to be profitable. 

* In addition, FHFB officials cited other factors, such as type of 
investment and degree of leveraging, that can also affect the level of 
earnings generated by each FHLBanks investments through excess stock. 

The proposed rule would have placed limitations on member excess stock: 

* Limited the amount of member excess stock that a FHLBank could have 
outstanding to 1 percent of its total assets. 

* Required a FHLBank with excess stock greater than 1 percent of assets 
to submit a plan to FHFB describing how the FHLBank would come into 
compliance. 

* Prohibited a FHLBank from paying stock dividends regardless of how 
much excess stock it had outstanding and issuing any additional shares 
of excess stock to members. 

The proposed rule also would have required each FHLBank to achieve and 
maintain a minimum level of retained earnings. 

* The retained earnings provision would have also barred FHLBanks not 
meeting the minimum level from distributing more than 50 percent of net 
income as dividends, unless permitted by FHFB. 

* The retained earnings provision was not included in the final rule 
due to concerns by FHLBanks, their members, and trade groups that it 
would adversely affect the value of FHLBank membership. 

FHFB officials stated that they plan to address the retained earnings 
requirement in the future, but not earlier than 2008. 

Main provisions of the final rule that became effective on January 29, 
2007: 

* A FHLBank may not issue new shares of excess stock once the value of 
its total excess stock is greater than 1 percent of its total assets. 

* A FHLBank also may not pay stock dividends once its total excess 
stock is greater than 1 percent of its total assets. 

* FHLBanks with excess stock below the threshold are not limited in 
issuing additional excess stock or paying stock dividends, unless doing 
so would result in the value of the bank's excess stock exceeding 1 
percent of its total assets. 

* FHLBanks with excess stock exceeding the 1 percent barrier are not 
required to develop a plan to bring their level into compliance, but 
may not increase their level of excess stock. 

Potential Impact of Excess Stock Rule: 

As of the end of September 2006, four FHLBanks had excess stock with a 
value greater than 1 percent of total assets, and one of these was 
paying stock dividends. 

Officials at two FHLBanks told us that the final rule could limit the 
ability of FHLBanks to increase capital over time because: 

* When a FHLBank exceeds the 1 percent threshold, it can no longer pay 
dividends in the form of stock. 

* Paying cash dividends lowers the amount of funds available to 
generate income through FHLBank investments, such as mortgage-backed 
securities that could generate earnings over time. 

FHLBank and trade group officials we interviewed said this could have 
an impact on AHP. 

* Since FHLBanks are required to contribute a minimum of 10 percent of 
net earnings to AHP, lower levels of FHLBank investments could lower 
net earnings, which in turn reduce FHLBank contributions to AHP. 

For example, during 2006, one FHLBank paid $205 million in stock 
dividends to members. 

* According to the FHLBank's officials, if this amount had been paid in 
cash dividends, the FHLBank would have realized lower net income for 
the year since the money would not have been available to invest in 
interest-earning assets. 

* Based on the bank officials' estimates, the resulting reduction in 
annual AHP funding would have been about $1.2 million. 

The FHLBank in the example is the only one that as of September 2006 
had excess stock that exceeded 1 percent of total assets and was paying 
a stock dividend. This FHLBank can no longer issue excess stock or pay 
stock dividends until the value of its excess stock drops to 1 percent 
or less of its total assets. 

As of September 2006, three FHLBanks had excess stock that exceeded 1 
percent of total assets but were not paying a stock dividend to 
members. 

Had the final rule been in effect during 2006, these three FHLBanks 
would have been prohibited from issuing additional excess stock. 

FHLBank and trade group officials we interviewed said it was too early 
to tell what the exact impact of the final rule on AHP will be. 

* FHLBank officials stated that while the final rule could reduce the 
ability of banks to increase capital, it is too early to make an 
accurate assessment whether FHLBank capital growth may decrease, by how 
much, and to what extent this could affect earnings and contributions 
to AHP. 

* Officials from two trade groups stated that the final rule has not 
had a noticeable impact on AHP subsidies for affordable housing 
projects, but that this could change since the rule has only been in 
effect since the end of January 2007. 

[End of section] 

(250332): 

FOOTNOTES 

[1] Excess stock is stock that is held by a member and exceeds that 
member's required minimum investment in FHLBank capital stock. 

[2] Financial Institutions Reform, Recovery, and Enforcement Act of 
1989 (FIRREA), Pub. L. No. 101-73,  721, 12 U.S.C. 1430(j)(5). 

[3] AHP subsidizes the cost of owner-occupied housing for individuals 
and families with incomes at or below 80 percent of the area median 
income, and rental housing in which at least 20 percent of the units 
are reserved for households with incomes at or below 50 percent of area 
median income. The subsidy may be in the form of a grant or a below- 
cost, or subsidized, interest rate on a secured loan from a FHLBank to 
a member lender. 

[4] AHP subsidizes the cost of owner-occupied housing for individuals 
and families with incomes at or below 80 percent of the area median 
income, and rental housing in which at least 20 percent of the units 
are reserved for households with incomes at or below 50 percent of area 
median income. The subsidy may be in the form of a grant or a 
subsidized interest rate on a secured loan from a FHLBank to a member 
lender. 

[5] Financial Institutions Reform, Recovery, and Enforcement Act of 
1989 (FIRREA), Pub. L. No. 101-73,  721, 12 U.S.C. 1430 (j) (5). 

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