Federal Home Loan Banks Standing in for Commercial Paper Buyers

I had wondered why, given the swift and brutal contraction of the commercial paper market in August and September, that there weren’t more apparent signs of distress. Outstandings fell an eyepopping $368 billion.

Commercial paper is short-term borrowings, maximum 270 days, but typically much shorter. If a borrower can’t roll his commercial paper but still needs the dough, he has to either find other sources of funding pronto or sell other assets. And given that the contraction was almost entirely in the asset backed commercial paper market, meaning CP supported by mortgages, car loans, credit card receivables, one would have expected to see a change in borrowing terms in those markets.

Now the mystery has been unraveled. It turns out many mortgage-related ABCP issuers have gone to a lender of last resort, namely the Federal Home Loan Banks, which have extended $163 billion of loans to them. Like Freddie Mac and Fannie Mae, they are considered to be government sponsored enterprises. Even though the Federal Home Loan Banks are technically a cooperative of private banks, the Federal government is sufficiently involved in their oversight (for example, their board is appointed by the President and approved by the Senate) that they are regarded as enjoying government support and fund at favorable rates. Worryingly, and again like Fannie Mae and Freddie Mac, they have had accounting issues, but legislation mandating tougher oversight stalled in the Senate.

So risk has been passed from institutions that could have been permitted to fail (or at least suffer) to one too big too fail. We’ll learn all too soon whether this was a move that we will regret.

From Bloomberg:

Banks shut out of the market for short-term loans are finding salvation in a government lending program set up to revive housing during the Great Depression.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is “taking a lot of risks through the Federal Home Loan Banks that are unnecessary,” according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

The home loan banks, known as FHLBs, are increasing risks to taxpayers by assuming the role as a lender of last resort, said Wallison. That’s the job of the Federal Reserve, he said.

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said.

U.S. lawmakers need to ensure “the institutions don’t blow up in the taxpayer’s face,” Representative Christopher Shays of Connecticut, a Republican on the House Financial Services Committee that is responsible for oversight of the system, said in an interview.

The FHLBs are cooperatives created by President Herbert Hoover in 1932 to spur mortgage lending. The system’s 8,100 owners and customers range from New York-based Citigroup Inc., the largest U.S. bank, to the single-branch Custer Federal Savings & Loan in Broken Bow, Nebraska. Their government ties support top AAA ratings from Standard & Poor’s and Moody’s Investors Service.

They borrow in the bond market and lend the money to their members. Federal Home Loan Bank obligations, when combined with the $1.5 trillion debt and $4.7 trillion in bond guarantees of Washington-based Fannie Mae and Freddie Mac in McLean, Virginia, are 46 percent more than the $5.04 trillion of Treasury debt held by the public.

Lenders turned to the FHLB as two main sources of funding, short-term IOUs backed by mortgages and mortgage-bond sales, began to dry up in August. That’s when losses on securities tied to subprime home loans began to spread throughout the credit markets and investors retreated to the relative safety of Treasuries and their equivalents.

Asset-backed commercial paper outstanding fell 25 percent to $883.7 billion as of last week from $1.18 trillion on Aug. 8, data compiled by the Fed show.

Sales of mortgage bonds, excluding those issued by Fannie Mae and Freddie Mac have tumbled by 66 percent to a monthly average of $39 billion from $115 billion in 2006, according to Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

The home loan banks “were the only game in town for a lot of borrowers,” said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are “like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it’s the only timepiece you have.”

In July, lenders could raise funds by issuing one-month asset-backed commercial paper that yielded 1.8 basis points less on average than the one-month London interbank offered rate. A basis point is 0.01 percentage point.

In September, the asset-backed commercial paper, when it was available, cost as much as 51 basis points more than Libor. At the same time, the Federal Home Loan Bank of New York offered one-month funds at an average of 48 basis points below Libor, making their loans more attractive.

The FHLB’s outstanding discount notes rose to a record $311 billion in the first three quarters, the most since 2001, according to data compiled by Zurich-based Credit Suisse Group.

FHLB loans probably will continue to grow in the next few months, though at a slower rate than during August and September, said Margaret Kerins, an agency debt strategist at RBS Greenwich Capital in Greenwich, Connecticut.

“Each day we seem to have new financial institutions announcing losses and so this probably isn’t over,” she said.

The home loan banks can lend at below-market rates because their government charter enables them to borrow more cheaply than other financial institutions. The ties to the government suggest the U.S. will bail them out in times of trouble.

The system sold $3 billion of two-year notes on Oct. 26 at a yield of 4.26 percent, or 46 basis points more than Treasuries of similar maturity. Stamford, Connecticut-based General Electric Co., also rated AAA, has $1 billion of notes due a month later that yield 4.6 percent.

Some lawmakers said they are concerned the FHLBs are taking on too much debt after they were unable to account properly for their own risks.

Five of the banks, including the Atlanta and Pittsburgh branches, restated earnings from 2001 through 2004, while the Chicago and Topeka branches corrected mistakes from 2001 through 2003. All of them fixed accounting errors for financial contracts used to protect against swings in interest rates.

The mistakes at the home loan banks, as well as those at Fannie Mae and Freddie Mac, prompted Republican lawmakers to spend the past four years pushing for legislation to create a tougher regulator for the government-chartered enterprises. While the House passed legislation in May, the Senate Banking Committee has yet to do so.

The failure to create new laws “is predicting disaster,” Baker, a Republican on the financial services panel, said in an interview. The FHLBs “have the potential for adverse economic impact if not properly administered,” he said.

The banks require borrowers to put up mortgages, mortgage bonds and other assets as collateral. None has experienced “a credit loss on an advance to a member, ever,” Ronald Rosenfeld, chairman of the Federal Housing Finance Board, the Washington- based regulator of the FHLBs, said in an e-mail.

The New York bank looks at detailed data on each asset when deciding how much to extend against it and doesn’t accept delinquent loans or non-AAA rated bonds as collateral, Paul Heroux, its head of member services said in an interview.

“The home loan banks are extremely low-risk institutions,” Allan Mendelowitz, one of five directors of the Federal Housing Finance Board, said in an interview. “There is probably no contingent risk to the taxpayer.”

Investors said the same about mortgage securities, which had home loans as collateral and were given top AAA ratings by S&P and Moody’s. Then defaults soared for loans to people with poor credit and some securities fell as much as 80 cents on the dollar.

A collapse would create “tremendous pressure to have the taxpayer bear the cost of a bailout,” said Representative Ed Royce, a Republican from California on the House Financial Services Committee.

The FHLBs have $276 billion of bonds maturing in 2008 and $174 billion in 2009, according to data compiled by Bloomberg. The system last week began to refinance about $144 billion of its so-called discount notes sold in August and September with maturities ranging from eight to 12 weeks, FTN’s Vogel said.

Borrowing from the system during that period was probably a record for a two-month span, Vogel said. The FHLBs disclose their borrowing at the end of each quarter.

Calabasas, California-based Countrywide, the largest U.S. mortgage lender, almost doubled borrowings from the Federal Home Loan Bank of Atlanta to $51 billion during the quarter, the company said in a statement last week.

Countrywide began to use the FHLBs in August as analysts at New York-based Merrill Lynch & Co. raised the possibility that the company could go bankrupt after it had trouble raising funds in the commercial paper market. Countrywide later sold a $2 billion stake to Charlotte, North Carolina-based Bank of America Corp., the second-biggest in the U.S. after Citigroup.

“You don’t want to use the phrase `going out of business’ in the press, but they would be in a much, much worse liquidity position if they didn’t have the Federal Home Loan Bank system sitting out there,” said Paul Miller, an analyst at Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

Washington Mutual, the largest U.S. savings and loan, boosted its borrowing from the FHLBs by $31 billion, the company said this month.

The Seattle-based lender’s “funding flexibility” put it in “a much stronger position to withstand the market disruptions of the third quarter,” Chief Financial Officer Thomas Casey said on a Oct. 17 conference call with investors. Washington Mutual spokeswoman Libby Hutchinson declined to comment further.

Paramus, New Jersey-based Hudson City Bancorp, the third- largest thrift in the U.S., borrowed $800 million from the FHLBs in the third quarter, 25 percent more than a year earlier, said Chief Executive Officer Ronald Hermance.

“Even AAA rated credits were having a tough time issuing paper,” Hermance said. “It took everybody back to the Federal Home Loan Banks.”

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  1. bob

    This is a f***ing outrage! Whoever is in charge of the FHLB should be fired immediately, if not shot! This is complete crap!

  2. Yves Smith

    I couldn’t agree more. No one is going to let the FHLBs fail, and even though Fannie and Freddie have so far not gotten too deeply involved in bailing out banks that got in too deep in the mortgage mess, those banks have managed to find a back door to a quasi-public salvage operation.

  3. bob

    I’ve just emailed both my senators about this outrage. I suggest all here do the same.

    I don’t give a sh*t if every commercial and investment bank in the country dies, now. Hell, I hope some of them do. I am furious.

    It is especially galling that Tangelo was borrowing from FHLB while unloading his stock and having mass layoffs – how in the world could the FHLB accept anything from Countrywide as collateral?

  4. michael

    Truly unbelievable. It also saddens me that this is not getting more attention. So this is how the bad debt that Countrywide created is monetized. Shameful and nauseating.

  5. Bernard

    This quote is absolutely pivotal:

    “EVEN AAA RATED CREDITS were having a tough time issuing paper,” Hermance said. “It took EVERYBODY BACK to the Federal Home Loan Banks.”

    Is there any theoretical limit to how much credit the FHLB can extend to these lenders if they are unable to rollover their debt??? Correct me if I’m wrong, but it looks like maybe the sky really is the limit.

    When the credit market refuses to roll over debt, this would normally result in CREDIT CONTRACTION.

    The FHLB is acting as a de facto central bank that is effectively nationalizing all of the debt in the country that the free market refuses to finance any more.

    By performing this nationalization of debt, they prevent a reduction in the nation’s total outstanding total debt.

    Yves, I think you should maybe re-name your blog from “Naked Capitalism” to “Debt Finance Socialism”.

    Don’t worry about extending credit recklessly: No problem, the government will take over your lender’s credit for you!

    That’s what they’re already doing in England with Northern Rock (to the tune of $30 billion), aren’t they?

    Lenders are happy, borrowers are happy, and everyone can keep going further into debt. It is the genuine socialist paradise that those Communists kept talking about. A society where all financial risks are socialized. A SOCIETY WHERE RISK NO LONGER EXISTS.

    When we ALL HAVE TO WORRY is when the government’s foreign creditors refuse to roll over ITS DEBT. That’s when we will all re-learn the meaning of risk.

  6. Bernard

    One more thought:

    We have an insane system.

    We allow for freewheeling deregulated financial markets where everyone is free to take risks as they choose.

    However, at the same time, the government provides a safety net to bail out everyone when the risk-taking turns out badly.

    This is the government subsidization of risk. The more you subsidize risk, the more risk you will get.

    This is INSANE. Such a system can only self-destruct.

  7. Citizen Bagholder

    I am outraged, but I expected this. Our government is brain-dead.

    I think Jim Rodgers made a timely call when he recently announced he was moving all his assets out of dollars.

  8. jan perlwitz

    Well, that’s what I call bailing out, in contrast to what the Fed does when they lower the Fed Funds target rate. But what the heck! I don’t believe in free market capitalism anyway.

  9. jan perlwitz

    bob wrote:
    “This is a f***ing outrage! Whoever is in charge of the FHLB should be fired immediately, if not shot! This is complete crap!”

    Objections! I am against the death penalty. (Except for those people who make bad TV commercials.)

  10. Anonymous


    Can you still access this article on Bloomberg? I’ve been searching for it and can’t find it.

    Thank you for posting it here.


  11. Yves Smith

    Anon of 1:17 AM,

    Sorry for neglecting to include the link. It is now in the post. And yes, Bloomberg’s search is pretty bad. I went hunting for the article about Rubin posted later, and couldn’t find it by searching under “Rubin”. I had to go through my browser’s history to locate it again.

  12. Anonymous

    Every empire collapses not by the external forces but rather by the internal rots and corrupts. Our govt believes we as a nation are too big to fail, that the world can’t afford to see us falling into hard time. Our corporations believe that they are too important to fail — they must be preserved at all cost– and so all losses must be socialized. And American citizen thinks he is from the mightiest country on earth and that should entitle him/her to everything on earth even at the cost of loss of lives of others (1M Iraquis and counting).

  13. Anonymous

    stupid FHLB taking unnecessary risk. are they trying to add risky debts to themselves? trust me if those risky debts gone back, taxpayer will monetize those trouble. whooping 200 or 300 or 400 billion or more. as more and more bankers and hedge funds turn to FHLB for rescue. FHLB will monetize all bad debt. I mean taxpayer will monetize all bad debt.

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