The FHLBank System Was Established to Facilitate Housing Finance and Has Undergone Significant Changes in Recent Decades

Congress passed the Federal Home Loan Bank Act (FHLBank Act) in 1932  and established the FHLBank System to facilitate the extension of  mortgage credit and the housing finance market, which had been severely  affected by the Great Depression. The business of the FHLBank System and its members essentially  remained unchanged from the 1930s until the 1980s. However, due to regional downturns, sharply rising  interest rates, and poor management, hundreds of FHLBank member  thrifts failed during the 1980s, causing a contraction in FHLBank System  business. Although FIRREA is credited with helping to restore the financial  condition and supervision of the thrift industry during the 1990s, the  capital structure of the FHLBank System and the financial obligations that  the act imposed on the System and its members subsequently raised  concerns. This change minimized  the financial obligation on the System during periods of relatively low  profitability but increased the total payment when profits increased; and   Expanded the amounts and types of collateral that FHLBanks could  accept for advances from small members known as community financial  institutions (CFI). In addition to providing advances to its members, the FHLBank System  provides member institutions other benefits and services. For example,  FHLBanks generally pay dividends to their member financial institutions. The FHLBanks hold  the mortgages on their books and bear the interest-rate risks associated  with them. FHFB Regulates FHLBank System Safety and Soundness and Mission Achievement

FHFB is responsible for regulating the FHLBank System’s safety and  soundness as well as its mission achievement. Although FHFB does not  have PCA authority, FHFB officials believe they have all the necessary  authorities to carry out their responsibilities; and   FHFB has the statutory authority to liquidate or reorganize a critically  undercapitalized FHLBank “whenever  finds that the efficient and  economical accomplishment of the purposes of the  will be  aided by such action.”

	FHLBank System Membership, Asset Composition, and Capital Structure Have Undergone Significant Changes in the Past 15 Years

Until 1989, the FHLBank System consisted of the 12 FHLBanks, OF, and  thrifts, which were required to join. As shown in figure 3, commercial banks now account for  almost half of the System’s capital and advances. In 1990, advances represented about 70 percent of all the System’s assets,  but declined to about 50 percent between 1991 and 1996. By 2003, such mortgage assets grew to almost 14 percent of all the  System’s assets (about $113 billion in total System mortgage assets at year- end 2003). FHLBank System Has Implemented a New Capital Structure

As I discussed earlier, prior to 1999 voluntary FHLBank members, such as  commercial banks, could withdraw their capital on 6-months notice, which  raised questions about the stability of the FHLBanks’ capital structure. FHLBank System Faces Important Challenges and Questions

Finally, I would like to discuss some important challenges and questions  affecting the FHLBank System. They include risk-management practices,  the securitization of mortgage assets, the extent to which the FHLBank  System is meeting its mission requirements, and the alleged impacts that  large financial institutions are having on the System’s traditional  cooperative structure and AHP program. FHFB Has Questioned FHLBanks’ Risk- Management Practices

Over the past year, FHFB identified risk-management deficiencies at two  FHLBanks—Chicago and Seattle—primarily related to their management  of the interest-rate risks associated with mortgage purchases. Proposals to Use Securitization to Expand FHLBanks’ Mortgage Purchase Programs Are Controversial

In recent years, proposals have been made to permit the FHLBanks to  securitize mortgage assets to provide for the continued growth of the  mortgage purchase programs.
Why GAO Did This Study

The FHLBank System (FHLBank System or System) is a government-sponsored enterprise (GSE) that consists of 12 Federal Home Loan Banks (FHLBanks) and is cooperatively owned by member financial institutions, typically commercial banks and thrifts. The primary mission of the FHLBank System is to promote housing and community development generally by making loans, also known as advances, to member financial institutions. To minimize the potential for significant financial problems, the Federal Housing Finance Board (FHFB) regulates the FHLBank System's safety and soundness. Over time, a number of developments have affected the System's safety and soundness and have created pressures on its traditional cooperative structure. To assist the committee in understanding the important issues surrounding the FHLBank System and its regulation, this testimony provides information on the development of the System; two legislative changes and FHFB rulemaking that led to changes in membership, asset composition, and capital structure; and important challenges and questions the FHLBank System currently faces.

What GAO Found

Established in 1932 to facilitate the extension of mortgage credit, the FHLBank System has undergone significant statutory changes in the last 15 years. Between the 1930s and the 1980s, the System consisted primarily of thrift members that accepted advances from the FHLBanks. However, during the 1980s, hundreds of FHLBank member thrifts failed forcing Congress to fundamentally reform the System through the Financial Institutions Recovery, Reform, and Enforcement Act of 1989 (FIRREA). For example, FIRREA permitted commercial banks to join the System. Although FIRREA is credited with strengthening the thrift industry and the System, concerns were raised during the 1990s about the System's capital structure. In particular, commercial bank members could remove stock from their FHLBank on 6-months notice, which raised concerns about the System's financial stability. Among other provisions, the Gramm-Leach-Bilely Act (GLBA) of 1999 created a more permanent and risk-based capital structure for the System. Due to these statutes and FHFB rulemaking, the FHLBank System has evolved substantially since 1990. For example, commercial banks now account for more than 70 percent of all System members. The composition of FHLBank System assets has also fluctuated considerably over the years. For example, FHFB authorized the FHLBanks to purchase mortgages directly from their members in the 1990s. The System's mortgage assets grew to about $113 billion at yearend 2003 representing about 14 percent of total assets. However, the rapid growth in System mortgage assets leveled off in 2004 as two FHLBanks experienced problems managing the interest-rate risks associated with holding mortgages on their books. As provided by GLBA, System capital is now more permanent as members generally must invest capital for a period of 5 years and the FHLBanks are subject to new leverage and risk-based capital requirements. The FHLBank System faces important challenges and questions going forward. For example, FHFB has called the FHLBanks' risk-management practices into question, particularly those related to mortgage purchase programs. Further, proposals to permit the FHLBanks to issue mortgage-backed securities (securitization) could help ensure the growth of the mortgage purchase business and improve risk management, however these proposals raise questions regarding the FHLBanks' capacity to manage the related risks. Additionally, there is limited empirical information available regarding the extent to which the System is fulfilling its housing and community mission. Finally, questions have been raised regarding the potential negative affects that large financial institutions may have on the traditional cooperative structure of the FHLBank System and its programs designed to benefit targeted groups.