Federal Home Loan Bank Standby Letters of Credit

FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 938 and 943

[No. 98-49]

RIN 3069-AA61

Federal Home Loan Bank Standby Letters of Credit

AGENCY: Federal Housing Finance Board.

ACTION: Final rule.

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SUMMARY: The Federal Housing Finance Board is codifying its existing

policy on Federal Home Loan Bank (FHLBank) standby letters of credit

(LOCs) in a regulation and amending the policy to allow for broader use

of standby LOCs by FHLBank members and eligible nonmember mortgagees.

This final rule also eliminates or modifies some of the restrictions

currently imposed on standby LOCs issued or confirmed by FHLBanks that

limit the usefulness of these products to members and eligible

nonmember mortgagees.

DATES: This final rule is effective on December 30, 1998.

FOR FURTHER INFORMATION CONTACT: Diane E. Dorius, Associate Director,

Program Development, Office of Policy, (202) 408-2576; or Eric M.

Raudenbush, Attorney-Advisor, Office of General Counsel, (202) 408-

2932, Federal Housing Finance Board, 1777 F Street, NW, Washington, DC

20006.

SUPPLEMENTARY INFORMATION:

I. Background

On May 8, 1998, the Federal Housing Finance Board (Finance Board)

published, and requested public comments on, a proposed rule to add to

its regulations a new part 938, governing the issuance and confirmation

of standby LOCs by FHLBanks. See 63 FR 25726 (May 8, 1998). The

rulemaking proposed to amend the Finance Board's existing policy on

FHLBank standby LOCs to provide the FHLBanks with greater flexibility

to respond to member needs for these products in a manner that would be

consistent with the FHLBank System's housing and community investment

mission, and to codify the amended policy into regulatory form.

The ninety day public comment period closed on August 6, 1998. The

Finance Board received a total of 24 comments: eleven from FHLBanks,

two from FHLBank Advisory Councils, eight from trade associations, and

one each from an executive agency of the U.S. Government, a FHLBank

member, and a private law firm. The FHLBanks that commented generally

supported the proposed rule. The executive agency, FHLBank member and

several trade associations opposed the rule.

The proposed rule established uniform standards for the issuance of

standby LOCs that addressed eligible purposes, collateral requirements,

nonmember use of LOCs, maturity limits, FHLBank capital stock, and

other policy requirements. The purpose of the proposal, and of the

final rule, is to provide the FHLBanks with greater flexibility and

discretion, consistent with safe and sound operation, than exist under

the Finance Board's current Interim Policy Guidelines for FHLBank

Standby LOCs (Interim Guidelines).

Specifically, the Finance Board proposed that the enumeration of

specific permissible uses for FHLBank LOCs that is set forth in the

Interim Guidelines be replaced with a provision authorizing the

FHLBanks to issue or confirm standby LOCs for any of four general

purposes: to assist members in facilitating residential housing

finance; to assist members in facilitating community lending (so-called

in the final rule, this was referred to as ``targeted economic

development'' in the proposed rule); to assist members with asset/

liability management; and to assist members with liquidity and other

funding.

The proposed rule permitted FHLBanks to issue and confirm standby

LOCs on behalf of nonmember borrowers for the same purposes as members

if such LOCs were secured by Federal Housing Administration (FHA)

insured loans or Government National Mortgage Association (GNMA)

securities backed by FHA loans. Under the proposed rule, FHLBanks could

issue or conform standby LOCs on behalf of nonmember borrowers that are

state housing finance agencies (SHFAs) for residential or economic

development lending that benefits individuals or families meeting the

income requirements in sections 142(d) or 143(f) of the Internal

Revenue Code, 12 U.S.C. 142(d), 143(f), if these LOCs were secured by

collateral with which an SHFA may secure advances under section 10B(b)

of the Federal Home Loan Bank Act (Bank Act). 12 U.S.C. 1430b(b).

Under the proposed rule, all LOCs were required to be fully

collateralized at the time of issuance by collateral eligible to secure

advances to members (or, as appropriate, nonmember mortgagees) and, in

the case of standby LOCs issued or confirmed on behalf of members for

housing or community lending purposes, also by certain other high-

quality collateral. Unlike the existing Interim Guidelines, the

proposed rule neither required nor permitted outstanding LOCs to be

taken into account in the computation of a member's advances-to-FHLBank

capital stock ratio.

Finally, the proposed rule required that: LOCs have a specific

expiration date or be for a definite term; LOC renewals be conditioned

upon the member/applicant meeting the FHLBank's credit criteria at the

time of renewal; and the FHLBank issuing an LOC would approve any

transfer of the LOC.

The final standby LOC regulation remains unchanged on most

substantive points from the rule as proposed, although the Finance

Board has made several amendments for purposes of clarity and in order

to make the regulation conform to the final Community Investment Cash

Advances (CICA) regulation, (published in the November 27, 1998 edition

of the Federal Register), to which the community lending provisions of

the rule are tied. These changes are described in detail below. Also

provided below are clarifications of certain issues that were raised in

the comment letters.

II. Statutory Basis for FHLBank Standby Letter of Credit Authority

Nine commenters explicitly addressed the statutory authority of

FHLBanks to issue and confirm LOCs pursuant to the terms set forth in

the proposed rule.

[[Page 65694]]

Three of these (two FHLBanks and one trade association) expressly

supported the view that, under the Bank Act, 12 U.S.C. 1421-49,

FHLBanks have such statutory authority. Six commenters (one FHLBank

member, the executive agency and four trade associations) questioned

the statutory bases underlying the proposed rule. Two of the trade

associations, in letters that were nearly identical, queried whether

the FHLBanks have statutory authority to issue standby LOCs under any

circumstances. The Finance Board has reviewed the legal reasoning

underlying the provisions of the proposed rule and has concluded that

there is ample authority under the Bank Act to permit the FHLBanks to

issue and confirm standby LOCs under the terms of the final rule.

A. Legal Determinations of the FHLBB Regarding FHLBank LOCs

Although the Bank Act does not expressly address LOCs, the FHLBanks

have been explicitly permitted to engage in standby LOC transactions

since 1983, when the predecessor agency to the Finance Board, the

former Federal Home Loan Bank Board (FHLBB), first adopted Policy

Guidelines for Issuance of FHLBank Standby Letters of Credit (FHLBB

Policy). Underlying the adoption of the FHLBB Policy was an opinion

rendered by the FHLBB General Counsel that, because a FHLBank standby

LOC is the functional equivalent of a loan between the FHLBank and its

member, FHLBanks have authority to issue standby LOCs as part of their

power to make advances under section 10 of the Bank Act, 12 U.S.C.

1430, provided that the member has the unconditional obligation to

reimburse the FHLBank for any payment made thereunder. As an

alternative, the FHLBB further concluded that the issuance by a FHLBank

of a standby LOC on behalf of a member and payment by the FHLBank of a

draft presented by the beneficiary thereunder is incidental to a

FHLBank's payment instrument processing authority under section

11(e)(2) of the Bank Act, 12 U.S.C. 1431(e)(2), so long as the

disbursement process under the LOC is directly linked to the member's

FHLBank demand deposit account. However, having relied on the section

10 advances authority as its primary rationale, the FHLBB imposed upon

each FHLBank standby LOC at the time of issuance all statutory

requirements that applied to outstanding advances, including

requirements as to capital stock ratio and purchase, purpose and

collateral. (The Finance Board later permitted FHLBanks to issue

standby LOCs on behalf of eligible nonmember mortgagees pursuant to the

FHLBanks' section 10b advances authority. See 12 U.S.C. 1430b.)

After numerous requests over a period of years from several

FHLBanks, the Finance Board undertook a comprehensive legal and policy

review of the Interim Guidelines in order to determine whether any of

these advances-related restrictions could be eliminated, so as to make

FHLBank LOCs more useful to their members and eligible nonmember

mortgagees. As a result of its legal review, the Finance Board's Office

of General Counsel (OGC) determined that, while the legal authority for

issuing LOCs articulated in the original FHLBB legal analysis remains

valid, it is not necessary to view a LOC as an outstanding advance at

the time the LOC is issued, nor is it necessary as a matter of law to

subject LOCs to all of the statutory restrictions and limitations that

apply to outstanding advances. OGC concluded that the authority to

engage in standby LOC transactions also arises from the FHLBanks'

authority to accept deposits and process payments under section 11(e)

of the Bank Act, 12 U.S.C. 1431(e), and from their incidental authority

to enter into commitments to make advances under sections 9, 10(a), and

11(a) of the Bank Act. Id. 1429, 1430(a), 1431(a).

B. FHLBank Deposit Taking and Payment Processing Authorities

Section 11(e)(1) of the Bank Act authorizes each FHLBank to accept

deposits from members, upon such terms and conditions as the Finance

Board shall prescribe. Id. 1431(e)(1). In addition, section 11(e)(2)(A)

authorizes the Finance Board to permit FHLBanks, among other things, to

be drawees of drafts drawn on members of any FHLBank and to have such

incidental powers as the Finance Board shall find necessary for the

exercise of such powers. Id. 1431(e)(2)(A).

A FHLBank that has issued a standby LOC on behalf of a member would

be the drawee of--that is, the financial institution directed to make

payment upon--any draft presented to it thereunder. Although the funds

paid by a FHLBank to a beneficiary pursuant to a LOC draft technically

are considered to be paid from the FHLBank's own funds, a LOC draft may

be regarded as being drawn on the member's deposit account at the

FHLBank where: (1) The FHLBank maintains an absolute right, either by

contract or operation of law, to offset the member's FHLBank deposit

account in the amount of the LOC draft; and (2) the member assumes an

absolute obligation to the FHLBank to have available in its account

sufficient funds to cover the amount of the LOC draft at the time of

the FHLBank's payment thereon. Because a primary purpose of a standby

LOC is to transfer the risk of default by the applicant from the

beneficiary to the issuer, it is consistent with the reality of a

standby LOC transaction to consider payment on a LOC draft to result in

a draw on a member/applicant's deposit account. These requirements have

been imposed upon FHLBank LOC transactions since they were first

permitted in 1983 and, in commercial practice, are common to standby

LOC transactions generally.

The plain language of section 11(e)(2) makes clear that the Finance

Board's powers to authorize FHLBank activity thereunder is to be

interpreted broadly, empowering the Finance Board both to implement

definitions of terms used therein and to permit the FHLBanks to engage

in such incidental activities as the Finance Board finds necessary for

the exercise of any authorities thereunder. See id. 1431(e)(2)(A). The

legislative history of section 11(e)(2) also stresses the broad range

of activities that may be authorized thereunder, explaining that ``it

is important that the [FHL]Banks have the ability to service the broad

and evolving financial service needs of members.'' H.R. Rep. No. 842,

96th Cong., 2nd Sess. 74 (1980). Given this expansive language, and

considering that section 11(e)(2) contains no limitation as to the

subject matter of the transaction of which the draft is a part, section

11(e)(2) permits the Finance Board to authorize FHLBanks to act as

drawee on drafts drawn on a member's FHLBank deposit account as part of

a standby LOC transaction.

Regardless of the purpose for which a standby LOC is issued, the

sole substantive undertaking by the issuer is to honor any conforming

draft that is presented by the beneficiary. All other apparent aspects

of a standby LOC transaction are merely by-products of this central

obligation. For example, while one might characterize the issuance of a

standby LOC as a guarantee of the applicant's obligation, or as a

lending of credit to the applicant, such characterizations are merely

means of describing the effect of the issuer's agreement to honor a

conforming draft presented by the beneficiary. In that, under section

11(e)(2) of the Bank Act, the Finance Board may authorize FHLBanks to

execute this central obligation by making payment on a conforming draft

presented by the beneficiary, the power to agree to undertake such an

obligation (by

[[Page 65695]]

contracting therefore with the member) and the power to undertake the

obligation (by issuing the standby LOC) are well within the FHLBanks'

incidental authority to engage in activities necessary to facilitate

the exercise of the FHLBanks' authority to make payment on the LOC

draft. Accordingly, under both the express terms and the incidental

powers clause of section 11(e)(2) of the Bank Act, the Finance Board is

authorized to permit FHLBanks to contract with members to issue standby

LOCs, to issue standby LOCs, and to honor conforming drafts presented

by a beneficiary pursuant to a standby LOC issued by a FHLBank.

C. FHLBanks' Incidental Power To Enter Commitments To Make Advances

While the Finance Board has concluded that section 11(e) provides

sufficient independent authority to permit a FHLBank to engage in a

standby LOC transaction, it has not rejected the FHLBB's position that

such activity is also authorized as part of the FHLBanks' statutory

advances powers. However, the Finance Board has concluded that, in

applying the statutory advances provisions to a standby LOC

transaction, a standby LOC is characterized more logically as a form of

advance commitment than as an outstanding advance. Section 9 of the

Bank Act authorizes any FHLBank member to apply in writing for

advances. See 12 U.S.C. 1429. In turn, section 10(a) authorizes each

FHLBank to extend to members advances that are fully secured at the

time of origination or renewal by a security interest in one or more of

the types of eligible collateral that are listed in that section. See

id. 1430(a). In addition to these express powers, section 11(a) of the

Bank Act authorizes the FHLBanks to do all things necessary for

carrying out the provisions of the Bank Act and ``all things incident

thereto.'' See id. 1431(a).

D. Legal Authority for Nonmember LOCs

Because the power to enter into a contractual commitment to extend

an advance is convenient and useful in connection with the FHLBanks'

express authority to make advances and to accept applications for

advances, such power is incidental to both of these express

authorities. A standby LOC is a form of advance commitment in that both

may: (1) Involve the FHLBank entering into an obligation, intended to

benefit its member, to disburse funds at some future date; (2) require

reimbursement by the member in the event that the commitment to fund is

exercised; and (3) result in an advance. The proposed regulation

further tied standby LOC authority to the FHLBanks' power to enter into

advance commitments by authorizing the FHLBanks to issue standby LOCs

only when: (1) the member has assumed an unconditional obligation to

reimburse the FHLBank for any amounts paid to the beneficiary pursuant

to a LOC draft; and (2) prior to agreeing to issue a standby LOC, the

FHLBank performs the same type of credit analysis of the member that

would occur before entering into a traditional commitment. Accordingly,

the FHLBanks' incidental power to enter into commitments to make

advances provides an alternative source of authority for the FHLBanks

to engage in standby LOC transactions.

Because the FHLBanks' express deposit taking and payment processing

authorities set forth in section 11(e) of the Bank Act apply only to

dealings with members and those eligible to make application to become

members, the power of the FHLBanks to issue standby LOCs on behalf of

nonmember mortgagees arises only from the FHLBanks' authority, detailed

in section 10b of the Bank Act, 12 U.S.C. 1430b, to make and to commit

to make advances to nonmember mortgagees. Because the Finance Board

cannot authorize the FHLBanks, as part of this payment processing

power, to be a drawee on a draft drawn on the deposit account of a

nonmember, the provisions of the proposed rule authorizing FHLBanks to

issue standby LOCs on behalf of nonmembers is grounded entirely in the

FHLBanks' powers to make advances to nonmember mortgagees and to enter

into commitments to make such advances.

III. Comments on Proposed Rule and Analysis of Changes Made in

Final Rule

A. Definitions

Section 938.1 of both the proposed and final rules set forth the

definitions of terms used in part 938. One of the purposes for which

FHLBank members, and certain nonmembers, may issue standby LOCs under

both the proposed and final rules is to assist members in facilitating

the financing of community lending eligible for any of the FHLBanks'

CICA programs under part 970 of the Finance Board's regulations.

Because, at the time that the proposed LOC rule was published, the CICA

regulation had not been codified as a final rule, the Finance Board

included definitions of all CICA-related terms explicitly in the

proposed LOC rule for purposes of clarity. However, because the Finance

Board has now promulgated a final CICA rule, the Finance Board has

removed most of the CICA-related definitions from the final LOC rule

and has merely cross-referenced the CICA regulation, where appropriate.

The one remaining CICA-related term that is set forth in Sec. 938.1

is ``community lending,'' which is intended to refer to non-housing

activities addressed in the CICA regulation. In the proposed LOC rule,

these activities were referred to as ``economic development projects

that would benefit families with incomes at or below a targeted income

level'' (the individual terms in this phrase were each defined

separately in the proposed rule). This terminology has been changed in

the final LOC rule so that it remains consistent with that used in the

CICA regulation. Aside from the elimination of the CICA-related

definitions and the substitution of the term ``community lending,''

Sec. 938.1 remains unchanged in the final rule.

B. Purposes for Which a FHLBank May Issue or Confirm a Standby LOC

Sections 938.2 and 938.3 of the proposed and final rules govern

FHLBank issuance and confirmation of standby LOCs on behalf of members

and eligible nonmembers, respectively. Sections 938.2(a) (1)-(4) set

forth the four general purposes for which a FHLBank may issue or

confirm a standby LOC on behalf of a member, while Secs. 938.3(a) (1)-

(4) enumerate the same four general purposes with respect to standby

LOCs issued or confirmed on behalf of eligible nonmember mortgagees

that are not SHFAs. In the final rule, both Sec. 938.2(a)(2) and

Sec. 938.3(a)(2) have been amended to refer to community lending that

is eligible for any of the FHLBanks' CICA programs under part 970 of

the regulations, as opposed to ``economic development projects that

benefit families with incomes at or below a targeted income level.''

This was done in order to make clear the connection between the LOC and

CICA regulations, to eliminate the need to address in the LOC

regulation terms of art that are defined in detail in the CICA

regulation and, as explained above, to conform to the terminology used

in the final CICA rule.

Although this amended wording was not intended to result in a

substantive change, changes made to the community lending (i.e., non-

housing) provisions of the CICA regulation in the final CICA rule have

resulted in a slightly altered scope for both Secs. 938.2(a)(2) and

938.3(a)(2) in the final standby LOC rule. These changes, as well as

comments received regarding the scope of what is now termed ``community

lending,'' are addressed in detail in the preamble to the final CICA

rule.

[[Page 65696]]

Four commenters (the executive agency and three trade associations)

criticized the enumerated purposes for which FHLBanks would be

permitted to issue or confirm standby LOCs. All four commenters

expressed concern that the breadth of the proposed purposes would allow

the FHLBanks to finance, with government subsidized funds, a wide array

of economic activities and other transactions that may have little or

no relation to the FHLBank System's mission. All four also stated that

the Finance Board had failed to show that expanding the FHLBanks'

authority to issue LOCs is necessary to overcome a market failure and

that the regulation appeared to allow the FHLBanks to intrude into

private markets for credit enhancements by unfairly taking advantage of

their funding subsidy to supplant, rather than supplement, the role of

private sector financial services providers. Two of the trade

associations and the executive agency also stated that FHLBank LOCs

will serve merely as a substitute for advances.

There exists no statutory provision that limits the FHLBanks to

providing to their members and eligible nonmembers only those products

or services for which there has been a failure of the market. Moreover,

the FHLBanks have been issuing LOCs on behalf of members since 1983,

and on behalf of nonmember mortgagees since 1993, and such issuance has

not resulted in a diversion of attention or funds from the FHLBanks'

advances programs. Although a FHLBank LOC technically could be

structured so as to serve as a substitute for an advance, there are

many instances where it is more logical to provide a LOC to support a

particular transaction than an advance. For example, a LOC may be

issued to support the issuance of bonds, to guarantee a member's

performance in a swap transaction, or to secure public unit deposits.

The use of an advance to support any of these transactions would be

both cumbersome and not in keeping with modern business practices. The

Finance Board's decision to permit FHLBanks to issue or confirm LOCs

for such purposes, and for asset/liability management and liquidity

purposes generally, is in keeping with Congress's expressed desire to

allow the FHLBanks to service the broad and evolving financial service

needs of their members. See H.R. Rep. No. 842, 96th Cong., 2nd Sess. 74

(1980); 108 Cong. Rec. H4994 (daily ed. Aug. 3, 1989) (statement of

Rep. Garcia).

The only truly new use that has been authorized for FHLBank LOCs

under the proposed and final rules is for CICA-defined community

lending activities, which clearly is consistent with the System's

housing and community lending mission, and is expressly mentioned in

the Bank Act as an authorized use of advances. See 12 U.S.C.

1430(j)(10). Even this authorization is not a wholesale departure from

past practice, as the FHLBanks have been permitted since 1993 to issue

LOCs to support targeted economic development activities under their

Community Investment Programs. In addition, by permitting only mission-

related LOCs to be secured by collateral that would not be eligible to

secure advances (discussed more thoroughly below), the Finance Board is

encouraging the FHLBanks to concentrate on providing LOCs to support

mission-related activities.

C. Collateral for Standby LOCs

1. Full Collateralization

Sections 938.2(b) and 938.3(b) of the proposed rule, addressing

collateralization of member and nonmember LOCs, respectively, required

that all LOCs be fully collateralized at the time of issuance. The

Finance Board specifically requested comment on: (1) Whether there are

any circumstances under which the FHLBanks could safely and soundly

issue LOCs that are not fully collateralized; and (2) whether there are

other assets, in addition to those enumerated in the proposed rule,

that should be considered as eligible collateral for LOCs and whether

the Finance Board should establish limits on these additional types of

collateral. Three FHLBanks supported continuing to require full

collateralization of LOCs and stated that they were unaware of any

circumstance where less than full collateralization would be

appropriate or prudent. These FHLBanks also stated that they believed

the expanded types of collateral provided sufficient flexibility to

members and that maintenance of the AAA rating of each FHLBank and the

FHLBank System as a whole far outweighed any possible perceived benefit

to permitting issuance of less than fully secured LOCs.

Three FHLBanks supported giving the FHLBanks the authority to issue

LOCs that are not fully collateralized. One FHLBank stated that

commercial banks issue unsecured LOCs based on their credit

underwriting and their assessment of the business relationship with the

applicant and that FHLBanks similarly should be permitted to use their

business judgment in determining the assets it will accept as

collateral. Another FHLBank recommended that the FHLBanks be permitted

to take into account the probability of actual loss on a LOC in

determining the level of collateralization necessary.

Sections 938.2(b) and 938.3(b) of the final rule continue to

require that LOCs issued or confirmed on behalf of members or

nonmembers, respectively, be fully collateralized at the time of

issuance or confirmation. Requiring that LOCs be fully collateralized

at the time of issuance provides protection from credit risk and

ensures that a FHLBank is not involved in underwriting the transaction

that is supported by the LOC.

2. Collateral Eligible To Secure FHLBank Standby LOCs for Members

Section 938.2(c) of the proposed rule authorized a FHLBank, at its

discretion, to accept from members as collateral for LOCs for housing

and community lending purposes, in addition to the section 10(a)

collateral required for advances: secured or federally guaranteed loans

to small businesses; investment-grade obligations of state or local

government agencies; and ``other real estate-related'' collateral in

excess of the ``30 percent of capital'' limitation applicable to such

collateral used for advances, see 12 CFR 935.9(a)(4). Sections

938.2(c)(1) and (2) have been amended in the final rule to make clear

that standby LOCs that are confirmed on behalf of a member, as well as

those that are issued on behalf of a member, must be secured by assets

that fall within the enumerated categories of eligible collateral. The

words ``or confirmed'' had been omitted inadvertently from both

sections in the proposed rule.

In addition, the last sentence of paragraph (c)(1) has been amended

to eliminate reference to ``outstanding advances,'' so as not to imply

that an FHLBank standby LOC is, or must otherwise be treated as, an

outstanding advance. The first sentence of Sec. 938.2(c)(1) permits the

FHLBanks to accept as collateral for standby LOCs any collateral that

is eligible to secure advances under Sec. 935.9(a) of the regulations.

Under Sec. 935.9(a)(4) of the regulations, and as required by section

10(a)(4) of the Bank Act, 12 U.S.C. 1430(a)(4), a FHLBank may not

accept as collateral for advances so-called ``other real estate related

collateral'' in an amount exceeding 30 percent of the borrowing

member's capital. See 12 U.S.C. 1430(a)(4), 12 CFR 935.9(a)(4). As

discussed above, the Finance Board has concluded that statutory

requirements pertaining to FHLBank advances need not be applied to LOCs

at the time of issuance. Therefore, as a legal matter, the Finance

Board may permit the FHLBanks to accept ``other real estate

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related collateral'' as security for standby LOCs without regard to the

statutory ``30 percent of capital'' limitation that applies to

advances, to the extent that the acceptance of such collateral is

consistent with the safe and sound operation of the FHLBanks.

However, as a matter of regulatory policy, the Finance Board is

permitting FHLBanks to accept ``other real estate-related collateral''

in excess of the ``30 percent of capital'' limitation only where the

LOC being secured is issued or confirmed for one of the mission-related

purposes enumerated in Sec. Sec. 938.2(a)(1) and (2). This policy is

expressed in negative terms in the second sentence of Sec. 938.2(c)(1),

which qualifies the presumption that LOCs must be secured by collateral

that is eligible to secure advances by stating that only those LOCs

that are issued or confirmed for the non-mission-related purposes

enumerated in Sec. Sec. 938.2(a)(3) and (4) are subject to the ``30

percent of capital limitation.'' In other words, Sec. 938.2(c)(1)

requires that the combined amount of advances and outstanding standby

LOCs issued or confirmed for purposes enumerated in

Sec. Sec. 938.2(a)(3) and (4) that are secured by ``other real estate-

related collateral'' may not exceed 30 percent of a member's capital.

The intent behind the second sentence of Sec. 938.2(c)(1) is to permit

FHLBanks to accept without limitation as security for mission-related

standby LOCs--that is, those issued or confirmed to assist members in

facilitating residential housing finance or community lending--``other

real estate related collateral'' referred to in Sec. 935.9(a)(4) of the

regulations.

Seven commenters (five FHLBanks and two trade associations)

supported the expanded types of eligible collateral identified in the

proposed rule. One commenter noted in particular that residential

acquisition, development and construction loans that otherwise would be

subject to the ``30 percent of capital'' limitation applied to ``other

real estate related collateral'' have proven to be profitable and

performed quite well. In addition, requiring the FHLBanks to establish

policies and procedures for valuing and securing this collateral could

allay any safety and soundness concerns. Five commenters (four FHLBanks

and one advisory council) supported leaving the eligible collateral to

the discretion of the FHLBank. Three commenters (the executive agency

and two trade associations) opposed expanding the categories of

eligible collateral for LOCs.

In the final rule, the Finance Board has retained the collateral

requirements that were included in the proposed rule. Because the Bank

Act does not specify the types of collateral that may be used to secure

LOCs, the Finance Board has the discretion to specify the eligible

types of collateral, consistent with the safe and sound operation of

the FHLBanks, and even to authorize the FHLBanks themselves to

determine the appropriate types of collateral. The proposed rule

identified additional types of collateral that may be used only to

finance activities that are clearly linked to the FHLBanks' mission of

supporting housing and community lending. Accordingly, the Finance

Board's determination to allow FHLBanks to accept such collateral is

clearly tied to a beneficial public policy goal. In addition, the

expanded types of collateral (secured or federally guaranteed loans to

small businesses, investment-grade obligations of state or local

government agencies and ``other real estate-related'' collateral in

excess of the 30 percent of capital limitation) build upon the

experience the FHLBanks currently have in valuing and securing such

collateral.

The FHLBanks already are permitted to accept ``other real-estate

related collateral'' to secure LOCs and advances (within the ``30

percent of capital'' limitation). Thus, the FHLBanks already manage the

credit, liquidity and marketability risks, as well as other risks,

associated with these types of collateral. There is no evidence that

permitting the FHLBanks to accept these types of collateral for LOCs in

excess of that which is allowed for advances will subject the FHLBanks

to underwriting tasks that are beyond their ability to manage.

With regard to the FHLBanks' acceptance of small business loans as

collateral, the Finance Board requires that the FHLBanks have

underwriting expertise and credit policies in place before accepting

such loans as collateral. Specifically, Sec. 935.5 of the Finance

Board's advances regulation, 12 CFR 935.5, requires that the FHLBanks

establish written procedures for determining the value of collateral

and to follow these procedures in ascertaining the value of particular

assets used as collateral. This requirement has been applied to LOC

transactions in Sec. 938.5(a)(1)(ii) of the proposed and final rules.

Under Sec. 935.12 of the regulations, which has also been made to apply

to LOCs under Sec. 938.5(b)(2) of the proposed and final rules, the

FHLBanks also are permitted 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.

The Finance Board is requiring each FHLBank to review its

collateral procedures, and amend them as necessary to reflect the

changes made in the final rule before accepting any newly authorized

assets as collateral for LOCs. 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 small business 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 re-

valuation for various types of collateral. In short, the above-

described FHLBank practices, regulatory requirements, and Finance Board

examination oversight, all serve to ensure that the safety and

soundness of the FHLBanks would not be compromised by authorizing the

expanded collateral options in the final rule.

3. Collateral Securing Nonmember Standby LOCs

Under Sec. 938.3 of the proposed rule, nonmember borrowers were

permitted to secure LOCs with the same types of collateral that they

may use to secure advances. Under proposed Sec. 938.3(a), nonmember

borrowers (including SHFAs) were permitted to use FHA-insured loans or

GNMA securities backed by FHA-insured loans as collateral for LOCs used

for any of the same four purposes permitted for LOCs on behalf of

members. Under Sec. 938.2(b), a SHFA may secure LOCs with collateral

eligible to secure advances under section 10(a) of the Bank Act, 12

U.S.C. 1430(a), provided the LOCs are used to facilitate residential or

commercial lending that benefits individuals or families meeting the

income requirements in section 142(d) or 143(f) of the Internal Revenue

Code.

[[Page 65698]]

See 26 U.S.C. 142(d), 143(f). Both of these provisions remain unchanged

in the final rule.

Noting that the proposed rule would permit members to use

investment grade debt securities of a SHFA as eligible collateral for

LOCs, one commenter (a private law firm) recommended that nonmember

SHFAs be permitted to obtain LOCs backed only by an investment-grade

general obligation of the SHFA, where the obligation is secured by a

statutory lien on the SHFA's unencumbered assets. The commenter stated

that the ability to combine collateral types (the SHFA's investment

grade obligation and the statutory lien, and the option of the mortgage

being financed) may be the only way to provide economical tax-exempt

financing for housing and economic development projects. While this

suggestion has logical merit, as explained above, the Finance Board has

concluded that, as a matter of law, LOCs may be issued or confirmed on

behalf of nonmembers only under the same conditions that apply to

nonmember advances. See 12 U.S.C. 1430b, 12 CFR 935.24. Therefore,

under the Bank Act, the Finance Board may not authorize a nonmember

SHFA to offer as collateral its general obligation, even under the

conditions recommended by this commenter.

D. Additional Provisions Applying to FHLBank Standby LOCs

1. Special Pricing Provisions in FHLBank Standby LOC Policies

In the final rule, Sec. 938.5(a)(1)(iii), regarding pricing

criteria that must be set forth in each FHLBank's standby LOC policy,

has been amended to cross-reference the codified CICA regulation,

thereby eliminating the need to use and define in the LOC regulation

terms of art that are explained thoroughly in the CICA regulation.

2. Cost of Capital Adjustment Factor

In the proposed rule, the Finance Board requested comments on

whether FHLBank fees for LOCs may be subject to a cost of capital

adjustment factor under section 11(e)(2) of the Bank Act, 12 U.S.C.

1431(e)(2), given that the FHLBanks' power to make payments upon

standby LOCs arises partially from the FHLBanks' payment processing

powers. Five commenters (three FHLBanks, one advisory council and one

trade association) opposed applying the adjustment factor to LOC fees.

Section 11(e)(2)(B) of the Bank Act requires FHLBanks to make

charges for payment processing services provided under section

11(e)(2), including the payment of drafts, in a manner consistent with

the criteria established for pricing of Federal Reserve Bank payment

processing under section 11A(c) of the Federal Reserve Act. 12 U.S.C.

248a(c). This statutory requirement has been implemented through part

943 of the Finance Board's regulations. 12 CFR part 943. Specifically,

the pricing of services is addressed in Sec. 943.6(b), which requires

that the FHLBanks apply a cost of capital adjustment factor to their

payment processing charges in order to take into account all direct and

indirect costs of such services and the imputed rate of return that

would have been earned and the taxes that would have been paid if the

FHLBanks were wholly private corporations. See id. 943.6(b).

Accordingly, the Finance Board has concluded that, for any draw

made by a beneficiary under a standby LOC, the applicant must be

charged a processing fee calculated in accordance with the requirements

of Sec. 943.6(b) of the Finance Board's regulations. In the final rule,

Sec. 938.5(a)(1) has been amended to add a new paragraph (iv) requiring

that each FHLBank's standby LOC policy require such a charge. This

requirement does not extend to fees, periodic or otherwise, charged to

a customer to issue, confirm, or renew a standby LOC.

In addition, in the final rule, the Finance Board has amended

Sec. 943.6(c) of its regulations to exempt fees collected for draws

upon a LOC from the publication requirement set forth therein. The Bank

Act does not require that FHLBank payment processing fees be published

in the Federal Register.

3. Members' FHLBank Capital Stock

Section 938.5(b)(2) has been amended in the final rule to make

clear that the provisions regarding advances collateral that are set

forth in Sec. Sec. 935.9(d) and 935.10 of the Finance Board's

regulations apply also to collateral pledged to secure a FHLBank LOC.

Section 935.9(d) of the regulations provides that each FHLBank shall

have a lien upon the stock of its members for all indebtedness of the

member to the FHLBank. The cross-reference to this section that has

been added to Sec. 938.5(b)(2) of the final rule is intended to make

clear that each FHLBank shall have a lien upon its member's FHLBank

stock for any indebtedness that may result from a draw upon a LOC

issued or confirmed by the FHLBank on behalf of that member. This

reference is intended only to require a lien on FHLBank stock that the

member already owns and should not be read as requiring or permitting a

FHLBank to include standby LOCs in the calculation of its members'

capital stock-to-advances leverage ratio. Stock purchase would be

required only if and when an LOC is drawn and the FHLBank and its

member agree to fund any resulting overdraft of the member's deposit

account with an advance.

Seven commenters (five FHLBanks, one advisory council and one trade

association) supported this provision. One FHLBank noted that the

elimination of the stock purchase requirement contained in the current

policy would improve the FHLBank's leverage position and make the

program more attractive to shareholders. Four commenters (one FHLBank

and three trade associations) believed LOCs, like advances, should be

subjected to a stock purchase requirement. One FHLBank noted that this

minimizes risk to the FHLBank if the LOC must be drawn upon. One of the

trade associations stated that the proposal could exacerbate the risks

to which the FHLBanks would be exposed by permitting them to deduct

LOCs from their capital calculation and from their reported balances of

outstanding advances, permitting a dangerous leveraging of FHLBank

balance sheets which would be undetectable to the Finance Board and

outside analysts. The other two trade associations stated that unlike

commercial banks or other private financial service providers, the

FHLBanks operate without an adequate cushion of permanent stock. Most

members are free to redeem their stock and give up their membership,

and in times of financial difficulty, the Finance Board is unlikely to

be able to prevent these members from fleeing the FHLBank System.

Further, they believed that the FHLBanks would issue or confirm a much

higher volume of LOCs if they are free from requirements to reserve

capital to protect taxpayers from the consequences of any mistakes.

The Finance Board's decision not to require that LOCs be included

in a member's advances-to-capital stock ratio calculation will not

undermine the safety and soundness of the FHLBank System. Under the

capital requirements of the FHLBanks specified in the Bank Act, members

must purchase capital in their FHLBank equal to the greater of 1

percent of their residential mortgage assets, 0.3 percent of total

assets, or 5 percent of their outstanding advance balances. See 12

U.S.C. 1426. These statutory capital requirements, together with the

Finance Board's regulation limiting the FHLBank System's debt to 20

times capital, assure that the FHLBanks have capital-to-asset ratios

which approximates the 5 percent ratio for well-capitalized depository

[[Page 65699]]

institutions and is about twice the 2.5 percent capital-to-asset

requirements for Fannie Mae and Freddie Mac.

On a risk-adjusted basis, the FHLBanks are even better capitalized

than the raw numbers would indicate. To be considered well-capitalized,

depository institutions must have total risk-based capital of 10

percent and, as of year-end 1997, insured depository institutions held

12.65 percent risk-based capital on average. By comparison, the

FHLBanks held over 22 percent risk-based capital at year-end 1997. As

of year-end 1997, advances outstanding to members totaled $202.2

billion and LOCs outstanding totaled $2.9 billion. Even if, as a result

of the changes in policy implemented by this final rule, the total

amount of LOCs outstanding increased, FHLBanks would remain well-

capitalized.

Because a LOC must be fully collateralized at time of issuance, a

FHLBank would have secured sufficient collateral to reimburse the

FHLBank for any draw, minimizing the financial risk to the FHLBank. In

fact, unlike commercial financial institutions, the FHLBanks generally

have required members to secure LOCs with collateral in excess of the

value of the LOC. Because the regulation clarifies that the contingent

liability of an LOC is covered by section 10(c) of the Bank Act that

provides a FHLBank shall have a lien upon the stock of a member as

further collateral security for all indebtedness of the member to the

FHLBank, the FHLBank's position would be further secured. In addition,

Sec. 938.5(a)(1)(ii) provides that a member or nonmember requesting an

LOC is subject to the same underwriting criteria that applies to the

making of advances. It is anticipated that FHLBanks will use this

information to minimize their exposure to credit risk. Therefore,

eliminating the requirement that LOCs be supported by the purchase of

capital stock does not present any safety and soundness concerns.

4. Priority Lien on Member Collateral

The cross-reference to Sec. 935.10 that has been added to

Sec. 938.5(b) is intended to make clear that the statutory priority

lien that applies to any security interest granted by a member, or an

affiliate of a member, to a FHLBank, see 12 U.S.C. 1430(f), applies to

security interests in collateral pledged to secure standby LOCs.

IV. Regulatory Flexibility Act

The final rule applies only to the FHLBanks, which do not come

within the meaning of ``small business,'' as defined in the Regulatory

Flexibility Act (RFA). See 5 U.S.C. 601(6). Therefore, in accordance

with section 605(b) of the RFA, 5 U.S.C. 605(b), the Finance Board

hereby certifies that this final rule will not have a significant

economic impact on a substantial number of small entities.

List of Subjects

12 CFR Part 938

Federal home loan banks, Credit, Letters of credit, Community

development and housing.

12 CFR Part 943

Federal home loan banks, Checks, Price controls, Reporting and

recordkeeping requirements.

Accordingly, the Finance Board hereby amends chapter IX, title 12,

Code of Federal Regulations, as follows:

1. Add part 938 to read as follows:

PART 938--STANDBY LETTERS OF CREDIT

Sec.

938.1 Definitions.

938.2 Standby letters of credit on behalf of members.

938.3 Standby letters of credit on behalf of nonmember mortgagees.

938.4 Obligation to Bank under all standby letters of credit.

938.5 Additional provisions applying to all standby letters of

credit.

Authority: 12 U.S.C. 1422b, 1429, 1430, 1430b, 1431.

Sec. 938.1 Definitions.

As used in this part:

Act means the Federal Home Loan Bank Act, as amended (12 U.S.C.

1421-49).

Applicant means a person or entity at whose request or for whose

account a standby letter of credit is issued.

Bank means a Federal Home Loan Bank established under the authority

of the Act.

Beneficiary means a person or entity who, under the terms of a

standby letter of credit, is entitled to have its complying

presentation honored.

Community Lending has the meaning set forth in Sec. 970.4 of this

chapter.

Confirm means to undertake, at the request or with the consent of

the issuer, to honor a presentation under a standby letter of credit

issued by a member or nonmember mortgagee.

Document means a draft or other demand, document of title,

investment security, certificate, invoice, or other record, statement,

or representation of fact, law, right, or opinion that is presented

under the terms of a standby letter of credit.

Finance Board means the agency established by the Act as the

Federal Housing Finance Board.

Issuer means a person or entity that issues a standby letter of

credit.

Member means an institution that has been approved for membership

in a Bank and has purchased capital stock in the Bank in accordance

with Sec. Sec. 933.20 and 933.24 of this chapter.

Nonmember mortgagee means an entity certified as a nonmember

mortgagee pursuant to Sec. 935.22(b) of this chapter.

Nonmember SHFA means a nonmember mortgagee that is a ``state

housing finance agency,'' as that term is defined in Sec. 935.1 of this

chapter, and that has met the requirements of Sec. 935.22(d) of this

chapter.

Presentation means delivery of a document to an issuer, or an

entity that has undertaken a confirmation at the request or with the

consent of the issuer, for the giving of value under a standby letter

of credit.

Residential housing finance means:

(1) The purchase or funding of ``residential housing finance

assets,'' as that term is defined in Sec. 935.1 of this chapter; or

(2) Other activities that support the development or construction

of residential housing.

Small business means a ``small business concern,'' as that term is

defined by section 3(a) of the Small Business Act (15 U.S.C. 632(a))

and implemented by the Small Business Administration at 13 CFR part

121, or any successor provisions.

Standby letter of credit means a definite undertaking by an issuer

on behalf of an applicant that represents an obligation to the

beneficiary, pursuant to a complying presentation: to repay money

borrowed by, advanced to, or for the account of the applicant; to make

payment on account of any indebtedness undertaken by the applicant; or

to make payment on account of any default by the applicant in the

performance of an obligation. The term standby letter of credit does

not include a commercial letter of credit, or any short-term self-

liquidating instrument used to finance the movement of goods.

Sec. 938.2 Standby letters of credit on behalf of members.

(a) Authority and purposes. Each Bank is authorized to issue or

confirm on behalf of members standby letters of credit that comply with

the requirements of this part, for any of the following purposes:

(1) To assist members in facilitating residential housing finance;

(2) To assist members in facilitating community lending that is

eligible for

[[Page 65700]]

any of the Banks' CICA programs under part 970 of this chapter;

(3) To assist members with asset/liability management; or

(4) To provide members with liquidity or other funding.

(b) Fully secured. A Bank, at the time it issues or confirms a

standby letter of credit on behalf of a member, shall obtain and

maintain a security interest in collateral that is sufficient to secure

fully the member's unconditional obligation described in

Sec. 938.4(a)(2) of this part, and that complies with the requirements

set forth in paragraph (c) of this section.

(c) Eligible collateral. (1) Any standby letter of credit issued or

confirmed on behalf of a member may be secured by collateral that is

eligible to secure advances under Sec. 935.9(a) of this chapter. Only

standby letters of credit issued for the purposes described in

paragraphs (a)(3) or (a)(4) of this section shall be counted in making

the calculation required under Sec. 935.9(a)(4)(iii).

(2) A standby letter of credit issued or confirmed on behalf of a

member for a purpose described in paragraph (a)(1) or (a)(2) of this

section may, in addition to the collateral described in paragraph

(c)(1) of this section, be secured by:

(i) Secured or federally-guaranteed loans to small businesses or

securities representing interests in such loans; or

(ii) Obligations of state or local government units or agencies,

rated as investment grade by a nationally-recognized rating agency.

Sec. 938.3 Standby letters of credit on behalf of nonmember

mortgagees.

(a) Nonmember mortgagees. Each Bank is authorized to issue or

confirm on behalf of nonmember mortgagees standby letters of credit

that are fully secured by collateral described in

Sec. Sec. 935.24(b)(1)(i) or (ii) of this chapter, and that otherwise

comply with the requirements of this part, for any of the following

purposes:

(1) To assist nonmember mortgagees in facilitating residential

housing finance;

(2) To assist nonmember mortgagees in facilitating community

lending that is eligible for any of the Banks' CICA programs under part

970 of this chapter;

(3) To assist nonmember mortgagees with asset/liability management;

or

(4) To provide nonmember mortgagees with liquidity or other

funding.

(b) Nonmember SHFAs. Each Bank is authorized to issue or confirm on

behalf of nonmember SHFAs standby letters of credit that are fully

secured by collateral described in Sec. 935.24(b)(2)(i)(A), (B) or (C)

of this chapter, and that otherwise comply with the requirements of

this part, for the purpose of facilitating residential or commercial

mortgage lending that benefits individuals or families meeting the

income requirements in section 142(d) or 143(f) of the Internal Revenue

Code (26 U.S.C. 142(d) or 143(f)).

Sec. 938.4 Obligation to Bank under all standby letters of credit.

(a) Obligation to reimburse. A Bank may issue or confirm a standby

letter of credit only on behalf of a member or nonmember mortgagee that

has:

(1) Established with the Bank a cash account pursuant to

Sec. Sec. 934.5, 935.24(b)(2)(i)(B) or 935.24(d) of this chapter; and

(2) Assumed an unconditional obligation to reimburse the Bank for

value given by the Bank to the beneficiary under the terms of the

standby letter of credit by depositing immediately available funds into

the account described in paragraph (a)(1) of this section not later

than the date of the Bank's payment of funds to the beneficiary.

(b) Prompt action to recover funds. If a member or nonmember

mortgagee fails to fulfill the obligation described in paragraph (a)(2)

of this section, the Bank shall take action promptly to recover the

funds that such member or nonmember mortgagee is obligated to repay.

(c) Obligation financed by advance. Notwithstanding the obligations

and duties of the Bank and its member or nonmember mortgagee under

paragraphs (a) and (b) of this section, the Bank may, at its

discretion, permit such member or nonmember mortgagee to finance

repayment of the obligation described in paragraph (a)(2) of this

section by receiving an advance that complies with sections 10 or 10b

of the Act and part 935 of this chapter.

Sec. 938.5 Additional provisions applying to all standby letters of

credit.

(a) Written policy; other requirements. Each standby letter of

credit issued or confirmed by a Bank shall:

(1) Be issued or confirmed only in compliance with a written

policy, developed and implemented by the Bank to govern its standby

letter of credit programs, that:

(i) Is consistent with the provisions of the Act and this part;

(ii) Sets forth credit underwriting criteria, consistent with the

provisions of Sec. 935.5 of this chapter, to be applied in evaluating

applications for standby letters of credit and renewals thereof;

(iii) Sets forth criteria regarding the pricing of standby letters

of credit, including any special pricing provisions for letters of

credit that facilitate the financing of projects that are eligible for

any of the Banks' CICA programs under part 970 of this chapter; and

(iv) Provides that, for any draw made by a beneficiary under a

standby letter of credit, the applicant will be charged a processing

fee calculated in accordance with the requirements of Sec. 943.6(b) of

this chapter;

(2) Contain a specific expiration date, or be for a specific term;

and

(3) Require approval in advance by the Bank of any transfer of the

standby letter of credit from the original beneficiary to another

person or entity;

(b) Additional collateral provisions. (1) A Bank may take such

steps as it deems necessary to protect its secured position on standby

letters of credit, including requiring additional collateral, whether

or not such additional collateral conforms to the requirements of

Sec. Sec. 938.2 or 938.3 of this part.

(2) Collateral pledged by a member or nonmember mortgagee to secure

a letter of credit issued or confirmed on its behalf by a Bank shall be

subject to the provisions of Secs. 935.9(b), 935.9(d), 935.9(e),

935.10, 935.11 and 935.12 of this chapter.

PART 943--COLLECTION, SETTLEMENT, AND PROCESSING OF PAYMENT

INSTRUMENTS

2. The authority citation for part 943 continues to read as

follows:

Authority: 12 U.S.C. 1430, 1431.

3. Amend Sec. 943.6 by revising paragraph (c) to read as follows:

Sec. 943.6 Pricing of services.

* * * * *

(c) Review and publication. The Finance Board shall from time to

time and at least annually review the cost of capital adjustment factor

and review prices for services authorized in this part for compliance

with the principles set forth in paragraphs (a) and (b) of this

section. All prices for Bank services authorized in this part will be

published annually in the Federal Register, except those for fees

charged to an applicant for draws made by a beneficiary under a standby

letter of credit.

Dated: October 28, 1998.

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

Bruce A. Morrison,

Chairman.

[FR Doc. 98-31837 Filed 11-27-98; 8:45 am]

BILLING CODE 6725-01-P