In an era of low interest rates, weak loan demand and unprecedented efforts by the Federal Reserve Board to pump liquidity into the economy, the demand for Federal Home Loan Bank (FHLB) advances has plummeted to a 10-year low, raising questions about the system's future as the government weighs a redesign of the housing finance sector.

Total outstanding advances fell to $402 billion in the third quarter, their lowest point since 1999, and far below their $809 billion total at the end of 2007. At the same time, the number of member banks holding such advances has also cratered, to 4,671, the fewest in more than a decade.

Though advances rise and fall with member demand, the abrupt decline comes at a key time for the Home Loan banks. Advances are the banks' traditional business, and recent efforts to expand into other areas by buying mortgages from member institutions and investing in mortgage-backed securities have caused steep losses at several Home Loan banks.

"The FHLBs have a serious strategic challenge: providing a funding source … for mortgages that aren't being made in portfolio to insured depositories that are shrinking in number," said Karen Shaw Petrou, the managing partner at Federal Financial Analytics.

"To counter this," she said, "the banks tried to augment earnings by turning themselves into investors, holding hundreds of millions each in private-label, mortgage-backed securities to boost profits in a 'mortgage' arena. That, of course, was then. Now, the losses on these untoward investments are exacerbating the banks' strategic problem and giving them — and [the Federal Housing Finance Agency (FHFA)] — lots less time to solve it."

To be sure, the Home Loan banks and their regulator say the decline in advances is just a reaction to the market's needs and that its recent boost during the financial crisis was never expected to be sustained.

"The simple reality is that the extent to which the banks are going to be growing or contracting advances is largely going to be dependent upon the demand of their member institutions," said Stephen Cross, the acting senior deputy director and chief operating officer of the FHFA's division of Federal Home Loan Banks. "Advances fill a gap," he said, "and what has happened is, the gap is smaller because of the relatively weak economy, high levels of deposits and liquidity at the member institutions and relatively weak demand on the part of their customers for loans."

"What we all recognize is, this was a particularly severe cycle and the extent to which advances grew and contracted is virtually unprecedented over time," Cross said.

Still, questions persist about the Home Loan banks' future as the Obama administration crafts a housing reform package. For their part, the banks have argued that they should largely be left alone, contending that their role is the same as it has always been: to provide liquidity to members.

The drop in advances mostly reflects their fulfillment of that role during the financial crisis, when there was a liquidity crunch, they say. Advances peaked at $1 trillion in October 2008 during the crisis and began to decline only after the Fed began to pump money into the market. "During the financial crisis, the banks grew their advances tremendously," said Alfred DelliBovi, the president and CEO of the Federal Home Loan Bank of New York. "That's exactly what the system was created to do — to provide liquidity in times of stress. We did that."

Since then, advances began plummeting, falling to $631 billion by the end of 2009 and below $500 billion this year. DelliBovi said that was to be expected.

"I don't think anybody expected that the level of advances we provided was going to be the new normal," he said. "The beauty of the Home Loan Bank System is that it is able to expand and contract as community lenders need liquidity and don't need it."

But the shrinkage coincided with another challenge: steep losses for some of the banks on investments in mortgage-backed securities.

In a report to Congress this month, the FHFA expressed concern about the credit-related impairment charges on the banks' holdings of private-label MBS, which totaled $900 million in fiscal year 2010. At Sept. 30, the Home Loan banks held private-label MBS equivalent to 4.5% of assets, according to the agency.

To date, shortfalls in principal or interest have occurred in 1% of those private-label MBS, but collectively they have recognized $3.3 billion in credit-related impairments and an additional $10.8 billion in noncredit-related, other-than-temporary impairment on those investments, according to FHFA's report.

"Like other financial institutions or investors that purchased private-label MBS in 2005, 2006, 2007, 2008, any of the Home Loan banks that were buying private-label MBS in those years have a higher likelihood of having recognized losses on those investments," said Cross.

But they have hurt some far worse than others.

Seven banks "have any appreciable exposure to private-label MBS for those years, and these have some degree of other-than-temporary impairment," said Cross. "Seattle was an extreme case, but there are others that have other-than-temporary impairment," including the San Francisco, Pittsburgh, Boston, Atlanta, Indianapolis and Chicago banks.

The losses have sparked worries among investors. A recent report by analyst Brian Harris of Moody's Investors Service said the ratings agency "believes that the primary financial risk to the FHLBank System remains its $42.6 billion private-label, MBS portfolio as of June 30."

As a result, the FHFA has encouraged the banks to refocus their efforts on their advance business. But that is easier said than done. The Seattle bank, in particular, has lost its largest advance client, Washington Mutual Inc., which failed in 2008. It saw its advances fall 38%, to $15.4 billion, in the third quarter and said this was primarily due to repayment of maturing advances, prepayments and significantly lower advance demand from its members.

But the Dallas and San Francisco banks also saw steep advance declines during the third quarter.
Dallas said its business shrank nearly by half, to $27.3 billion, compared with $50 billion a year earlier. It said the reduction in advances was driven largely by declines from the bank's two largest borrowers. During the quarter ended Sept. 30, advances to those two borrowers fell by $13.8 billion.

In the case of San Francisco, its advance business shrank 42%, to $89.3 billion, from $155 billion a year earlier. "The sharp drop in new advance business complicates the system's ability to cover continuing loss," said Petrou.

To be sure, unlike last year, the banks are making money. They earned $732 million in the third quarter, compared with a net loss of $165 million to the same point last year. "The system's health continues to be strong," said DelliBovi. "People have been predicting the death of the Home Loan Bank System forever. But the fact of the matter is … the Home Loan Bank System is a system that keeps credit flowing to every city and town in the country. It's a system that has weathered the storm."

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