There’s no room for REITs, captive insurers at Home Loan Banks

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An August rating agency report should be a wake-up call to every shareholder in the eleven Federal Home Loan banks.

While the Standard and Poor’s report is overall positive on the Federal Home Loan Bank System — with an AA+/Stable rating — it highlights a budding danger to the system’s 7,000 members: shadow nonbanks slowly infiltrating this vital source of liquidity for the nation’s local lenders.

Specifically, S&P calls out the “small, but growing, exposure to non-depository financial institutions” as a weakness facing the Home Loan Bank System. These “captive” insurance companies and real estate investment trusts, or REITs — highly levered investment vehicles with very troubling “borrow short, lend long” balance sheets — seek Home Loan bank membership to access low-cost financing for their risky real-estate lending.

These organizations pose a threat to the Federal Home Loan banks because, unlike traditional members, they lack direct, prudential supervision, they are not insured by the Federal Deposit Insurance Corp. and they have no real capital. That means that, if they were to access the system through even just one Federal Home Loan bank and their loans were to turn sour, all 11 banks and their members, which hold FHLB stock, would be the ones that take the hit.

As the former president of the Federal Home Loan Bank of New York, I view this risk as reminiscent of the savings and loan crisis of the 1980s. At that time, savings and loan associations were permitted to use federally-insured deposits to make risky loans — including investing in speculative real estate, fast food franchises and windmills. When these loans blew up, the result was a $132 billion taxpayer funded bailout.

Just as the S&Ls used political muscle and lobbying to expand into risky lending, today the captive insurers and the REITs are working behind closed doors in Washington to rollback safeguards imposed in 2016 by the system’s regulator, the Federal Housing Finance Agency.

Legitimate mortgage companies that want to join a Federal Home Loan bank to fund their business have a tried and proven path to follow: Buy a bank or form one. But captives and REITS don’t want to do that. Why? They don’t want to pay the price for coming out of the shadows. They don’t want to comply with consumer protection regulations, the Community Reinvestment Act, bank secrecy laws, risk-based capital requirements and all the other regulations banks are required to follow. And, of course, these shadow operations don’t want to be the subject of intrusive, but necessary, safety and soundness exams, with their express and independent focus on credit quality and interest-rate risk.

Several years ago, Ronald Rosenfeld, a former top regulator of the Federal Home Loan Bank System, warned in American Banker that “the Home Loan Banks were established to provide liquidity to tightly regulated community lenders, and to traditional life and property casualty insurance companies, not to riskier, unregulated shadow lenders draped in the artificial mantle of insurance company membership.”

Mr. Rosenfeld understood that captive and REIT members could very likely have a negative impact on the value of Home Loan bank stock held by regulated members. Ironically, reckless mortgage lending by captives and REITs could lead to a capital call from the traditional regulated FHLB members.

Members are not the only stakeholders put at risk by shadow nonbanks’ desire for membership. The Federal Home Loan Bank System is one of the largest supporters of affordable housing in the nation, providing hundreds of millions of dollars in housing grants each year.

Last November, 136 nonprofit housing organizations serving communities in more than 20 states sent a letter to the FHFA highlighting the problem when REITs are admitted to membership in an FHLB.

They reported that one REIT was “using relatively cheap funding … to buy non-Qualified Mortgage loans. These loans do not meet federal ability to repay standards and are therefore riskier for the borrowers and the lender,” the group said.

The housing advocates also expressed concern that REITs “have a perverse incentive to engage in poor mortgage servicing of these loans in order to foreclose and add more homes to its REO rental empire.” Such actions would run counter to the system’s housing mission.

In its August 2018 report, S&P stated a strength of the Home Loan Bank system is its “critical public-policy role as one of the primary liquidity providers to U.S. mortgage market participants, especially in times of stress.”

But captive insurers and REITs are creating their own stress points within this critical system.

There may be room for captive insurers and REITS in the shadow banking world, but they have no place in the Federal Home Loan Bank System.

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