Prohibition on Payment of Fee In Lieu of Mandatory Excess Capital Stock Redemption

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

its regulation governing Federal Home Loan Bank (Bank) advances to

prohibit the Banks from imposing or accepting a fee in lieu of

redeeming a member's excess capital stock held in the Bank. The Finance

Board has determined that allowing the payment of such fees would

detract from the agency's ongoing efforts and initiatives to ensure

that the Banks carry out their housing finance and community investment

mission.

EFFECTIVE DATE: This interim final rule shall be effective on April 6,

1999. The Finance Board will accept written comments on this interim

final rule on or before May 6, 1999.

FOR FURTHER INFORMATION CONTACT: Joseph A. McKenzie, Deputy Chief

Economist, (202) 408-2845, Office of Policy, Research and Analysis; or

Sharon B. Like, Senior Attorney-Advisor, (202) 408-2930, or Jane S.

Converse, Senior Attorney-Advisor, (202) 408-2976, Office of General

Counsel, Federal Housing Finance Board, 1777 F Street, N.W.,

Washington, D.C. 20006.

SUPPLEMENTARY INFORMATION:

I. Statutory and Regulatory Background

A. The Banks' Housing Finance and Community Investment Mission

The Federal Home Loan Bank System (Bank System) is comprised of 12

District Banks that are federally chartered and managed by boards of

directors that set policies pursuant to regulations established by the

Finance Board. As government-sponsored enterprises (GSEs), the Banks

act as intermediaries in the capital markets, raising funds on

favorable terms and passing the proceeds on to member institutions in

the form of advances (loans).

Under section 10(a) of the Federal Home Loan Bank Act (Bank Act)

and part 935 of the Finance Board's regulations, the Banks have broad

authority to make advances in support of housing finance, which

includes community investment finance. See 12 U.S.C. 1430(a), (i), (j);

12 CFR part 935. The Banks also are required to offer two programs, the

Affordable Housing Program (AHP) and the Community Investment Program

(CIP), to provide subsidized or at-cost advances, respectively, in

support of unmet housing finance or economic development credit needs.

See 12 U.S.C. 1430(i), (j); 12 CFR parts 960, 970. In addition, section

10(j)(10) of the Bank Act, as implemented by a recently issued Finance

Board regulation, authorizes the Banks to establish Community

Investment Cash Advance (CICA) Programs for community lending, defined

as providing financing for economic development projects for targeted

beneficiaries. See 12 U.S.C. 1430(j)(10); 63 FR 65536 (Nov. 27, 1998).

The Bank Act provides that the Finance Board's primary duty is to

ensure that the Banks operate in a financially safe and sound manner.

See id. section 1422a(a)(3)(A). The Bank Act further provides that, to

the extent consistent with this primary duty, the Finance Board also is

responsible for supervising the Banks, ensuring that the Banks carry

out their housing finance mission, and ensuring that the Banks remain

adequately capitalized and able to raise funds in the capital markets.

See id. section 1422a(a)(3)(B).

B. Statutory and Regulatory Minimum Capital Stock, Dividend and

Redemption Provisions

Under the Bank Act and implementing Finance Board regulations, a

member's required minimum capital stock investment in its Bank is the

greater of: (1) 1 percent of the member's aggregate unpaid loan

principal (defined as the member's home mortgage loans, home purchase

contracts, and similar obligations) but not less than $500; (2) 0.3

percent of the member's total assets; or (3) 5 percent of total

advances outstanding to the member. In the case of members that are not

``qualified thrift lenders'' (QTLs), the third option is computed as 5

percent of total advances outstanding to the member divided by the

member's ``actual thrift investment percentage'' (as defined in 12

U.S.C. 1467a(m)). See 12 U.S.C. 1426(b)(1), (2), (4); 1430(c), (e)(1),

(3); 12 CFR 933.20(a).

Section 6(b)(1) further provides that the Bank shall annually

adjust, at such time and in such manner as the Finance Board may by

regulations or otherwise prescribe, the amount of capital stock held by

each member so that such member shall have invested its minimum capital

stock requirement. See id. section 1426(b)(1); 12 CFR 933.22(b)(1).

Section 6(b)(1) also provides that if the Bank finds that the

investment of any member in capital stock is greater than that required

under section 6(b), the Bank may, unless prohibited by the Finance

Board, in its discretion and upon application of the member, retire the

capital stock of such member in excess of the amount so required. See

id. section 1426(b)(1); 12 CFR 933.22(b)(2).

Section 16(a) of the Bank Act provides, among other things, that

dividends may be paid by the Banks with the approval of the Finance

Board. See 12 U.S.C. 1436(a). Section 6(g) of the Bank Act provides

that all stock of any Bank shall share in dividend distributions

without preference. See id. section 1426(g). Section 934.17 of the

Finance Board's regulations on the operations of the Banks implements

these provisions by providing, among other things, that dividends may

be paid by the Banks in cash or in the form of stock. See 12 CFR 932.3;

63 FR 65683, 65687 (Nov. 30, 1998) (redesignating Sec. 932.3 as

Sec. 934.17).

Section 935.15(b) of the Finance Board's Advances Regulation

provides that ``[a] Bank, after providing 15 calendar days advance

written notice to a member, may unilaterally redeem that amount of the

member's Bank stock that exceeds'' the member's minimum statutory and

regulatory capital stock requirements. See 12 CFR 935.15(b). Section

935.15(b) further provides that the Bank shall have discretion to

determine the timing of such unilateral redemption, provided that the

Bank's redemption policy is consistent with the requirement in section

7(j) of the Bank Act that the affairs of the Bank shall be administered

fairly and impartially and without discrimination in favor of or

against member borrowers, see 12 U.S.C. section 1427(j).

The Bank Act and Sec. 935.15(b) of the Advances regulation are

silent on whether a Bank, in administering its mandatory redemption

policy, may impose on or accept from a member a fee in lieu of

redeeming the member's excess Bank capital stock.

II. Analysis of the Interim Final Rule

A. Proposed Fee In Lieu of Mandatory Excess Capital Stock Redemption

A Bank has adopted a policy, effective March 31, 1999, pursuant to

which the Bank generally will redeem that amount of each member's

capital stock exceeding 115 percent of the member's minimum statutory

capital stock requirement, with an option, if lawful and appropriate,

for the member to pay

[[Page 16789]]

a fee to the Bank in lieu of such redemption. The Bank has requested

confirmation from the Finance Board that the proposed fee would be

authorized under the Bank Act and Finance Board regulations.

As noted above, the Bank Act and Sec. 935.15(b) of the Finance

Board's Advances regulation are silent on whether a Bank may impose on

or accept from a member a fee in lieu of redeeming the member's excess

Bank capital stock. Even though the Bank Act is susceptible to an

interpretation that the payment of such fees would be authorized under

law, the Finance Board has determined that allowing the payment of such

fees would detract from the agency's ongoing efforts and initiatives to

ensure that the Banks carry out their housing finance and community

investment mission, as discussed below. Therefore, the Finance Board is

adopting this interim final rule prohibiting the payment of such fees.

Although this interim final rule will become effective on the date of

publication in the Federal Register, the Finance Board requests comment

on all aspects of the rule during a 30-day comment period.

According to the Bank, the purpose of the Bank's proposed

redemption policy is to enhance the Bank's competitiveness vis a vis

other Banks by increasing its earnings per share and therefore its

dividend rate. The Bank forecasts that mandatory redemption of surplus

capital stock or payment of the fee in lieu of redemption would add

approximately 12 basis points to the Bank's quarterly dividend. The

Bank has a number of large members owned by holding companies that also

have subsidiaries located in other Bank districts. The Bank is

concerned that these members may discontinue borrowing from the Bank

and that their affiliates will become members and borrow from these

other Banks because those Banks pay higher dividend rates than the

Bank.

Under the Bank's proposed policy, the Bank would unilaterally

redeem ``surplus'' capital stock (defined by the Bank as capital stock

in excess of 115 percent of minimum capital stock requirements but not

less than $100,000) held by all members, unless the member pays a fee

to the Bank, on a monthly basis, to continue holding its surplus

capital stock. The 115 percent threshold was adopted to allow

membership flexibility for future borrowings from the Bank and absorb

the stock dividends. The $100,000 minimum was adopted in order to

reduce the operational impact of the redemption policy on smaller

members. The Bank states that the fee, which is 1.65 percent of the

value of a member's surplus capital stock, was designed to make the

Bank financially indifferent to a member's decision to continue to hold

surplus capital stock. The fee income paid to the Bank would act as an

offset to the dividend dilution caused by those members holding surplus

capital stock.

As of August 31, 1998, the Bank had excess capital stock of $554

million, or 14 percent of its total capital of $3.9 billion. The Bank's

total ``surplus'' capital stock, as of August 31, 1998, was $312

million. One mandatory thrift member held 70 percent of the Bank's

total surplus capital stock as of that date. The Bank has excess

capital stock, in part, because it pays members quarterly stock

dividends rather than cash dividends. The Bank has indicated that

paying a stock dividend rather than a cash dividend provides tax

benefits for its members, and the Bank intends to continue paying stock

dividends for this reason.

B. The Banks Are Significantly Overcapitalized

By many standards, the 12 Banks are significantly overcapitalized.

As of December 31, 1998, the 12 Banks had total capital stock of $22.8

billion, with $2.8 billion, or 12.6 percent, of this amount

constituting capital stock in excess of the Banks' statutory minimum

capital stock requirements. On a risk-adjusted basis (using the current

risk-based standards applicable to federally regulated depositories),

the total capital is estimated at 22 percent of the Banks' total

assets, a level far above that of large commercial banks and other

housing GSEs.\1\ The highest percentage of excess capital stock to

total capital stock at a Bank was 30.1 percent, and the lowest was 1.2

percent.

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\1\ A depository institution generally is deemed to be ``well-

capitalized'' if it has a total risk-based capital ratio of 10

percent or greater, a Tier 1 risk-based capital ratio of 6 percent

or greater, and a leverage ratio of 5 percent or greater. See 12 CFR

6.4(b)(1), 208.33(b)(1), 325.103(b)(1), 565.4(b)(1). The minimum

capital requirement for the other housing GSEs--the Federal National

Mortgage Association and the Federal Home Loan Mortgage

Corporation--generally is 2.5 percent of on-balance sheet assets

plus .45 percent of off-balance sheet obligations. See 12 U.S.C.

4612(a).

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Even without excess capital stock in the Bank System, i.e., capital

stock at only the statutorily required minimum stock levels, the Banks

would be significantly overcapitalized. A redemption of all excess

capital stock in the Bank System would reduce the Banks' risk-based

capital ratio to approximately 19.2 percent.

Members have excess capital stock holdings, in part, because they

receive stock dividends from the Banks. Currently, five Banks pay stock

dividends, and seven Banks pay cash dividends. The Internal Revenue

Service has ruled that the issuance of stock dividends by the Banks is

not taxable income for members. See IRS Rev. Rul. 90-98, November 26,

1990, 1990-48-I.R.B.4, 26 CFR 1.305-2. However, cash dividends and

redemptions of stock received as dividends generally are taxable income

to members. See 26 U.S.C. 301(c), 302(a). Because of the deferred tax

liability associated with stock dividends, many members may have

allowed their stock dividends to accumulate rather than request

redemption of their capital stock, as is their option under the Bank

Act. See 12 U.S.C. 1426(b)(1).

The members' holdings of excess capital stock are concentrated,

with the largest holder of excess capital stock having 9 percent of the

Bank System's total excess capital stock. The top five holders of

excess capital stock represent 19 percent of the Bank System's total

excess capital stock.

Excess capital stock holdings also arise where members' total

assets, home mortgage loans or outstanding advances have decreased

since their last capital stock purchases, or where members have changed

to QTL status, thereby reducing their advances-based capital stock

requirement. Members may continue to hold some excess capital stock in

order to minimize the transaction costs associated with capital stock

purchases that would be required if the member's levels of total

assets, home mortgage loans or outstanding advances fluctuate.

C. The Banks' Arbitrage Activities With Non-Core Mission Assets Detract

From the Mission of the Banks To Promote Housing Finance and Community

Investment

The Banks pay dividends on all capital stock, including excess

capital stock. Since the average Bank System dividend rate of 6.64

percent exceeds the rate of return a Bank can earn by investing

members' capital in core mission assets, a Bank must leverage its

excess capital stock to pay dividends. The leveraging cannot involve

advances, since they are already capitalized by required capital stock.

Thus, the Banks must leverage excess capital stock by investing in non-

core mission assets in order to generate sufficient earnings to pay a

uniform dividend on all capital stock, including the excess capital

stock.

There is a strong correlation between the amount of excess capital

stock at a Bank and the level of that Bank's non-

[[Page 16790]]

core mission assets. In demonstrating the correlation between excess

capital stock and non-mission-related assets, the Finance Board looked

at the concept of ``core mission assets,'' defined as Bank advances,

which include AHP advances and subsidies, CIP advances, community

lending advances, Mortgage Partnership Finance assets, and other assets

generated for the Banks by members and nonmember borrowers. Core

mission assets do not include mortgage-backed securities (MBS) and

money market instruments, which are not generated for the Banks by

members or nonmember borrowers and their purchase by the Banks does not

materially facilitate housing and community lending by members or

nonmember borrowers. As demonstrated in the following table, the Banks

with the highest levels of excess capital stock also have the lowest

ratios of core mission assets to consolidated obligations:

Excess Capital Stock and Core Mission Assets

----------------------------------------------------------------------------------------------------------------

Core mission

assets to Excess capital

Bank consolidated Descending stock to total Rank

obligations rank capital stock

(%) (%)

----------------------------------------------------------------------------------------------------------------

A............................................... 86.5 1 10.4 7

B............................................... 85.1 2 1.0 1

C............................................... 81.8 3 10.2 6

D............................................... 81.3 4 4.2 2

E............................................... 80.7 5 3.0 3

F............................................... 79.7 6 7.8 4

G............................................... 70.5 7 9.3 5

H............................................... 69.4 8 17.1 10

I............................................... 65.4 9 26.8 11

J............................................... 63.8 10 15.2 8

K............................................... 59.9 11 30.1 12

L............................................... 58.6 12 16.2 9

Bank System..................................... 75.8 .............. 12.6 ..............

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Approximately 75.8 percent of total Bank System consolidated

obligations are invested in core mission assets.

The four Banks with the highest ratios of core mission assets to

consolidated obligations had ratios of excess capital stock to total

capital stock of 10.4 percent, 1.2 percent, 10.4 percent, and 4.2

percent. The five Banks with the lowest ratios of core mission assets

to consolidated obligations had the highest ratios of excess capital

stock to total capital stock. Of these five, three pay stock dividends,

and one pays the highest dividend in the Bank System. At present, core

mission assets are no more than 86.5 percent of consolidated

obligations at any Bank.

The Finance Board believes that the Banks' arbitrage activities for

the purpose of generating sufficient earnings to pay adequate dividends

on excess capital stock detract from the mission of the Banks to

promote housing finance and community investment, by encouraging

activities not related to the Banks' mission and thereby detracting

from the financial incentive to engage in mission-related activity.

While the Banks' interest in paying a reasonable dividend to members is

a legitimate business consideration, and it is appropriate to redeem

excess capital stock to assist in this purpose, allowing members to pay

a fee in lieu of such mandatory redemption would perpetuate excess

capital stock at the Banks and the Banks' continued need to invest in

non-core mission assets to pay dividends on such excess stock.

D. Amendment of Advances Regulation To Prohibit Payment of Fee In Lieu

of Mandatory Excess Capital Stock Redemption--Sec. 935.15(b)

For the reasons discussed above, this interim final rule amends

Sec. 935.15(b) of the Finance Board's Advances regulation to prohibit

the Banks from imposing on or accepting from a member a fee in lieu of

mandatory redemption of the member's excess capital stock.

Specifically, the interim final rule adds a new paragraph (b)(2) which

provides that: ``A Bank may not impose on or accept from a member a fee

in lieu of redeeming the member's excess Bank capital stock.''

In addition, the second sentence of current Sec. 935.15(b), which

is redesignated as paragraph (b)(1), is revised to clarify that the

Bank's implementation of its redemption policy, and not just the timing

of redemptions, shall be consistent with the requirement of section

7(j) of the Bank Act (12 U.S.C. 1427(j)) that the affairs of the Bank

shall be administered fairly and impartially and without discrimination

in favor of or against any member borrower.

This action is taken as an interim final rule, effective on the

date of publication in the Federal Register, because the Bank's

proposed fee policy is intended to be effective on March 31, 1999.

III. Issues For Consideration

Reducing Levels of Excess Capital Stock by Prohibiting Payment of Stock

Dividends and Requiring Unilateral Redemption of Excess Capital Stock

The Finance Board believes that the Banks' levels of excess capital

stock should be significantly reduced. As discussed above, the Banks

are substantially overcapitalized and, thus, reduction in the amount of

their excess capital would not adversely affect the safety and

soundness of the Banks. The statutory minimum capital stock

requirements guarantee that a Bank's capital stock will grow as the

scope of its operations increases.

As discussed above, excess capital stock requires the Banks to

generate earnings, through investments in non-core mission assets, in

order to pay dividends on such stock, which is not needed to capitalize

advances and other core mission assets. The Banks' arbitrage activities

for this purpose detract from the mission of the Banks to promote

housing finance and community investment, by encouraging activities not

related to the Banks' mission and thereby detracting from the financial

incentive to engage in mission-related activity. A reduction in the

amount of excess capital stock would reduce the amount of capital stock

on which dividends must be paid, thereby

[[Page 16791]]

reducing the level of arbitrage activities conducted in order to

generate earnings to pay dividends on such capital stock.

One cause of the Banks' excess capital stock levels is the payment

by some Banks of stock dividends rather than cash dividends to members.

Prohibiting the Banks from paying stock dividends would help reduce

excess capital stock levels in the Bank System and the consequent

arbitrage activities.

Another way to reduce excess capital stock in the Bank System and

thereby reduce arbitrage activities in non-core mission assets by the

Banks, would be to require the Banks to unilaterally redeem members'

excess capital stock. In the past year, five Banks unilaterally

redeemed their excess capital stock expressly for the purpose of

reducing the amount of their money market investments.

The Finance Board recognizes that payment of stock dividends has

Federal tax advantages to members over payment of cash dividends, and

that excess capital stock redemptions incur Federal tax liabilities for

members. However, the private financial advantage to members from

minimizing their taxes through the payment of stock dividends, while

having no safety and soundness implications for the Banks, ultimately

detracts from the Banks' housing finance and community investment

mission and serves no other legitimate business purpose for the Banks.

Accordingly, simultaneously with this rulemaking, the Finance Board

in a separate Advance Notice of Proposed Rulemaking (ANPRM) published

elsewhere in this issue of the Federal Register, is requesting comment

on how, by what means, and to what extent prohibiting or limiting the

Banks' ability to pay stock dividends to members would assist the

Finance Board in achieving the goal of reducing excess capital stock in

the Bank System. Similarly, the Finance Board is requesting comment on

whether the Banks should be required to unilaterally redeem members'

excess Bank capital stock to help achieve the goal of reducing excess

capital stock in the Bank System. Regarding required unilateral

redemption of excess capital stock, the Finance Board specifically

requests comment on whether a member should be allowed to maintain some

amount of excess capital stock, e.g., 10 percent of its total minimum

capital stock requirement, in anticipation of fluctuations in its

assets or outstanding advances that may affect its minimum capital

stock requirement. The Finance Board also requests comment on what the

timing of unilateral redemptions should be, e.g., no less frequently

than quarterly, semi-annually, or annually at the time of the Banks'

adjustments of the members' minimum capital stock requirements? The

Finance Board also requests comment on whether the currently required

15 days' notice to members before redemption should be retained or

modified. In addition, the Finance Board requests comment on whether

Sec. 933.23 of the Finance Board's membership regulation, which permits

a member to purchase excess capital stock if approved by the Bank,

should be removed or modified. See 12 CFR 933.23.

In the alternative, the Finance Board requests comment on whether

the Banks should be permitted to hold excess capital stock, but be

prohibited from paying dividends on such stock, as a way to reduce the

Banks' arbitrage activities with non-core mission assets. The Finance

Board also requests comment on whether and to what extent excess

capital stock holdings could be allowed so long as they are not being

leveraged in the consolidated obligations market. In addition, the

Finance Board requests comment on whether excess capital stock holdings

should be permitted for a limited period of time, such as up to six

months, where the member indicates that it intends to increase its

advance borrowings during that time period.

Comments received in response to the ANPRM will be reviewed and

considered by the Finance Board in preparation for further action in

connection with the issues discussed in the ANPRM.

IV. Regulatory Flexibility Act

Because no notice of proposed rulemaking is required for this

interim final rule, the provisions of the Regulatory Flexibility Act (5

U.S.C. 601 et seq.) do not apply.

V. Paperwork Reduction Act

This interim final rule does not contain any collections of

information pursuant to the Paperwork Reduction Act of 1995. See 44

U.S.C. 3501 et seq. Therefore, the Finance Board has not submitted any

information to the Office of Management and Budget for review.

VI. Notice and Public Participation

The Finance Board for good cause finds that the notice and public

comment procedure required by the Administrative Procedure Act is

impracticable, unnecessary or contrary to the public interest in this

instance, because the change made by this interim final rule prohibits

an immediately pending Bank action that would detract from the Banks'

mission to promote housing finance and community investment. See 5

U.S.C. 553(b)(3)(B).

List of Subjects in 12 CFR Part 935

Credit, Federal home loan banks, Reporting and recordkeeping

requirements.

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

part 935 of the Code of Federal Regulations as follows:

PART 935--ADVANCES

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

follows:

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

1430b, 1431.

2. Section 935.15 is amended by revising paragraph (b) to read as

follows:

Sec. 935.15 Capital stock requirements; unilateral redemption of

excess stock.

* * * * *

(b) Unilateral redemption of excess capital stock; fee in lieu

prohibited. (1) A Bank, after providing 15 calendar days advance

written notice to a member, may require the redemption of that amount

of the member's Bank capital stock that exceeds the capital stock

requirements set forth in paragraph (a) of this section or, in the case

of a non-QTL member, the capital stock requirements set forth in

Sec. 935.13(a)(1)(ii) of this part, provided the minimum amount

required in sections 6(b)(1) and 10(e)(3) of the Act is maintained. The

Bank shall have the discretion to determine the timing of such

unilateral redemption. The Bank's implementation of its redemption

policy shall be consistent with the requirement of section 7(j) of the

Act (12 U.S.C. 1427(j)) that the affairs of the Bank shall be

administered fairly and impartially and without discrimination in favor

of or against any member borrower.

(2) A Bank may not impose on or accept from a member a fee in lieu

of redeeming the member's excess Bank capital stock.

Dated: March 19, 1999.

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

Bruce A. Morrison,

Chairman.

[FR Doc. 99-8357 Filed 4-5-99; 8:45 am]

BILLING CODE 6725-01-P