Members of Federal Home Loan Banks

Federal RegisterJan 20, 2016

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FEDERAL HOUSING FINANCE AGENCY

12 CFR Part 1263

RIN 2590-AA39

Members of Federal Home Loan Banks

AGENCY:

Federal Housing Finance Agency.

ACTION:

Final rule.

SUMMARY:

The Federal Housing Finance Agency (FHFA) has adopted a final rule revising its regulations governing Federal Home Loan Bank (Bank) membership. The final rule adopts several key revisions included in the Notice of Proposed Rulemaking. These revisions will prevent the circumvention of the statute's membership restrictions by ineligible entities using captive insurers as conduits for Bank membership by defining the term “insurance company” to exclude captive insurers, thereby making them ineligible for Bank membership; permit any Bank that has admitted captives to membership a transition period within which to wind down its affairs with those entities; require a Bank to obtain and review an insurance company's audited financial statements when considering its application for membership; clarify the standards by which a Bank is to determine the “principal place of business” for its members, including specific standards for insurance companies and community development financial institutions; and remove obsolete provisions and make numerous non-substantive textual revisions so as to provide greater clarity. The final rule does not implement the proposed rule's provisions with respect to continuing eligibility requirements, in order, as explained below, to avoid compliance burdens that may outweigh the benefits. The specific revisions made, and the rationale for making them, are set forth in the

SUPPLEMENTARY INFORMATION

below.

DATES:

Effective Date:

February 19, 2016.

FOR FURTHER INFORMATION CONTACT:

Eric M. Raudenbush, Assistant General Counsel, Office of General Counsel,

Eric.Raudenbush@fhfa.gov,

(202) 649-3084; or Julie Paller, Senior Financial Analyst, Supervisory and Regulatory Policy, Division of Bank Regulation,

Julie.Paller@fhfa.gov,

(202) 649-3201 (not toll-free numbers), Federal Housing Finance Agency, 400 Seventh Street SW., Washington, DC 20219. The telephone number for the Telecommunications Device for the Hearing Impaired is (800) 877-8339.

SUPPLEMENTARY INFORMATION:

I. Background

A. Overview of the Existing Bank Membership Requirements

1. Statutory Requirements

The Federal Home Loan Bank System (Bank System) consists of eleven district Banks and the Office of Finance. The Banks are wholesale financial institutions, organized under authority of the Federal Home Loan Bank Act (Bank Act) to serve the public interest by enhancing the availability of residential housing finance and community lending credit through their member institutions and, to a very limited extent, through certain eligible nonmembers.

Each Bank is structured as a regional cooperative in that it is owned and controlled by member institutions located within its district, which are its primary customers.

See

12 U.S.C. 1423, 1431(e), 1432(a).

see also

National Association of Insurance Commissioners, Captive and Special Purpose Vehicle Use Subgroup of the Financial Condition Committee,

Captives and Special Purpose Vehicles—An NAIC White Paper

(June 6, 2013),

http://www.naic.org/store/free/SPV-OP-13-ELS.pdf

(last visited Dec. 8, 2015).

The proposed rule would have addressed this supervisory concern by defining the term “insurance company”—which is not defined in either the Bank Act or the existing regulation—to exclude captives, thereby rendering those types of entities ineligible for Bank membership. Specifically, the proposed rule would have defined “insurance company” to mean “a company whose primary business is the underwriting of insurance for nonaffiliated persons or entities.” A typical captive, whose primary business is the underwriting of insurance for its parent company or for other affiliates, would not be included within the scope of the proposed definition of “insurance company.” Because, as discussed above, the Bank Act and the membership regulation limit eligibility for Bank membership to institutions that qualify as an insured depository institution, a CDFI, or an insurance company, defining “insurance company” to exclude captives effectively removes such entities from among the types of institutions that may be eligible for membership.

Although the proposed rule would have made all captives ineligible for membership, it would have permitted any captive that had been admitted to membership prior to the publication date of the proposed rule to remain a member of its current Bank for five years following the effective date of the final rule. However, the rule would have capped the amount of advances that a Bank could have outstanding to such a member at 40 percent of the member's total assets and prohibited a Bank from making a new advance, or renewing an existing advance, with a maturity date beyond the five-year grace period. As proposed, the regulatory text would not have explicitly addressed the treatment of any captives that a Bank may have admitted to membership on or after the date on which the proposed rule was published. FHFA stated in the

SUPPLEMENTARY INFORMATION

to the proposed rule, however, that it would interpret the regulation to require the immediate termination of such captives' membership and the prompt liquidation of any outstanding advances.

The proposed rule also would have made several other substantive, but less fundamental, changes: (1) To expand the list of assets that qualify as “home mortgage loans” to include all types of mortgage-backed securities (MBS) (as opposed to only mortgage pass-through securities) that are fully backed by qualifying whole loans; (2) to require that a Bank examine an insurance company applicant's most recent audited financial statements in determining whether it meets the “financial condition” eligibility requirement; and (3) to revise the existing regulation and add a new provision addressing how a Bank should determine the “principal place of business” (and, therefore, the appropriate Bank district for membership) for insurance companies or CDFIs. In addition to those primary revisions, FHFA also proposed to make a number of conforming changes necessary to integrate the new requirements into the regulation and to make numerous non-substantive revisions to clarify various regulatory provisions.

D. Overview of Comments on the Proposed Rule

The proposed rule initially provided for a comment period of 60 days, but, in response to numerous requests, FHFA extended the comment period to 120 days.

The extended comment period closed on January 12, 2015, and FHFA received over 1,300 comment letters in response to the proposed rule. Nearly 60 percent of the comment letters came from bank and thrift institutions and related trade associations; about 12 percent came from credit unions and related trade associations. The remainder of the letters were from the Banks (all of which sent more than one letter), insurance companies, CDFIs, affordable housing agencies and organizations, various types of community support organizations, home builders, REITs, public officials, and others. About two-thirds of all letters were versions of one form letter template or another.

See

79 FR 60384 (Oct. 7, 2014).

Few of the comment letters expressed support for any aspect of the proposed rule, and the vast majority expressed opposition to, or requested that FHFA withdraw, the entire rule. The most commonly expressed concerns arose from a belief that the rule, if implemented, would result in the Banks having fewer members on average and that this, in turn, would result in a reduction in their income. This, commenters contended, would compromise the Banks' ability to act as reliable sources of liquidity, inhibit their ability to carry out their housing

finance and community development mission, and reduce the amount of funds available for their Affordable Housing Programs and Community Investment Cash Advance programs. However, few of the commenters expressing these views provided factual support for their opinions or attempted to quantify the effects they believed the rule would have on the Banks' operations.

FHFA reviewed every comment letter and considered all of the comments in developing the final rule. The primary comments regarding each of the substantive aspects of the proposed rule, as well as FHFA's responses to some of those comments, are discussed immediately below. Comments addressing specific rule provisions are discussed in part III of this

SUPPLEMENTARY INFORMATION

, which describes the final rule in detail and the ways in which it differs from the proposed rule.

1. Comments on the Proposed Ongoing Asset Ratio Requirements

Over 800 of the comment letters addressed FHFA's proposal to measure compliance with the “makes long-term home mortgage loans” requirement based on a quantitative standard and to apply that quantitative requirement to members on an ongoing basis. Over 600 of the letters addressed the proposal to apply the “10 percent” requirement to members on an ongoing basis. Almost all of the commenters addressing those proposals were opposed to the proposed revisions. Approximately 66 percent of those opposed to the ongoing quantitative “makes long-term home mortgage loans” requirement and approximately 51 percent of those opposed to the ongoing “10 percent” requirement stated that managing their balance sheets for compliance would hinder members' business by putting them in the position of choosing between optimal balance sheet management and continued access to their Banks as a source of liquidity. About half of the commenters opposed to the proposed revisions stated that members would be harmed by losing membership in the Bank System and about half also cited concerns regarding the additional regulatory burden on members.

As further objections to the proposal, commenters also stated, among other things, that the proposal would create a significant operational burden on the Banks because the member financial information required to determine compliance with the ongoing requirements is not perfectly aligned with specific call report line items; the proposal would provide little or no benefit to the Bank System; members could never be certain that FHFA would not increase the quantitative requirements in the future; the proposed ongoing requirements would reduce membership levels at the Banks; the current regulations and collateral requirements already ensure that members maintain a nexus to the Banks' housing finance mission; the proposed ongoing requirements have no foundation in the Bank Act or its legislative history; and the requirements do not take into account that financial services organizations are often structured such that they hold mortgages and mortgage securities in various entities within their corporate organization for a range of business reasons.

Commenters also expressed concerns specific to the proposal to make the “10 percent” requirement ongoing, including that CFIs with total assets approaching the CFI threshold amount might forego acquiring another institution or reduce other activities that could grow their business solely because doing so would push their asset size above the CFI threshold and thus make them immediately subject to the “10 percent” requirement. In addition, some commenters expressed concern that, because the Bank Act does not exempt smaller credit unions from the “10 percent” requirement as it does for small banks and thrifts, the proposed changes would impose a disproportionately greater compliance burden on small credit unions than they would on small banks and thrifts.

Having reviewed all of the comment letters addressing the proposed ongoing asset ratio requirements, FHFA has decided not to include those revised requirements in the final rule. The Agency's research indicates that over 98 percent of current members likely would be in compliance with both proposed requirements (as applicable). This suggests that, for the time being, FHFA can address its supervisory concerns about members abandoning their commitment to housing finance by continuing to monitor the levels of residential mortgage assets held by members.

FHFA also recognizes that establishing a system to monitor members' compliance with the proposed ongoing asset ratio requirements could pose an additional incremental burden on the Banks and their members, particularly on members whose asset ratios are close to the required minimums. FHFA also carefully considered the comments received from the credit union industry, which contended that the proposed ongoing “10 percent” requirement would impose a disproportionate burden on small credit unions because they cannot qualify as CFIs. That view is consistent with the Agency's recent research, which indicates that, of the current members that would not meet an ongoing “10 percent” requirement, about 68 percent of them would be small credit unions.

Although FHFA has determined not to adopt the ongoing asset ratio requirements as part of the final rule, the Agency believes that members' ongoing commitment to housing finance is important to ensuring fidelity to the Bank Act and the purposes for which the Bank System was established and that the issue warrants continued monitoring going forward. FHFA therefore will continue to monitor this issue carefully and may revisit the issue in the future should its monitoring reveal a need for further action. Any such action would be undertaken through a separate rulemaking, with prior notice to, and an opportunity for comments from, all interested parties.

2. Comments on the Proposed Exclusion of Captives From Membership

About 400 of the comment letters addressed FHFA's proposal to exclude captives from Bank membership to some degree, with about 60 of those letters treating the issue in some depth. Almost all of the letters expressed opposition to all aspects of the captives proposal and none expressed support for the overall proposal. Almost all of the commenters' specific arguments in opposition to the captives proposal fell into two general categories: (1) That FHFA does not have the legal authority to implement the proposal; and (2) that the proposal is flawed from a policy perspective. Many commenters included arguments falling into both categories in their letters.

A few of the comment letters expressed no opposition to the proposal, but suggested some clarifying textual revisions. One commenter explicitly supported the idea of excluding REIT-controlled captives from membership, stating that, because REITs are uninsured, they pose “unnecessary risks” to the Bank system and, because REITs already benefit from tax preferences, it is questionable public policy to allow them access to the lower cost funding the Banks provide. However, that commenter was opposed to the exclusion of captives controlled by other types of entities.

a. Comments on FHFA's Legal Authority To Implement the Captives Proposal

Commenters who expressed legally based objections to the captives proposal made three types of arguments in support of those objections: (1) FHFA lacks the legal authority to define the term “insurance company” to exclude captives; (2) irrespective of its general authority, FHFA cannot legally exclude all captives from membership as proposed because the proposal lacks a factual basis, arbitrarily singles out captives, or is overly broad; and (3) in any event, FHFA lacks the legal authority to terminate or require termination of a captive member. These three general categories, including most of the specific legal arguments offered within those categories, are addressed in turn below.

The general legal argument expressed most frequently in the comment letters was that FHFA lacks the legal authority to define the term “insurance company” to exclude captives. Many commenters stated that, because “insurance company” is not defined in the statute, the term must be given what they believe to be its plain meaning—

i.e.,

that a captive must be considered to be an “insurance company” under the Bank Act, apparently because it is chartered or licensed under state insurance laws. Because a captive is considered to be an “insurance company” under the laws of the states that have captive insurance statutes, these commenters argued, FHFA has no authority to interpret the term any differently for purposes of the Bank Act, and thus cannot exclude captives from the category of “insurance company” as used in the Bank Act. In support of this argument, several commenters specifically cited the federal McCarran-Ferguson Act,

which reserves to the states the authority to regulate and tax the business of insurance, except in cases where Congress has adopted a statutory provision that explicitly provides otherwise.

15 U.S.C. 1011-1015.

Numerous commenters argued that FHFA's proposal to define “insurance company” to exclude captives from membership is outside the Agency's authority because it runs contrary to Congress's clear intent regarding the meaning of the term and the scope of Bank membership. In this vein, many cited the fact that the Bank Act provides that “any” insurance company may be eligible for membership as evidence of Congress's unambiguous intent to prohibit the Bank System regulator from narrowing the scope of the term to exclude any entity chartered as any type of insurance company. Others disputed FHFA's assertion in the proposed rule that in 1932 Congress could not have contemplated that the term “insurance company” would include captives because they did not exist at that time. These commenters contended that the concept of “self-insurance” has existed for hundreds of years and that other types of self-insurance vehicles did exist in 1932, although they were not at that time referred to as “captives.” Several commenters also noted that Congress has never acted to exclude captives from membership, despite the fact that an increasing number of states have adopted captive insurance statutes since the first such statutes were enacted domestically in the 1970s. Finally, many commenters cited Congress's decision to extend eligibility for Bank membership to commercial banks and credit unions in 1989 and to CDFIs in 2008 as evidence of its intent to effect “an inclusive and expansive approach” to membership and characterized FHFA's attempt to exclude captives from membership as running counter to that intent.

In addition to the broader assertions that FHFA lacks any authority to interpret the scope of the term “insurance company” as not including captives, numerous commenters argued, more narrowly, that the Agency cannot legally implement the specific approach set forth in the proposed rule because it lacks any factual basis to justify that approach. Many of the commenters advancing such arguments mischaracterized the Agency's proposal to exclude captives as being based primarily on either safety and soundness concerns or a view that captives (or their parents) do not support housing finance. Those making such mischaracterizations asserted, and in some cases cited specific evidence, that the assumptions underlying those purported bases are erroneous. Others, who correctly characterized FHFA's primary goal as being to prevent the circumvention of the statute by ineligible entities, such as REITs, that have formed captives for the express purpose of gaining access to Bank funding to which they are not legally entitled, argued that the proposed rule provided no evidence to show a factual basis for those concerns.

Some commenters argued that, even if FHFA has a legitimate factual basis for its concerns regarding the ability of ineligible entities to obtain indirect access to Bank funding through eligible subsidiaries, the Agency's decision to focus only on the exclusion of captives in the proposed rule is arbitrary because it disregards the possibility that other types of members could be utilized for a similar purpose.

While commenters advancing the foregoing argument asserted that the proposed prohibition would be too narrow, others asserted that it would be overly broad. Commenters taking the latter view contended that, if FHFA wishes to prevent entities that are not eligible for Bank membership from using captives to access Bank funding, then it should exclude from membership only captives that are owned by ineligible entities or, even more narrowly, only captives that FHFA has determined are actually being used as a funding conduit for an ineligible parent.

Finally, a number of commenters, while not conceding that FHFA has the authority to prevent the Banks from accepting captives as new members going forward, argued specifically that the Agency may not terminate, or require the Banks to terminate, captives that have already been approved for membership under the existing regulations. In support of this contention, several commenters noted that, while the Bank Act at one time explicitly authorized the Bank System regulator to require a Bank to terminate a member in certain circumstances, Congress removed this explicit authorization in 1999.

Another commenter who focused on FHFA's comments in the proposed rule

SUPPLEMENTARY INFORMATION

regarding the possibility that captive membership may pose unique safety and soundness issues asserted that those concerns could not serve as a basis for requiring the termination of captive members until the Agency had taken the steps required by section 8 of the Bank Act.

Specifically, the commenter asserted that section 8 of the Bank Act requires FHFA, if it believes that any of the state laws under which captives are regulated give rise to safety and soundness concerns, to undertake a study of those laws and that only after concluding that a state's laws fail to provide adequate protection to the Banks may FHFA restrict the membership of otherwise eligible members in that state.

12 U.S.C. 1428.

One commenter asserted that termination of existing captive members would give rise to a “takings” claim against the United States in that it would deprive former captive members of their right to a pro rata share of the retained earnings of their former Banks and of access to Bank advances and other products and services without adequate compensation. The commenter

argued that, therefore, such termination is prohibited under a ruling by the U.S. Court of Appeals for the D.C. Circuit that no federal agency may adopt a rule that would give rise to a “takings” claim against the United States unless it is expressly authorized it to do so by statute.

See Bell Atlantic Tel. Cos.

FCC,

24 F.3d 1441, 1445-46 (D.C. Cir. 1994).

b. Comments Asserting That the Proposal Is Flawed From a Policy Perspective

While many of the commenters did not address FHFA's legal authority to implement the proposed exclusion of captives from membership, almost all of the commenters asserted that doing so would represent a poor policy choice. The arguments made in support of commenters' policy-based objections focused primarily on issues of (1) safety and soundness, (2) mission achievement, and (3) the financial health of the Banks, their members, and the overall residential mortgage market.

Again focusing on FHFA's comments regarding the possibility that captive membership may pose unique safety and soundness issues, numerous commenters argued that captives do not pose safety and soundness risks that are materially greater than or different from those posed by other types of members. These commenters offered a number of contentions in support of this argument, including that captives are subject to regulatory regimes that are generally the same as those that apply to traditional insurers and are supervised in a similar fashion; captives have a lower rate of insolvency and default than traditional insurers because they tend to be over-capitalized and operated conservatively so as to ensure that they will be able to pay the claims of their owners; and Banks have been admitting captives as members for over 20 years and have experienced no losses on advances to captive members. Other commenters asserted that to the extent that captives may present unique safety and soundness concerns, those concerns can be addressed with more targeted requirements, such as requiring captive members to meet special seasoning requirements, minimum capital levels, or maximum leverage ratios. Still others contended that the Banks already have sufficient processes and procedures to manage any additional risk that captives may pose.

Many commenters urged FHFA to continue to allow captives—particularly those controlled by REIT parents—to be admitted to Bank membership, stressing that mortgage REITs' substantial commitment to the residential mortgage market in the U.S. is consistent with the mission of the Banks. Going further, many argued that, contrary to the approach taken in the proposed rule, FHFA should actually encourage membership approval for REIT-controlled captives as a means of increasing the level of private capital in the residential mortgage market. Several of these commenters asserted that the collateral requirements applying to Bank advances would tend to dissuade entities whose business practices are not consistent with the housing finance mission of the Banks from forming captives in order to gain access to Bank advances.

A number of commenters argued that FHFA offered no analysis of the financial impact the proposed exclusion of captives would have on the Banks and their members. Many commenters noted that the Bank System benefits from a diverse and robust membership and asserted that eliminating one class of existing and potential members would result in lost income for the Banks now and in the future. At least one commenter asserted that, for certain Banks, the financial impact of the proposal could be so significant as to jeopardize their independent status, thereby forcing them to consolidate with other Banks. Many commenters pointed out that any action that might reduce the income of any Bank to any extent would necessarily reduce the amount of funds available for those Banks' Affordable Housing Programs (AHP) because the statute requires 10 percent of a Bank's earnings to be dedicated to its AHP.

In addition to the predictions of negative consequences for the Banks and their members, a number of commenters asserted that preventing mortgage REITs and similar companies from accessing Bank funding through captive subsidiaries would have negative consequences for the overall residential mortgage market. Noting that the long-term and reliable nature of Bank funding assists in reducing the likelihood that mortgage market crises will occur and in mitigating such crises when they do occur, several of these commenters argued that preventing captive parents from accessing that funding could increase instability in the residential mortgage market by reducing liquidity and curtailing the availability of long-term funding.

c. Comment Letters Suggesting Alternative Approaches

A number of commenters suggested alternative approaches to address what they perceived to be FHFA's concerns regarding captives that would be less severe than the outright exclusion of all captives from Bank membership.

Several commenters that believed FHFA's concerns to be primarily related to safety-and-soundness or mission achievement issues suggested that the Agency could address these concerns by adopting borrowing, financial condition, or mission standards to apply specifically to captives (or, in some cases, to insurance companies generally). For example, one commenter suggested that FHFA could require ongoing periodic reporting to the Bank of information that would allow it to adequately assess the financial health and investment strategies of, and other risk metrics pertaining to, both the captive and its parent; apply a more stringent mission test to potential captive members and their parents using asset or income tests; or require that all collateral pledged by captives or their parents to secure advances be real estate related.

Commenters that more appropriately focused on FHFA's primary concern—the misuse of the captive vehicle by non-eligible entities—stated that FHFA should prevent those practices specifically, without excluding all captives from membership. For example, some suggested that the final rule allow captives with a parent or affiliate that is itself eligible for Bank membership to remain eligible. One such commenter favored the use of captives to allow parent companies that are themselves eligible for membership (“particularly . . . institutions that now have substantially higher liquidity requirements than in the past”) essentially to become members of more than one Bank, which the commenter asserted “would not only help to serve the industry's liquidity needs, but would reduce the concentration risk posed by large institutions belonging to only one or two [Banks].”

Other commenters suggested that the final rule exclude from membership only captives that FHFA or the Banks have determined are owned by non-eligible entities that are using or have used those captives as conduits to receive Bank funding for their own use. Those commenters did not provide much detail as to how that would be accomplished, although one suggested that FHFA itself should review captives' applications for Bank membership in order to determine the purpose behind each application. Finally, one commenter, who asserted that FHFA “is not well informed about captives,” suggested that the Agency should “increase its knowledge in this area and find ways to address issues raised in the

[proposed rule] by participating in a task force with insurance regulators and others in the captive insurance industry.”

d. Results of FHFA's Review of Comments on the Captives Proposal

FHFA has reviewed all of the comments regarding its proposal to exclude captives from Bank membership and has studied especially closely the considered opinions of those commenters that addressed the issue in depth. After giving careful consideration to all of the viewpoints expressed, the Agency has decided to finalize the captives provisions essentially as proposed, albeit with some minor modifications to the transition provisions. The final provisions, the reasons FHFA has decided to adopt them, the bases for FHFA's conclusion that it possesses the authority to adopt those provisions, and the Agency's responses to the points raised in the comment letters are all discussed in detail in parts II and III of this

SUPPLEMENTARY INFORMATION

3. Comments on the Other Substantive Proposed Revisions

About 80 commenters addressed the proposal to require a Bank to obtain and review an insurance company applicant's most recent audited financial statements in determining whether it meets the “financial condition” eligibility requirement. Nearly all of the commenters opposed the inclusion of that requirement in the final rule. Most of those commenters based their objections on the assertion that the requirement would be burdensome for insurance companies—especially those that are not required by law to have their financial statements reviewed by an outside auditor. FHFA has considered these concerns, but has decided to include the requirement, as proposed, in the final rule.

The Agency recognizes that there are costs associated with obtaining audited financial statements. It also believes, however, that there are significant benefits to the Banks from being able to rely on financial statements that have been audited by a third party, particularly when assessing an insurance company's financial condition prior to admitting it to membership, which is the only time at which this requirement will apply. Even with this additional requirement, the financial information that insurance company applicants will be required to provide to the Banks will be far less than the financial information that insured depository institution applicants must provide.

About 80 of the comment letters addressed the parts of the proposed rule that would have amended the regulations governing how an institution's principal place of business is to be determined which, in turn, dictates the Bank it may join. The proposal included one provision specific to insurance companies and CDFIs, which would have required a Bank to use objective factors to identify the geographic location from which an insurance company or CDFI conducts the predominant portion of its business operations. The proposal also would have revised the general provision, which presumes the location of an institution's “home office” to be its principal place of business, by adding a requirement that the institution actually conduct business from its home office in order to benefit from that presumption. The effect of that revision would have been to prevent a Bank from relying solely on an institution's state of domicile or incorporation as the principal place of business for Bank membership purposes.

Most of the comments focused specifically on the effect the proposed revisions would have on insurance companies.

Almost all of those commenters (with the exception of a few of the Banks, as discussed below) opposed the proposed revisions and stated their preference that the final rule should instead provide that an insurance company's principal place of business shall in all cases be its state of domicile (

i.e.,

the state in which it is chartered). The commenters preferred the latter approach to the standard set forth in the proposed rule because they believed that it would be simpler to apply and would ultimately impose less burden on both the Banks and state insurance regulators. In other words, under a state of domicile standard each Bank would then need to deal only with the insurance regulators and insurance laws of the states within its district, and each insurance regulator would then need to establish a working relationship only with its local Bank.

One comment letter addressed the issue specifically as it relates to CDFIs and expressed support for the approach taken in the proposed rule.

FHFA expects each Bank to communicate regularly with the regulator for each of its insurance company members and to be thoroughly familiar with the state insurance laws that apply to each of those members.

See

FHFA Advisory Bulletin AB 2013-09,

Collateralization of Advances and Other Credit Products to Insurance Company Members

(Dec. 23, 2013). Regardless of where an insurance company may be licensed to do business or where it carries out its back office operations, it is regulated and supervised by the insurance regulator of its state of domicile under the laws of that state.

Although there may be some practical benefits to using the state of domicile as a proxy for an institution's principal place of business, the core question is whether such an approach would be consistent with the requirements of the Bank Act. FHFA has previously determined that the term “principal place of business” contemplates a physical location at which a company conducts the predominant portion of its business activities, and that a “presence” that is legal only, without any actual business activity, falls short of what the Bank Act requires. While the state laws under which insurance companies and CDFIs are chartered typically require companies to provide an in-state address for service of legal notices or for other purposes, those laws do not necessarily require a company to maintain any kind of business presence in the state. It is possible, then, that an insurance company or a CDFI may not conduct

any

of its business in its state of domicile. To amend the regulation, as the commenters suggest, to provide that the principal place of business of an insurance company or CDFI is in all cases to be its state of domicile would allow for the possibility that a Bank member's principal place of business could be a location at which it actually has

place of business. Such a result would not comport with FHFA's view of the term “principal place of business” and thus would not be consistent with the requirements of the Bank Act.

II. Treatment of Captive Insurers Under the Final Rule

FHFA has carefully considered the thoughts and opinions expressed in the comment letters and thoroughly analyzed possible alternative means of addressing its concerns about the use of captive insurers by entities not eligible for Bank membership to gain access to Bank advances. Having done so, the Agency has decided to include in the final rule, with some modifications, the provisions excluding captives from Bank membership and requiring the Banks, after a transition period, to terminate the membership of all captives that were admitted under the existing regulations. As proposed, the final rule defines “insurance company” to exclude captives, thereby making them ineligible for Bank membership.

These provisions of the final rule address FHFA's supervisory concerns about the ability of entities ineligible for Bank membership (including mortgage REITs and other entities) to circumvent the Bank Act and obtain

de facto

Bank membership through captive subsidiaries that become members and then act as conduits to low-cost Bank

funding for the ineligible entity. The use of captives for this purpose under the existing regulation has grown dramatically in recent years, and has continued since the publication of the proposed rule. FHFA has well-founded concerns that this use of captive subsidiaries is open to multiple types of ineligible entities such as equity REITs, hedge funds, investment banks, and finance companies and that the practice may spread to those and other types of ineligible entities once they become aware of the advantages of gaining

de facto

Bank membership through such arrangements. As regulator of the Bank System, FHFA is responsible for ensuring the effective implementation of the provisions and purposes of the Bank Act. That responsibility includes ensuring that only entities eligible for Bank membership obtain the benefits of membership. FHFA is fulfilling that responsibility by including in this final rule provisions intended to prevent further use of captives to circumvent the membership eligibility requirements of the Bank Act.

Like the proposed rule, the final rule also sets forth a transition provision permitting captives that became members prior to the publication date of the proposed rule to remain members for five years after the effective date of the final rule, but limiting their outstanding advances to 40 percent of their assets and, while permitting new advances below the 40 percent threshold, prohibiting new advances or renewals that mature beyond the five-year transition period. The final rule also contains an additional transition provision, not included in the proposed rule, to address the treatment of captives admitted to membership on or after the date of publication of the proposed rule. This provision permits any Bank that has admitted such captives one year following the effective date of the final rule within which to terminate the membership of those captives. The rule allows such captives until the end of that one-year period (or until the date of termination, if earlier) to repay their existing advances, but prohibits them from taking new advances or renewing existing advances that expire during that grace period.

In reaching its decision to include these provisions in the final rule, FHFA gave due consideration to the fact that the vast majority of commenters addressing the proposed exclusion of captives from membership objected to that aspect of the proposed rule. Ultimately, however, the volume of adverse comments does not drive FHFA's policy determinations, particularly in this case, where FHFA has found significant evidence that REITs and other entities have been forming captives solely for the purpose of providing ineligible institutions access to Bank advances.

FHFA carefully considered the merits of the opinions expressed and assertions made by commenters, including from those commenters that provided verifiable information that the Agency could assess as part of the rulemaking process. The arguments taken as a whole did not persuade the Agency that the existing statute should be applied to allow admission of captives to membership. The policy reasons behind FHFA's decision to include the captives provisions in the final rule, the legal bases for including those provisions, and the Agency's responses to a number of specific comments are set forth in detail below.

A. Policy Reasons for Excluding Captives From Bank Membership

1. Until Recently, Only a Few Captives Had Become Bank Members, and Most of Those Had Parents or Other Affiliated Entities That Were Eligible To Be Bank Members Themselves

As mentioned above, the Bank Act provides that, in addition to insured depository institutions and CDFIs, “any . . . insurance company” shall be eligible to become a member of a Bank if it meets the applicable requirements. The Bank Act does not define “insurance company,” and neither FHFA nor its predecessor agencies had previously adopted a regulatory definition of that term. Consequently, as a practical matter, any entity chartered or licensed as an “insurance company” under state law and that has met the other applicable requirements historically has been permitted to become a Bank member. Because captive insurers are chartered or licensed as insurance companies under the laws of states that have enacted captive insurance statutes, a number of those types of entities have been permitted to become Bank members under the existing membership regulation.

Although a Bank first admitted a captive to membership over twenty years ago, until recently Banks had accepted very few captives. The first captive to be admitted became a member in 1994. In the ensuing years, up until mid-2012, no more than eleven additional captives joined the Bank System. Most of the captive members that were admitted during that time period have parent companies that either are themselves eligible to be Bank members or are holding companies that own another eligible entity.

2. Recently, There Has Been a Dramatic Increase in Captive Members and Applicants, Almost All of Which Are Controlled by Ineligible Entities Seeking Access to Bank Funding

Over the last several years, however, new captive members and membership applications by captives have shown a significant and accelerating increase. Since mid-2012, the Banks have admitted 27 new captive members, 25 of which are owned by mortgage REITs, finance companies, and other types of entities that are not themselves eligible for membership. Twenty of those 25 have become members since the publication of the proposed rule in September of 2014. This trend has become a matter of growing concern to FHFA, as it has become increasingly clear that captives are being promoted and used as vehicles to provide access to Bank funding and to other benefits of membership for institutions that are legally ineligible for membership. The Banks that have accepted these captive members have based their approvals on the financial strength of the parent and not the captive itself and have projected a level of advances activity that is disproportionately large in relation to the captives own business operations and related investment needs. In many cases (although, to date, not all), captive members have fulfilled the projections reflected in the membership digests by maintaining disproportionately large levels of outstanding advances, almost all of which have been secured by collateral provided by the parent. As a result of these developments, FHFA sees a current need to define “insurance company” in a manner that will prevent the creation of such

de facto

membership arrangements.

The information contained in the membership application digests prepared by the Banks in connection with the admission of most of those captive subsidiaries supports a conclusion that they applied for membership—and, in fact, were established—for the primary purpose of accessing Bank funding for their parents' business needs; they did not seek membership to obtain support for their own operations or investments.

As an initial matter, those digests indicate that all but one of the 25 captive members owned by a REIT or similar ineligible entity were

de novo

entities at the time they applied for membership; at least 20 of the 25 had been chartered within the preceding six months and all but one of the remaining five had been chartered within the preceding 12 months. The digests also show that the dollar amounts of anticipated advances to be made to most of those captives are grossly disproportionate to the amount of insurance business underwritten by the captive, contemplate that the parents will provide both the collateral and a guaranty for the captives' debt, and, in some cases, acknowledge that the captives will use the advance proceeds to make loans to their parents. The Banks themselves recognized the conduit nature of these captives by basing their assessment of the financial condition of their new captive members, and the amount of advances they may obtain, on the financial resources of their parents, rather than on the captives themselves.

The regulations require that a Bank “prepare a written digest for each applicant stating whether or not the applicant meets each of the [applicable membership eligibility requirements], the Bank's findings, and the reasons therefor.”

See

12 CFR 1263.2(b). Since September 2012, FHFA has had a special data request in place pursuant to which it has received from the Banks the membership digests for each new insurance company and CDFI

member approved during that time period.

See

FHFA Special Data Request SDR 2012-02, “Membership Decision Documentation for New Insurance Company and CDFI Members” (Sept. 17, 2012).

The chart below illustrates the recent dramatic increases in the number of captive members and in the amount of advances outstanding to captive members.

ER20JA16.000

3. There Are Currently Ongoing Efforts To Encourage Ineligible Entities To Use Captive Subsidiaries as a Means of Accessing Low-Cost Bank Funding

Numerous public statements made by captive management companies and consultants, insurance regulators, and the parent companies themselves tend to confirm that almost all of the captives in the recent wave of new members and applicants were established and applied for membership for the purpose of providing their ineligible parents with access to Bank funding and other benefits of membership. For example, Marsh & McLennan (Marsh), a firm that characterizes itself as “the world's leading captive manager,” published an article in its quarterly newsletter in early 2014 stating that it had been working with REIT clients since the summer of 2013 “to create captives for the purpose of accessing funding with the Federal Home Loan Bank system” and advertising that “low-cost funding” obtained from a Bank through a captive subsidiary can allow a REIT parent to “increase leverage and improve liquidity at attractive rates.”

After noting that captives were being formed in two particular states to permit access to the two Banks in whose respective districts those states lie, Marsh concluded by stating that its captive advisory team “is likely to begin forming captives in other domiciles to access additional branches of the [Bank System].” It is clear from that article, as well as from a contemporaneous Marsh report containing similar statements,

that the firm is not encouraging existing captives to become Bank members to obtain funding for their own investments and operations, but is instead encouraging REITs and possibly other ineligible entities to create new captives to use as conduits to low-cost Bank funding for their own operations.

See

Marsh & McLennan Companies,

Using Captives to Access Federal Home Loan Banking System Funding,

Marsh Insights: Captives (Mar. 2014) at 5,

http://usa.marsh.com/Portals/9/Documents/6454MA14-12785CAPNewsletter03-2014.pdf

(last visited Dec. 8, 2015).

See

Marsh & McLennan Companies,

The Evolution of Captives: 50 Years Later (Annual Captive Benchmarking Report)

(May 2014) at 2, 5.

At around the same time that Marsh published those materials, another firm, Willis Group Holdings PLC (which describes itself as “a leading global risk advisor, insurance and reinsurance broker”) published a brochure on its Web site entitled “Joining the Federal Home Loan Bank Offers Significant Advantages for Captive Owners, Including Low Interest Loans and Letters of Credits [sic].”

After describing how the firm had “experienced a significant increase in existing and prospective captive owners looking to join [a Bank] via a captive subsidiary” and summarizing the benefits of Bank membership, the brochure concludes by encouraging “[p]rospective members [to] contact Willis or the regional [Bank] to discuss the prospect of their captive joining the [Bank].”

Willis Group Holdings,

Joining the Federal Home Loan Bank Offers Significant Advantages for Captive Owners, Including Low Interest Loans and Letters of Credits,

Willis Global Captive Management Alert (Apr. 2014),

http://www.willis.com/documents/publications/services/captives/20140426_50294_PUBLICATION_Global_Captive_Management_Alert_FINAL.pdf

(last visited Dec. 8, 2015).

Even state insurance regulators have been publicly extolling the advantages a company can enjoy by having a captive subsidiary become a Bank member. For example, a recent article that focused on the formation of so-called “831(b) captives” quoted one state's regulator as remarking that such captive entities can be “a portal for membership” in the Bank System.

In the same vein, several of the mortgage REITs that commented on the proposed rule revealed their intentions regarding their captive subsidiaries by advocating “access by mortgage REITs” to the Bank System, describing the proposed rule as “[d]enying access to [Bank] funding for a mortgage REIT,” or making similar statements.

See

Caroline McDonald,

Steady As She Goes: 2014 Domicile Captive Review,

Risk Management (Aug. 1, 2014),

http://www.rmmagazine.com/2014/08/01/steady-as-she-goes-2014-captive-domicile-review/

(last visited Dec. 8, 2015). An “831(b) captive,” sometimes referred to as a “microcaptive,” is a captive that does not underwrite life insurance and that generates annual premiums of $1.2 million or less. Under section 831(b) of the Internal Revenue Code, such an entity can elect to pay federal income tax based only on its investment income instead of on its taxable income as a corporation. 26 U.S.C. 831(b). The use of 831(b) captives by individuals and businesses has drawn close scrutiny from the Internal Revenue Service in recent years.

4. Captives Are Uniquely Suited To Act as Conduits for Accessing the Bank System

Among the types of institutions that, to date, have been considered eligible for Bank membership, captive insurers are uniquely suited to act as conduit vehicles for business entities that wish to gain access to the Bank System, but that are ineligible to become members in their own right. Because captives are self-insurance mechanisms and typically do not sell insurance policies to the public at large, it is generally far easier and less expensive to charter, capitalize, and operate a captive than to establish and operate a traditional life or casualty company that sells policies to the public.

This was cogently explained by the captive regulator of one of the leading domestic captive domiciles in a response to a “Frequently Asked Question” (FAQ) appearing on its official Web site. There, the regulator noted that, while “[c]ommercial insurance companies sell insurance to the general public and are licensed in all states in which they do business,” captives by contrast “directly insure only their owners,” are “licensed in only one state, and operate[] under the captive insurance law of that domicile.” Because of those differences, the regulator explained, “the degree of regulatory oversight required for captives is less than that which is required for commercial insurers.”

See

Daniel Schwarcz,

A Critical Take on Group Regulation of Insurers in the United States,

5 U.C. Irvine L. Rev. 537, 555 (Aug. 2015) (stating that captives have typically been viewed “as presenting limited regulatory concerns” due to their status as self-insurance mechanisms and that “[a]s a result, captives are subject to very limited regulatory restrictions: Their financial statements are not publicly available, they do not have to comply with statutory accounting rules and the associated reserve requirements, and they generally are not subject to standard risk-based capital requirements”). One state insurance regulator, in reporting to the state legislature on the desirability of enacting insurance legislation specific to captives, stated that a captive “is not regulated like an admitted insurance carrier, but operates under relaxed rules governing the captive's formation, capitalization, and solvency.” In noting in this Supplementary Information the differences between the regulation of captives and the other types of institutions that have, to date, been considered eligible for Bank membership, FHFA is not expressing any judgment as to the adequacy of captive regulation generally or in any particular state with a captive statute, for purposes of the limited businesses for which captives are organized.

Despite the fact that captives are already easier to establish and more lightly regulated than commercial insurance companies, the competition among states to attract businesses to organize captive subsidiaries in their respective borders is leading some states to amend, or modify the manner in which they apply, their captive laws to further reduce the regulatory burdens in relation to those imposed by other states. In a recent report prepared by a state insurance regulator that was required by statute to study the advisability of establishing a captive insurer industry in that state, that regulator recommended that the state's legislature “forgo captive legislation at this time” in part because “the industry has developed in ways that have caused considerable regulatory concern at the federal and state levels.” The report explained, “To become a thriving captive domicile today, a state must be willing to relax important regulatory

safeguards. Attractive new domiciles are those that have a high risk appetite, demand few hurdles to formation, have low premium taxes and fees, have minimal solvency and capital requirements, and require little in the way of reporting.”

In addition, a 2011 New York Times article entitled “Seeking Business, States Loosen Insurance Rules,” came to conclusions that were similar to those reached by the state insurance regulator quoted above. The article, which appeared on the newspaper's front page, cited numerous examples of states competing among themselves to relax their regulatory requirements in order to attract captives to their respective domiciles. It reported that one state, after observing the success of another in attracting captives, responded by amending its laws governing the tax rates captives must pay on premium revenues to make its rates lower than those of the other state; this prompted the other state to reconsider its own rates. The article also noted that the number of captives domiciled in a particular state had doubled in the preceding calendar year, after its insurance commissioner was given the power to exempt captives from various provisions of the state's captive insurer laws. The bulk of the article was devoted to investigating the growing trend of commercial insurance companies forming captives to reinsure blocks of outstanding policies in order to take advantage of the lower reserve requirements that apply to captives under the laws of some states.

See

Mary Williams Walsh and Louise Story,

Seeking Business, States Loosen Insurance Rules,

New York Times (New York ed.) (May 8, 2011) at A1,

http://www.nytimes.com/2011/05/09/business/economy/09insure.html?pagewanted=all&_r=0

(last visited on Dec. 8, 2015).

The competition between states is further evidenced by a proliferation of press releases from state insurance regulators touting their selection as, or nomination for, a “U.S. captive domicile of the year” award that is bestowed annually by a major captive industry magazine. For example, one state regulator noted in a press release regarding its selection as a finalist for the 2015 award that, after having twice amended its captive laws in recent years, the state had “positioned itself to become a preferred domicile to companies seeking a sophisticated regulatory infrastructure.” An article in the sponsoring magazine announcing the winner of the 2015 award (which, ultimately, was not the state regulator that issued the above-quoted press release) stated that its judges selected the announced winner in part because, “despite being an established jurisdiction, [the victorious domicile] continues to review its statute on an annual basis to ensure it continues delivering efficiency and value.”

See

Richard Cutcher,

2015 US Captive Services Awards: Winners Announced,

Captive Review (Aug. 11, 2015),

http://captivereview.com/news/2015-us-captive-services-awards-winners-announced/

(last visited on Dec. 8, 2015).

The same characteristics that make captives far more viable than traditional insurance companies to use as vehicles for achieving

de facto

Bank membership also set them apart from insured depository institutions in that respect. Given the many obstacles to obtaining a commercial bank, savings and loan, or credit union charter,

as well as the comprehensive systems of prudential regulation and supervision to which those types of institutions are subject, FHFA must regard as highly improbable the prospect of an ineligible entity chartering a depository institution for the primary purpose of providing itself with

de facto

Bank membership. FHFA is unaware of a single instance of such an occurrence in the history of the Bank System. The additional layer of supervision and examination to which a company would become subject under either the Bank Holding Company Act

or the Savings and Loan Holding Company Act

if it were to acquire control of a commercial bank or savings and loan association makes those types of institutions even more unlikely to be used as mere conduits to Bank funding. In contrast, the lack of any such requirements applying to the parent of a captive makes captives an especially attractive membership channel for REITs and other ineligible entities that are not subject to the type of inspection and regulation that applies to institutions that are eligible for Bank membership. The requirements for certification of CDFIs similarly make them unsuitable vehicles to serve as conduits for Bank funding to ineligible parents.

See, e.g.,

Patricia A. McCoy,

Banking Law Manual: Federal Regulation of Financial Holding Companies, Banks and Thrifts

§ 3.02[2] (Matthew Bender, 2nd ed. 2015) (explaining that, because depository institution charters “can be (and often are) denied for a variety of reasons, including unacceptable management, poor prospects for financial success, no perceived need for the institution's services or a competitive threat to existing institutions in the same market,” they serve as “powerful if erratic controls on entry into commercial banking and the thrift industry”).

See

12 U.S.C. 1844;