THE FEDERAL HOME LOAN BANKS
AND RISK DISTRIBUTION IN
U.S. HOUSING FINANCE
ALEX J. POLLOCK
March 11, 2003
157843
OUTLINE
I.
Overview of the Federal Home Loan Banks
I.
Risk Distribution Perspective
I.
Historical Development of the FHLBs
I.
Postulates of Housing Finance
2
ESSENCE OF FHLBs
FHLBs efficiently link
long-term residential mortgages
with the bond markets.
3
FEDERAL HOME LOAN BANKS
Overview
• AAA/Aaa rated government-sponsored
enterprise (GSE) created by Congress to
provide economical housing finance.
• FHLB debt raised in the global capital
markets provides financing for 7,900 member
financial institutions.
• Over 75% of U.S. banks and thrifts are
members.
• Each FHLB has own board and management.
• 70 years of profitability.
• No losses on advances to members.
4
FHLBs HAVE SIGNIFICANT SIZE
U.S. Banking Companies & Housing GSEs
As of 12/31/02, in Billions
Rank
1
2
3
4
5
6
7
8
9
10
11
12
Organization
Citigroup
Fannie Mae
Federal Home Loan Banks
J.P Morgan Chase
Freddie Mac
Bank of America
Wells Fargo
Wachovia
Bank One
Washington Mutual
MetLife
Taunus
Source: Bloomberg Professional, National Information Center (Federal Reserve System),
FHLB 2nd Quarter 2002 Financial report ; *3Q 2002 Financial Information
Assets
$1,097
$887
$766
$759
$722
$660
$349
$342
$277
$271
$268*
$254*
5
FHLBs COMBINED BALANCE SHEET
As of 12/31/02, in millions
Advances
Mortgage loans
Investments
TOTAL ASSETS
$489,598
60,553
215,723
$765,874
Bonds and discount notes
Deposits
TOTAL LIABILITIES
674,841
27,679
$729,570
Capital stock
Retained earnings
TOTAL CAPITAL
35,188
1,191
$36,304
6
FHLB MEMBERSHIP
As of Sept. 30, 2002
% of Industry
Banks
5,873
74%
Thrifts
1,408
95%
Ins. Cos. / CUs
TOTAL
711
7,992
7
THE FUNDAMENTAL RISK
DISTRIBUTION PERSPECTIVE
• Who has which risk?
• Who should have which risk?
• Mortgage Finance Systems =
Different patterns of risk distribution
8
CREDIT RISK
9
CREDIT QUALITY AND
GEOGRAPHIC CONCENTRATION
Distribution of One-Year Net Charge-Off Ratios
FHLB Chicago Thrift Members by Institution 1994-1998
70%
60%
Mean:
Mean + 1SD:
Mean + 3SD:
Mean + 5SD:
2.8
15.1
39.9
64.6
Observations:
438
Frequency
50%
40%
Mean + 3SD: 39.9 bp
(98.2% of Distr)
30%
20%
Mean: 2.8 bp
(81.3% of Distr)
10%
0%
-8
0
8
16
24
32
40
Net Charge-Off Ratio (bp)
48
56
64
72
10
INTEREST RATE RISK
AND
PREPAYMENT RISK
11
WHO HAS THE INTEREST RATE /
PREPAYMENT RISK?
• Variable Rate Mortgages
• Mark-to-Market Prepayment Fees
• Bond-Based Systems
• Pass-Through MBS
• GSE Balance Sheets
• Deposit Insurance
}
Borrower
}
Capital
Market
Participants
}
Government
Support
12
STRUCTURAL MODELS FOR
PROVISION OF HOUSING FINANCE
• Banking Model
– Deposit financed, portfolio lenders
• European Mortgage Model
– Bond financed, specialized portfolio lenders
• Contract Savings Model
– Deposit financed, specialized institutions
offering loan-linked savings contracts
• Secondary Market Model
– Bond financed, securitizing loans from
primary lenders
13
STRENGTHS OF EUROPEAN
MORTGAGE BANK SYSTEM
• Specialized Institutions Viewed as Lower Risk
– More transparent
– Separate and specialized regulatory focus
• Focus on Pure Mortgage Finance
• Ability to tap Capital Market Funding
– Source for longer term fixed rate funds
• Tested Model
– 200 years in Denmark, 100 years in Germany,
70 years in the U.S.
14
FHLBs LINK MEMBER LENDERS
TO THE GLOBAL BOND MARKETS
• The U.S. mortgage finance system must
distribute the risks inherent in long-term,
fixed-rate mortgages.
• Private credit institutions require an efficient
link to the bond markets in order to prudently
make long-term fixed-rate mortgages.
• The Federal Home Loan Banks are such an
effective link for member lenders.
15
AMERICAN HOMEOWNERSHIP RATES
1900
47%
1940
43%
1980
65%
1995
65%
2000
67.7%
16
HOMEOWNERSHIP RATES
INTERNATIONAL PERSPECTIVE
Ireland
Spain
Italy
Norway
Luxembourg
New Zealand
Australia
U.S.
U.K.
Finland
Belgium
Canada
80%
78%
78%
76%
72%
71%
70%
67.7%
67%
67%
65%
64%
Source: International Housing Finance Sourcebook 2000. (International Union for Housing Finance, 2001)
17
FEDERAL HOME LOAN BANKS
1932  2002
18
FHLB OWNERSHIP
1932:
U.S. Treasury purchases
initial capital
1933 – 1951:
Transition to private
ownership
1951 – Present:
100% private ownership by
member institutions
19
FHLB MEMBERSHIP
1932 – 1933:
Voluntary
1933 – 1989:
Primarily Mandatory
1989 – 1999:
Federal Thrifts – Mandatory
All Others – Voluntary
1999 – Present:
Entirely Voluntary
20
FHLB GOVERNANCE
Mixed Boards of Directors
Stockholder majority
Gov’t appointed minority
1932
9
2
11
Present
10
6
16
Chairmen of FHLB Boards
1932-1999:
Appointed by government
2000-Present:
Elected by Board of Directors
21
FHLB GOVERNANCE
Government oversight of the FHLBs has changed
1932-1989:
Federal Home Loan Bank Board
Manager / Regulator / Cheerleader
of FHLBs and thrift industry
1989-1999:
Federal Housing Finance Board
Manager / Regulator / Cheerleader
of only FHLBs
1999-Present:
Federal Housing Finance Board
Regulator of FHLBs
22
TRADITIONAL FHLB PRODUCTS
• Loans (advances) -- fully collateralized, low-cost,
short and long-term, fixed and floating-rate
• Affordable housing and community
development funding (AHP and CIP)
• Deposits
• Off balance sheet / risk management products
(Letters of credit, interest rate swaps, caps,
floors)
• Operating services
23
MORTGAGE PARTNERSHIP FINANCE®
A new line of business for the FHLBs
• An alternative for financial institutions to fund
fixed-rate, conventional mortgages.
• Creates a partnership between the FHLB and its
members to manage the risks of mortgages
– Each handles what it does best
• Adds needed competition to secondary market
– FHLB members and their customers benefit
– Credit risk is dispersed, not concentrated in
GSEs
24
MPF®: A BETTER METHOD OF
FUNDING HOME MORTGAGE LOANS
• Management of credit risk is not the problem.
• Financial institutions should be rewarded for
creating high-quality loans.
• Financial institutions should receive fees for
managing the credit risks of the loans they
originate, rather than paying GSEs to manage
those risks.
25
MPF® KEY CONCEPT:
MORTGAGES ARE BUNDLES OF RISKS
Natural Competitive
Advantage
•
•
•
Marketing Risk
Credit Risk
Servicing/Operations Risk
}
Financial Institution
•
•
•
Funding Risk
Interest Rate Risk
Options/Prepayment Risk
}
GSE
26
EVOLUTION OF RISK DISTRIBUTION
Allocation by
Mortgage Program
Traditional
Lending
Secondary
Market
MPF
Program
Interest Rate and
Options Risk
Lender
GSE
FHLB
Credit
Risk
Lender
GSE
Lender
27
BASIC POSTULATES OF HOUSING FINANCE
• Homeownership is important for every society,
as it promotes individual progress and social
stability.
• A robust mortgage financing system is needed
to achieve widespread homeownership.
• Robust mortgage finance requires private credit
institutions, with market incentives to balance
risk and return, innovate, allocate resources and
increase productivity.
• For lenders to offer long-term fixed-rate
mortgages, an effective link to the bond markets
is required.
28
“As a people we need at all times the
encouragement of home ownership.”
-- President Herbert Hoover,
proposing the Federal Home
Loan Bank Act in 1932
29
THE FEDERAL HOME LOAN BANKS
AND RISK DISTRIBUTION IN
U.S. HOUSING FINANCE
ALEX J. POLLOCK
March 11, 2003
30