The Federal Housing Finance Board, which regulates the Federal Home Loan banks, has proposed a regulation that would mandate increasing retained earnings by cutting dividends to member banks, even though the FHLBs have plenty of capital.

Resident Fellow Alex J. Pollock

FHLB members are not pleased, and rightly so, because the Finance Board's position is misguided and conceptually confused.

Interestingly, this same confusion was evidenced more than a decade ago by the Finance Board staff, a few years after the agency emerged from the demise of the old Federal Home Loan Bank Board. Since in the interim there were FHLB capital reforms in the Gramm-Leach-Bliley Act, the position is more off the mark now than it was then.

The role of equity capital, in the FHLBs as elsewhere, is to protect bondholders, depositors, and other creditors. It is not to protect the equity, as in the Finance Board's proposed regulation, where retained earnings are thought to protect paid-in capital. In other words, the Finance Board's idea is to punish the equity investors in order to protect them against themselves.

What apparently has the Finance Board confused is the "par value" notion of FHLB stock. In normal times, members can withdraw their stock at the par value of $100 a share. You might imagine a regulator worrying that if things don't go well, members will withdraw capital.

However, since Gramm-Leach-Bliley was enacted in 1999, the withdrawal right is completely trumped by the statutory prohibition of any withdrawal if the required capital ratio would be breached. Under GLB, there can then be no withdrawals whatsoever. Hence, capital equal to 4% of assets cannot be withdrawn--and 4% is a very conservative capital ratio, given the low risk of FHLBs.

So fear of capital withdrawal is six years out of date.

But the Finance Board's confusion runs to a deeper level.

They are worried that the par value for members might not be protected. Suppose an FHLB lost money (this has happened, though very infrequently), and the value of its shares dropped below par. Wouldn't it be terrible if the value of the members' stock was $99, instead of $100? Maybe the accountants would make them write down the carrying value by $1.

Two observations:

• No, it wouldn't be so terrible--the economic effect on members is exactly the same as cutting dividends by $1.
  
  
• The Finance Board seems to think FHLB stock is a money market fund.

Note that this issue is not about the safety and soundness of the FHLBs or about protecting bondholders and depositors. It is all an issue inside the equity account.

In its proposal to force the FHLBs to cut dividends and increase retained earnings as a buffer for the par value, the Finance Board is telling the member shareholders: "Here's how we will protect you from yourselves. We will take away a dollar from you today. You can never have this dollar back. In exchange, you will be protected from the minor chance that you might lose a dollar someday in the future."

This is roughly equivalent to offering to buy a dollar from you for a nickel. No one would find such a deal sensible, and naturally, the FHLB members don't. Of course, the idea is not to offer it as a deal, but to impose it as a regulatory mandate.

The situation is made even worse by another part of the Finance Board's proposal, which would force increased taxes on the FHLB members. It would do this by mandating that all dividends be paid in cash, which subjects the members to corporate income taxes. FHLBs have always had the option of paying stock dividends, which result in deferred income taxes for the members.

Because of this effect, the Finance Board proposal is even more expensive for the members.
It is possible that a good many of them are wishing the GSE reform bills pending in Congress, which would create a new regulatory structure, would get moving.

Alex J. Pollock is a resident fellow at AEI.