Public Funds Investment Institute

Federal Home Loan Banks Under Review

September 5, 2023

A Federal review could lead to significant changes in this major issuer of high-quality investment securities held by public funds investors.

The short story. Bonds and notes issued by the Federal Home Loan Banks (FHLB) are a foundation investment for many public funds investors because they are considered nearly risk-free, are liquid and in plentiful supply.  Later this month the Banks’ regulator, the Federal Housing Finance Agency (FHFA), will complete a review of the FHLB begun last year that could recommend changes in the mission and operations, perhaps affecting the supply and creditworthiness of future issuances of FHLB bonds.

There are potentially two paths:

  • The FHFA could recommend focusing the FHLB on their original mission, which was to support mortgage origination and affordable housing in local communities (a “rein in” recommendation?); or
  • The Agency could recognize the more expansive current role of the FHLB to provide financing and liquidity to the banking and insurance industry and could even broaden this to include non-bank financial institutions that have a hand in the mortgage markets (a “go bigger” recommendation?).

One would likely constrain the size and scope of the FHL Banks; the other would support continued expansion.

Deeper dive.  The Federal Home Loan Bank system has evolved over its 90 year history from a small government sponsored enterprise that initially supported the then-novel idea of 30 year fixed rate mortgages originated by thrift institutions (who remembers these small community-based savings and loan associations?) into today’s financial behemoth that played a significant role in helping the banking system to avoid disaster in the aftermath of the Silicon Valley Bank failure this spring.

Along the way the FHLB grew, particularly in the last 15 years, to the point where it had $1.164 trillion of discount notes and bonds outstanding at the end of 2022.  This dwarfs issuance of Fannie Mae and Freddie Mac, which are perhaps better known (notorious?), whose combined debt totaled about $320 billion.  These agencies were forced to shrink by nearly 80% following their near collapse in 2008.

Today the FHLB is a major source of liquidity for banks and insurance companies of all sizes.  Some would say that it’s not a matter of mission creep but a matter of a changed mission. 

The below chart of the growth of FHLB advances (loans) provides a good picture of the evolution.  

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The chart illustrates not just the growth of FHLB but the fact that in times of financial stress (2008, 2020) banks have turned to the FHL Banks for liquidity to buffer market uncertainty. To put numbers to this: the FHLB had $819 billion of advances (loans to member banks and insurance companies) outstanding as of December 31, 2022. When the Silicon Valley Bank crisis roiled the financial system in March, Bloomberg reported that advances rose by $304 billion in a single week! As of March 31, advances outstanding totaled $1.044 trillion.  It is clear that, along with the Federal Reserve,  the FHLBs are a key source of market-sustaining liquidity for banks when other avenues dry up.

The bottom line for public funds investors. Notes and bonds of the FHLB are held in many public funds portfolios because they offer a small, but meaningful income advantage over Treasuries.  Moreover, FHLB discount notes with maturities of under 60 days are counted within the SEC’s definition of weekly liquid assets; this provides added value for local government investment pools that follow the SEC’s minimum liquidity rule.

Letters of credit issued by the FHL Banks are another important element in public sector investment schemes. As of December 31, 2022, they totaled $169 billion.  While the beneficiaries include entities other than state and local governments, a main use is to collateralize public funds deposits.

One line of criticism that was leveled during the FHFA review is that the FHL Banks have strayed far from their original mission, and they should be pulled back to focus narrowly on mortgage origination, affordable housing, and community development financing.  This would no doubt lead to a reduced financial market presence and reduced issuance of notes and bonds.

More recently a second path forward has been promoted by some advisors close to the Biden administration. Bloomberg notes that this would expand access to the FHLB lending facilities to include non-banks (mortgage lenders like Rocket Mortgage, perhaps real estate investment trusts and private credit lenders).  With access would come regulation, however.   And changes of this nature will require Congress to act. 

As to timing. . . If the timeline for reforming Fannie Mae and Freddie Mac after their bailouts in 2008 is any measure, it could be a while until change comes about. The Fannie Mae/Freddie Mac reforms have been under consideration for 15 years and counting.

Comments Anyone?  The Next Act on the Bank Regulatory Front

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Last week the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Comptroller of the Currency approved a notice of proposed rulemaking that would apply new capital standards to large banks. 

The rules, if approved after comments, would apply to banks with assets of $100-$250 billion.  There are about 15 banks in this tier and the group included the three banks that failed this spring.

There is a Federal Reserve staff memo that summarizes the proposal and its impact.  You can read it here.  In broad terms, the proposal would require these large banks to establish and maintain capital buffers to facilitate resolution in the event of failure, while limiting exposure of the Federal Deposit Insurance Fund.  (The largest banks are already subject to enhanced capital and liquidity rules.)

The affected banks are likely to tap the public markets to raise the added debt capital—estimated at about $70 billion—not a huge amount given the overall size of the corporate bond market.  Since they would be competing with the largest banks for capital the affected banks are likely to improve their balance sheets and credit (including credit ratings) to gain this access. The cost of complying could encourage consolidation of banks with assets above the $100 billion threshold and discourage growth of mid-sized banks that might push them into this tier.

All of this would be phased in over three years.  So the effects are likely to be gradual.

Look for the new regulations to lead to some consolidation of banks and some additional supply of investment grade  bank debt obligations  which could be purchased by public funds investors.


Talk of a Federal government shutdown has escalated

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With Congress back in session this week there will be about three weeks for agreement on spending for the Federal fiscal year that begins on October 1, or for a short-term fix to keep the government in business.  Will this happen?  Never say never but at this point it seems prudent for state and local authorities to begin preparations for an interruption in the flow of “non-essential” Federal funds that a shutdown would bring.  What’s considered non-essential is not entirely clear but state and local cash flows could be severely impacted by a shutdown and this might require that investment balances be drawn down. A shutdown could well unsettle the financial markets, but not nearly to the degree of a debt ceiling crisis. Stay tuned.

Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

Best regards,
Marty Margolis

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