A vital cog in the US financial system is under threat. For 89 years, the Federal Home Loan Bank System has been a reliable source of liquidity for most banks, credit unions and insurance companies nationwide. Without significant change, this remarkable public-private partnership is nearing the end of its relevance.
Created in 1932 during the final days of the Hoover administration, this complex structure of 11 – then 12 – banks scattered across the United States has been a bulwark of our financial system. Owned by their members but backed by the federal government, these 11 banks provided relief liquidity to their members through guaranteed advances. The system is able to finance itself through debt securities it issues which carry reduced risk premiums due to the implicit guarantee of the federal government.
The home loan banks that make up the system are cooperatively owned by the financial institutions in their districts. This stands in stark contrast to their distant cousins in government-sponsored companies, Fannie Mae and Freddie Mac, which were owned by profit-seeking shareholders and are now in trusteeship. Each federal mortgage bank devotes a significant portion of its net income to affordable housing and economic development in its neighborhood.
During the Great Depression, numerous recessions, the Year 2000 scare, the savings and loans debacle, and other financial market stresses, the system has been a stable source of funding for financial intermediaries. Long before the Federal Reserve rolled out its “urgent and demanding” instruments in the 2008 financial crisis, the system provided an oasis of funding when few others were in sight.
Now, this beacon of the financial system is itself under threat — not by its own missteps, but rather by the pandemic-driven actions of the same federal government that created it. The Federal Reserve has flooded the financial system with so much liquidity that member owners of the system’s banks no longer need to borrow from it, thus calling into question its very raison d’être.
Advances to member institutions, the cornerstone of the system, currently stand at $350 billion. This contrasts with $658 billion two years ago. The system’s assets, over $1.2 trillion during the financial crisis, now stand at about half that. Not a jolt, this precipitous decline in advances and assets should persist in the years to come. Moreover, even when interest rates normalize, the system will still face enormous challenges as its members will have other competitive sources of funding available to them.
It would be easy, given its dwindling use and relevance, to leave the system to the fate of, say, the Civil Aeronautics Board and other government agencies that have outlived their goals. The mortgage banking system, however, is different. Like a important study observed, the 11 mortgage banks “make a difference in what is done in the world”. Indeed, they do. From affordable housing to job creation, to economic development, to the preservation of community banks, the system and its banks have made a difference.
The question is: will mortgage lending banks be relevant in the future?
Most would like governmental and quasi-governmental institutions to be as lean and efficient as possible. Focusing this efficiency lens on the system at this point could easily lead to the conclusion that the system should be dissolved or that the 11 banks should be consolidated. Before it’s relegated to the heap of bureaucratic dust, however, it’s worth taking a closer look at its unique business model and how, with modest modifications, it could be repurposed to meet the challenges of the modern age.
The system combines the benefits of federal government support with local vision and control on the ground through its semi-autonomous federal home loan banks. Each bank is closely monitored by the Federal Housing Finance Agency. Each bank’s board of directors is made up of member directors and independent directors from its region. All banks are jointly and severally liable for the obligations of their peer banks, which adds a reinforcing level of self-discipline. According to the law and the culture, the system is mission-driven – perhaps even wrongly so.
Congress, having created the system, should take a hard look at its potential social and economic usefulness. Such an analysis will likely lead to the conclusion that the system’s business model, although antiquated, is uniquely suited to today’s financial needs and challenges.
In this important undertaking, recent remarks by Acting Comptroller of the Currency Michael Hsu are instructive. He directly addressed the problem facing banks when challenged by fintechs invading their regulatory perimeter. Rather than sticking to the rote stance of expanding the regulatory perimeter of banks to include fintechs, he challenged banks, fintechs and regulators to reinvent the regulatory perimeter for the modern age, a approach he called “upgrading”.
If Congress chooses this more enlightened path of upgrading the federal mortgage system, the framework for doing so is relatively clear. The adjustments needed to restore the current relevance of the system fall into three categories. They are: the mission, the adhesion and the guarantee. As a guide in examining each category, to paraphrase the late Senator Robert Kennedy, the most productive inquiry is not “Why?” but why not?”
In terms of the system’s mission, why not expand it beyond housing finance to include finance initiatives in the areas of climate change, infrastructure development and economic equity? The current mission has been narrowly interpreted by the FHFA and even more narrowly interpreted by each of the banks. Yet the demands of today’s economy have far exceeded those of the 1930s.
As for its membership, why not open membership eligibility to small business lenders in the country that create two-thirds of all new jobs, fintechs that drive financial inclusion, and non-banks that are the origin of most current mortgages? The leveled perimeter will include many of them, and furthermore, banks and credit unions are a decreasing part of the financial system.
With respect to collateral, why not expand the collateral eligible for system advances to include the many asset classes, in addition to mortgages, that support the new system’s more modern mission? Housing is vital, but so are roads, bridges, renewable energy, small businesses and sustainable farms. Why not extend the scope of guarantees that each bank in the system can accept as collateral for its advances?
Here is the challenge.
The system enjoys a huge financial advantage. However, the change is unlikely to come from within its ranks. Member institutions tend to view their modest holdings in their respective federal mortgage banks as a claim on each bank’s capital. Members generally fail to recognize that each bank’s capital, including more than $22 billion in retained earnings, has been accumulated over nine decades largely through the implicit federal guarantee of the system’s debt obligations.
The upgrade process should lead every discerning member-owner of the Federal Mortgage Lending Banks to recognize that the increased value of their investment in a redesigned and dynamic system far outweighs any short-term dilution of their current investment in the banks, which are in a state of secular decline. The system will survive on growth, not on one-time spending cuts.
Thus, change will have to come from informed external sources. The opportunity for the Biden administration to appoint a new forward-looking leader (including the appointment of the current acting director) to lead the FHFA is one such source. The same goes for the many and varied players who could benefit from access to a new and improved system. Nowhere does it say that leveling up has to be hard work. It can also open many doors of opportunity.
The views expressed are solely those of the authors and do not necessarily represent the views of any organization with which the authors have been or are currently affiliated.