The Federal Home Loan banks (FHLBanks) increasingly turned to offering short-term, unsecured credit to financial institutions exposed to the turmoil in Europe as the 12-member cooperative's own core business dwindled, a government watchdog said Thursday.

The report by the Federal Housing Finance Agency's (FHFA) Office of the Inspector General depicts a startling picture where the banks, facing sluggish demand for advances, extended unsecured credit to domestic and foreign firms that were at times on the brink of failure.

"It appears that in the aftermath of the domestic financial crisis some FHLBanks extended unsecured credit to foreign financial institutions in order to offset declining advance demand,"  the report said, which was undertaken to evaluate FHFA's oversight of the Home Loan banks' risk management practices and how it conducts its oversight.

The level of Home Loan bank advances has plummeted since its height in 2008, when it reached $930 billion, falling to $418 billion as of yearend 2011.

While the OIG concluded that several of the FHFA's initiatives contributed to the Home Loan banks' decision to reduce their exposure to foreign institutions by the end of last year, it said some Home Loan banks put the system at risk by violating regulations that set limits on the amount of unsecured credit.

The report cited several Home Loan banks that extended credit to particular foreign banks even though there had been signs of heightened risk at those institutions.

In one example, four Home Loan banks throughout 2010 extended credit to a European bank that was provided a multibillion dollar government assistance package in 2008, placed on credit watch by 2011 and was later downgraded. Three of the Home Loan banks eventually stopped extending credit due to the heightened risk, but one persisted. OIG did not specify the names of the banks or the financial firms.

"Despite the increased risk involved in extending unsecured credit to the bank in question, one of the four FHLBanks continued to do during much of 2011 — at times lending more than $1 billion," the report said. "Although the FHLBank suspended credit extensions to the European bank while it was subject to the credit watch, it resumed such credit extensions after the bank's credit rating was downgraded."

Several Home Loan banks also were found to have extended unsecured overnight and short-term credit exceeding $2 billion at times during 2011 to a second European bank also facing financial challenges.

"In FHFA-OIG's view, these examples raise questions about FHLBanks' recognition of the totality of the risks associated with extending unsecured credit," the report says. "Despite the various controls that the FHLBanks employed to monitor regulatory compliance and unsecured credit risks, undetected violations and risky practices occurred."

Documents collected from FHFA during this period showed that officials had been concerned "about the growth of such lending; the relatively high exposures as a percentage of regulatory capital; increasing housing mission and image risks; and other risk management issues."

A first quarter 2010 financial analysis of the Home Loan Bank System explicitly stated concerns about exposure to troubled European countries like Spain.

"As of March 31, 2010, notable European exposures included $5.6 billion to … two Spanish banking entities that could experience significant problems if the European debt crisis extends to Spain," the report says.

The Home Loan banks appeared to increase their risk to Europe while the FHFA was distracted by other issues facing the system. FHFA officials agreed that the risks associated with unsecured credit increased significantly in 2011, but said they were more focused on losses incurred by several banks from private-label mortgage-backed securities.

As a result, "extensions of unsecured credit were not viewed as an item of equal or greater risk," the report says.

The OIG also noted that the agency's capacity to assess risks with extensions of unsecured credit may have been lessened because of a lack of examiners.

Like other financial institutions, Home Loan banks are allowed to be active in short-term, unsecured credit markets like commercial paper, banknotes, and federal funds, which typically takes place on an overnight basis or for no longer than a nine-month period. But such activities are not typically considered a core of part of their banks' mission.

Among the 12 Banks, extensions of unsecured credit to foreign institutions accounted for 10.2% of the system's assets and 28.6% of its investment portfolio as of June 2011. Those with the largest exposures included the Home Loan banks in Seattle (20.2%), Topeka (15.5%), and Boston (14.9%).

More specifically, unsecured credit lending rose to $123 billion by early 2011, up from $66 billion at the end of 2008, according to data collected by the OIG.

Lending to foreign financial institutions accounted for the preponderance of the increased exposure. Unsecured credit to those institutions doubled to $101 billion by last April, as compared to lending to domestic institutions, which remained relatively static.

"Unsecured credit to foreign borrowers was the driving force behind the FHLBanks' increased unsecured credit extensions in 2010 and early 2011," the report stated.

Of the $101 billion total to foreign institutions, 70% of the unsecured credit issued by the banks was made to European financial institutions. More than half were to firms in the Eurozone, like Germany and France, while another 25% went to non-Eurozone countries like Sweden. The rest of the exposures were made to firms in Canada and Australia, 22% and 10% respectively.

Other data collected by the OIG demonstrated just how risky these extensions of unsecured credit to European financial institutions were. For example, Home Loan banks extended a total of $6 billion, or 8% of all foreign exposure, to institutions in Spain, whose sovereign debt rating was riskier than that of other European countries. The Home Loan banks have since ended such lending to Spanish firms.

Three Home Loan banks — Seattle, Boston, and Topeka — held the most exposure to foreign borrowers as a percentage of regulatory capital. Topeka held 360%, Seattle held 340%, and Boston held nearly 300%. All those ratios have since dramatically declined.

Credit risk is always the biggest gamble associated with unsecured lending in case a borrower fails or defaults on its obligations. It's also much riskier than cash advances, which are typically secured by eligible collateral such as single-family mortgages or investment grade securities.

While FHFA officials have considered the credit risk of unsecured lending by Home Loan banks as "manageable" given its short-term nature, others warn that the banks don't always price unsecured credit sufficiently to offset any increased risk it might pose. For example, large unsecured credit losses could potentially wipe out a Home Loan bank's retained earnings and end up compromising its ability to meet its housing mission with its members.

To be sure, as the banks grasped the risk associated with such unsecured lines of credit to firms facing potential turmoil, they eventually reduced their exposure to $57 billion by the end of 2011.

"As 2011 progressed, FHLBanks began to appreciate fully the risks associated with such extensions of credit and significantly reduced their exposures," the report says.

The OIG issued two recommendations to the FHFA, which included following up with the Home Loan banks that showed potential evidence of violations of existing regulatory limits and taking supervisory and enforcement actions as needed.

Secondly, the watchdog recommended that the FHFA determine the extent to which inadequate systems and controls may have compromised the Home Loan banks' ability to comply with regulatory limits.

FHFA agreed to comply with both recommendations. In the agency's response, Stephen Cross, deputy director of the FHFA's division of Home Loan bank regulation, said the banks reduced their exposure to Europe further this year as trouble there increased.

"Credit to US branches of foreign counterparties dropped by more than 50% in twelve months through March 31, 2012, totaling less than 6% of FLHBank assets," Cross wrote.

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