It is not by accident that the Federal Home Loan Bank System continues to work after more than 80 years. It is by design. When Congress created the Federal Home Loan Bank System in 1932, it produced a national network of regional cooperatives tasked with the mission to provide reliable liquidity to community-based member institutions to support housing finance and community investment through collateralized wholesale loans. And for the past eight decades, the 11 Federal Home Loan banks have operated within the parameters set by Congress and overseen by a series of federal regulators as the system evolved. On Jan. 12, the Federal Housing Finance Agency — the system’s regulator — finalized its FHLB membership rule, ensuring that the Home Loan banks will continue to operate as Congress intended, and that our nation’s local lenders will continue to have access to a reliable, cost-effective source of funding.
As the former top prudential regulator of the Federal Home Loan Bank System, I am familiar with the full scope of its stakeholders: its membership of more than 7,200 brick-and-mortar financial institutions; housing organizations; policymakers; and elected officials at the federal, state and local levels. This broad spectrum was well-represented in the critical response the FHFA received on its proposal for the membership rule.
The agency received an unprecedented 1,300 comment letters. Nearly all of them called for the elimination of a proposed annual mortgage test to remain in the system. If adopted, this test would have required that members maintain ongoing minimum levels of investment in specified residential mortgage assets as a condition for eligibility. The FHFA listened to the industry concerns and removed the asset test in the final regulation, thereby reaffirming that each member maintains uninterrupted access to the funding the Home Loan banks provide. In its final regulation, the FHFA also clarified the rules pertaining to a member’s principal place of business, maintaining the regional framework of the system — the original structure Congress designed 80 years ago and still one of the system’s greatest strengths today.
Both of these actions have been widely accepted by the system’s stakeholders. It is the third major element of the rule — the removal of captive insurance company members from the system — that has still generated controversy. But the FHFA got this aspect of the rule right too. Criticism of the captive insurance provision was not brought by longstanding stakeholders in the system.
In December 2005, I was designated chairman of the Federal Housing Finance Board, which back then regulated the FHLB system before the creation of the FHFA. At the time, the system had two captive insurance company members, the first of which joined in 2000. By the time my service ended three years later, the system had five captive members. But in recent years, the number of captives in the system has skyrocketed, driven by consultants encouraging real estate investment trusts to form captive subsidiaries to access the Federal Home Loan Bank System.
In fact, in early 2014, one such consulting firm stated in its quarterly newsletter that it was working with REIT clients "to create captives for the purpose of accessing funding with the Federal Home Loan Bank System." In 2014 and 2015 alone, at least 25 captives joined various Home Loan Banks, and at the end of the third quarter of 2015, there were 40 captive members in the system with more than $30 billion in borrowings. This sudden inflow caused considerable concern at the FHFA.
In the final rule, the agency said it had grown worried "about the ability of entities ineligible for Bank membership (including mortgage REITs and other entities) to circumvent the Bank Act and obtain de facto Bank membership through captive subsidiaries that become members and then act as conduits to low-cost Bank funding for the ineligible entity."
The FHFA went on to express "well-founded concerns" that captive subsidiaries could grant system access to hedge funds, investment banks and others, circumventing membership requirements laid out in the Federal Home Loan Bank Act and introducing risks to the system that Congress never intended. Indeed, the Home Loan banks were established to provide liquidity to tightly regulated community lenders, and to traditional life and property and casualty insurance companies, not to riskier, unregulated shadow lenders draped in the artificial mantle of insurance company membership. In fact, in its report on the final rule, Moody’s stated that the regulation is "credit positive for the FHLBank System because it eliminates the elevated risks of lending to captive insurance companies versus lending to bank and traditional insurance company members."
Simply put, the FHFA got it right with this regulation. The membership rule ensures that the system remains a reliable source of liquidity for its members; continues to operate in a regional, localized manner; and does not take on any unnecessary risk. This is how Congress designed the system to work more than 80 years ago and how it has worked ever since.