April 2007

The Federal Home Loan Banks and State and Local Revenue Bonds

The Federal Home Loan Bank (FHLB) System is a government-sponsored enterprise (GSE) consisting of twelve cooperatively owned institutions that are regulated by the Federal Housing Finance Board. Shares in the individual FHLBs are owned exclusively by banks, savings institutions, credit unions, and insurance companies. Like Fannie Mae and Freddie Mac, FHLB debt is not explicitly guaranteed by the federal government, but FHLBs are able to borrow at better than AAA rates because of their government charters and the market perception that they are performing a government mission and will not be allowed to fail.

In 1998, the Federal Housing Finance Board authorized the FHLBs to enhance the credit of a broader range of state and local revenue bonds by issuing letters of credit in support of these instruments. Although the use of this authorization has been held up by a tax issue, it has also raised the question of competition between the FHLBs and private financial guarantee companies. The FHLBs argue that they will credit-enhance only the bonds of underserved localities, and the interest costs thus saved will enable these localities to build and operate schools, provide long-term care for the elderly, and make other necessary infrastructure improvements. Private financial guarantee companies, however, currently credit-enhance state and local revenue bonds, and argue that there is no need for the FHLBs to enter this market. At an April 11 AEI conference, panelists examined the arguments on both sides of this debate.

Peter J. Wallison
AEI

In 1998, the Federal Housing Finance Board expanded the FHLBs' authority to guarantee the debt securities of state and local governments, thereby enabling them to receive more favorable interest rates on their securities than they would otherwise be able to attain. The Treasury Department questioned this policy, pointing out in a letter that it is not in response to "any demonstrated market failure" and would involve the banks' going beyond their defined housing mission and taking on risks with which they have little experience. The overriding issue in this policy debate is the proper involvement of GSEs in private financial markets. The private financial guarantee industry contends that there is no market failure and that all communities that need and qualify for financing receive it. Supporters of the FHLBs' activity in this area argue that this service helps "underserved" communities. This raises questions about how to determine whether a community really is "underserved" and how to differentiate the underserved communities from every other state and local issuer that would like the banks' support.

Lawrence J. White
New York University

The Federal Home Loan Bank System is a relatively unknown GSE, but with over $1 trillion in assets--more than either Fannie Mae or Freddie Mac--it is a major player in U.S. financial markets. The system is composed of twelve banks each covering a geographic region and cooperatively owned by over 8,000 members (1,245 savings institutions, 5,871 banks, 875 credit unions, and 134 insurance companies). As a GSE, a FHLB has several advantages over normal banks and as a result can borrow at about 40 basis points below what its financial condition would otherwise warrant. Moreover, its government-sponsored status leads most people invested in FHLB debt to believe that the federal government will never let the banks fail. Although the system was created in 1932 with the primary mission of providing funds to local lenders so that they could offer long-term fixed-rate mortgages, a number of changes in the U.S. housing market and banking industry have led the FHLBs to expand into other areas of the financial markets. In 1983, the banks received authority to issue standby letters of credit (SLOCs), a guarantee by a third party that if a borrower fails to meet its loan payments, the SLOC issuer will fulfill the obligation. The borrower pays a fee for this service, but at the same time obtains a lower interest rate, especially if the SLOC issuer has a better debt rating than the borrower. The FHLBs currently have $20 billion in SLOCs outstanding. Currently, however, if a local government receives an FHLB SLOC, the municipal bonds lose their tax-exempt status, and there has been legislation proposed that would enable these bonds to remain tax-free. As Congress considers this specific proposal, it is important to consider the broader issues of whether the FHLBs' ability to issue SLOCs is good policy: whether it is actually responding to a market failure or if it is just an instance of a GSE extending its advantages.

John R. Price
Federal Home Loan Bank of Pittsburgh

The proposed legislation will allow FHLBs to issue SLOCs through their member banks to credit enhance municipal bonds. This is intended to benefit communities that are currently underserved by major financial institutions and bond insurers. These institutions are generally more hesitant to do business with smaller communities because it is not cost-effective for them to underwrite deals of this size. They also fear that doing so will jeopardize their AAA bond rating. If this legislation passes, the SLOCs issued by FHLBs would go primarily toward modest projects such as small economic development projects, local colleges, and health-care facilities. Moreover, the community banks within the FHLB system are best suited for such projects, given their more intimate knowledge of their local markets and the schools, hospitals, and other programs for which municipal bonds are being issued. There would be little overlap between the FHLBs and the major financial institutions and bond insurers, which would still dominate the market for larger transactions. This legislation is not intended to enable FHLBs to divert business from other financial institutions, but rather to help community banks serve the needs of their own communities.

Gary C. Dunton
MBIA Inc.

The private-sector financial guarantee industry has served U.S. financial markets well for the past thirty-six years, insuring bonds and asset-backed securities transparently and efficiently. Through the private system, bond issuers obtain rates that accurately reflect their risk and creditworthiness. If the proposed legislation passes, the FHLBs will have an unfair competitive advantage over private insurers, and several negative consequences will result. Regarding the unfair competitive edge, a SLOC from the FHLB System would not only let municipal bonds retain their tax-exempt status, but they will also be backed by a GSE, which already has significant advantages over private firms. In addition, allowing the GSEs entry into this business could encourage local governments to be less fiscally responsible, displacing the private sector and thereby reducing tax revenues.

Alex J. Pollock
AEI

The arguments we have heard for and against the proposed legislation reflect perspectives from outside and inside the GSE system. From an outside perspective, it is evident that all housing GSEs, including the FHLBs, were created to deal with economic situations which no longer exist. The original FHLB members were primarily small mutual savings and loan associations whose only meaningful assets were home mortgages. FHLB funding was thus structurally confined to mortgages. Now the vast majority of FHLB members are stockholder-owned banking companies, and the majority of FHLB lending goes to large institutions which can use the funds for any corporate purpose. Therefore, most of the benefits of the FHLBs' $950 billion in government-sponsored debt go the shareholders of big banks. For example, $148 billion in loans from the San Francisco FHLB, representing 80 percent of its total loans, go to only five large institutions. It is thus possible to think of the San Francisco FHLB as an efficient way to transfer the value of government sponsorship to the "needy" shareholders of Citibank, Washington Mutual, Wachovia, IndyMac, and Bank of America. This is a good example of how all GSEs morph in time into enterprises never imagined by the politicians who granted their advantages. On the other hand, viewed from inside the GSE system, the executives of the FHLBs--and of all GSEs--have a fiduciary responsibility to their shareholders to extract the maximum value from government support and from the U.S. Treasury's credit in order to profit these shareholders. Thus, FHLB executives must support this proposal for the FHLBs to be able to use their government advantage to guarantee tax-exempt municipal bonds, although municipal finance is far from their corporate experience and competence. Both perspectives show why Congress should never grant perpetual GSE charters and why the GSE life cycle should end with privatization.

AEI research assistant Daniel Geary prepared this summary.