In February of this year, the Federal Housing Finance Agency (FHFA), regulator of Freddie Mac, Fannie Mae, and the eleven Federal Home Loan Banks (FHLBs), put out a request for input (RFI) concerning what type of companies are eligible to be members of the FHLB system, thereby gaining access to its low-cost advances.
The FHLB system consists of eleven regional banks that are cooperatives owned by their members, which their congressional charters currently specify can include commercial banks, thrifts, credit unions, insurance companies, and certain other organizations. The FHLBs borrow in the capital markets, with government support, and lend the funds—called “advances”—to their member-owners, secured by certain types of loans or securities (also as specified in the charters) and with extra margin to provide credit protection. Because of the government support for their borrowings, the advances are low-cost compared to the regular market-rate funding available to the member-owners. The original focus of the FHLB system, established as the Great Depression got into full swing and as implied by its name, was on mortgage lending and mortgage-centric financial institutions that were not eligible to be members of the Federal Reserve system (i.e., it excluded commercial banks) and which were in great distress at that time. Since then, as described in my new paper “The Role of the Implied Guarantee Subsidy in FHLB Membership: Beautiful Politics but Ugly Policy,” the system has undergone material mission creep.
As the late-June deadline for the RFI neared, articles appeared in the mortgage industry press to report on the views of various interest groups. “Industry trade groups have once again come out in favor of expanding the membership base of the Federal Home Loan Bank system,” summarized one such article. It made specific reference to the American Bankers Association (ABA) and the Mortgage Bankers Association (MBA), large and well-established industry associations that naturally represent the interests of their many members—which for the ABA includes the FHLBs themselves, and which for the MBA includes independent mortgage banks (IMBs)—and others advocating for expanded membership. It also referenced the Urban Institute’s support of allowing, in particular, IMBs to become members.
Many of the comments, including in the RFI document itself, focused on whether it was legitimate and good policy for some mortgage-specialized real estate investment trusts (mREITS), which by themselves would not be eligible to be members, to effectively become eligible through the usage of a “conduit”—in this case, a specially-created insurance subsidiary, because insurance companies are eligible to be members. They also focused on the mechanics needed to ensure that any new class of member would be strong enough to not hurt the collective financial strength of the FHLBs, which is a necessary consideration due to their cooperative structure.
The benefit of FHLB membership is almost always cited by the system’s supporters as access to funding in stressed markets. However, as outlined in my paper, the reality is far more complex. Membership allows all members to access funds not just in stressed periods, but on an everyday, long-term basis. Given the government support of their borrowings, FHLB advances are cheaper than members could get elsewhere, so that borrowings available on that everyday, long-term basis have become a source of subsidy to borrowing members. And the subsidy has grown over time, to the point where it is now quite large, and also very politically attractive.
Thus, at its core, the real story of FHLB membership expansion is a scramble to get in on one of the largest and most politically attractive subsidies from the taxpayer available to the mortgage industry today. The subsidy, which provides under-market-rate funding to routinely carry mortgage (and some other) assets, is, I estimate, worth billions of dollars per year, and is growing quickly. When commercial banks won the right to become members back in 1989, the win represented a major long-term lobbying accomplishment with the payback of subsidized funding costs ever since.
This was a classic unintended consequence: the FHLB mission had crept over decades from mainly providing stressed funding for small thrifts to now routinely providing large amounts of subsidized funding to the country’s biggest banks. Everyone in the mortgage industry is aware of it, but in all the submitted comments on the issue of expanding FHLB membership, no one comes out and says it plainly and clearly (although a few get close). It seems to be taboo, something one is not supposed to talk about in polite company.
The FHLB subsidy stems from the implied guarantee of its debts by the US government. Historically, this implied guaranty subsidy is best known in the context of Freddie Mac and Fannie Mae using it, and arguably abusing it. In fact, prior to their entering conservatorship in 2008, the implied guarantee subsidy was the source of the majority of GSE profits. As a subsidy, it was highly attractive because it was so well-hidden: it appears on no government budget line, does not appear on any list of tax expenditures, and does not require annual congressional approval. Interestingly, in their public pronouncements, the two government-sponsored enterprises (GSEs) even denied that it existed. As a result of this history, when the two companies entered conservatorship, a key feature of the rescue was a massive forced reduction in the inappropriate use of the subsidy.
Yet, that same implied guarantee subsidy is alive and well and growing at the FHLBs today. Although it is the source of virtually all their profits, they officially deny it exists (while privately admitting that it does). With no obvious limit on how large it can get, no need for annual congressional reapproval, and no transparency into its size on any budget report or list of tax expenditures, a subsidy doesn’t get much more politically attractive. One could even argue that it is the most politically beautiful subsidy ever invented. Naturally, once such an attractive subsidy is created, everyone wants their piece of the pie. After all, who wouldn’t want a subsidy that is well-hidden yet profitable, and can go on year after year, growing without limit? For decades, there has been lobbying for legislative changes, influencing for favorable regulations, and the cutting of deals to get in on the FHLB subsidy gravy train. It’s all part of how Washington works in this type of situation, and over decades it has worked quite well for the FHLBs and their members. With a steady expansion of both membership criteria and the assets that can be funded by the subsidized money, only the taxpayer is the poorer. It is an excellent example of how politics and economics merge in America’s housing finance system to take advantage of the taxpayer to benefit mortgage industry middlemen, with little if any of the subsidy going to homeowners.