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Before the Committee on Banking, Housing, and Urban Affairs, U.S. 

United States Government Accountability Office:


For Release on Delivery Expected at 10:00 a.m. EDT:

Wednesday, April 13, 2005:

Federal Home Loan Bank System:

An Overview of Changes and Current Issues Affecting the System:

Statement of Thomas J. McCool, Managing Director, Financial Markets and 
Community Investment:


GAO Highlights:

Highlights of GAO-05-489T, a testimony to the Committee on Banking, 
Housing, and Urban Affairs, U.S. Senate: 

Why GAO Did This Study:

The FHLBank System (FHLBank System or System) is a government-sponsored 
enterprise (GSE) that consists of 12 Federal Home Loan Banks (FHLBanks) 
and is cooperatively owned by member financial institutions, typically 
commercial banks and thrifts. The primary mission of the FHLBank System 
is to promote housing and community development generally by making 
loans, also known as advances, to member financial institutions. To 
minimize the potential for significant financial problems, the Federal 
Housing Finance Board (FHFB) regulates the FHLBank System’s safety and 
soundness. Over time, a number of developments have affected the 
System’s safety and soundness and have created pressures on its 
traditional cooperative structure. 

To assist the committee in understanding the important issues 
surrounding the FHLBank System and its regulation, this testimony 
provides information on the development of the System; two legislative 
changes and FHFB rulemaking that led to changes in membership, asset 
composition, and capital structure; and important challenges and 
questions the FHLBank System currently faces.

What GAO Found:

Established in 1932 to facilitate the extension of mortgage credit, the 
FHLBank System has undergone significant statutory changes in the last 
15 years. Between the 1930s and the 1980s, the System consisted 
primarily of thrift members that accepted advances from the FHLBanks. 
However, during the 1980s, hundreds of FHLBank member thrifts failed 
forcing Congress to fundamentally reform the System through the 
Financial Institutions Recovery, Reform, and Enforcement Act of 1989 
(FIRREA). For example, FIRREA permitted commercial banks to join the 
System. Although FIRREA is credited with strengthening the thrift 
industry and the System, concerns were raised during the 1990s about 
the System’s capital structure. In particular, commercial bank members 
could remove stock from their FHLBank on 6-months notice, which raised 
concerns about the System’s financial stability. Among other 
provisions, the Gramm-Leach-Bilely Act (GLBA) of 1999 created a more 
permanent and risk-based capital structure for the System. 

Due to these statutes and FHFB rulemaking, the FHLBank System has 
evolved substantially since 1990. For example, commercial banks now 
account for more than 70 percent of all System members. The composition 
of FHLBank System assets has also fluctuated considerably over the 
years. For example, FHFB authorized the FHLBanks to purchase mortgages 
directly from their members in the 1990s. The System’s mortgage assets 
grew to about $113 billion at yearend 2003 representing about 14 
percent of total assets. However, the rapid growth in System mortgage 
assets leveled off in 2004 as two FHLBanks experienced problems 
managing the interest-rate risks associated with holding mortgages on 
their books. As provided by GLBA, System capital is now more permanent 
as members generally must invest capital for a period of 5 years and 
the FHLBanks are subject to new leverage and risk-based capital 

The FHLBank System faces important challenges and questions going 
forward. For example, FHFB has called the FHLBanks’ risk-management 
practices into question, particularly those related to mortgage 
purchase programs. Further, proposals to permit the FHLBanks to issue 
mortgage-backed securities (securitization) could help ensure the 
growth of the mortgage purchase business and improve risk management, 
however these proposals raise questions regarding the FHLBanks’ 
capacity to manage the related risks. Additionally, there is limited 
empirical information available regarding the extent to which the 
System is fulfilling its housing and community mission. Finally, 
questions have been raised regarding the potential negative affects 
that large financial institutions may have on the traditional 
cooperative structure of the FHLBank System and its programs designed 
to benefit targeted groups.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Thomas J. McCool at (202) 
512-8678 or

[End of section]

Dear Mr. Chairman and Members of the Committee:

I appreciate the opportunity to participate in today's hearing to 
provide an overview on the Federal Home Loan Bank System's (FHLBank 
System or System) operations, its federal oversight, and challenges 
that it faces. As you know, the FHLBank System is a government- 
sponsored enterprise (GSE) that consists of 12 Federal Home Loan Banks 
(FHLBanks) and is cooperatively owned by member financial institutions, 
typically commercial banks and thrifts (or savings and loans). The 
primary mission of the FHLBank System is to promote housing and 
community development generally by making loans, also known as 
advances, to member financial institutions. These institutions are 
required to secure FHLBank advances with high-quality collateral (such 
as single-family mortgages) and may use the advances to fund mortgages. 
To raise the funds necessary to carry out its activities, the FHLBank 
System issues debt in the capital markets at favorable rates compared 
to commercial borrowers due to its GSE status. According to the Federal 
Housing Finance Board (FHFB), as of December 31, 2004, the System had 
$855 billion in outstanding debt obligations.[Footnote 1]

Because the FHLBank System is a GSE, the potential exists that the 
federal government would be called on to provide financial assistance 
to the System if it was unable to meet its financial obligations. To 
minimize the potential that the FHLBank System would experience 
significant financial problems, Congress established the FHFB as the 
System's safety and soundness regulator in 1989. FHFB is also 
responsible for helping to ensure that the FHLBanks fulfill their 
housing and community development mission.

In recent years, the FHLBank System has undergone important changes and 
questions have been raised regarding the adequacy of FHLBanks' risk- 
management practices and the functioning of the System's cooperative 
structure. For example, since 1997, the FHLBank System has moved beyond 
the traditional advance business by establishing programs to purchase 
mortgages directly from member financial institutions, an activity 
similar to the mortgage purchase business of the two other housing 
GSEs: Fannie Mae and Freddie Mac. Although such mortgage purchase 
programs have the potential to increase profitability and better serve 
member institutions, they also expose FHLBanks to interest-rate and 
credit risk.[Footnote 2] FHFB recently identified interest-rate risk 
management deficiencies at two FHLBanks and required them to take 
corrective measures. The traditional cooperative structure of the 
FHLBank System has also been challenged by sometimes sharp differences 
in business strategies among the 12 FHLBanks. In particular, FHLBanks 
have disagreed over proposals to permit securitization of mortgage 
assets.[Footnote 3] While securitization may permit FHLBanks to expand 
their purchase of mortgage assets, some FHLBanks also regard it as 
changing the business of the System and increasing potential risks.

To assist the committee in understanding the important issues 
surrounding the FHLBank System and its regulation, my testimony today 
is divided into three parts. First, I will provide an overview on the 
development of the FHLBank System and its supervision with a focus on 
how two statutes: the Financial Institutions Recovery, Reform, and 
Enforcement Act of 1989 (FIRREA) and the Gramm-Leach-Bliley Act of 1999 
(GLBA) made substantial changes to the System's original structure and 
capital requirements. Second, I will provide more detailed information 
as to how FIRREA and GLBA, as well as FHFB rulemaking have changed the 
System's membership, asset composition, and capital structure over the 
past 15 years. Third, I will discuss important challenges and questions 
affecting the FHLBank System.

In summary:

* Congress established the FHLBank System in 1932 to help rescue the 
housing finance market, which had been decimated by the Great 
Depression. Between the 1930s and the 1980s, each FHLBank made advances 
to thrifts in its district that were required to be members of the 
System, and these activities were credited with helping to develop a 
unified housing finance market. However, in response to the thrift 
crisis of the 1980s, Congress enacted FIRREA which, among other 
provisions, opened FHLBank System membership to commercial banks and 
other insured depository institutions on a voluntary basis and 
permitted such members to withdraw capital from the System with 6- 
months notice (whereas thrifts were still required to become members 
and as mandatory members could not withdraw their minimum required 
amount of capital). In 1999, due to concerns that voluntary members' 
ability to withdraw capital increased risks to the System, GLBA made 
System membership voluntary for all institutions but required a more 
permanent capital structure with leverage and risk-based capital 

* Due to FIRREA, GLBA, and FHFB rulemaking, the FHLBank System has 
evolved substantially since 1990. For example, commercial banks now 
account for more than 70 percent of all the System members, whereas 
thrifts accounted for nearly 100 percent of all members in 1990. The 
composition of FHLBank System assets have also fluctuated considerably 
over the years, although advances remain the largest asset. In the 
early to mid 1990s, advances declined from about 70 percent of the 
System's assets to about 50 percent as the FHLBanks increased 
investments in mortgage-backed and other types of securities 
(investments increased from about 27 percent of the System assets in 
1990 to 43 percent in 1996). System investment assets increased as 
FHLBanks sought higher returns than those available from the 
traditional advance business. Between 1997 and 2003, FHLBank System 
mortgage holdings increased as a percentage of assets, relative to 
advances and other investments. However, mortgage holdings leveled off 
in 2004 as a result of the financial difficulties some FHLBanks 
experienced with their mortgage purchase programs. Consistent with 
GLBA, the FHLBank System has also largely implemented its new capital 

* The FHLBank System is currently facing several important challenges 
and questions regarding its risk-management practices, future business 
strategies, mission accomplishment, and organizational structure. As I 
described previously, FHFB has entered into written supervisory 
agreements with two FHLBanks due to risk management deficiencies in 
their mortgage purchase programs--including the Chicago bank which has 
been the engine of growth for the System's mortgage purchases--and 
placed limits on future purchases until identified deficiencies are 
corrected. Although securitization has been proposed as a means to 
permit the FHLBank System to continue expanding its mortgage purchase 
programs over the long-term, the idea is highly controversial. Another 
challenge facing the System is that there is limited empirical 
information on the extent to which FHLBank advances and other services 
benefit housing and community finance. Finally, concerns have been 
raised that large financial institutions that may have subsidiaries 
with memberships in two or more FHLBank districts could generate 
dangerous competition within the System and negatively affect its 
community development efforts.

To prepare for this testimony, we reviewed several reports and 
testimonies that we have completed on the FHLBank System and 
FHFB.[Footnote 4] We also obtained FHLBank System financial data for 
2004 from FHFB. Additionally, we interviewed several FHLBank presidents 
as well as the FHFB Chairman, two FHFB board members, and agency 
officials. We conducted our work in Washington, D.C., between March and 
April 2005 in accordance with generally accepted government auditing 

Overview of the Federal Home Loan Bank System and Its Regulation:

I would like to begin my testimony by briefly describing the 
development of the FHLBank System, significant statutory changes to the 
System, and its operations. Then, I will describe FHFB's structure and 

The FHLBank System Was Established to Facilitate Housing Finance and 
Has Undergone Significant Changes in Recent Decades:

Congress passed the Federal Home Loan Bank Act (FHLBank Act) in 1932 
and established the FHLBank System to facilitate the extension of 
mortgage credit and the housing finance market, which had been severely 
affected by the Great Depression. The FHLBank Act required all 
federally chartered thrifts to become members of the FHLBank located in 
their districts (see fig. 1) and invest capital in the FHLBanks. The 
System acted as a central credit facility that made advances to thrifts 
which, in turn, were expected to make additional mortgage credit 
available to homebuyers and thereby revive the housing finance market. 
The act also established safeguards to help ensure the financial 
soundness of the FHLBanks. In particular, thrifts had to pledge high- 
quality assets in excess of the value of their advances as collateral. 
In addition, the act created the Federal Home Loan Bank Board (Bank 
Board) to oversee the safety and soundness regulation of the FHLBanks 
as well as the thrift industry. However, between 1985 and 1989, the 
Bank Board delegated its oversight responsibility of the thrift 
industry to each of the FHLBanks.

Figure 1: Location of the 12 Federal Home Loan Banks:

[See PDF for image]

[End of figure]

The business of the FHLBank System and its members essentially remained 
unchanged from the 1930s until the 1980s. The System is generally 
credited with serving as a relatively low-cost funding source for 
thrifts during that period and helping to overcome regional shortages 
in housing credit. However, due to regional downturns, sharply rising 
interest rates, and poor management, hundreds of FHLBank member thrifts 
failed during the 1980s, causing a contraction in FHLBank System 
business. As a result, Congress appropriated billions of dollars to 
cover the costs associated with ensuring the payment of insured thrift 
deposits. In addition, the regulatory structure for the thrift 
industry--where FHLBanks supervised thrifts on behalf of the Bank 
Board--involved significant conflicts of interest. These conflicts 
(such as FHLBanks regulating institutions to which they made advances) 
compromised the safety and soundness oversight of the thrift industry. 
In response to these issues, Congress enacted the FIRREA, which made 
substantial changes to the FHLBank System's membership, regulation, and 
mission requirements as summarized below:

* FIRREA opened FHLBank system membership to commercial banks and 
credit unions that engaged in mortgage activities. These voluntary 
members were required to invest capital in their FHLBank but could 
normally withdraw such capital on 6-months notice. However, FIRREA 
still required thrifts to be members of their FHLBank and did not allow 
them to withdraw their capital contributions.

* FIRREA required the System to capitalize the Resolution Funding 
Corporation (REFCORP) to help pay for the deposit insurance fund losses 
resulting from thrift failures. Furthermore, the System had to pay up 
to $300 million per year of annual earnings to contribute towards 
interest payments on bonds issued by REFCORP to pay for thrift losses.

* FIRREA abolished the Bank Board and established FHFB to regulate the 
12 FHLBanks. FIRREA also transferred the Bank Board's previous 
supervisory and regulatory responsibilities for thrift institutions and 
their holding companies to the newly created Office of Thrift 

* FIRREA also directed each FHLBank to establish or maintain two low- 
and moderate-income housing programs--the Community Investment Program 
(CIP) and the Affordable Housing Program (AHP). As part of CIP, each 
FHLBank makes advances to finance the purchase or rehabilitation of 
housing for eligible households and finance other projects benefiting 
residents of low-and moderate-income neighborhoods. 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.

Although FIRREA is credited with helping to restore the financial 
condition and supervision of the thrift industry during the 1990s, the 
capital structure of the FHLBank System and the financial obligations 
that the act imposed on the System and its members subsequently raised 
concerns. In particular, the fact that voluntary members, such as 
commercial banks, had the option of removing their capital from the 
System with 6-months notice appeared to increase financial risks to the 
System. Additionally, since the FHLBanks' earnings had been weakened by 
the declining profitability of the thrift industry, the $300 million 
REFCORP obligation posed a challenge. Consequently, FHLBanks looked for 
new sources of revenue and increased investments in mortgage-backed 
securities that offered potentially higher returns, but exposed them to 
increased risks.

After years of attempting to resolve these issues, Congress passed the 
Gramm-Leach-Bliley Act of 1999 (GLBA), which contained provisions that: 

* Eliminated the requirement that thrift institutions be members of the 
FHLBank System and made membership voluntary for all members. 
Additionally, GLBA established new capital requirements for FHLBank 
members that were intended to make the System's capital more permanent. 
I will describe the capital provisions of GLBA in more detail later in 
my testimony;

* Revised the System's REFCORP obligations, moving from a fixed annual 
payment of about $300 million to a specified percentage (20 percent) of 
the System's annual earnings after AHP expenses. This change minimized 
the financial obligation on the System during periods of relatively low 
profitability but increased the total payment when profits increased; 

* Expanded the amounts and types of collateral that FHLBanks could 
accept for advances from small members known as community financial 
institutions (CFI).[Footnote 5] GLBA permitted CFIs to pledge small 
business and agricultural loans as collateral for FHLBank advances.

The Structure and Operations of the FHLBank System:

Each of the 12 FHLBanks has a board of directors of at least 14 
persons, with 8 elected by members and at least 6 appointed by FHFB. 
The FHFB appointed directors are commonly referred to as public 
interest directors.[Footnote 6] Additionally, each FHLBank board 
appoints a president who is responsible for overseeing the 
institution's staff (see table 1). The president and staff are 
responsible for such activities as the FHLBank's asset and liability 
management, AHP and other community development activities, and 
compliance with laws and regulations.

Table 1: Staff at Each FHLBank as of December 31, 2003:

FHLBank: Boston; 
Full-time: 154; 
Part-time: 2; 
Total: 156.

FHLBank: New York; 
Full-time: 204; 
Part-time: 4; 
Total: 208.

FHLBank: Pittsburgh; 
Full-time: 192; 
Part-time: 5; 
Total: 197.

FHLBank: Atlanta; 
Full-time: 278; 
Part-time: 0; 
Total: 278.

FHLBank: Cincinnati; 
Full-time: 144; 
Part-time: 2; 
Total: 146.

FHLBank: Indianapolis; 
Full-time: 127; 
Part-time: 7; 
Total: 134.

FHLBank: Chicago; 
Full-time: 295; 
Part-time: 6; 
Total: 301.

FHLBank: Des Moines; 
Full-time: 154; 
Part-time: 17; 
Total: 171.

FHLBank: Dallas; 
Full-time: 135; 
Part-time: 0; 
Total: 135.

FHLBank: Topeka; 
Full-time: 135; 
Part-time: 2; 
Total: 137.

FHLBank: San Francisco; 
Full-time: 220; 
Part-time: 4; 
Total: 224.

FHLBank: Seattle; 
Full-time: 148; 
Part-time: 3; 
Total: 151.

Source: FHLBank System Office of Finance.

[End of table]

The FHLBank System raises funds in the capital markets through its 
Office of Finance (OF), which has a board of directors consisting of 
three individuals who serve 3-year terms. FHFB appoints the OF chair 
and selects two FHLBank presidents to serve as the other OF board 
members. As I discussed earlier, the FHLBank System can issue debt, 
generally referred to as consolidated obligations, at a relatively low 
cost due to its GSE status, which may allow members to fund mortgages 
at lower rates. Consolidated obligations are the "joint and several" 
obligations of the FHLBanks. That is, if an FHLBank defaults on its 
repayment obligations, all the other FHLBanks may have to cover its 
obligations. Although the federal government does not explicitly 
guarantee that it would provide financial assistance to the FHLBank 
System in a financial emergency, investors perceive an implied 
guarantee because of the ties between the government and the System. 
For example, each FHLBank has a federal charter and consolidated 
obligations are exempt from federal, state, and local taxes. Moreover, 
the federal government did provide financial assistance to other GSEs, 
such as Fannie Mae and the Farm Credit System, when they experienced 
financial difficulties during the 1980s.

In addition to providing advances to its members, the FHLBank System 
provides member institutions other benefits and services. For example, 
FHLBanks generally pay dividends to their member financial 
institutions. Other services FHLBanks may offer members include 
providing discounts on advances for large transactions, funding the AHP 
and CIP programs to help members finance affordable housing and 
community development activities, and offering mortgage purchase 
programs as discussed next.

Although reportedly no FHLBank has ever suffered a credit loss on an 
advance, the business activities of the FHLBanks have become 
increasingly complex and potentially risky in recent years largely due 
to the implementation of the mortgage purchase programs. All of the 
FHLBanks are authorized to purchase mortgages from members through 
programs such as the Mortgage Partnership Finance (MPF) program and the 
Mortgage Purchase Program (MPP).[Footnote 7] Through these mortgage 
purchase programs, FHLBanks purchase conventional or government- 
guaranteed mortgages directly from their members. The FHLBanks hold the 
mortgages on their books and bear the interest-rate risks associated 
with them.[Footnote 8] To manage the interest-rate risks, FHLBanks must 
employ sophisticated risk-management techniques including the use of 
financial derivatives. Although such strategies are appropriate for 
risk management, they require specialized expertise, sophisticated 
information systems, and an understanding and application of sometimes 
complex accounting rules. As I discuss later, some FHLBanks recently 
have encountered financial problems in managing the interest rate risks 
associated with their mortgage portfolios.

FHFB Regulates FHLBank System Safety and Soundness and Mission 

FHFB is responsible for regulating the FHLBank System's safety and 
soundness as well as its mission achievement. The agency has a five- 
member board, with the President of the United States appointing four 
board members, subject to Senate approval. Each appointee serves a 7- 
year term. The fifth board member is the Secretary of the Department of 
Housing and Urban Development, or the secretary's designee. The 
President also designates one of the four appointed board members as 
the chair, subject to Senate approval. FHFB is located in Washington, 
D.C. and has a staff of about 124 individuals, including 17 examiners 
in eight cities where FHLBanks are located.

FHFB supervises the FHLBanks by conducting annual on-site examinations 
and off-site monitoring to ensure that the Banks satisfy capitalization 
requirements and maintain their ability to raise funds in the capital 
markets. On-site examinations are focused on particular risk areas 
(interest-rate risk, credit risk, and operational risk) and compliance 
with mission requirements such as the AHP program.[Footnote 9] 
Examiners set the scope for the examinations based on potential issues 
identified at previous examinations, as well as through quarterly 
monitoring. Off-site monitoring involves FHFB headquarters staff 
reviewing financial data on the FHLBanks on a continual basis. FHFB 
also conducts systemwide reviews of significant FHLBank operational, 
governance, and other practices and uses advisory bulletins and 
regulatory interpretations to convey guidance that addresses 
supervisory issues with systemwide implications.

Under the FHLBank Act, FHFB is authorized to promulgate and enforce 
such regulations and orders that it deems necessary to carry out its 
responsibilities. The following summarizes several of FHFB's key 

* FHFB has the authority to issue cease-and-desist orders and other 
enforcement actions to address unsafe FHLBank practices. FHFB also has 
the authority to remove FHLBank officials and prohibit actions by 
FHLBank officers and directors.

* FHFB does not have specific statutory authority to establish a prompt 
corrective action (PCA) mechanism as do other federal banking 
regulators such as the Office of the Comptroller of the Currency and 
the Federal Deposit Insurance Corporation. Under such PCA authorities, 
bank regulators are required to take specific supervisory actions when 
bank capital levels fall below specified levels and may take other 
actions when specified unsafe and unsound actions occur. Although FHFB 
does not have PCA authority, FHFB officials believe they have all the 
necessary authorities to carry out their responsibilities; and:

* FHFB has the statutory authority to liquidate or reorganize a 
critically undercapitalized FHLBank "whenever [FHFB] finds that the 
efficient and economical accomplishment of the purposes of the [FHLB 
Act] will be aided by such action."[Footnote 10]

FHLBank System Membership, Asset Composition, and Capital Structure 
Have Undergone Significant Changes in the Past 15 Years:

Until 1989, the FHLBank System consisted of the 12 FHLBanks, OF, and 
thrifts, which were required to join. However, FIRREA and GLBA made 
substantial changes to this traditional structure. In this section, I 
will describe in more detail how FHLBank System membership, asset 
composition, and capital structure have changed over the past 15 years 
after the implementation of these statutes and FHFB regulations.

Commercial Banks Currently Account for the Majority of System Members 
and Advances:

Between 1990 and 2004, FHLBank System membership nearly tripled from 
2,855 to 8,131 institutions (see fig. 2). As shown in the figure, the 
vast majority of membership increase can be attributed to commercial 
banks; whereas in the same period, thrift membership declined markedly. 
In 1990, thrifts accounted for 98 percent of all the System members but 
only 16 percent in 2004. In contrast, commercial banks accounted for 2 
percent of all members in 1990 and 73 percent in 2004.[Footnote 11] A 
variety of factors may account for the surge in commercial bank 
membership. First, FHLBanks actively recruited commercial banks as 
members after FIRREA. Commercial banks may also have been attracted by 
the fact that FHLBank advances represent a stable and relatively low- 
cost source of funding. Additionally, in an attempt to offset declining 
membership resulting from the failure of many thrifts, FHLBanks 
modified their services and products to attract new members. For 
example FHLBanks made changes in advance pricing and terms in response 
to market pressures.

Figure 2: Composition of FHLBank System Membership, 1990 and 2004, by 
Member Institution Type:

[See PDF for image]

[End of figure]

Not only do commercial banks represent a large percentage of FHLBank 
System members, they also hold a large percentage of System capital and 
advances.[Footnote 12] As shown in figure 3, commercial banks now 
account for almost half of the System's capital and advances. However, 
member thrifts still account for 43 percent of all system capital and 
50 percent of all advances. Although thrifts account for a relatively 
small percentage of FHLBank members, they have remained significant 
customers of the FHLBank System due to their focus on mortgage 

Figure 3: System Capital and Advances, by Member Institution Type, as 
of December 31, 2004:

[See PDF for image]

[End of figure]

Mix of System Asset Types Has Fluctuated Significantly from 1990 
through 2004:

FHLBank System assets, which consist of advances, investments, and 
mortgages, increased from $165 billion in 1990 to $934 billion in 2004. 
As shown in figure 4, the mix of the three asset types has fluctuated 
in this time period although advances remained the largest category of 
assets. However, I note that the System did not hold mortgage assets 
until 1997.

In 1990, advances represented about 70 percent of all the System's 
assets, but declined to about 50 percent between 1991 and 1996. In 
contrast, FHLBank System investments--such as holdings of mortgage- 
backed securities (MBS) issued by Fannie Mae and Freddie Mac--increased 
from 27 percent of all assets in 1990 to 43 percent in 1996. During 
that period, as I have discussed, the number of thrifts declined, 
resulting in a loss of System advance customers and concerns were 
raised that REFCORP obligations imposed significant financial burdens 
on the FHLBanks. Investments in MBS were viewed within the System as 
more profitable than traditional advances and a potential means to 
comply with the REFCORP obligations. Through rulemaking, FHFB 
facilitated the FHLBanks' ability to invest in MBS. In 1991, FHFB 
increased the percentage of MBS that the FHLBanks could hold as a 
percentage of their capital from 50 percent to 200 percent and, in 
1993, FHFB raised the MBS to capital ratio to 300 percent. I note that 
investments as a percentage of all the System's assets began to decline 
in 1995 while advances began to increase perhaps due, in part, to the 
increase in commercial bank members joining the System and taking 

Figure 4: Mix of System Assets between 1990 and 2004, by Advances, 
Mortgages, and Investments:

[See PDF for image]

Note: Data from 1990 to 2003 is from Office of Finance annual reports. 
According to the Office of Finance, the FHLBank of Chicago restated its 
2003 financial results, which resulted in changes to certain FHLBank 
System financial information. As of the date of this testimony, the 
restated report was not available, so we used the originally reported 
data for 2003. Since the Office of Finance 2004 annual report was not 
available at the time of this testimony, we used yearend 2004 data from 
FHFB. However, FHFB and the Office of Finance calculate investments 
differently. Therefore, we obtained 2004 data on investments from 
highlights of the upcoming Office of Finance 2004 annual report.

[End of figure]

As I have discussed, FHFB also authorized the FHLBanks to begin 
purchasing mortgage assets through mortgage purchase programs in 1997. 
By 2003, such mortgage assets grew to almost 14 percent of all the 
System's assets (about $113 billion in total System mortgage assets at 
year-end 2003). The growth in mortgages generally occurred relative to 
investments which declined from 40 percent of all assets in 1997 to 23 
percent in 2003. However, in 2004, the System's mortgage assets leveled 
off, partly because of difficulties identified at some FHLBanks in 
managing such assets. I discuss this issue in the next section.

FHLBank System Has Implemented a New Capital Structure:

As I discussed earlier, prior to 1999 voluntary FHLBank members, such 
as commercial banks, could withdraw their capital on 6-months notice, 
which raised questions about the stability of the FHLBanks' capital 
structure. To address this concern, GLBA established that FHLBank 
membership was voluntary but required that financial institutions that 
choose to become members invest more permanent stock in their FHLBank. 
Under the new capital structure, FHLBanks can issue class A stock, 
which can be redeemed with 6-months notice, and class B stock, which 
can be redeemed with 5-years notice, or both. To help ensure that 
capital does not dissipate due to redemption in times of stress, GLBA 
does not allow an FHLBank to redeem or repurchase capital if following 
the redemption the FHLBank would fail to satisfy any minimum capital 

Under GLBA, the FHLBanks are also subject to both a leverage 
requirement (minimum capital-to-assets ratio) and a risk-based capital 
calculation. Under the leverage requirements, each FHLBank must comply 
with two minimum capital ratios. First, permanent capital (equal to 
amounts paid in for class B stock plus retained earnings) plus class A 
stock is to be at least 4 percent of assets. Second, class A stock plus 
1.5 times permanent capital is to be at least 5 percent of assets. The 
risk-based capital standards account for credit risk, interest-rate 
risk, and operations risk. For credit risk, a FHFB regulation specifies 
capital requirements according to the mix of activities (advances, 
mortgages, etc.) in which the individual FHLBank is engaging. For 
interest-rate risk, each of the FHLBanks must have a FHFB-approved 
interest-rate risk model that provides an estimate of the market value 
of the FHLBank's portfolio during periods of market stress. The capital 
requirement for operations risk is generally 30 percent of the total 
capital charge for credit and interest-rate risk.

GLBA required each FHLBank to submit a capital plan to FHFB for review 
and approval. FHFB approved all 12 FHLBank capital plans by 2002 and 11 
of the 12 FHLBanks have implemented their capital plans. According to 
FHFB, 10 of the 12 capital plans rely entirely on class B stock and two 
of the capital plans include class A stock. As part of the capital plan 
implementation process, FHFB has required the FHLBanks to submit plans 
for modeling interest-rate risk and related procedures for managing 
these risks.

FHLBank System Faces Important Challenges and Questions:

Finally, I would like to discuss some important challenges and 
questions affecting the FHLBank System. They include risk-management 
practices, the securitization of mortgage assets, the extent to which 
the FHLBank System is meeting its mission requirements, and the alleged 
impacts that large financial institutions are having on the System's 
traditional cooperative structure and AHP program.

FHFB Has Questioned FHLBanks' Risk-Management Practices:

Over the past year, FHFB identified risk-management deficiencies at two 
FHLBanks--Chicago and Seattle--primarily related to their management of 
the interest-rate risks associated with mortgage purchases. FHFB 
identified weaknesses at these FHLBanks in such areas as corporate 
governance, financial recordkeeping, audit, and financial performance. 
Additionally, FHFB entered into written enforcement agreements with 
both FHLBanks that require improvements in accounting practices and 
internal controls. The Chicago and Seattle FHLBanks were both required 
to submit 3-year business and capital plans to FHFB and hire outside 
management consultants to review the banks' management and their 
board's oversight of the banks. The Chicago FHLBank has submitted its 
plan to FHFB, which accepted it. The Seattle FHLBank received an 
extension and submitted its plan to FHFB on April 5, 2005.

The financial problems identified at the Chicago and Seattle FHLBanks 
have had significant effects on their operations and business 
practices. For example, FHFB required the Chicago FHLBank to restate 
its financial results for 2003 and placed limits on the growth of the 
institution's mortgage purchases until its risk-management practices 
improve. Previously, the Chicago FHLBank had been the primary engine of 
growth for the mortgage purchase programs within the FHLBank System. 
The Seattle FHLBank has decided to exit from the MPP program and 
thereby stop purchasing mortgages from its members.

FHFB officials told us they continue to monitor risk management 
practices within the FHLBank System, particularly the management of 
interest-rate risks. FHFB officials said that their examinations 
continue to identify deficiencies in these areas and that they are 
working with the FHLBanks to correct them.

Proposals to Use Securitization to Expand FHLBanks' Mortgage Purchase 
Programs Are Controversial:

In recent years, proposals have been made to permit the FHLBanks to 
securitize mortgage assets to provide for the continued growth of the 
mortgage purchase programs. Without securitization, which would permit 
FHLBanks to remove mortgage assets from their balance sheets, the 
System's ability to increase its mortgage purchases may be constrained 
by capital requirements. That is, since the FHLBanks must comply with 
capital requirements for assets such as mortgages held on their balance 
sheets, they would not be able to expand these programs without 
obtaining additional capital from their members, which may prove 
difficult. According to FHFB's chair, the agency should defer to 
Congress on the question of whether FHLBanks should be permitted to 
securitize their mortgage assets.

Securitization offers potential benefits to the FHLBank System but it 
raises questions as well. One potential benefit of securitization is 
that it would provide the FHLBanks with an additional tool to manage 
the interest-rate risks associated with mortgage purchases. Authorizing 
the FHLBanks to securitize mortgage assets has also been advocated as a 
means to increase competition in the secondary mortgage market, which 
could benefit lenders and homebuyers. However, questions exist on 
whether the FHLBanks would be able to develop the necessary 
infrastructure, including hiring staff with specialized expertise, to 
effectively manage securitization programs. Some FHLBank System members 
have also commented that securitization would further alter the 
System's traditional focus on providing advances to member 
institutions, and therefore, be undesirable.

Limited Information Exists on the Extent to Which the FHLBank System Is 
Meeting Its Mission:

Although anecdotal information exists on the benefits of the FHLBank 
System, limited quantitative analysis exists on the extent to which the 
FHLBanks' activities benefit homebuyers, mortgage finance, and 
community development. We recognize that conducting such research is 
challenging. First, isolating the FHLBanks' effects on mortgage markets 
is a complex and technical undertaking. Second, with the addition of 
mortgage purchase programs, the financial activities of the FHLBanks 
have become more sophisticated, thus complicating any analyses of 
benefits and costs. Nevertheless, assessing the outcomes of the FHLBank 
System's activities is important for Congress and others to determine 
whether the risks associated with the System are offset by the 
potential benefits.

I would now like to highlight information and data limitations that 
hamper any assessment of mission achievement:

* We are not aware of any studies on the extent to which FHLBank 
advances, mortgage purchase, and other activities directly benefit 
homebuyers through lower mortgage costs. In contrast, several studies 
have estimated the potential savings to homebuyers associated with the 
mortgage purchase activities of Fannie Mae and Freddie Mac. Some of 
these studies estimate a substantial savings to homebuyers while others 
conclude that the savings are small and that Fannie Mae and Freddie Mac 
as well as their shareholders are the primary beneficiaries. Although 
the studies' findings may differ, they provide an empirical basis for 
discussing the costs and benefits of Fannie Mae and Freddie Mac's 

* Similarly, there is minimal empirical evidence on the extent to which 
the FHLBank System's advance business encourages lenders to expand 
their mortgage business. We have identified one existing study on this 
subject: a 2002 report by the Federal Reserve Bank of 
Cleveland.[Footnote 13] The study found that there is a significant 
positive relationship between an FHLBank member's use of advances and 
its mortgage finance activity. However, we believe the report has 
certain methodological limitations and should be interpreted with 
caution. For example, the report does not demonstrate that members 
increased their mortgage assets as a result of joining the System, it 
only shows that System members have relatively high mortgage assets 
compared to non-System members (We are also aware that the FHLBank 
Council recently released two reports on this subject but we have not 
had time to analyze them in preparation for this testimony).

* There is limited information as to why the placement of small 
business and agricultural collateral by small community financial 
institutions (CFI) to secure FHLBank advances has been minimal. GLBA 
expanded the types of collateral (including small business and 
agricultural collateral) that CFIs could pledge to secure FHLBank 
advances in the view that doing so would allow the System to better 
meet the needs of small institutions. However, FHFB data indicates that 
such collateral represents less than 1 percent of all collateral 
pledged to secure System advances. On the one hand, it may be the case 
that very few institutions are willing to pledge such collateral to 
secure advances. However, the potential also exists that FHLBanks have 
established such strict underwriting standards--for example by applying 
significant haircuts to the collateral--that CFIs have been discouraged 
from pledging it.[Footnote 14] We understand that FHFB is planning a 
conference later this year to gather additional information on the use 
of CFI collateral.

Questions Have Been Raised About the Impact of Large Holding Companies 
on the FHLBank System:

In recent years, questions have been raised about the potential impacts 
of holding companies who may have mortgage subsidiaries that are 
members of two or more FHLBank districts on the FHLBank System 
structure, which traditionally involved each financial institution 
belonging to one FHLBank. In a 2003 report, we noted that there are 
about 100 holding companies that had subsidiaries who were members of 
two or more FHLBank districts.[Footnote 15] Some observers have 
expressed concerns that such large financial institutions could 
pressure the FHLBanks to compete with one another on advance pricing 
terms--such as interest rates and collateral requirements--and that 
this competition could impair the overall safety and soundness of the 
FHLBanks. Our report noted significant differences in advance term 
pricing among the 12 FHLBanks and that the opportunity existed for 
holding companies to obtain advances from the FHLBank that offered the 
most favorable advance terms. Some FHLBank officials also said that 
holding companies seek to play one FHLBank off another creating 
competition within the System. However, we also found that FHFB had not 
identified any material safety and soundness issues related to 
FHLBanks' advance-term pricing. I would reiterate a statement in our 
2003 report that FHFB has a continued responsibility to monitor the 
FHLBanks to help ensure that any competition within the System does not 
result in unsafe and unsound practices.

Concerns have also been raised that the activities of large financial 
institutions such as holding companies are having negative affects on 
the AHP program in certain FHLBank districts. Under FIRREA, FHLBanks 
must contribute 10 percent of their previous year's earnings to 
subsidize housing finance for targeted groups. In some cases, financial 
institutions located in one FHLBank district have purchased banks or 
thrifts in other FHLBank districts. As such financial institutions grow 
through out-of-area acquisitions, they may be able to increase their 
business relations with their local FHLBank thereby increasing its 
profitability. For example, such financial institutions may take out 
additional advances or sell additional mortgages to the FHLBank. With 
potentially increased profits from doing business with a larger member, 
the FHLBank would have additional funds to devote to the AHP program. 
In contrast, FHLBanks whose members were acquired potentially lose net 
income and AHP funding dollars. According to one FHLBank president, 
such acquisitions have hurt AHP funding in his bank's district. 
However, according to FHFB officials, recent research they conducted 
shows that mergers may have a short-term impact on AHP funding, but 
these effects seem to balance out over time. For example, financial 
institutions in a FHLBank district that lost members through 
acquisitions may purchase financial institutions in other FHLBank 
districts thereby recapturing AHP funds. FHFB officials also said that 
they may develop a regulation to address any concerns associated with 
mergers on AHP funding.

Mr. Chairman, this completes my prepared statement. I would be happy to 
respond to any questions that you or other members of the committee may 
have at this time.

Staff Contacts and Acknowledgments:

For further information regarding this testimony, please contact me at 
202-512-8678 or or William B. Shear, Director, at 202- 
512-8678 or, or Wesley M. Phillips, Assistant Director, 
at 202-512-5660 or Individuals making contributions 
to this testimony include Rachel DeMarcus, Austin Kelly, Jill M. 
Naamane, Andy Pauline, Mitchell B. Rachlis, and Barbara Roesmann.


[1] As of the date of this testimony, the FHLBanks 2004 annual combined 
financial report was not yet available. For this testimony, we used 
FHLBank System's Office of Finance data from 1990 through 2003 and 
obtained the best available data for 2004 from FHFB.

[2] Interest-rate risk is the risk that relative and absolute changes 
in interest rates may adversely affect an institution's financial 
condition. Credit risk is the risk of nonperformance by counterparties 
to derivative agreements and other obligations or the risk that an 
FHLBank member would default on an advance. No FHLBank has reportedly 
ever suffered a credit loss on an advance due, in part, to the System's 
collateral requirements. Also, FHLBanks have a priority lien status on 
the assets of members who experience financial problems and are placed 
into receivership.

[3] Securitization is the process of aggregating similar instruments, 
such as loans or mortgages, into pools and selling investors securities 
that are backed by cash flows from these loan pools. Proposals have 
been made to permit FHLBanks to securitize mortgages that they purchase 
and issue mortgage-backed securities to investors. Fannie Mae and 
Freddie Mac are large issuers of mortgage-backed securities.

[4] See GAO, Federal Home Loan Bank System: Reforms Needed to Promote 
Its Safety, Soundness, and Effectiveness, GAO/GGD-94-38 (Washington, 
D.C.: Dec. 8, 1993); Capital Structure of the Federal Home Loan Bank 
System, GAO/GGD-99-177R (Washington, D.C.: Aug. 31, 1999); Comparison 
of Financial Institution Regulators' Enforcement and Prompt Corrective 
Action Authorities, GAO-01-322R (Washington, D.C.: Jan. 31, 2001); 
Federal Home Loan Bank System: Establishment of a New Capital 
Structure, GAO-01-873 (Washington, D.C.: Jul. 20, 2001); Financial 
Regulation: Review of Selected Operations of the Federal Housing 
Finance Board, GAO-03-364 (Washington, D.C.: Feb. 28, 2003); and 
Federal Home Loan Bank System: Key Loan Pricing Terms Can Differ 
Significantly, GAO-03-973 (Washington, D.C.: Sep. 8, 2003).

[5] CFIs are defined as Federal Deposit Insurance Corporation insured 
institutions that have less than $500 million in total assets, adjusted 
for inflation. In 2004, the CFI designation was $548 million. GLBA also 
allowed FHLBank members to make greater use of other real estate 
related collateral--such as commercial real estate loans and home 
equity loans--as collateral for FHLBank advances.

[6] At least two of the public interest directors are designated as 
community development directors because of their ties to the local 

[7] In 1997, the FHLBank of Chicago received approval from FHFB to 
begin operating a pilot program for MPF. In 1998, FHFB granted all 12 
FHLBanks the authority to establish similar mortgage purchase programs. 
Today, 9 FHLBanks offer MPF in conjunction with the Chicago FHLBank, 
and the remaining 3 (Cincinnati, Indianapolis, and Seattle) offer their 
own individual MPPs. However, the Seattle FHLBank recently announced 
its intention to exit from its MPP.

[8] Interest-rate risk management has always been necessary to deal 
with advances and holdings of investments in mortgage backed 
securities, but the increasing purchases of mortgages from members 
through MPF and MPP has increased the FHLBanks' need to manage the 
interest-rate risk associated with holding mortgage assets. 

[9] Operational risk is the risk of potential loss due to human error, 
systems malfunctions, man-made or natural disasters, fraud, or 
circumvention or failure of internal controls.

[10] 12 U.S.C. §1446.

[11] As of 1999 before GLBA made membership voluntary for all members, 
commercial banks accounted for 72 percent of all System members.

[12] FHLBank members are required to invest capital in their FHLBank as 
a condition for membership. Members are generally also required to 
place additional capital in their FHLBank on the basis of the size of 
their advance business or mortgage purchases.

[13] James B. Thompson, "Commercial Banks' Borrowing from the Federal 
Home Loan Banks," Federal Reserve Bank of Cleveland, July 2002.

[14] Haircuts refer to the discounts that FHLBanks apply to collateral 
that is used to secure advances. For example, if the FHLBank has a 40 
percent haircut for single-family mortgage loans, an FHLBank member 
could borrow up to 60 percent of the value of the single-family 
mortgages loans that it pledged as collateral.

[15] See GAO, "Federal Home Loan Bank System: Key Loan Pricing Terms 
Can Differ Significantly," GAO-03-973 (Washington, D.C.: Sep. 8, 2003).