Hearing on FHLBank Investment Practices and an Approach for Limiting Certain Non-Housing-Related Investments

FEDERAL HOUSING FINANCE BOARD

Hearing on FHLBank Investment Practices and an Approach for

Limiting Certain Non-Housing-Related Investments

AGENCY: Federal Housing Finance Board.

ACTION: Notice of public hearing.

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

announcing a public hearing on Federal Home Loan Bank (FHLBank)

investment practices and an approach for limiting certain non-housing-

related investments.

DATES: The public hearing will be held on May 11, 1998 beginning at

9:00 a.m.. Written requests to participate in the hearing must be

received no later than Monday, April 13, 1998.

ADDRESSES: The hearing will be held at the Office of Thrift Supervision

Amphitheater, 1700 G Street, N.W., Washington, D.C. 20552. Send

requests to participate in the hearing, written statements, or other

written comments to Elaine Baker, Executive Secretariat, Federal

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

submission may be mailed, hand delivered, or sent by facsimile

transmission to (202) 408-2895. Submissions must be received by 5:00

p.m. on the day they are due in order to be considered by the Finance

Board. Late, misaddressed, or misidentified submissions may affect

eligibility to participate in the hearing.

FOR FURTHER INFORMATION CONTACT: Kerrie Ann Sullivan, External Affairs

Specialist, at (202) 408-2515, or Christine M. Freidel, Associate

Director, Office of Policy at (202) 408-2976, Federal Housing Finance

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

SUPPLEMENTARY INFORMATION: The Finance Board is interested in the views

of System members, community groups, trade associations, federal or

state agencies and departments, elected officials, and others on the

implications of FHLBank investment practices for Finance Board

investment policy. Specific questions that the Finance Board would like

hearing participants to address and a Finance Board staff discussion

paper follow:

Questions

(Question 1) Should the Finance Board limit FHLBank purchase of

money market investments (MMI) beyond the level necessary for liquidity

and cash management?

(Question 2) Should any limits on MMI apply to each FHLBank or to

the FHLBank System? If a limit were applied to the System, should there

be a mechanism allowing FHLBanks to trade the right to hold MMI beyond

their pro-rata share of the System limit?

(Question 3) Could mission limits on FHLBank MMI affect the safe

and sound operation of the FHLBanks? If so, how could such effects be

mitigated?

(Question 4) The Finance Board is considering a definition of MMI

that is total investments less mortgage and asset-backed securities and

investments that support housing and targeted economic development.

This definition includes fed funds, resale agreements, deposits,

commercial paper, bank and thrift notes, bankers' acceptances, and U.S.

government, U.S. government-guaranteed, and agency non-mortgage-backed

securities (MBS) and asset-backed securities. Should all these assets

be included in the definition of MMI?

(Question 5) What is the appropriate level of liquidity for the

FHLBanks, taking into account their access to the government-sponsored

enterprise (GSE) capital markets? Are the liquidity requirements in the

Finance Board's Financial Management Policy (FMP) adequate?

1 If not, why not?

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\1\ The Federal Home Loan Bank Act requires each Bank to

maintain an amount equal to the total deposits received from its

members invested in: obligations of the United States; deposits in

banks or trust companies (as defined in Finance Board regulation)

which are eligible financial institutions; and advances that mature

in 5 years or less to members. In addition, each Bank is required to

maintain a daily average liquidity level each month in an amount not

less than 20 percent of the sum of its daily average demand and

overnight deposits and other overnight borrowings during the month,

plus 10 percent of the sum of its daily average term deposits, COs

and other borrowings that mature within one year. Certain money

market investments authorized under the FMP may be used to satisfy

the liquidity requirements.

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(Question 6) Are there circumstances where it is appropriate for

the FHLBanks to hold MMI in levels greater than their liquidity and

cash management needs?

(Question 7) What is the minimum appropriate level of advances as a

percent of consolidated obligations (COs) and the maximum appropriate

level of MMI funded with COs? Are there other approaches for limiting

Bank MMI?

(Question 8) What should be the assumed spreads on MMI and MBS?

(Question 9) To what extent do MBS investments further the FHLBank

System's housing finance mission? Should the FHLBanks be subject to

additional MBS investment limitations?

(Question 10) How much of a decline in dividends would trigger a

reassessment by voluntary members of

[[Page 16506]]

the benefits of FHLBank System membership. How do institutions

determine the minimum required return on FHLBank stock? What is an

appropriate benchmark for FHLBank dividends and what is the minimum

required spread over the benchmark?

(Question 11) Would FHLBank borrowing costs fall if CO issuance

declined?

(Question 12) What is an appropriate transition rule for: (1)

implementation of any new limits on FHLBank investment activity; and

(2) FHLBanks that fall out of compliance due to situations such as

merger activity and regional and cyclical downturns in advance demand?

(Question 13) What changes in interest rates and advances should be

assumed to simulate the effects of investment limits during a cyclical

economic downturn?

(Question 14) Should the FHLBank System's $300 million annual

REFCorp payment be changed to a percentage of net income and should the

Finance Board defer establishing limits on FHLBank money market

investments until Congress has made such a change?

(Question 15) Should the FHLBanks be permitted to make a small

amount of narrowly targeted investments in people and communities left

behind, that would have credit quality significantly below the double-A

level, and that might be more heavily weighted in evaluating the

mission-related character of the overall portfolio?

Staff Analysis

Background

Prior to the thrift crisis and enactment of the Financial

Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)

(Pub. L. 101-73, 103 Stat. 183 (1989)), the assets on the Federal Home

Loan Banks' (FHLBanks or Banks) balance sheets were predominantly

advances. The Banks maintained relatively small investment portfolios,

primarily for liquidity purposes.2 For the period 1980

through 1988, Bank System advances represented, on average, about 84

percent of System assets, while total investments represented about 14

percent of assets.

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\2\ The Federal Home Loan Bank Board's (FHLBB) Investment Policy

and the subsequent Funds Management Policy, adopted in 1988, set

forth authorized investments for the FHLBanks. This list of eligible

investments was similar to the current list of eligible investments

in the Financial Management Policy (FMP). Currently, permissible

Bank investments include overnight and term fed funds, overnight and

term resale agreements, deposits, commercial paper, bank and thrift

notes, bankers' acceptances, securities issued or guaranteed by the

U.S., agency securities, mortgage-backed securities (MBS), and

certain other assets that support housing and community development.

Bank investments in MBS, prior to adoption of the FMP, were limited

to 50 percent of a Bank's capital; such investments, along with

investments in other eligible asset-backed securities, are currently

limited to 300 percent of a Bank's capital.

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Significant and rapid changes in the structure of the FHLBank

System's balance sheet and its profitability occurred following the

enactment of FIRREA in 1989. The legislation, among other things,

required: (1) closure of failing thrift institutions that resulted in

advance prepayments and stock redemptions; (2) new, higher statutory

capital requirements for thrifts that caused many Bank System thrift

members during the early 1990s to either reduce their asset size and

prepay advances or to stop growing and reduce their demand for new

advances; (3) transfer of $2.5 billion in FHLBank retained earnings to

the Resolution Funding Corporation (REFCorp) to help pay for the cost

of thrift resolutions; 3 (4) a $300 million annual payment

toward interest on the REFCorp bonds; and (5) a payment, beginning in

1990, of the greater of five percent of net income or $50 million and

increasing by steps to the greater of ten percent of net income or $100

million in 1995 and thereafter, to fund the newly-required Affordable

Housing Program (AHP). One other important provision in FIRREA also

allowed federally insured commercial banks with at least 10 percent of

their assets in residential mortgage loans to join the Bank System. The

changes that occurred in the Banks' assets, liabilities, net income and

membership in the post-FIRREA period are shown in the attached graphs.

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\3\ This payment was in addition to the FHLBanks' payment of

$0.7 billion in retained earnings to defease the Financing

Corporation bonds as required under the Competitive Equality Banking

Act of 1987. (Pub.L. 100-86, 101 Stat. 552 (1987)).

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After growing steadily during the 1980s, Bank System advances

peaked at $166.7 billion in April 1989 and then declined 15 percent to

$142 billion at year-end 1989. The shrinkage continued for two years,

with advances declining 18 percent in 1990 to $117 billion and then an

additional 32 percent to $79 billion at year-end 1991. Beginning in

1989, the Banks began to replace repaid and prepaid advances with

generally lower-yielding investments.4 Investments doubled

from 1988 to 1989 from $17 billion to $34 billion and more than

quadrupled between 1988 and 1991 to $72 billion. By year-end 1991,

advances comprised about 51 percent of the System assets, down from 78

percent at year-end 1989. In addition, for the reasons discussed above,

Bank capital levels fell by 25 percent between 1989 to 1991. Lower

capital levels resulted in lowered Bank net earnings because a greater

amount of Bank assets were funded with the proceeds from the issuance

of consolidated obligations (COs) instead of by FHLBank capital.

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\4\ The Banks had funded these advances largely with the

proceeds from non-callable consolidated obligations (COs). The Banks

repurchased and retired some of this debt to the extent it was

economically feasible, but a large portion remained outstanding

after the advances were prepaid. The Banks reinvested these CO

proceeds in allowable investments.

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Reduced spreads on earning assets, lower capital levels, and a

lower interest rate environment all contributed to a marked decline in

Bank System net income during the early 1990s. Net income peaked at

$1.78 billion in 1989 and fell almost 18 percent to $1.47 billion in

1990. Net income fell an additional 21 percent in 1991 to $1.16

billion, and then 27 percent in 1992 bottoming out at $850 million. Net

interest margin (net interest income divided by earning assets) fell by

more than half from 1989 to 1992, from 1.13 percent to 0.47 percent,

although the decline in net interest income was partially offset by

advance prepayment fee income. Return on assets (ROA) declined from 95

basis points in 1989 to 53 basis points in 1992.

Declining System net income and weak demand for advances raised

questions about the Banks' future ability to pay their statutorily

mandated REFCorp and AHP obligations, and pay an adequate return to

shareholders. The $300 million REFCorp payment as a percentage of Bank

System net income increased from about 20 percent in 1990, to 26

percent in 1991, and to 35 percent in 1992.

Concerns about income pressures on the Bank System led the Finance

Board to increase the FHLBanks' mortgage-backed security (MBS)

investment authority from 50 percent to 200 percent of capital when it

adopted the Financial Management Policy (FMP) in June 1991.5

The Finance Board attached a two-year sunset to the expanded authority,

although it removed the sunset before it would have become effective.

In December 1992, the Finance Board changed the Bank System's

regulatory leverage limit and the components of the leverage ratio.

Prior to this time, Finance Board regulations had limited FHLBank

System COs to 12 times the total paid-in capital stock of the FHLBanks;

the amended regulation

[[Page 16507]]

raised the leverage limit to 20 times total capital and included COs

and unsecured senior liabilities (e.g., deposits) in the leverage

ratio. The expanded leverage ratio became effective September 22, 1993.

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\5\ The FMP consolidated into one document the policy guidelines

governing much of the FHLBanks' non-advance financial activity and

also established limits on unsecured credit risk and interest rate

risk. The FMP restated the eligible investments in the Funds

Management Policy and expanded the list of authorized investment to

include private triple-A rated MBS and commercial paper.

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In December 1993, the Finance Board again increased the Banks'

authority to invest in MBS, raising the limit from 200 to 300 percent

of capital. Financial projections indicated that the Banks would have

adequate earnings to meet their financial obligations in 1994. However,

prepayment income, which represented nearly 25 percent of 1993 net

earnings was declining (down from 46 percent of earnings in 1992), and

the Finance Board was concerned that interest income from advances

might be insufficient to offset the earnings decline. In addition, the

Finance Board believed an absence of a quorum to be imminent and felt

obliged to provide the Banks with sufficient investment capacity to

adjust to near-term structural changes in their balance sheets.

Another major change in the Bank System was the growth of

commercial bank membership. Until 1989, actual membership consisted

almost exclusively of thrift institutions. (Prior to 1989, insurance

companies were also eligible to become members, but very few actually

joined and there was minimal borrowing activity.) System membership

declined from 1989 to 1990 due to the closing of failed institutions,

but rose rapidly thereafter as significant numbers of commercial banks

joined the System. Total Bank System membership increased from 2,855 at

year-end 1990 to 6,504 at year-end 1997. The greatest growth occurred

at the FHLBanks of Des Moines, Atlanta, and Dallas. The volume of

residential mortgage loans held by members increased from $905 billion

in 1989 to $1.24 trillion in 1997.6

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\6\ Residential mortgage loans include housing construction

loans, mortgage loans for single- and multi-family housing, and MBS.

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At year-end 1997, commercial bank members comprised 69 percent of

System members and held 44 percent of Bank System capital stock. About

55 percent of commercial bank members had advances outstanding.

Commercial banks borrow relatively less than thrifts. However,

commercial bank share of outstanding advances has increased steadily

over the last five years, from 8 percent ($6.4 billion) of outstanding

advances in 1992 to 29 percent ($57.4 billion) of outstanding advances

at year-end 1997. At year-end 1997, commercial bank members

collectively held $578 billion in residential mortgage loans,

indicating a sizable pool of collateral eligible to secure advances.

After bottoming out in 1992, advance levels ended the year at

slightly higher levels relative to 1991 and then increased

significantly each year thereafter except for 1995. Advances increased

by 154 percent between 1992 and 1997--from $80 billion to $203 billion.

In second quarter 1997, advance levels surpassed the previous all-time

high of $166.7 billion. Although the Banks initially grew investments

as a substitute for advances, FHLBank investments have generally

increased over the past five years along with advances. Investments

increased by 88 percent between 1992 and 1997--from $79 billion to $149

billion. At year-end 1997, advances represented about 57 percent of

balance sheet assets, compared to about 79 percent in 1989.

As a result of the increases in advances and investments, the Bank

System's balance sheet assets more than doubled between 1992 and 1997,

increasing from $162 billion in 1992 to $359 billion at year-end 1997.

An increase in capital due to new members joining the System and the

decision by the Finance Board to expand the regulatory leverage limit

allowed the Banks to grow their balance sheets. Between 1992 and 1997,

capital levels almost doubled, from just under $11 billion to over $19

billion, and the Bank System's ratio of capital to assets declined from

6.5 percent to 5.4 percent.

Bank System liabilities increased to fund the expanded investments

and advances. Between 1992 and 1997, COs (bonds and discount notes)

outstanding increased by 174 percent--from $115 billion to $314

billion. Due to the short-term of the discount notes, discount note

issuance increased many times more than outstandings. From 1992 to

1997, discount note issuance increased 20 times--from $97 billion to

just under $2 trillion. As a result of the rapid increase in discount

notes and their shortening maturity, the Finance Board in 1994 changed

the limit in the Office of Finance's 1995 debt authorization from one

based on obligations issued to one based on obligations outstanding.\7\

The debt authorizations for 1996 and 1997 limited the level of COs

outstanding and senior, unsecured obligations to 20 times total

capital, the regulatory leverage limit.

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\7\ The Office of Finance (OF) is a joint office of the FHLBanks

and serves as the FHLBanks' fiscal agent. The OF also acts as agent

of the Finance Board in issuing consolidated obligations.

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Bank System net income bottomed out at $850 million in 1992 and

increased 79 percent to $1.5 billion in 1997. Spreads on advances have

generally narrowed over the last several years and much of the income

growth has been due to greater levels of earning assets. The Bank

System's net interest margin recovered somewhat from its low in 1992

but remains lower than the levels in the 1980s. The lower net interest

margin is largely due to reduced spreads on advances and significantly

larger volumes of lower-yielding investments on the balance sheet. Bank

System return on assets declined slightly from 1992 to 1997, from 53

basis points to 47 basis points.

Given the large increase in voluntary members since 1989,

maintaining a dividend adequate to retain voluntary members has been

considered necessary for ensuring a stable System.8 Dividend

payments to shareholders have varied by Bank. From third quarter 1992

through fourth quarter 1997, the Bank System average dividend was 6.5

percent; eight Banks paid average dividends above the System average

dividend.

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\8\ With the exception of federally-chartered savings

associations, all of the Bank System's members are now voluntary.

(The Office of Thrift Supervision in April 1995 ceased requiring

state-chartered thrifts to maintain Bank System membership.) At

year-end 1997, voluntary members represented 85 percent (5,502) of

the System's membership base and held 57 percent ($10.4 billion) of

total System capital stock.

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Each Bank establishes its own dividend target and dividend

benchmarks vary. Since at any point in time a voluntary member can

withdraw from the System with six-month notice, one dividend benchmark

may be the return on a six-month maturity CO, with a spread to

compensate members for the relative illiquidity of the stock investment

and the additional risk associated with holding equity relative to

debt. With the exception of one FHLBank, all the FHLBanks paid

dividends with returns above the six-month CO coupon between 1992 and

1997. The average spread was 157 basis points, ranging from a low of 27

basis points to a high of 409 basis points. Some members may view their

cost of funds as a floor on Bank dividends. From third quarter 1992 to

fourth quarter 1997, Bank dividends on average exceeded System members'

average cost of funds by 214 basis points. Variation among the Banks

ranged from a low of 23 basis points to a high of 461 basis points.

Member perceptions of an adequate dividend clearly vary across the

districts.9 One of the Banks that has paid one of the lowest

dividends in the System has been very successful at attracting new

members. The on-going

[[Page 16508]]

adequacy of Bank System dividends is suggested by the fact that large

numbers of voluntary members have joined the System while only a few

have exited, and that as of year-end 1996 members collectively held

$2.3 billion in capital stock beyond the amount they were required by

law to hold. Of course, the benefit of System membership exceeds the

return on stock. Besides receiving a dividend, System members maintain

on-going access to liquidity, long-term funding, and access to FHLBank

programs, products, and services.

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\9\ The Furash Group is currently surveying members about their

views of an adequate dividend and the other benefits of FHLBank

membership.

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Issue

The FHLBanks, as governmentally sponsored enterprises (GSEs), can

be viewed as representing a social compact between the Banks and their

members and the federal government. The federal government bestows upon

the Banks certain benefits through their GSE status, including: (1) an

ability to borrow at rates only slightly above Treasury borrowing rates

due to the perception of an implicit federal guarantee of GSE debt, as

well as the ability to issue large amounts of debt, including debt with

complex structures; (2) exemption from Securities and Exchange

Commission registration and reporting requirements and fees; and (3)

exemption from state and local income taxes. In exchange for these

benefits, the Banks have a responsibility to serve the public by

enhancing the availability of residential mortgage and targeted

community development credit through their member institutions. As

such, the federal benefits, most importantly the funding advantage,

should be used to fund activities that safely and soundly further the

Banks' public purpose.

During the period of rapidly declining advances and shrinking

thrift membership in the early 1990s, the Finance Board took rational

steps to alleviate earnings pressures by expanding the Banks'

investment authority and increasing the leverage limit. However,

despite the remarkable recovery that has since occurred in advances and

System membership, Bank investments continue to increase. While

advances at year-end 1997 were a record $202.7 billion, the System's

advances to assets ratio of 56.6 percent was still slightly lower than

the advances to assets ratio of 57.6 percent at year-end 1993 when

advances were $103 billion.

Many of the assets in the Banks' investment portfolios--Treasury

and agency securities, fed funds, resale agreements, commercial paper,

bank and thrift notes, bankers' acceptances and deposits--bear little

if any relationship to the Banks' mission of enhancing the provision of

credit through members for housing and community development. Such

investments, beyond those required for liquidity, can thus be

considered non-mission related.10

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\10\ It is important to note that several of the FHLBanks have

recently taken action to reduce their money market investments.

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The principal purpose of these primarily short-term money market

investments has been to generate income to help the Banks satisfy their

REFCorp and AHP obligations and pay a dividend sufficient to attract

and retain voluntary members and offer competitively priced products. A

large volume of money markets investments may have been justified

during a temporary period of contracting advances, declining

membership, and severe income pressures. However, now that membership

and advances are at record levels and System income exceeds $1.5

billion, the need to maintain such investments--which averaged $98

billion during 1997--should be examined in light of the Banks' public

mission as GSEs.

The Banks also hold substantial MBS investments--System-wide MBS

investments averaged $47 billion in 1997. Although MBS are housing-

related, the extent to which these investments support the Banks'

housing finance mission is debatable. MBS generally are traded in

large, well-established and liquid markets. The FHLBanks' presence in

these markets may not result in increased availability of funds for

housing, or in lower cost funds. Bank investment in MBS, therefore,

could be considered as providing less ``value'' to housing than

advances or other investments that provide financing that is not

generally available or is available at lower levels or under less

attractive terms.

However, absent any legislative reforms to the fixed $300 million

REFCorp obligation and the Banks' capital structure, or any substantial

and sustained increase in advances demand or other high yielding

mission assets, a substantial reduction in the Banks' MBS authority

would have a significant adverse impact on the Banks' net income and

dividends. The Bank System's capital level is based on ``subscription

capital,'' i.e., statutory member stock purchase requirements, rather

than the risk of its operations.11 As a result, the System

holds more capital than it can adequately leverage in advances business

with members. Capital not supporting advances must be leveraged with

other assets (e.g., money market assets, MBS subject to the 300 percent

of capital limit, and other investments supporting housing and targeted

community development) in order to generate earnings for dividends.

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\11\ By law, each member is required to hold capital stock equal

to the greater of one percent of residential mortgage loans, 0.3

percent of total assets, or five percent of advance. Members that do

not meet the definition of qualified thrift lender are required to

hold stock against advances equal to five percent divided by their

actual thrift investment percentage.

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Assuming a 60 basis point spread on MBS, elimination of the Banks'

$47 billion in MBS would reduce System income by $282 million. Other

things being equal, and assuming 1997 average capital stock balances,

this would reduce the average dividend by 161 basis points. With the

decline in income, the $300 million REFCorp payment would represent a

larger share of System net income. On the other hand, and as discussed

in more detail below, significant volumes of low yielding money market

assets can be rolled-off with a much smaller reduction in income. For

example, assuming a 10 basis point spread on money market assets, the

Banks could reduce these assets by $50 billion and net income would

fall by $50 million. Other things being equal, this would result in an

average decline in dividends of approximately 29 basis points assuming

1997 average capital stock balances.

Possible Approaches to Limiting Money Market Investments

There are several possible approaches to limiting Bank money market

investments. One approach would be simply to restore the more

restrictive leverage limit that existed before 1993. However, while

such an approach could require the Banks to shrink their balance

sheets, there would be no guarantee that the shrinkage would occur in

money market investments rather than in investments that add more value

in terms of advancing the System's public purpose.

Another approach would be to place restrictions on the composition

of the liability side of the Banks' balance sheets. After the Finance

Board ceased placing limits on debt issuance effective with the 1995

debt authorization, there were substantial, contemporaneous increases

in the volumes of both discount notes and short-term money market

investments. In December 1997, the Finance Board authorized a three-

month extension of the Office of Finance's debt issuance authority so

that staff could examine the relationship between discount notes and

money market investments. As discussed in the debt authorization issues

paper, staff concluded that the Banks could respond

[[Page 16509]]

to any limitations placed on the discount note issuance by funding

short term money market investments with longer term COs or by creating

synthetic short-term funding instruments with possibly increased risk

and cost.\12\

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\13\ The Finance Board on March 13, 1998, authorized the Office

of Finance to issue debt through year-end 1998. The debt

authorization does not contain any limits on System debt issuance.

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A more direct approach to limiting the holding of money market

assets would be to place constraints on the Banks' holdings of such

investments. If the policy objective is to ensure that the System's

principal federal benefit-- its GSE funding advantage--is being used to

meet the System's public purpose, there is some logic to tying

allowable levels of money market investments to the levels of COs

outstanding. Such an approach would constrain the use of the GSE

funding advantage to finance assets, beyond reasonable liquidity needs,

not related to the Banks' housing and community investment mission.

Money market investments funded with deposits and capital would not be

subject to these limits because these sources of funds are not raised

in the GSE debt market.

Implementing limits on Bank money market investments obviously

requires making a distinction between non-mission related, money market

investments and other types of assets, and could be an additional step

toward evaluating on a systematic basis the degree to which Bank assets

and products further System mission fulfillment. Bank System assets and

products can be viewed on a continuum from those that are most mission-

related, that is provide the greatest benefit to users of residential

and community development credit, to those that are not mission-related

and held solely for purposes of liquidity and income generation.

Presumably, FHLBank products and services that are not readily

available in the capital markets, such as long-term advances, could be

considered the most mission-related. As part of its study, the Furash

group will be attempting to develop a methodology for measuring System

mission achievement, which could be helpful in making further

distinctions among System assets and products.

Working within this conceptual approach, staff evaluated three

options that placed limits on the allowable levels of money market

investments. For simplicity of exposition, System assets were

classified into three categories: Advances, MBS, and money market

investments (MMI).\13\ The three options were as follows:

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\13\ Money market investments are defined as fed funds, resale

agreements, deposits, commercial paper, bank and thrift notes,

bankers' acceptances, and Treasury and agency non-MBS securities. As

the Banks develop investments to support housing and community

development, the classifications could be refined. For example, the

Finance Board recently authorized the FHLBanks to invest in

federally insured deposits of all members to enhance the Banks'

ability to provide liquidity to members, particularly smaller

members that do not have sufficient capital or the required rating

to be deemed an eligible financial institution as set forth in the

FMP. To the extent it is deemed appropriate, future refinements

could allow these investments to be reclassified as mission related.

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(1) Advances required to be a minimum of 65 percent of COs, with

MBS limited to the maximum of either the existing 300 percent of

capital limit or 20 percent of COs;

(2) Advances required to be a minimum of 70 percent of COs, with

MBS limited to the maximum of the existing 300 percent of capital limit

or 20 percent of COs; and

(3) Advances required to be a minimum of 80 percent of COs, with

MBS limited to the maximum of the existing 300 percent of capital limit

or 20 percent of COs.

The change in the MBS limit from one based solely on capital to one

based on COs represents a change in how the limit should be viewed. The

Finance Board initially limited MBS investments to a multiple of

capital in part because it was concerned about the Banks' ability to

manage the interest rate and options risk associated with these assets.

However, now that the Banks have developed more effective techniques

for hedging these risks, and there are policy limits in place

constraining the Banks' interest rate risk exposure, the MBS limit

could be viewed as more of a mission than a safety and soundness

constraint. Accordingly, under this approach, MBS investments would be

limited to a percentage of COs outstanding. However, to the extent that

the existing 300 percent of capital limit is less restrictive, it

should also be retained so that the Banks would not be required to

shrink their MBS portfolios.

Under this approach, the Banks could fund MMI through capital and

deposits. Assuming MBS investments equal at least 20 percent of

liabilities, allowable amounts of MMI funded by COs would be no more

than 15 percent of COs in option one and no more than 10 percent of COs

in option two. In option three, MMI could only be funded with deposits

and capital to the extent a Bank maximizes its use of the MBS

authority.14

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\14\ From 1980 through 1988, advances averaged 118 percent of

COs, indicating that the Banks funded advances with deposits and

capital, as well as COs.

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At year-end 1997, advance to CO ratios at the individual FHLBanks

ranged from a low of 45 percent to a high of 89 percent. The System

average was 65 percent, with seven Banks below the average. The ratio

of advances and MBS to COs ranged from 62 percent to 99 percent. The

System average was 81 percent. The ratio of MBS to COs ranged from 10

percent to 23 percent, with a System average of 16 percent. MMI to CO

ratios (excluding MMI funded with deposits and capital) ranged from one

percent to 39 percent. The System average was about 20 percent.

Simulations

Staff generated simulations applying the limitations under each of

the options to each Bank's 1997 average balance sheet. The simulations

assume that Banks not meeting the minimum requirement for advances

would reduce their levels of COs and money market investments until the

minimum advance to CO requirement was satisfied. Advance and capital

levels were fixed at 1997 average balances. As money market investments

are reduced, therefore, Bank leverage decreases and capital-to-asset

ratios increase.

Because these simulations assume no behavioral responses on the

part of the Banks, the results should not be considered predictions of

what would have happened had these investment restrictions actually

been in place in 1997. Rather, they should be considered an indication

of the magnitude of the Banks' required balance sheet adjustments, and

the potential impact on net income and dividends. The simulations

assume that all adjustments occur instantaneously, while in reality

there would be a transition period.

Based on analysis of empirical data and discussions with FHLBank

staff, the simulations assume that money market investments generate a

spread of 10 basis points and MBS have a spread of 60 basis points. The

low return on MMI should generally allow the Banks to roll-off

substantial amounts of MMI without significantly reducing net income.

Overall, Bank System MMI would fall by 50 percent or $49 billion

under option two. The effects of the approach vary by Bank and are

related to a Bank's advances to CO ratio. The Banks with the lowest

advances to CO ratios, and correspondingly the highest ratios of MMI to

COs, would be required to roll-

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off the greatest volume of MMI. Reductions in MMI at the individual

Banks would range from no change to an 80 percent decline.15

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\15\ Discussion centers on option two since it is the middle

option.the magnitude of effects should be less for option one and

greater for option three.

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Total System assets would decline by 14 percent or $47 billion

under option two. Reductions in assets at the individual Banks would

range from no change to a 36 percent decline. With the exception of one

FHLBank, leverage at all the Banks would decrease in option two due to

the reduction in assets. The average System capital to asset ratio

would increase from 5.6 percent in the base case to 6.6 percent.

Capital to asset ratios at the Banks would range from 5.8 percent to

8.1 percent.

The approach allows the Banks to hold MBS equal to the greater of

300 percent of capital or 20 percent of COs. In most cases, the 300

percent of capital limit would be more permissive than the 20 percent

of COs constraint. In option one, two Banks would hold MBS in levels

greater than 300 percent of capital; in option two, only one Bank would

have MBS greater than 300 percent of capital; and in option three, no

FHLBank would have MBS greater than 300 percent of capital. In general,

MBS would represent a greater percentage of COs at those Banks with the

least leverage.

System-wide, MBS would average 21 percent of COs, compared to 17

percent in the base case. The ratio of MBS to COs would range from a

low of 11 percent to a high of about 29 percent. System MBS levels

would grow modestly, $2.6 billion or 5 percent, under the three options

because the model assumes that each Bank maximizes its MBS holdings

subject to Finance Board or Bank board requirements.16 The

growth in MBS mitigates the reduction in earnings resulting from the

roll-off in MMI. System-wide, MMI (less MMI funded with deposits and

capital) would decline from 23 percent of COs in the base case to about

six percent in option two.

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\16\ In the base case, each Bank's average MBS balance was less

than either 300 percentof capital or, with one exception, 20 percent

of COs.

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Under option two, System net income would fall by $30 million, or

two percent, to $1.49 billion. Declines in net income would range from

no change to a reduction of seven percent. Under option two, the

average System dividend would drop by 17 basis points. As a result of

the decline in System income, funding for the AHP program would fall by

approximately $3 million, slightly less than three percent.

Dividend reductions would range from no change to a 54 basis point

decline. System-wide, the average dividend under option two would have

a spread of 106 basis points over the six-month CO rate. This spread is

17 basis points lower than the 123 basis point spread in the base case.

Spreads over the six-month CO rate would range from 16 basis points to

216 basis points. Dividend spreads over member cost of funds under

option two would range from 124 basis points to 309 basis points.

System-wide, the average spread would be 228 basis points.

This analysis suggests that reducing MMI would generally result in

modest declines in net income, with the magnitude of the effects

varying across the Banks. To the extent the resulting return on equity

(ROE) at a Bank is below its target ROE, the Bank could attempt to

increase its return by taking greater risk. The Finance Board's FMP

contains limits on the FHLBanks' interest rate risk and unsecured

credit risk exposure. These limits, as well as regular on-site

examination of the FHLBanks, should constrain incentives to increase

risk. Another option would be to increase the spreads on advances to

generate additional income. However, increased spreads would likely

reduce demand for advances, and the Banks would be limited in their

ability to replace advances with MMI.

Issues Requiring Further Analysis

This preliminary analysis suggests that the investment restrictions

in option two, when applied to the 1997 average balance sheet, would

achieve a 50 percent reduction in MMI--$49 billion--without

significantly affecting Bank System net income and dividends. It seems

unlikely that the relatively small reductions in dividends would

trigger widespread withdrawal by voluntary members given that dividend

spreads over comparable benchmarks generally would not be significantly

lower than the spreads in the base case. Transition rules would be

needed to facilitate Bank adjustment to any new investment limitations,

particularly for those Banks requiring the greatest reduction in MMI.

Transitional rules would also be needed for Banks that fall out of

compliance due to situations such as merger activity and regional and

cyclical downturns in advance demand.

This analysis assumed constant levels of advances and capital. The

impact of limits on Bank MMI in a period of declining advances and

interest rates should be analyzed, as well as the implications of

declining capital levels due to the redemption of stock held in excess

of the minimum statutory requirements. Another issue involves the

payment of stock dividends by the FHLBanks. Stock dividends involve a

greater taxpayer subsidy because taxes are deferred, and the Banks

currently may leverage the stock in investments that do not support

their public purpose.

It is also important that any Finance Board limits on Bank MMI do

not result in inadequate levels of liquidity at the FHLBanks. The Banks

are currently subject to statutory liquidity requirements and

additional liquidity requirements set forth in the FMP.17

Preliminary analysis indicates that all the Banks would have met their

requirements at year-end 1997 under options one and two. One Bank would

not have met its requirements under option three. Finance Board staff

will be examining the adequacy of these liquidity requirements as part

of its review of the FMP.

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\17\ The Bank Act requires each bank to maintain an amount equal

to the total deposits received from its members invested in:

obligations of the United States; deposits in banks or trust

companies (as defined in Finance Board regualtion) which are

eligible financial institutions; and advances that mature in 5 years

or less to members. In addition, each Bank is required to maintain a

daily average liquidity level each month in an amount not less than

20 percent of the sum of its daily average demand and overnight

deposits and other overnight borrowings during the month, plus 10

percent of the sum of its daily average term deposits, COs and other

borrowings that mature within one year. Certain money market

investments authorized under the FMP may be used to satisfy the

liquidity requirements.

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This analysis also made no assumptions about changes in FHLBank

funding costs. It has been suggested that Bank borrowing costs could

fall if CO issuance declined. Staff could review the existing research

that has been done is this area and incorporate expected changes, if

any, into the simulations.

Conclusions

The FHLBanks, as GSEs, can be viewed as representing a social

compact between the Banks and their members and the federal government.

The federal government bestows upon the Banks certain benefits through

their GSE status, and such federal benefits should be used to fund

activities that safely and soundly further the Banks' public purpose.

The System acted rationally during the transition period following the

resolution of the thrift crisis when it replaced declining advance

balances with increasing levels of investments. However, now that the

demand for advances has rebounded and reached record levels, and System

membership is at record levels as well, the on-going maintenance of

large balances of MMI

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appears to be inconsistent with the Banks' mission.

With the goal that the System's principal federal benefit--its GSE

funding advantage--be used to meet the System's public purpose, staff

evaluated three options that tied allowable levels of money market

investments to the levels of consolidated obligations outstanding. Such

an approach would constrain the use of the GSE funding advantage to

finance money market assets. Preliminary analysis suggests that

reducing low-yielding MMI by 50 percent, while holding advances and

capital constant, would generally result in relatively small reductions

in dividends. In most cases, FHLBank dividend spreads over comparable

benchmarks would be only modestly lower than historical averages. It

appears unlikely that these dividend reductions would result in a

reassessment by voluntary members of the benefits of System membership.

Setting limits on Bank MMI could be viewed as another near-term

step in restructuring the Banks' balance sheets. Longer-term efforts

could involve Finance Board consideration of additional limits on Bank

MBS investments, as well as the Banks' continued development of new and

innovative investments that support housing and targeted community

development.

Persons wishing to participate in the hearing should send a written

request to the address listed in the ADDRESSES portion of this notice,

to be received no later than Monday April 13, 1998. A request to

participate in the hearing must include the following information:

(A) The name, title, address, business telephone and fax number of

the participant; and

(B) The entity or entities that the participant will be

representing.

Depending on the number of requests received, participants may be

limited in the length of their oral presentations. All submissions will

be included as part of the record, including written testimony not

presented orally, although extraneous material may be deleted from the

printed record to reduce printing costs. The Finance Board will notify

those selected to make oral presentations if more requests are received

for participation than may be accommodated in the time available.

Participants will be required to submit 100 copies of their written

statements in advance of the hearing date. These written statements

should incorporate the major points to be presented at the hearing and

should be accompanied by an executive summary of no more than two

pages. Written statements must be received no later than Friday, May 1,

1998, and should be sent to the address listed in the ADDRESSES portion

of this notice. Anyone selected for an oral presentation whose

testimony has not been received by Friday, May 1, 1998 may not testify

except by special permission of the Finance Board.

By the Federal Housing Finance Board.

Bruce A. Morrison,

Chairman.

BILLING CODE 6725-01-P

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[FR Doc. 98-8508 Filed 4-2-98; 8:45 am]

BILLING CODE 6725-01-C