Shocking Revelation: America’s Bizarre Penultimate Lenders Pose a Grave Threat!

Stephen Cecchetti is a professor of international finance at the Brandeis International Business School. Kim Schoenholtz is a clinical professor emeritus at NYU’s Stern School of Business. Lawrence White is a professor of economics at NYU’s Stern School of Business and was regulator of the FHLB system in 1986-89.

Some government financial institutions enforce the system; others not. Nowhere is that clearer than with the tangled mess of the Federal Bank for Real Estate Loans system.

In the United States, the Federal Reserve plays a vital role in financial stabilization as a lender of last resort. In contrast, the FHLB system – government-sponsored enterprises which currently in practice act as lenders of last resort – plays a role destabilizing role, artificially keeping dying institutions alive and raising the ultimate costs of their failures.

But first, a quick introduction to this extraordinarily strange aspect of the US financial system. Please stay with us, as their discreet but important role is often underestimated.

In the FHL Biverse

The federal regional home loan banks are part of the Federal Home Loan Bank system, a government-sponsored enterprise, that predates better-known cousins ​​such as Fannie Mae and Freddie Mac. Created by federal law in 1932, the FHLB system is was designed to provide wholesale loans to support residential mortgage financing.

Here is a map of today’s 11 FHLB districts:

At its founding, eligible members of the scheme were savings and loan (S&L) institutions and life insurance companies (which, in the 1930s, originated a significant portion of all residential mortgages). The limited nature of the membership meant that FHLB loans were very likely to be used for residential mortgage financing.

Legislation expanded both eligible membership and mission in the 1980s and 1990s: Commercial banks, credit unions, and non-custodian community development financial institutions (CDFIs) could also become members and tap into the FHLBs for financing.

Large bank members are required to allocate at least 10 percent of their assets to residential mortgage financing; insurance companies and CDFIs are required to allocate at least 5 per cent of their assets to residential mortgage financing; and small depositors must be involved in community lending (including residential mortgage financing).

Super-lien me

In theory, their loans are very safe. FHLB advances to members are always over-collateralised. It is the responsibility of each FHLB to establish a credit limit for each borrower, with limits typically ranging from 20 to 60 percent of the borrower’s assets, although it is possible to exceed the limit with management or board approval.

In the event that the borrowing member defaults and goes into receivership, the lender FHLB has super lien (legal) over the borrower’s assets – and thus subordinates all other claimants, including the Federal Reserve and the FDIC.

Today, the FHLBs are basically large, interconnected wholesale banks that lend to their members – about 6,000 banks and about 500 insurance companies – and their importance has increased substantially since the 1990s. Together, they now hold about $1.5 trillion in total assets, over $1 trillion of which is loans to their members.

FHLBs raise their funds in debt markets through their municipality Finance office. They are jointly responsible for their release. Because they are GSE, investors assume that FHLB debt has an implied federal guarantee, even as the system itself emphasizes that That:

Federal Home Loan Bank consolidated obligations are not obligations of the United States and are not guaranteed by the United States. No person other than the federal home loan banks will have any obligation or liability under the consolidated obligations.

However, a sign of their special status is that only the federal government’s money market funds are allowed to hold FHLB debt. Another indication is that FHLB debt counts as a high-quality liquid asset to meet banks’ liquidity requirements.

Reflecting these legislative and regulatory advantages, FHLBs can borrow at prime rates that are only modestly higher than the rates paid on US Treasury bills. The FHLBs are expected to pass these favorable loan rates on to their members in the form of lower interest rates on the loans they use.

The role of FHLBs as penultimate lenders it first came into prominence during the 2007-2009 financial crisis. In that time, FHLB’s advances increased by nearly two-thirds by lending to large, lightly capitalized banks — some of which, like Washington Mutual, Countrywide and Wachovia — eventually failed.

Because these terms are systematically risky

We have seen this dangerous pattern again over the last year when loans from FHLBs tripled to a record over $1 trillionhelping to postpone the inevitable showdown for Silicon Valley Bank (SVB), Signature Bank and First Republic Bank.

While their mission is to promote residential mortgage financing and community development, the FHLBs routinely include wholesale loans to banks that are highly vulnerable to runs. These loans have different extremely undesirable properties.

1. They come with a “super privilege”: if borrowers go bust, the FHLBs get paid first, first of all, including the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC).

2. There is little timely disclosure about who borrows or the amounts they borrow.

3. Reflecting super-privilege, the excessive collateralization of their loans, and the implicit federal guarantee of their liabilities (GSE), the FHLBs appear utterly indifferent to the profitability of their borrowers.

This is why the FHLBs have been lending large sums to troubled banks. In their narrow and distorted view, the combination of overcollateralisation and super-lien made these loans extremely safe, even as the loans increased the risk that borrowers would default.

If SVB, Firma and Prima Repubblica had instead been forced to face market discipline during the 2022their financial burdens would have been much higher. These expenses probably would have motivated the banks to face their losses at an earlier stage, so that the banks could have survived (or at least could have been absorbed by other banks at a lower public cost than actually occurred).

But it’s easy to see why the SVB, Signature Bank and First Republic then turned to the FHLB to stay afloat when large unrealized losses eroded (or even wiped out) their capital.

In addition to avoiding greater market scrutiny — or the regulatory scrutiny that would have accompanied the Fed’s lending of last resort — the FHLB loans allowed these banks to delay asset sales that would have forced loss recognition and forced to raise equity first or to shrink. Instead, the banks gambled on the FHLB’s mispriced government-sponsored funding-backed resurrection.

It was a failed gamble.

Here’s how we can fix things (at least a little)

To improve the resilience of the US financial system, policymakers should eliminate the unofficial and destabilizing role of the FHLB system as a lender of penultimate resort:

1. Remove the super privilege.

2. Require that banking regulators, including the Federal Reserve and the Comptroller of the Currency, approve loans (advances) from their FHLB-controlled banks beyond a normal level.

3. Require full and immediate public disclosure by FHLBs of their loans (or, at least, advances over a certain amount threshold), including loan terms, collateral and borrowers.

Eliminating super-lien would encourage FHLBs to actually consider the viability of their borrowers, helping reduce lending to zombie banks. Giving the regulators of vulnerable banks a say in limiting their access to cheap government-subsidized debt would strengthen the discipline that the Fed – as the official lender of last resort – should impose on weak and failing banks. The same goes for greater transparency: better disclosure would focus the attention of the counterparty and the regulator to which it belongs, on the weaker banks.

Yes, some of these proposals require legislative action. But the FHLB overseer (the Federal Housing Financing Agency) and bank regulators should act quickly to implement what is feasible even without legislation.

There are also other reform possibilities, such as limiting the size of the FHLB loan, but these three changes would greatly limit the role of FHLBs as sources of liquidity to banks in difficulty without affecting their legislative purpose: to support residential mortgages and community finance.

Arguments that hacking into the FHLB system would be like “removal of a storm barrier that successfully protected a fragile coastline for 90 yearsare, well, a pretty weak sauce.

As it stands, FHLBs are a clearly destabilizing force in the US financial system, providing unsubsidized lending during times of stress and undermining the current lender of last resort, the Federal Reserve. Fixing this problem would improve financial resilience by creating greater incentives for banks to manage their risks.