Eligibility for Membership and Advances

FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 933 and 935

[No. 98-15]

[RIN 3069-AA69]

Eligibility for Membership and Advances

AGENCY: Federal Housing Finance Board.

ACTION: Final rule.

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SUMMARY: The Federal Housing Finance Board (Finance Board) is amending

the definitions in its membership and advances regulations relating to

combination business or farm properties on which a residence is

located. For institutions with total assets of $500,000,000 or less,

the amendments eliminate the requirement that at least 50 percent of

the value of such properties be attributable to the residential portion

of the property, and require instead that the residence constitute an

integral part of the property. The amendments are intended to assist

smaller depository institutions, particularly those located in rural

areas, that have combination farm or business property loans in their

portfolios, to qualify for Federal Home Loan Bank (FHLBank) membership

and, once admitted, to provide the collateral necessary to obtain

FHLBank advances. For those institutions with assets in excess of

$500,000,000, the amendments retain the existing 50 percent of value

requirement. The amendments also allow loans that would satisfy the

statutory and regulatory requirements under the Community Investment

Program, or under the community investment cash advance provisions, of

the Federal Home Loan Bank Act (Bank Act), to qualify for membership

eligibility purposes.

DATES: Effective July 29, 1998.

FOR FURTHER INFORMATION CONTACT: Julie Paller, Senior Financial

Analyst, Office of Policy, (202) 408-2842; Neil R. Crowley, Associate

General Counsel, (202) 408-2990, Sharon B. Like, Senior Attorney-

Adviser, (202) 408-2930, Office of General Counsel; Federal Housing

Finance Board, 1777 F Street, N.W., Washington D.C. 20006.

SUPPLEMENTARY INFORMATION:

I. FHLBank System and Finance Board Roles and Responsibilities

Under the Bank Act, the Finance Board is responsible for the

supervision and regulation of the 12 FHLBanks. See 12 U.S.C. 1422a(a),

1422b(a)(1). Specifically, the Finance Board is responsible for

ensuring that the FHLBanks operate in a financially safe and sound

manner and carry out their housing finance and community investment

mission, and that they remain adequately capitalized and able to raise

funds in the capital markets. See id. section 1422a(a)(3). The Bank Act

also empowers the Finance Board to promulgate and enforce such

regulations and orders as are necessary from time to time to carry out

the provisions of the Bank Act, including regulations on FHLBank

membership eligibility and advances collateral requirements. See id.

section 1422b(a)(1).

II. Current 50 Percent Test For Loans Secured By Combination

Property Under the Membership and Advances Regulations

The regulations of the Finance Board allow certain types of

mortgage loans to be used in determining an institution's eligibility

to become a FHLBank member and its ability to borrow from the FHLBank,

after becoming a member. As described below, loans secured by

combination properties can be used for these purposes only if at least

50 percent of the total appraised value of the combined property is

attributable to the residential portion of the property (50 percent

test). See 12 CFR

[[Page 35118]]

933.1(n)(1)(iii), 935.1. For both purposes, that test is the same.

A. Membership Eligibility

Section 4(a) of the Bank Act establishes the eligibility criteria

for institutions to become members of the FHLBank System. See 12 U.S.C.

1424(a). Section 4(a)(2)(A) of the Bank Act requires, in part, that an

insured depository institution have ``at least 10 percent of its total

assets in residential mortgage loans'' in order to be eligible for

FHLBank membership (10 percent requirement). See id. section

1424(a)(2)(A) (emphasis added). The Bank Act does not define the term

``residential mortgage loan.'' The Finance Board's current membership

regulation defines ``residential mortgage loan'' to include, among

other things, a ``home mortgage loan.'' See 12 CFR 933.1(bb)(1). The

Bank Act defines a ``home mortgage loan'' as ``a loan made by a member

or a nonmember borrower upon the security of a home mortgage.'' See 12

U.S.C. 1422(5). The Bank Act defines a ``home mortgage'' generally as a

mortgage upon real estate ``upon which is located, or which comprises

or includes, one or more homes or other dwelling units, all of which

may be defined by the [Finance] Board.'' See id. section 1422(6). The

membership regulation implements these statutory provisions by defining

``home mortgage loan'' to include, in part, a loan secured by a first

lien on ``[c]ombination business or farm property where at least 50

percent of the total appraised value of the combined property is

attributable to the residential portion of the property.'' See 12 CFR

933.1(n)(1)(iii). The term ``combination business or farm property''

means ``real property for which the total appraised value is

attributable to residential, and business or farm uses.'' Id.

Sec. 933.1(i).

B. Eligible Collateral for Advances

Section 10(a) of the Bank Act authorizes a FHLBank to make secured

advances to its members and specifies the types of collateral that a

FHLBank may accept when originating or renewing an advance. See 12

U.S.C. 1430(a). Section 10(a)(1) of the Bank Act requires a FHLBank

making or renewing an advance to its members to obtain and maintain a

security interest in certain specified types of collateral, among which

are ``[f]ully disbursed, whole first mortgages on improved residential

property (not more than 90 days delinquent).'' See id. section

1430(a)(1) (emphasis added). The Bank Act does not define ``residential

property'' or ``improved residential property.'' The Finance Board's

current advances regulation defines ``improved residential real

property'' to mean ``residential real property excluding real property

to be improved, or in the process of being improved, by the

construction of dwelling units.'' 12 CFR 935.1. The advances regulation

defines ``residential real property'' to include, among other things,

``combination business or farm property, provided that at least 50

percent of the total appraised value of the combined property is

attributable to the residential portion of the property.'' See id. The

term ``combination business or farm property'' means ``real property

for which the total appraised value is attributable to the combination

of residential, and business or farm uses.'' Id.

Thus, in order for a combination farm or business loan to qualify

as a ``residential mortgage loan'' for purposes of satisfying the 10

percent requirement under the current membership regulation, or to

qualify for purposes of satisfying advance collateral requirements

under the current advances regulation, the combination farm or business

property securing the loan must meet the 50 percent test.

III. Proposed Rulemaking

A. Derivation and Description of Proposed Rule

In early 1997, the Finance Board was approached by representatives

of community depository institutions, particularly those located in

rural areas, who advised that they have a need for alternative funding

sources to meet credit demands in their communities, which they

believed the FHLBank System was well-suited to provide. As discussed in

the preamble to the proposed rule, they indicated that community

depository institutions, particularly those in rural areas, often are

essential to the housing finance activities and the broader economic

well being of the communities they serve. Such institutions have less

demand for conventional single family and multifamily mortgage credit

and their service areas often are characterized by low population

density and a low level of economic activity. In such circumstances,

those institutions have not been able to originate a substantial number

of residential first mortgage loans. Moreover, many loans originated by

rural banks are made on the security of family farms, which are in part

residential but which often do not meet the 50 percent test. They

stated that the 50 percent test thus hinders the ability of rural banks

to become FHLBank System members or to take full advantage, as FHLBank

members, of the opportunity to obtain advances and thereby serve the

credit needs of their communities.

In response to these concerns, the Finance Board had reason to

believe that the 50 percent test may operate to exclude some number of

residential properties beyond what was intended when the Finance Board

adopted the test. Accordingly, the Finance Board reviewed the relevant

statutory and regulatory provisions governing membership eligibility

and advances collateral and determined, as discussed in greater detail

below, that the statute affords sufficient latitude to address the

issues by making changes to the current regulations.

In order to confirm whether the concerns raised by the community

institutions were well-founded, the Finance Board issued the proposed

rule, which would have eliminated the 50 percent test in both the

membership and advances regulations, and replaced it with a provision

permitting a loan to be eligible if it is secured by ``combination

business or farm property, on which is located a permanent structure

actually used as a residence, other than for temporary or seasonal

housing.'' See 62 FR 53251--53 (Oct. 14, 1997). The objective of the

proposal was to ease the burdens of the 50 percent test, within the

parameters of the statute. Doing so would allow more institutions with

combination family farm/residential loans or combination family

business/residential loans (such as loans secured by businesses where

the family owns and lives in a residential unit above the store) to be

eligible for FHLBank membership and borrowing from the FHLBanks. The

requirement that any eligible combination property must have a

permanent structure actually used as a residence was intended to ensure

that the property retained the requisite residential character required

by the statute, which was one reason why the Finance Board adopted the

50 percent test. The proposal was not intended to allow large

agribusiness or other large commercial loans to be used for membership

eligibility and advances collateral purposes.

In addition, the proposed rule defined ``residential mortgage

loan,'' for membership eligibility purposes, to include ``[l]oans that

finance properties or activities that, if made by a member, would

satisfy the statutory requirements for the Community Investment Program

[(CIP)] established under section 10(i) of the Bank Act, or the

regulatory requirements established for any community investment cash

advance program authorized by section 10(j)(10)

[[Page 35119]]

of the Bank Act.'' See 62 FR 53251--53; 12 U.S.C. 1430(i), (j)(10). The

intent of this proposed amendment was to allow such community

investment loans to be considered for purposes of eligibility for

membership, and to conform the membership regulation more closely to

the advances regulation, which already includes loans financed by

section 10(i) or section 10(j)(10) advances within the definition of

``residential housing finance assets.'' See 12 CFR 935.1.

B. General Discussion of Comments on Proposed Rule

The Finance Board received over 290 comment letters on the proposed

rule, which were split relatively evenly between those supporting and

those opposing the proposal. The commenters supporting the proposal

included five FHLBanks, FHLBank members, prospective members, banking

trade associations, and state finance departments. The overwhelming

majority of the letters supporting the proposal came from small

community banks and thrifts, predominantly in rural areas. The

remaining letters supporting the proposal followed closely a comment

letter submitted by a banking trade association.

All but one of the comment letters opposing the proposal were from

persons or entities associated with the Farm Credit System, a

nationwide network of federally chartered, borrower-owned cooperative

financial institutions and related service organizations specializing

in agricultural loans. The Farm Credit System institutions are major

competitors of commercial banks and other farm and rural housing

lenders within agricultural credit markets. See USDA Economic Research

Service Agricultural Economic Report Number 749, ``Credit in Rural

America'' (April 1997) at 42-43 (USDA Report). The trade association

for the Farm Credit System submitted a detailed comment letter opposing

the proposed rule. Nearly all of the remaining comment letters opposing

the proposed rule raised substantially the same issues, and many of

them were identical.

Commenters supporting the proposal confirmed the views expressed in

the proposed rule that there is a need for additional funding sources

in rural markets and that the proposal would further the FHLBank

System's housing finance mission by making available such funding for

combination farm/residential loans, which are important to rural

communities. Commenters confirmed that the 50 percent test is under-

inclusive, allowing only those combination loans secured by very small

farms to be used for membership eligibility and advances collateral

purposes. No commenter contended that the 50 percent test adequately

captures all of the family farms or businesses that make up combination

properties.

Commenters also stated that the 50 percent test may discriminate

against lower income individuals, who can afford only a modest

residence on their farm, in favor of more affluent persons, who can

place a more expensive residence on the same acreage. They contended

that the rule has the effect, in practice, of encouraging the FHLBanks

and their members to ignore the housing finance needs of the lower

income segments of their communities in favor of more wealthy

individuals, which is inconsistent with the FHLBanks' housing finance

mission. A banking trade association also emphasized that the 50

percent test may be unworkable in practice because even family farms

often are appraised based on their ability to generate income, using

the ``capitalization approach.'' Under that approach, the residential

portion rarely would be valued at a level approaching the 50 percent

test, notwithstanding that the residential portion of the property is

integral to the success of the farm on which it is located.

Representatives of the Farm Credit System contended, however, that

the proposal goes too far in the opposite direction and is apt to be

over-inclusive by allowing the use of loans secured by a combination

farm or business property with little or no residential value. They

argued that eliminating the 50 percent test is inconsistent with the

housing finance mission of the FHLBank System, that the test does not

hinder rural banks' ability to become FHLBank members, and that rural

banks do not have less demand for conventional single family and

multifamily mortgages. They also argued that the Finance Board failed

to consider the practical consequences and safety and soundness risks

of the proposal.

IV. Adoption of Revised Standard in the Final Rule

After considering the information received in the comment letters,

as well as its own resources, the Finance Board has decided to adopt

the final rule with one substantive change from the proposed rule, and

to limit the applicability of that change to community financial

institutions, which are defined as those of a certain asset size or

less. Each of those actions is intended to address concerns raised by

commenters about the possible overbreadth of the proposed rule. The

changes will apply to both the membership and advances collateral

provisions, and are intended to limit qualifying loans to combination

farm/residence and combination business/residence loans that have the

requisite residential nexus, and to exclude large agribusiness and

other large commercial loans, which do not. Specifically, the final

rule amends the definition of ``home mortgage loan'' in

Sec. 933.1(n)(1)(iii) of the membership regulation to include a loan

secured by ``combination business or farm property, on which is located

a permanent structure actually used as a residence (other than for

temporary or seasonal housing), where the residence constitutes an

integral part of the property.'' See Sec. 933.1(n)(1)(iii) (emphasis

added). That revision would apply only to ``community financial

institutions,'' which the final rule defines as institutions with

average total assets of $500,000,000 or less, based on the average of

total assets over the prior three years. For larger institutions, the

current 50 percent test would continue to apply. The definition of

``residential mortgage loan'' in Sec. 933.1(bb)(1) of the membership

regulation, because it already includes ``home mortgage loans,'' as

defined by these amendments, need not be specifically amended. See 12

CFR 933.1(bb)(1). The final rule amends the definition of ``residential

real property'' in Sec. 935.1 of the advances regulation in the same

manner. Thus, eligible collateral will include loans secured by

``combination business or farm property, on which is located a

permanent structure actually used as a residence (other than for

temporary or seasonal housing), where the residence constitutes an

integral part of the property.'' See Sec. 935.1 (emphasis added). As

with the membership provisions, this amendment would apply only for

institutions with average total assets of $500,000,000 or less over the

prior three years; larger institutions would remain subject to the 50

percent test.

V. Authority and Reasons for Changing the 50 Percent Test

A. Finance Board's General Statutory Authority

Congress has offered no guidance on how the Finance Board should

deal with combination properties. The Bank Act provides no definition

of ``residential mortgage loan,'' which is the operative term for

purposes of the 10 percent requirement, nor does it speak to what

combination properties may be encompassed by the term. See 12 U.S.C.

1424(a)(2)(A). The Bank Act does define a ``home mortgage loan'' as ``a

loan

[[Page 35120]]

made by a member or a nonmember borrower upon the security of a home

mortgage.'' See id. section 1422(5). The Bank Act also defines a ``home

mortgage'' generally as a mortgage upon real estate ``upon which is

located, or which comprises or includes, one or more homes or other

dwelling units, all of which may be defined by the [Finance] Board.''

See id. section 1422(6). The statute does not speak directly to the

issue of what constitutes a combination property for purposes of these

definitions, nor does the language used by Congress (``upon which is

located, or which comprises or includes'') suggest that the residential

portion of a combination property must meet any specified threshold in

order for a mortgage on such property to qualify as a ``home

mortgage.'' Indeed, the only statutory mandate, with respect to

eligibility for membership, is that the loan must be secured by real

estate on which there is located, or which comprises or includes, a

home or dwelling unit. See id. Moreover, the statute expressly

authorizes the Finance Board to define all of those terms.

Congress has offered no more guidance in the context of eligible

collateral for advances. Section 10(a) of the Bank Act authorizes each

FHLBank to make secured advances to its members upon collateral

sufficient, in the judgment of the FHLBank, to fully secure the

advances. See id. section 1430(a). The Bank Act sets forth the types of

collateral that may secure an advance, including ``[f]ully disbursed,

whole first mortgages on improved residential property (not more than

90 days delinquent).'' See id. section 1430(a)(1) (emphasis added).

Again, with regard to what is encompassed by ``residential property''

or ``improved residential property,'' Congress has opted to remain

silent and has not defined the terms. Thus, with respect to the use of

whole first mortgages as collateral for advances, the only statutory

mandate is that they attach to real property that previously has been

improved by the construction of a residence. See id.

In considering the comments and determining the terms of the final

rule, the Finance Board has been mindful of the requirement that it is

bound ultimately by the ``unambiguously expressed intent of Congress.''

See Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,

467 U.S. 837, 842-43 (1984) (Chevron); Independent Banks Association of

America, and American Bankers Association v. Farm Credit

Administration, Civil Action No. 97-00695 (Memorandum Opinion) (Nov.

24, 1997) at 8 (IBAA). As noted previously, Congress has opted not to

define ``residential mortgage loan'' and ``improved residential

property,'' which are the operative terms in the Bank Act underlying

these amendments to the membership and advances regulations. Moreover,

the only terms that Congress has defined, ``home mortgage'' and ``home

mortgage loan,'' are not implicated in the statutory provisions here at

issue. Even if they were, Congress has defined them in such a way that

does not address combination properties, and Congress has expressly

authorized the Finance Board to define the terms of the definitions.

Because there is nothing in the plain language of the Bank Act that

mandates that the residential portion of combination properties

constitute a specified percentage of the property's total appraised

value, the Finance Board, in the exercise of its informed discretion,

must interpret ``residential mortgage loan'' and ``improved residential

property'' for this purpose and must do so in a manner that is

``permissible'' in light of the statute's structure and purpose. See

Chevron, 467 U.S. at 843-45; IBAA at 8.

B. Reasons for Changing the 50 Percent Test

1. Bank Act and Legislative History Do Not Provide Particular Direction

Just as there is nothing in the plain language of the Bank Act that

suggests how to define ``residential mortgage loan'' and ``improved

residential property,'' there is nothing in the legislative history of

the Bank Act that indicates an intent of Congress about how to define

these terms, both of which were adopted by the Financial Institutions

Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Pub. Law 101-

73, 108 Stat. 183 (August 9, 1989). See FIRREA, Secs. 704(a), 714(a).

FIRREA added the 10 percent ``residential mortgage loans'' requirement

to section 4 of the Bank Act. See FIRREA, Sec. 704(a). The Conference

Report accompanying FIRREA states that, in order to qualify for

membership in a FHLBank, insured depository institutions ``must have at

least 10 percent of their assets in residential mortgage loans,

including 1-4 family, multifamily and funded residential construction

loans, to qualify for membership.'' See Joint Explanatory Statement of

the Committee of Conference, H.R. Conf. Rep. 101-222, 101st Cong., 1st

Sess. at 424 (1989) (FIRREA Conference Report). That statement is not

particularly helpful because the use of the term ``including''

indicates that it is at best a non-exclusive illustrative list of some

types of loans that Congress viewed as qualifying as ``residential

mortgage loans.''

The legislative history also indicates that the 10 percent

requirement was the product of a legislative compromise. The Senate

bill would have required a commercial bank to meet the Qualified Thrift

Lender (QTL) test, as revised by the Senate bill, in order to be

eligible for FHLBank membership. The QTL test, both before and after

FIRREA, required a savings association to maintain a certain percentage

of its assets in ``qualified thrift investments'' (QTIs), which FIRREA

defined in some detail. The FIRREA Conference Report describes QTIs as

``housing finance and related activities.'' See id. at 407. The House

bill would not have required commercial banks to meet any quantitative

assets test to be eligible for FHLBank membership. In conference, the

agreed upon compromise was to replace the Senate's QTL threshold test

with the 10 percent residential mortgage loans requirement.

The understanding of the Congress in reaching this compromise is

not evident from the legislative history. What is evident from the

statutes, however, is that Congress chose diametrically opposed

approaches for dealing with the concepts of QTIs and ``residential

mortgage loans'' or ``improved residential property,'' respectively.

Congress took great care to define by statute the categories of assets

that could be considered to be QTIs. See FIRREA, Sec. 303(a). Moreover,

Congress quite clearly expressed its intent that the QTI categories

established by statute were not to be modified, stating that the QTI

assets ``are specifically defined so as to prevent the inclusion of

other assets by regulatory interpretation.'' See FIRREA Conference

Report at 407. In contrast, Congress did not define what may be

included in ``residential mortgage loans'' for purposes of the 10

percent requirement, nor did it include any comparable language in the

FIRREA Conference Report. If any inference can be drawn from this

meager legislative history, it is that Congress must have intended to

leave the implementation of these terms to the informed judgment of the

Finance Board. Had it intended otherwise, it could have defined the

terms by statute or unequivocally expressed its intent as to how the

provisions are to be applied, both of which it did, in the same law,

for the QTL test.

Regarding eligible collateral for advances, prior to FIRREA each

FHLBank was authorized to make

[[Page 35121]]

secured advances to its members upon such security as the Federal Home

Loan Bank Board (FHLBB) may prescribe. See 12 U.S.C. 1430(a) (1989).

FIRREA amended section 10(a) to establish specific categories of

eligible collateral that a FHLBank may accept as security for advances

to members. See FIRREA, Sec. 714(a). Section 10(a)(1) eligible

collateral includes ``fully disbursed, whole first mortgages on

improved residential property (not more than 90 days delinquent). See

12 U.S.C. 1430(a)(1) (emphasis added). The FIRREA Conference Report

refers to the eligible collateral as ``low risk assets'' and describes

the section 10(a)(1) collateral generally as ``current first

residential mortgage loans.'' See FIRREA Conference Report at 427. The

FIRREA Conference Report does not further define ``improved residential

property'' or ``residential mortgage loans'' for advances collateral

purposes. For the reasons described for membership purposes, it appears

as well that Congress intended to allow the Finance Board to further

define these terms.

2. The 50 Percent Test Is Purely a Regulatory Creation That Can Be

Changed for Good Reason

The 50 percent test was purely a regulatory creation of the Finance

Board, adopted on the assumption that requiring at least half of the

value of the combination property to be attributable to a residence

would ensure that such properties possess the residential nexus

required by the statute and still meet the housing finance needs of

rural and other communities. In retrospect, it appears that the

decision to rely on the 50 percent test in all cases was unduly

restrictive, because properties not meeting the test still might

possess substantial residential characteristics that could be

recognized for membership and advances collateral purposes, consistent

with the statute. After considering the comments in favor of the

proposal, the Finance Board is persuaded that the 50 percent test is

not operating in practice to serve the purposes intended. Indeed, it

appears more likely that the test operates in some cases to frustrate

the mission of the FHLBank System by excluding important elements of

both rural and urban housing finance markets. The Finance Board is

particularly concerned about comments indicating that the test

discriminates against lower income persons, effectively precluding

current and prospective FHLBank members from using FHLBank services to

address the housing finance needs of that segment of the population.

As a general matter, an agency is free to change its interpretation

of its statute so long as its actions are rational, reasonable, not

arbitrary and capricious, involve no clear error of judgment, and a

satisfactory explanation for its actions is included in the record.

See, e.g., 5 U.S.C. 706(2)(A); Motor Vehicle Mfrs. Ass'n of United

States, Inc. v. State Farm Mutual Auto. Ins. Co., 463 U.S. 29, 41-43

(1983); Camp v. Pitts, 411 U.S. 138, 142 (1973) (per curiam); IBAA, at

8-9. This test is ``not particularly demanding,'' even when the agency

action consists of a change in a long-standing regulatory position on a

particular issue. See, e.g., Republican Nat. Committee v. Federal

Election Com'n., 76 F.3d 400, 407 (D.C. Cir. 1996), cert. denied, 117

S.Ct. 682 (1997); IBAA at 9. In fact, an agency is charged with the

responsibility of continually evaluating the appropriateness of its

regulatory policy, even regulatory policy already adopted. See Chevron,

467 U.S. at 863-64; IBAA at 9.

3. Specific Reasons for Changing the 50 Percent Test

Commenters supporting the proposal confirmed that it would further

the FHLBank System's housing finance mission by making available a

needed source of funding for combination farm/residential loans, which

are important to rural communities. Commenters also confirmed that the

50 percent test is under-inclusive, allowing only those combination

loans secured by very small farms to be used for membership eligibility

and advances collateral purposes. No commenter contended that the 50

percent test precisely captures all of the family farms or businesses

that make up combination properties having a sufficient residential

nexus. The Finance Board is of the view that the 50 percent test is

unnecessarily severe in excluding bona fide residences simply because

the non-residential portion may have a greater value than the

residential portion.

One difficulty in relying exclusively on an objective test, such as

the 50 percent test, is that it is apt to be over-or under-inclusive

because of geographic variations. Another difficulty with the 50

percent test is that it may discriminate against lower income

individuals, who can afford only a modest residence on their farm, in

favor of more affluent persons, who can place a more expensive

residence on the same acreage. One commenter raised precisely that

issue, providing examples of the value of certain types of residences

in relation to given acreage of farmland. A rule that encourages the

FHLBanks and their members to ignore the housing finance needs of the

lower income segments of their communities in favor of more wealthy

individuals is not consistent with carrying out the housing finance and

community investment mission of the FHLBanks, which relates to all

segments of the market.

Farm Credit System commenters contended, however, that the proposal

to eliminate the 50 percent test without providing a substitute

standard went too far in the opposite direction and is apt to be over-

inclusive by allowing the use of loans secured by a combination

business or farm property, even if the property were to possess only

the barest of residential characteristics. The Finance Board believes

that there may be merit in that argument, at least on the point that

the proposed rule might be construed by some as allowing properties

with only the slightest residential component to be included as

residential property. The proposal was not intended to be applied in

the manner suggested by the commenters. Nor was it intended to allow a

FHLBank to characterize large agribusiness and other large commercial

loans as residential loans. Instead, it was intended to make the

definitions recognize and conform to the practical realities of the

residential housing finance markets in rural communities. The Finance

Board agrees that the final rule should incorporate some further

standard that more clearly expresses the Finance Board's intention to

preclude the use of loans having only minimal residential

characteristics.

Therefore, the Finance Board is revising the definitions of ``home

mortgage loan'' and ``residential real property'' in the final rule to

include a standard that would limit qualifying loans to combination

farm/residence and combination business/residence loans with a

sufficient residential nexus. The final rule also limits the

application of the revised definition to institutions with assets of

$500,000,000 or less. By narrowing the substance of the definition and

by limiting its applicability, the Finance Board intends to target the

benefits of the rule change more precisely on the housing finance and

community investment mission of the FHLBank System, and to exclude the

types of large agribusiness and other large commercial loans that were

of concern to some commenters. Specifically, the final rule amends the

definition of ``home mortgage loan'' in Sec. 933.1(n)(1)(iii) of the

membership regulation to include a loan secured by ``combination

business or farm property, on which is located a permanent structure

actually used as a residence

[[Page 35122]]

(other than for temporary or seasonal housing), where the residence

constitutes an integral part of the property.'' See

Sec. 933.1(n)(1)(iii) (emphasis added). The amended rule would apply

only to institutions with average total assets of $500,000,000 or less,

determined over a three-year period; for larger institutions, the

current 50 percent test would remain in effect. The definition of

``residential mortgage loan'' in Sec. 933.1(bb)(1) of the membership

regulation includes the term ``home mortgage loans,'' as defined in

Sec. 933.1(n)(1)(iii), and therefore, need not be specifically amended

in order to include these revisions. See 12 CFR 933.1(bb)(1). The final

rule amends the definition of ``residential real property'' in

Sec. 935.1 of the advances regulation in a similar manner. See

Sec. 935.1.

The intent of the Finance Board in adding the ``integral''

requirement is to create a standard that will include only those

combination properties where the residence is inextricably linked to

the non-residential portion, such as in what is commonly understood as

a family farm or a family business with a residence ``above the

store.'' What constitutes such a property will vary from region to

region across the country; what constitutes a family farm in the

western states, for example, might well be larger in size than what

constitutes a family farm in New England, although the residential

portion of each property may be of comparable size. The Finance Board

believes adding the ``integral'' requirement will allow additional

latitude for the FHLBanks by providing for the inclusion of loans

secured by property containing a residence whose value cannot be

inconsequential in relation to the overall value of the property, while

excluding the types of large agribusiness and other large commercial

loans that concerned the commenters.

By adopting a more subjective standard, the Finance Board intends

to allow the FHLBanks, which are in a better position to know what

constitutes a family farm or business within their districts, to

determine for themselves which combination properties include a

residence that is so inextricably linked to the remainder of the

property as to be integral to the property as a whole. That is a

particularly fact-specific determination. For example, the ``integral''

standard would not necessarily preclude non-contiguous farm parcels

that secure the same loan, so long as, in the judgment of the FHLBank,

all of the parcels satisfy the ``integral'' standard. Clearly, a

parcel's proximity to the residence is apt to be a principal

consideration in determining whether the two properties are

``inextricably linked'' for these purposes. In any event, these would

be matters for the FHLBank to address. Likewise, the FHLBank must

determine how much documentation shall be provided by prospective and

current members in order to show that particular loans and their

collateral satisfy the standard. The Finance Board expects to review

the FHLBanks' implementation of the standard as part of the annual

examination process and will monitor compliance with this provision.

Limiting the applicability of the revised definitions to

institutions with assets of $500,000,000 or less would further address

the concerns of some commenters that the proposed rule could be

manipulated to allow very large commercial and large agribusiness loans

to be considered as ``residential'' simply by including a residence on

the underlying property. The Finance Board never intended the proposed

rule to encompass purely commercial or business loans, and has

incorporated the ``integral'' standard into the final rule in order to

ensure that any combination loan used for membership or collateral

purposes would have the requisite residential nexus. Nonetheless, the

Finance Board also believes that the inclusion of an additional

safeguard against the concerns expressed by the commenters would be

consistent with its goals and with the Bank Act.

One means of lessening the likelihood that an institution could

mischaracterize large commercial or large agribusiness loans as

``residential'' is to limit the maximum size of the loans that may

qualify under the ``integral'' standard. That result may be achieved

indirectly by limiting the size of the institutions that may take

advantage of the amended rule, because the maximum dollar amount of

loans that a depository institution may make is tied to its capital

levels, which in turn are a function of its size. As a general matter,

depository institutions are barred from extending credit to any one

borrower in an amount exceeding 15 percent of their capital and

surplus. 12 U.S.C. 84(a)(1). That lending limit applies to the

aggregate amount of all loans made to a single ``borrower,'' which term

may encompass other related persons and entities. See 12 CFR 32.5.

Although the dollar amount of the lending limit will vary from

institution to institution, the approximate cap for institutions with

assets of $500,000,000 or less should be sufficiently small to preclude

the type of large commercial and large agribusiness loans cited by the

commenters. For example, a depository institution must maintain minimum

total capital equal to 8 percent of its ``risk-weighted assets.'' Id.

Part 3, App. A, Sec. 4(b). Using that as a proxy for actual capital,

and assuming a 100 percent risk-weighting (which in practice is

unlikely to be the case), an institution with assets of $500,000,000

might have capital of approximately $40,000,000, with a lending limit

of approximately $6,000,000. An institution with $100,000,000 in assets

might have a lending limit of approximately $1,200,000. Those limits

would apply to the total amount of all loans made to a single borrower,

and thus would encompass both residential loans of the type permitted

under these amendments, as well as any commercial or personal loans.

Moreover, as a matter of sound banking practice, depository

institutions do not generally lend to the full amount permitted under

their lending limit, so the Finance Board anticipates that the dollar

amounts of loans made are apt to be considerably smaller than these

rough estimates. The Finance Board believes that effectively placing

the qualifying loans within the lending limits of members and

prospective members should help ensure that the loan amounts, and hence

their purposes, are more likely to be for bona fide residential

combination properties and not for large commercial or large

agribusiness loans.

4. Other Alternatives Considered

In attempting to reconcile the competing interests of commenters,

the Finance Board considered various other options for defining

qualifying ``residential mortgage loans'' and ``residential real

property.'' As discussed further below, in the Finance Board's view,

none of these alternatives would satisfactorily achieve the goal of

including true combination family farm and business loans, both of

which have the residential nexus required by the Bank Act, while

excluding large agribusiness and other large commercial loans, which do

not.

For example, the Finance Board considered adopting a specific

percentage test other than the 50 percent test. Such a test would

ensure that the property securing the loan has a greater residential

component than under the proposal, while continuing to qualify more

loans that now fail the 50 percent test. However, such a test would

establish a national standard that likely would remain under-inclusive,

that could not reflect differences in local real estate values, and

would continue to exclude from membership and borrowing any rural

institutions with combination farm or business loans that

[[Page 35123]]

could not meet the reduced percentage test, regardless of whether the

underlying properties included bona fide residences. For example, as a

commenter pointed out, even such a modified test likely would exclude

family ranches in areas where the land is very valuable relative to the

residence. The test also would create operational difficulties where

the existing appraisals held by the members originating the loan do not

separate the value of the residence from the value of the entire

property.

The Finance Board also considered adopting a specific acreage limit

or dollar limit as a proxy for identifying a family farm or business,

i.e., the combined farm property securing the loan could not exceed a

specific acreage limit, or the combination farm or business loan could

not exceed a specific dollar amount. If the acreage limit or dollar

limit were set low enough, the standard likely would qualify small

combination family farm or business loans, while excluding large

agricultural and other business loans. However, as pointed out by a

commenter, such limits once again would establish national standards

that cannot reflect differences in local business operations and real

estate values. The acreage size limit likely would be under-inclusive,

excluding some large-acreage farms that would be considered to be

family farms in certain locales, such as ranching areas. The dollar

limit likely would have the same problem, effectively requiring the

establishment of a nationwide standard that would not necessarily

reflect local market differences. In addition, an acreage limit or

dollar limit, by itself, would not necessarily guarantee an adequate

residential nexus, which the statute requires.

One FHLBank commenter suggested that the Finance Board adopt an

employee-based or ownership-based standard as a surrogate for small

combination family farm and business loans. Such an approach would

limit a qualifying farm or business obtaining the loan to no more than

a specific number of full-time equivalent employees. The commenter

suggested using 100 employees as an appropriate level. The commenter

also proposed limiting a farm or business corporation obtaining the

loan to no more than a specific number of shareholders, such as 10

shareholders. Such standards likely would encompass many of the type of

loans intended by the Finance Board, while excluding large agricultural

and other large business loans. However, again, this approach would

establish a national standard that would not work in all locales. It

also would be very difficult for the Finance Board to ascertain how

many employees or shareholders are typical for a family farm or

business throughout the country, and then craft a regulation based on

that information. In addition, an employee or shareholder test, by

itself, would not necessarily guarantee an adequate residential nexus,

which the statute requires.

Another option considered was to require that the combination farm

or business property securing the loan be owner-occupied. Such a

standard would exclude loans secured by large farms with only a

caretaker's residence located on the property. However, a commenter

indicated that this standard would be under-inclusive because it would

exclude a significant number of combination family farm or business

loans where a family member lives in the residence on the property but

the residence is owned in the name of another family member or a

family-owned corporation. Defining ownership also could create problems

in implementation of the standard, and possible conflicts with state

laws.

Another option presented was to limit the farm or business

obtaining the loan to family partnerships or proprietorships, i.e., not

corporations, on the theory that this would serve as a surrogate for

small combination family farm and business loans. However, as a

commenter pointed out, such a standard also would be under-inclusive

because it would eliminate many small family farms that are

incorporated for tax or other reasons.

The Finance Board also considered an option supported by a FHLBank

commenter to establish a ``materiality'' standard for the residential

portion of the combination property, with each FHLBank adopting its own

criteria for determining ``materiality'' based on local conditions.

Such a standard could be an independent requirement or combined with a

reduced percentage test. The standard would ensure that the property

securing the loan has a ``material'' residential component, and would

reflect differences in local combination farm or business properties,

which a national standard cannot do, thereby qualifying more

combination farm or business loans held by rural institutions that

might otherwise fail the 50 percent test or a reduced percentage test.

However, the term ``material'' is a term of art in other areas of the

law, such as the federal securities laws, and its use here might prompt

unintended and undue reliance on a standard established under a body of

law unrelated to the FHLBanks.

C. Comments on Finance Board's Authority to Change the 50 Percent Test

1. Mission and Goals of the FHLBank System

The Farm Credit System commenters contended that the proposed rule

would be inconsistent with the housing finance mission of the FHLBank

System, principally because it would have allowed the use of loans for

membership and collateral purposes that are not predominantly

residential in nature. As described previously, the final rule requires

not only that any eligible combination property must include a bona

fide permanent residence, but that the residential component of the

property must be ``integral'' to, or inextricably linked with, the

overall parcel.

The Finance Board believes that the ``integral'' standard will

ensure that any loan secured by such combination property will have the

necessary residential nexus required by the Bank Act, and thus will be

consistent with the FHLBanks' housing finance mission. The ``integral''

standard may well allow the use of some loans secured by combination

properties even if the value of the residential portion of the property

does not predominate, but the Bank Act clearly permits that

possibility, for reasons discussed previously. Moreover, the housing

finance mission of the FHLBanks includes a community investment

component, and the final rule is consistent with that aspect of the

mission as well. In 1989, the Congress mandated that each FHLBank must

establish a Community Investment Program (CIP); Congress also expressly

permitted the FHLBanks to establish additional community investment

cash advance programs (Section 10(j)(10) programs). See 12 U.S.C.

1430(i), (j)(10).

Under the CIP, ``community-oriented mortgage lending'' includes

loans to finance commercial and economic development activities that

benefit low-and moderate-income families or activities that are located

in low- and moderate-income neighborhoods. Id. at 1430(j)(2). The

Finance Board previously has determined that such targeted commercial

and economic development lending constitutes ``residential housing

finance,'' for purposes of allowing long-term CIP advances. See CIP

Policy Statement, Board Resolution No. 92-533 (July 17, 1992); 12 CFR

935.1, 935.14(b)(2). The section 10(j)(10) provisions do not specify

any targeting requirements, which suggests that Congress contemplated

that Section 10(j)(10) programs need not have the same targeting or

other eligibility

[[Page 35124]]

requirements as are required under the CIP.

It is possible under these provisions for a FHLBank to fund

targeted commercial or economic development that has no ``residential''

component, at least in the sense contemplated by the Farm Credit System

commenters. Yet, the Finance Board has determined that such funding

would be part of the FHLBank's housing finance mission, as described

above. It would be anomalous to find that a targeted loan for wholly

commercial or economic development purposes is so clearly within the

mission of the FHLBanks, but that a combination loan, even if similarly

targeted, would somehow be beyond the housing finance mission because

it may be in part related to a commercial business or farm property.

The Finance Board believes that some number of rural and urban

combination properties will necessarily be located in low-and moderate-

income neighborhoods. Further, limiting the size of the institutions

eligible to use the revised standard, and thereby limiting the size of

the combination loans to be made by these institutions, is itself a

method of targeting the use of this standard to the communities and

uses most in need of the relief. To accept the reasoning of the Farm

Credit System commenters and conclude otherwise would require the

Finance Board to ignore the community investment aspect of the housing

finance mission, which it is not prepared to do. In the view of the

Finance Board, the final rule is consistent with both the historical

concept of residential housing finance, as well as the more broadly

defined concept incorporated by Congress into the Bank Act in 1989.

2. ``Rational'' Basis for Changing Prior Agency Statutory

Interpretation

Some of the commenters opposing the proposed rule contended that

the proposal should be withdrawn as inconsistent with the Finance

Board's prior interpretations of the statutory provisions, suggesting

that the Finance Board has ignored those interpretations and is obliged

to adhere to them. The commenters noted, for example, that in the

original rulemaking when the 50 percent test for advances collateral

purposes was adopted, the Finance Board rejected a commenter's

suggestion to set the limit at 10 percent, explaining that the higher

percentage better reflected the FHLBanks' focus on housing finance. See

58 FR 29456, 29462 (May 20, 1993). Opposing commenters now question the

authority of the Finance Board to take what they believe is a

conflicting position.

The Finance Board by no means has ignored its prior positions and

interpretations relating to the 50 percent test. To the contrary, the

Finance Board has carefully and thoroughly considered its past

approaches to this issue, all of the comments and suggestions received

in response to the proposed rule, and various alternative approaches.

The Finance Board has elected now to adopt an approach that is

consistent with its prior intentions yet, at the same time, better

accomplishes its intentions, is more flexible and allows for more

subjective analysis in lieu of rigid adherence to a fixed percentage

test.

As previously noted, an agency is free to change its interpretation

of its statute so long as its actions are rational, reasonable, not

arbitrary and capricious, involve no clear error of judgment, and a

satisfactory explanation for its actions is included within the record.

See, e.g., 5 U.S.C. 706(2)(A); Motor Vehicle Mfrs. Ass'n, 463 U.S. at

41-43; Camp, 411 U.S. at 142; IBAA, at 8-9.

Nothing in the Bank Act or in the Administrative Procedure Act

alters the agency's authority in this regard. In fact, deference is

given to the administering agency's construction of an ambiguous

statute if it is ``permissible'' or ``reasonable'' in light of the

statute's overall structure and goals. Chevron, 467 U.S. at 843-45.

Deference to the Finance Board's policy judgments is particularly

appropriate given its expertise and the broad discretion Congress has

conferred upon it. The Finance Board regulates in an area--the

financial services context where courts have customarily deferred to

evolving administrative interpretations of statutory language as a

means of accommodating changes in the market place and customers'

service needs. See, e.g., Clarke v. Securities Industry Ass'n, 479 U.S.

388, 403-09 (1987); Board of Governors of Federal Reserve System v.

Investment Company Institute, 450 U.S. 46, 56-58, 68 (1981). A notable

example of such deference is IBAA v. Clarke, where the court, deferring

to a statutory construction by a federal banking regulatory agency that

recognized ``the realities of banking in the nineties'' and that ``the

financial industry is complex and changing,'' concluded that ``[t]his

kind of regulatory and competitive environment is especially suited to

the expert judgment of regulators accustomed to dealing with the

industry day to day.'' 917 F.2d 1126, 1129 (8th Cir. 1990). Thus, it is

firmly established that the Finance Board is entitled to deference as

the agency charged with administering the Bank Act. See Rust v.

Sullivan, 500 U.S. 173, 184, 186-187 (1991).

Change in statutory interpretation is not a problem ``since the

whole point of Chevron is to leave the discretion provided by the

ambiguities of a statute with the implementing agency.'' Smiley v.

Citibank (South Dakota), N.A., 116 S.Ct. 1730, 1734 (1996). As the U.S.

Supreme Court emphasized in Chevron, ``an initial agency interpretation

is not instantly carved in stone. On the contrary, the agency, to

engage in informed rulemaking, must consider varying interpretations

and the wisdom of its policy on a continuing basis.'' 467 U.S. at 863-

64. That is what the Finance Board is doing through this rulemaking.

3. Ability of Rural Banks to Become FHLBank Members; Need for FHLBank

Credit

Some commenters argued that the Finance Board offered no reasoned

explanation or empirical data to support its departure from prior

practice. The Farm Credit System trade association argued that the 50

percent test should be retained because it does not hinder rural banks'

ability to become FHLBank members, and rural banks do not have less

demand for conventional single family and multifamily mortgages.

As an initial matter, there is nothing that requires the Finance

Board to conduct empirical studies as a prerequisite to conducting a

rulemaking proceeding. Indeed, there are any number of issues on which

an agency may regulate, such as interpretations of a statute, where

empirical analysis would have little relevance or benefit. An empirical

study of rural credit and housing markets might better inform the

Finance Board about certain aspects of those markets. It would be of no

use, however, in determining what minimum residential characteristics

are required by Congress in order for loans on combination properties

to be eligible for membership and advances collateral purposes, which

is the issue addressed by this rule.

That said, in adopting this final rule, the Finance Board has

considered studies prepared by other parties as sources of information

about the need for alternative funding sources for rural banks and the

state of rural credit markets. See USDA Report; ``Second Annual

Community Bank Competitiveness Study,'' ABA/ABA Banking Journal (Feb.

1998); Farm Credit Situation Survey Report 1997 (American Bankers

Association 1997). The Finance Board also has taken into consideration

its initial discussions with industry representatives about the

shortcomings of the 50 percent test, as well as the comments supporting

the proposal, which confirm the need for

[[Page 35125]]

alternative funding sources for rural banks and the likelihood that the

proposal would address that need. The Finance Board does not believe

that it is required to undertake further independent empirical research

of the rural credit and housing markets in order to exercise its

rulemaking authority.

The Farm Credit System trade association cited to a statement in

the USDA Report that, ``[n]ationwide, rural-headquartered commercial

banks are as likely to be members of the [FHLBank System] as are other

banks'' to support its views. See USDA Report at 48 n.19. However, the

commenter also acknowledged in a footnote that, ``[n]otwithstanding

this conclusion, the [USDA] Report noted that `rural access' to FHLBank

membership was of `some concern' in three isolated markets.'' What the

commenter characterizes as three ``isolated markets'' are in fact three

FHLBank districts--Des Moines, Dallas and Topeka--which encompass 14

states. Moreover, the USDA Report indicates that there are a total of

900 ineligible rural banks in these districts. See id. The purpose of

the Finance Board's rule is to assist some of these 900 rural banks in

joining and borrowing from the FHLBank System, as well as to assist

current members in increasing their borrowing capacity. Two of the

FHLBanks cited in the USDA Report, Des Moines and Topeka, submitted

comment letters strongly supporting the proposal. The Des Moines letter

stated that eliminating the current 50 percent test will enable over

600 of the FHLBank's current small community bank members with assets

under $100 million to fully use FHLBank funding. In addition, the

FHLBank estimated that the expansion of the membership eligibility

criteria to include these combination loans will enable approximately

700 more financial institutions to join the Des Moines FHLBank. (The

USDA Report estimated 322 ineligible rural banks in the Des Moines

district, see id.; therefore, it is assumed that the estimate of 700

ineligible institutions provided by the Des Moines FHLBank covers non-

rural as well as rural institutions.)

In addition, the USDA Report states that there are concerns about

whether rural offices of large urban banks effectively serve their

rural customers. See id. at 63. The USDA Report also states that rural

FHLBank members are larger and hold a greater ratio of mortgage-related

assets than other rural banks that are not FHLBank members. See id. at

48 n.19. This suggests that smaller banks and their rural customers may

be underserved at present and that increased FHLBank access by small

rural banks is needed. Notwithstanding the arguments of the Farm Credit

System commenters, it appears that the information in the USDA Report

actually supports the Finance Board's view that the 50 percent test

operates in practice to hinder the ability of rural banks to become

FHLBank members.

In addition, in a subsequent comment letter the Farm Credit System

trade association suggested that it is concerned with commercial bank

competition in the agricultural markets and indicated that there are

already two government sponsored enterprises (GSEs) serving the credit

needs of agriculture--the Farm Credit System and the Federal

Agricultural Mortgage Corporation (Farmer Mac). As previously stated,

many family farm/residential loans, while not meeting the 50 percent

test, have a sufficient residential nexus to ensure consistency with

the FHLBank System's housing finance and community investment mission.

Because it is within the missions of the Farm Credit System and Farmer

Mac, as well as the FHLBank System, to support the rural housing

markets, there is clearly some overlap in the markets served by

different GSEs. Such overlap can result in competition among GSEs.

The primary benefit afforded to GSEs is the ability to borrow at

rates only slightly higher than Treasury borrowing rates. The Farm

Credit System, Farmer Mac and the FHLBanks all receive this benefit by

virtue of their GSE status. In return for this benefit, GSEs have a

responsibility to fulfill a public policy mission. One of the ways that

GSEs fulfill their mission is by passing along their funding advantage

to the end user. The FHLBank System's housing finance and community

investment mission requires the FHLBanks to provide funds to financial

institutions in all markets, including rural markets that also may

receive some assistance from one or more other GSEs. To the extent that

other GSEs also provide government subsidized assistance to certain

rural markets, the revisions to the FHLBanks' membership and collateral

provisions do not result in an introduction of a new subsidy to these

markets, but rather provide another source of government-subsidized

funding. In fact, competition among GSEs can be viewed as a positive

development because it helps ensure that government subsidies flow to

the end user and not to the GSE's managers and shareholders.

The Farm Credit System trade association also argued that its

analysis of the likely membership effects of the proposed rule does not

suggest that rural banks would uniquely benefit from elimination of the

50 percent test. The commenter indicated that, based on its own

analysis of the loan portfolios of non-metropolitan and metropolitan

banks, membership eligibility for non-metropolitan banks would increase

approximately 10.5 percent, while membership eligibility for

metropolitan banks would similarly increase by more than 8 percent.

Although the proposed rule was issued in response to concerns

raised by rural banks, and is intended specifically to assist rural

banks in accessing the FHLBank System, the Finance Board did not intend

that such benefits accrue solely to rural banks. These amendments apply

as well to combination properties involving a non-farm business and a

residence, and it is anticipated that loans secured by such properties

located in urban areas also will be used by members and prospective

members as a result of this rule. The mission of the FHLBank System

includes the provision of funds to financial institutions located in

all areas of the country, and to the extent the rule assists non-rural,

as well as rural, banks, it is entirely consistent with the FHLBank

System's mission.

The Farm Credit System trade association also claimed that

statements made in support of the proposed rule contradict and must be

reconciled with past Finance Board statements to Congress.

Specifically, the Finance Board has stated that ``[e]ligible [other

real estate related] collateral for [FHLBank] System advances is

already very broad,'' and ``[t]here is no evidence that advance demand

is constrained by a lack of eligible collateral.'' See Finance Board

Report on the Structure and Role of the Federal Home Loan Bank System

at 167 (March 19, 1993).

The advantages of expanding the scope of that category of eligible

collateral were not considered to be significant at that time. See id.

However, as acknowledged by the commenter, the Finance Board separately

recommended that Congress permit the FHLBanks to accept a broader range

of collateral to secure advances in order to carry out the FHLBank

System's mission as defined by the Finance Board. See id. In addition,

as explained in the proposed rule, since adoption of the 50 percent

test, the Finance Board has received new information from members and

nonmembers of the FHLBank System indicating that the 50 percent test

has proven to be under-inclusive and, consequently, is constraining

advance demand in certain markets. This was confirmed by a significant

number of commenters, many of whom contend

[[Page 35126]]

that eliminating the 50 percent test would further the FHLBank System's

housing finance mission by making available a needed source of funding

for combination farm/residential loans.

4. Practical Consequences of Changing the 50 Percent Test

The Farm Credit System trade association also argued that the

Finance Board failed to consider the practical consequences of the

proposal. For instance, the commenter stated that the proposed rule did

not indicate how, with a substantial increase of eligible collateral,

the Finance Board would reconcile the credit demand in rural markets

with the potential impact on credit supply. The commenter estimated

that more than $18 billion in loans held by non-metropolitan banks

could be newly pledged as collateral for FHLBank advances. The

commenter argued that such an analysis is one essential predicate to

deciding whether the proposed rule is appropriately tailored to the

Finance Board's statutory housing mission.

The most likely practical consequences resulting from the final

rule are that some number of rural institutions will become eligible to

become members of the FHLBank System, will do so, and will borrow from

their FHLBank to finance residential housing within their communities.

Obviously, if the rule has the desired effect, there should be some

corresponding increase in the aggregate amount of advances outstanding,

which currently total approximately $208 billion System-wide. The

Finance Board has no reason to believe that an additional $18 billion

of collateral, assuming for the sake of argument that $18 billion is an

accurate figure, will overwhelm the credit markets. For one thing, some

portion of that amount will be owned by institutions that choose not to

become members, and some will be owned by members who will not borrow

to their full potential. Additionally, the FHLBanks all have credit

policies that establish discounts for various types of collateral.

Given the circumstances and the prudent underwriting by the FHLBanks,

the Finance Board would expect that any FHLBank accepting newly-

authorized loans on combination properties would significantly discount

those loans pledged as collateral. This discounting, or

overcollateralization, would further diminish the amount of credit that

the newly-authorized collateral could support. Moreover, the insured

depository institutions that presumably would be borrowing against this

collateral are regulated by other agencies, which require the

institutions they regulate to limit asset growth to what is prudent.

See 12 CFR Part 30, App. A, Sec. II.F. The Finance Board believes that

those operational and regulatory checks will preclude any undue

consequences in the rural credit markets as a result of this rule.

5. Safety and Soundness Risks of Changing the 50 Percent Test

The Farm Credit System trade association also stated that the

Finance Board did not indicate how it will address the fact that a

mortgage on a combination property may be less liquid and marketable

than a conventional home mortgage. The commenter stated that a safety

and soundness issue may arise where a prospective member lender lacks

the necessary understanding of the agricultural lending process, which

may result in compromised underwriting practices and poor credit

decisions in pursuing loans on newly eligible combination properties,

increasing the likelihood of loan losses incurred by the FHLBanks.

In fact, the proposed rule discussed at length the fact that any

additional risks that might arise if such mortgage loans are used as

collateral for advances should be adequately managed in accordance with

the current provisions of the advances regulation and FHLBank credit

policies. The FHLBanks already accept combination loans, and have

expertise in underwriting advances secured by such loans. The final

rule, like the current advances regulation, does not mandate that the

FHLBanks accept combination farm or business loans as collateral for

advances. It merely includes such loans in the category of loans

eligible to be accepted by a FHLBank to secure advances.

The FHLBanks already are permitted to accept as collateral for

advances to members ``other real estate related collateral'' (provided

aggregate outstanding advances secured by such collateral do not exceed

30 percent of the member's capital). See 12 U.S.C. 1430(a)(4); 12 CFR

935.9(a)(4). Included in this category of permissible collateral are

loans on farms and other agricultural property, commercial mortgage

loans, construction loans, land development loans, and second mortgage

loans including home equity loans. See 12 CFR 935.9(a)(4)(ii). The

FHLBanks also may accept multifamily loans as eligible collateral,

without being subject to the 30 percent member capital limit. See 12

U.S.C. 1430(a)(1); 12 CFR 935.9(a)(1)(i). With respect to each of those

types of collateral, the FHLBanks already manage the credit, liquidity,

and marketability risks cited by the commenter, as well as other risks,

associated with non-one-to-four family residential mortgage collateral.

There is no evidence that these revisions will subject the FHLBanks to

underwriting tasks that are beyond their ability to manage.

The Finance Board requires that the FHLBanks have such underwriting

expertise and credit policies before accepting such loans as

collateral. Specifically, the advances regulation requires, among other

things, that the FHLBanks establish written procedures for determining

the value of collateral securing advances, and that the FHLBanks follow

those procedures in ascertaining the value of particular assets offered

as collateral. See 12 CFR 935.12. The regulation also permits the

FHLBanks to require a member to support the valuation of any collateral

with an appraisal or other investigation of the collateral as the

FHLBank deems necessary. See id.

Rural lending often requires collateral valuation practices that

may differ significantly from those typically employed in lending on

the security of one-to-four family homes. The Finance Board expects

each FHLBank to review its collateral valuation procedures, and amend

them as necessary to reflect the changes made in the final rule, before

accepting as collateral any newly authorized combination properties.

The Finance Board also expects that the FHLBanks, as a matter of

practice, will conduct careful review and, if necessary, require an

appraisal of such collateral, taking into account the additional risks

inherent in rural lending and each FHLBank's own capability to evaluate

those risks. In addition, the FHLBanks generally require that members

pledge additional collateral if the value of their original collateral

declines.

Finally, as the regulator of the FHLBanks, the Finance Board's

primary responsibility is to ensure that the FHLBanks operate in a

financially safe and sound manner. See 12 U.S.C. 1422a(a)(3)(A). The

Finance Board's oversight of the FHLBanks includes annual on-site

examinations and regular off-site review of FHLBank operations.

Emphasis is placed on areas of FHLBank operation that could potentially

expose the FHLBank and the FHLBank System to risk. As part of the

examination process, the Finance Board reviews and evaluates the

FHLBanks' management of collateral. Examiners review valuation

methodology, discounts applied to collateral, and frequency of review

or re-valuation for various types of collateral. Moreover, the loan

quality and underwriting practices of the individual members are

reviewed regularly by the

[[Page 35127]]

primary banking regulators through periodic examinations.

In short, the above-described FHLBank practices, regulatory

requirements, and Finance Board examination oversight, do not encourage

FHLBank members to approve unsafe or unsound loans that could be

pledged to the FHLBanks to secure advances.

In addition, increasing access to the FHLBank System would provide

current and prospective members with enhanced risk management options.

The USDA Report states that access to funds from GSEs, such as the

FHLBanks, enhances liquidity and can improve profitability and risk

management of depository financial intermediaries, including commercial

banks, credit unions, and thrifts. See USDA Report at 97. Risk

management is enhanced because GSE funds are available with longer

maturities than are usually available on deposits at commercial banks.

See id. at 98. Advances can be used to control interest rate risk by

allowing member banks to match the funding to the maturity, payment

structure, prepayment options, and other features of the loans they

make. See id.

The Finance Board specifically requested comment on whether

elimination of the 50 percent test might expose the FHLBanks to any

undue risk of loss should a FHLBank need to liquidate the combination

mortgage loans it holds as collateral for an advance. See 62 FR 53252.

Many commenters stated that the proposal would not present safety or

soundness risks for the FHLBanks because, as discussed above, the

FHLBanks do not lend against the full value of collateral, but rather

apply discounts depending on the riskiness of the collateral and the

difficulties in valuing it. Commenters also pointed out that the

FHLBanks obtain appraisals of collateral from members, and can require

additional collateral if necessary.

In addition, commenters noted that combination loans at rural banks

are solidly performing and generally exceed the loan quality of the

rest of the banking industry, with 1996 net charge-offs on average

loans at rural banks at 0.32 percent, while net charge-offs for banks

overall were 0.61 percent. One FHLBank commenter noted that the

experience of lenders in Iowa during the 1980s ``agricultural crisis''

was that, while there was a substantial decline in value of both one-

to-four family properties in rural areas and combination farm/residence

properties, the decline was not greater for the combination properties

than it was for those that were solely residential. In fact, the

combination properties were more likely to be sold since there remained

buyers interested in the agricultural portion of the land. Based on

this experience, the commenter did not believe that combination

property is more volatile than solely residential property located in

rural areas. The commenter stated that it planned to hire additional

experienced personnel to ensure that, through proper due diligence, its

practices are prudent and will not expose the FHLBank to undue risks of

loss.

Accordingly, the Finance Board believes that through due diligence,

overcollateralization, and prudent credit and collateral risk

management procedures and practices, the FHLBanks can adequately

prevent undue risk of loss on advances secured by combination loans.

Therefore, the Finance Board does not believe that there are undue

safety and soundness risks that would suggest that the Finance Board

lacks the ``rational'' basis for changing the 50 percent test in the

final rule.

VI. Definition of ``Residential Mortgage Loan'' in

Sec. 933.1(bb)(8) of the Final Rule

Consistent with the proposed rule, ``residential mortgage loan'' is

defined in Sec. 933.1(bb)(8) of the final rule to include, for

membership eligibility purposes, loans that finance properties or

activities that, if made by a member, would satisfy the statutory

requirements for the CIP established under section 10(i) of the Bank

Act, or the regulatory requirements established for any community

investment cash advance program authorized by section 10(j)(10) of the

Bank Act. See 12 U.S.C. 1430(i), (j)(10).

The intent of this amendment is to allow such community investment

loans to be considered for purposes of eligibility for membership, and

to conform the membership regulation more closely to the advances

regulation, which already includes loans financed by section 10(i) or

section 10(j)(10) advances within the definition of ``residential

housing finance assets.'' See 12 CFR 935.1. A banking trade association

specifically supported the proposed definition.

VII. Regulatory Flexibility Act

The final rule does not impose any additional reporting,

recordkeeping, or compliance requirements on prospective or current

FHLBank members. Although the Finance Board anticipates that the final

rule will be of benefit primarily to small depository institutions, it

will not have a disproportionate impact on small entities. Therefore,

in accordance with the Regulatory Flexibility Act, the Finance Board

hereby certifies that this final rule will not have a significant

economic impact on a substantial number of small entities. 5 U.S.C.

605(b).

VIII. Paperwork Reduction Act

The final rule does not contain any collections of information, as

defined by the Paperwork Reduction Act of 1995. See 44 U.S.C. 3501 et

seq. Consequently, the Finance Board has not submitted any information

to the Office of Management and Budget for review.

List of Subjects

12 CFR Part 933

Federal home loan banks, Reporting and recordkeeping requirements.

12 CFR Part 935

Credit, Federal home loan banks, Reporting and recordkeeping

requirements.

Accordingly, the Federal Housing Finance Board hereby amends title

12, chapter IX, parts 933 and 935 of the Code of Federal Regulations as

follows:

PART 933-MEMBERS OF THE BANKS

1. The authority citation for part 933 continues to read as

follows:

Authority: 12 U.S.C. 1422, 1422a, 1422b, 1423, 1424, 1426, 1430,

1442.

2. Amend Sec. 933.1 by revising paragraph (n)(1)(iii), removing

``or'' at the end of paragraph (bb)(6)(iii), removing the period at the

end of paragraph (bb)(7) and adding ``; or'' in its place, and adding

paragraph (bb)(8) to read as follows:

Sec. 933.1 Definitions.

* * * * *

(n) Home mortgage loan * * *

(1) * * *

(iii) Combination business or farm property where at least 50

percent of the total appraised value of the combined property is

attributable to the residential portion of the property or, in the case

of any community financial institution, combination business or farm

property, on which is located a permanent structure actually used as a

residence (other than for temporary or seasonal housing), where the

residence constitutes an integral part of the property. For purposes of

this subparagraph, the term ``community financial institution'' means

an institution that has average total assets of $500,000,000 or less,

based on an average of total assets over the three preceding years. The

Board shall adjust the limit annually based on the annual

[[Page 35128]]

increase, if any, in the Consumer Price Index for all urban consumers,

as published by the Department of Labor; or

* * * * *

(bb) Residential mortgage loan * * *

(8) Loans that finance properties or activities that, if made by a

member, would satisfy the statutory requirements for the Community

Investment Program established under section 10(i) of the Act, or the

regulatory requirements established for any community investment cash

advance program authorized by section 10(j)(10) of the Act.

* * * * *

PART 935--ADVANCES

1. The authority citation for part 935 continues to read as

follows:

Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1426, 1429, 1430,

1430b, 1431.

2. Amend Sec. 935.1 by revising paragraph (1)(v) in the definition

of ``Residential real property'' to read as follows:

Sec. 935.1 Definitions.

* * * * *

Residential real property * * *

(1) * * *

(v) Combination business or farm property where at least 50 percent

of the total appraised value of the combined property is attributable

to the residential portion of the property or, in the case of any

community financial institution, combination business or farm property,

on which is located a permanent structure actually used as a residence

(other than for temporary or seasonal housing), where the residence

constitutes an integral part of the property. For purposes of this

subparagraph, the term ``community financial institution'' means an

institution that has average total assets of $500,000,000 or less,

based on an average of total assets over the three preceding years. The

Board shall adjust the limit annually based on the annual increase, if

any, in the Consumer Price Index for all urban consumers, as published

by the Department of Labor.

* * * * *

Dated: April 14, 1998.

By the Board of Directors of the Federal Housing Finance Board.

Bruce A. Morrison,

Chairperson.

[FR Doc. 98-17163 Filed 6-26-98; 8:45 am]

BILLING CODE 6725-01-P