The Federal Housing Finance Board's approval of a proposal last week to phase out the arbitrage investments of the Federal Home Loan Bank (FHLB) system and divest the banks of their mortgage-backed securities assets over a five-year period turned many heads in the MBS community.

Though the decision, which will have a 90-day public comment period, was not completely unexpected, market players generally viewed it as a significant event, possibly impacting both spread product and buyside activity down the road due to the FHLB's status as one of the largest buyers of MBS, sources say.

"This has already had an impact," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "This type of liquidation is definitely a concern. The FHLB is one of the major forces in pushing spreads tighter, and now, one of the largest buyers will no longer be a buyer at all.

"[This decision] hurts spread product, making it more difficult, at these levels, to recover. This definitely puts a little bit of a wet blanket on the market."

"This will cut off buying right away," added Art Frank, director of mortgage research at Nomura Securities. "Though I wouldn't jump to conclusions that there will be a wholesale liquidation, the Federal Home Loan Banks were significant short-term CMO buyers."

The FHLB system, which held $59.7 billion in MBS as of March 31 - a rather large chunk of the approximately $2 trillion MBS market - had come under fire in the past several years for its investment tactics.

The banks used the proceeds of their security sales - and their special status as government-sponsored enterprises - to arbitrage investments in MBS and other high-yielding instruments that were completely unrelated and inconsistent with its core mission of promoting housing and community development.

According to the proposal from the Finance Board, which regulates the FHLB, the five-year phase-out of MBS purchases will begin on Jan. 1, 2000, when 80% of the money the banks raise will have to go to mission-related activities only; the year after that, 85% must be mission-consistent, increasing by 5% each year until Jan. 1, 2005, when 100% of what the system borrows must be compliant with mission-related guidelines.

The gradual, incremental transition will also require the banks to "roll off" their current MBS holdings, but the drawn-out nature of the change will not shock the market right away, sources say.

"The banks still could invest in MBS, but the money couldn't come from capital that they raised on Wall Street," said Bill Glavin, spokesman for the Finance Board. "They will only be able to invest in mortgages of their member institutions, or even pools of mortgages of their member institutions, so that is an alternative.

"But effectively, the banks won't have much incentive to invest in MBS anymore, since MBS will not be considered a permissible investment," he said.

Additionally, Glavin said that there will even be a "safe harbor" for the banks in 2005 if they still have MBS on their balance sheets.

"If they have a very good reason at that time for having MBS, we will make an exception," Glavin said.

New Territory for the FHLBs?

According to sources in the banking community, the new proposal was a culmination of many years on the part of the Finance Board of trying to point the FHLBs in a different direction in terms of the types of assets they purchased.

It was also an attempt to change the capital structure of the FHLB system from an asset-based structure to a risk-based one.

"Right now, the FHLBs are way overcapitalized," Glavin said. "If this new capital structure is in place, they won't be overcapitalized and they won't need to engage in arbitrage anymore."

The proposed regulation would create a risk-based capital requirement for the banks, based on credit risk, market risk and operations risk, similar to the structure of Fannie Mae and Freddie Mac.

According to Glavin, another piece of legislation currently going through Congress is also seeking to switch the FHLBs to a risk-based structure.

"The FHLBs are being asked to go into a new territory, and along with that, their boards and senior management are given more leeway to control what types of investments they make," Glavin added. "In fact, they will have more of an array of investments than they've had in the past in the past, if they choose to deal with their member institutions."

It is the Finance Board's view that the competitive spreads which the FHLBs garnered from MBS transactions and the loss of income suffered because of the new proposal can be made up by making other types of asset and loan purchases from individual FHLB members.

However, many market sources believe that the proposal will actually cut back, not increase, the banks' broad spectrum of investment opportunity.

"Management is going to have to be more creative now as far as coming up with some asset types," said Ann Gochala, director of bank operations for the Independent Community Bankers' Association, an advocate for some 5,400 community banks across the country. "Our member banks are very much in need of the FHLB as a funding source, and I actually think that the system is much more healthy and growing in the last few years."

According to Gochala, the impact of the proposal will largely depend upon how successful the individual Federal Home Loan Banks are with different asset types.

"Either way, this is certainly not the death knell for the FHLB system - in fact they have been doing well and advances and income have been increasing over time as they address their funding needs," she said.

Still, the proposal will deal a forceful blow to the banks' investment earnings, a large portion of which are already siphoned off on a yearly basis due to the continuing clean-up of the thrift/savings and loan debacle of the late 1980s.

The FHLBs differ from Fannie Mae and Freddie Mac in that the FHLBs are under the direct control of the federal government, while the GSEs retain only unofficial ties to Washington. Thus, as one source put it, the FHLBs had much less room to maneuver in terms of broadening their investments and were an easy target for a government crackdown.

Oddly enough, it was as a favor to the government that the FHLBs first wound up in the MBS market. In the late 1980s, as part of the thrift bailout undertaken by the federal government, the FHLBs took over payments of "FICO bonds," long-term debt obligations assessed on the thrifts. In order to maintain bond payments and keep up their own operations, the FHLBs began looking to improve their investment returns.

In order to help pay off the savings-and-loan bailout, the FHLB pays a yearly obligation of $300 million for Refcorp bonds, as well as another $100 million to fund affordable housing programs.

"For many years the banks had to turn to investments such as MBS for earnings," said one MBS veteran. "Now, there are a fair amount of demands put on them, and this impacts their ability to add better spread product to their portfolio."

Further, the FHLBs have become an important investor in mortgage securities, said Michael Youngblood, managing director of real estate capital markets for Banc of America Securities. "And we think that their elimination as an investor group is clearly a long-term negative for our market."

Some FHLB Branches Already Prepared

However, some branches such as the Chicago FHLB have been preparing for the eventuality of such a proposal for several years, creating alternative secondary market options that are 100% related to housing development.

"Each of the 12 home loan banks have a different view on the merits of the proposal, but it really has not been a problem for us to comply with," said David Feldhaus, a spokesman for the Chicago FHLB.

According to Feldhaus, in June 1997 the Chicago branch launched its Mortgage Partnership Finance (MPF) program, a new way of funding home loans that is perfectly mission-consistent.

"These are exactly the types of assets the Finance Board is trying to encourage other home loan banks to get into," Feldhaus said. "If anything, this decision [by the board] sort of validated our program. Our bank was moving down this path already and the Board is now simply nudging along the other banks to follow what we are doing."

Traditional FHLB procedure, which consisted of the banks making advances to members , could not guarantee that 100% of the money was directed towards housing finance, Feldhaus said.

The MPF program, on the other hand, assures that every penny - down to the loan that the member institution gives to the consumer - is completely housing- related.

"In fact, this program is mission-consistent in a way that even traditional advances haven't been able to be up to this point," Feldhaus added. "This action by the Board is consistent with our approach of moving down this path and restructuring our balance sheet in a favorable way."

The Chicago FHLB currently has $1.4 billion of loans outstanding in its MPF program with a total master commitment of close to $4 billion, Feldhaus said.

Additionally, a favorable ruling from the four federal banking agencies last week on the capital treatment of the loans involved in the program is expected to spur growth in the program, especially among community banks and savings banks.

"By the end of the year, five FHLBs will offer this program, and several more in the near future, in order to create assets in a partnership with our member banks and thrifts and jointly achieve our mission," Feldhaus added.

A spokesman from the New York FHLB would not comment on the Finance Board's proposal late last week.

"Our own members have been closely looking at the MPF programs for a long time as an alternative, and I expect, with the Finance Board's decision, that these programs will become even more popular going forward," said the ICBA's Gochala.

- AT/Christopher O'Leary

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