The Federal Housing Finance Agency this week released its long-promised review of the FHL Banks which aims to sharpen the focus on supporting housing finance and community development and avoid becoming a lender of last resort for banks and other financial institutions.
Public funds investors have come to rely on FHL Banks bonds and discount notes as an important element of their portfolios, and letters of credit issued by the FHL Banks have become an efficient way for depository institutions to collateralize public funds deposits. As we’ve observed in a previous Beyond the News post changes in the goals, structure and operations of the FHL Banks could alter the security behind FHL debt and the supply (and relative value) of these government-supported obligations.
In sum, the review recommended:
From a high altitude—and without the details that the FHFA and FHL Banks will lay out in future regulatory actions —changes like this are likely to improve the already-solid credit of FHL Banks debt. That would be good news for risk-adverse investors like state and local governments.
Operational changes could impact the use of letters of credit which have become common to secure public funds deposits.
In their current form they are somewhat freely available to deposit-taking institutions that are able to post a variety of collateral. Collateral requirements could be narrowed, which would reduce availability or increase the cost of letters of credit.
Operational changes including consolidation of district banks, the possibility of tying issuance of letters of credit more closely to lending for housing, and the move to coordinate more closely with regulators, could lead to modifications in the volume or terms related to letters of credit. If they become less available, public agencies will have to rely more heavily on collateral or direct credit of financial institution counterparties. In all events the cost to collateralize public funds deposits is reflected in the interest rates that depository institutions offer for public funds deposits.
Future Supply of FHL Debt. The FHL Banks have been the “go to” lender in recent periods of financial stress. The following chart, from the FHL Bank report, documents the spikes in FHL advances responding to the Great Recession and the 2023 market disruptions around the failure of Silicon Valley Bank.
These market stress events led FHL member institutions to borrow large amounts from the FHL Banks to strengthen their balance sheets or offset deposit outflows. The FHL Banks ramped up issuance of bonds and notes to meet the demand. FHL Banks debt outstanding grew by nearly $300 billion in the first quarter of 2023. This ramping up provided skittish investors with an attractive safe harbor at times of market stress.
Public funds portfolios reflect this, as allocations to FHL debt grew. Portfolio managers found that these securities were plentiful, particularly in the one-year-and-under tenor, and they offered a small interest premium over comparable-maturity Treasuries.
It is less likely that these “FHL Banks to the rescue” events will occur in the future, and risk-adverse investors will have to seek other places for funds—likely Treasury Bills which are risk-free and highly liquid, but usually offer a somewhat lower yield than Federal agency debt.
The overall supply of FHL Banks debt may also diminish over time if the FHL Banks focus more closely on supporting the housing sector as advances could be further limited by the volume of a financial institution's housing finance activities. As mortgage lending has shifted to non-bank institutions and banks have sought to diversify their business their balance sheets have changed as well. That might be good for the capital markets but disappointing for public funds investors who have relied on the FHL Banks to provide a nearly risk-free and liquid investment that pays a small premium over Treasury Bills and notes.
New LGIP Ratings
FitchRatings has recently rated two LGIP programs, the Orange County Treasurer’s Pool (rated AAAf for credit quality and S1 for market risk) and the Minnesota Association of Governments Investing for Counties (MAGIC) Term Portfolio (rated AAAf).
The Orange County Treasurer’s Pool is managed by the Orange County Treasurer. Orange County Treasurer Shari Freidenrich noted that that “having 100% of the pooled public funds entrusted to the Treasurer rated at AAAf provides additional independent oversight to the County of Orange, the School and Community College Districts, local cities and districts and taxpayers of the pool’s safety and that it is of the highest credit quality and with low sensitivity to market risk.” The County of Orange also has a Treasury Oversight Committee, which causes an annual compliance audit and other reviews and audits of the County Treasury public funds that are performed by external and internal County auditors adding to the independent oversight of public funds. The pool is comprised primarily of money deposited by local agencies whose participation in the pool is mandatory. Two money market components of the overall pool are rated AAAm by Standard & Poors.
The MAGIC Term Portfolio offers fixed rate investments for terms of 60 days to one year. MAGIC also offers a money market fund portfolio that is rated AAAm by S &P. MAGIC offers these to Minnesota counties.
Cybersecurity Front and Center
The Securities and Exchange Commission’s 2024 Examination Priorities released a couple of weeks ago reminded (if a reminder is needed? ) advisors and funds that information security and operational resiliency will be an exam priority next year. Not that the SEC examines public agencies, but it should be a reminder that cybersecurity should be front and center for investment programs. See the recent Research Note on board and management responsibilities here.