May 26, 2009 – The Federal Home Loan Banks, or FHLBs, may be the biggest financial players you've never heard of. Collectively, they hold $1.3 trillion in assets and are the largest U.S. borrower after the federal government.

A Subsidyscope review of the FHLBs’ financial statements has found that several of the banks are carrying substantial "unrealized losses" on their investments in mortgage-backed securities. Because the banks believe these losses are temporary, they don’t have to be recognized on the banks’ accounting statements.

What’s potentially worrisome is the sheer size of the losses. For the Federal Home Loan Bank of Seattle, they are substantially larger than the capital the bank holds to protect itself against such declines. If its mortgage-backed securities don’t regain their value, the bank will have to write them down, which could wipe out its capital buffer and raise risks for taxpayers.

A PUBLIC MISSION

The FLHBs' mission is to keep home loans flowing by borrowing money and lending it to the banks and other institutions that issue the loans. The system works as a cooperative: there are 12 regional banks, and they serve their members – 8,100 commercial banks, thrifts, credit unions, and insurance companies across the country. The FHLBs can borrow cheaply because investors believe that, like Fannie Mae and Freddie Mac, the government won't let them fail. The home loan banks are especially helpful to community banks and small thrifts because these smaller institutions typically find it more difficult to raise capital themselves.

The troubles began when several FHLBs invested heavily in mortgage-backed securities created by Wall Street. As the housing crisis developed, these investments lost a good deal of their value. A Subsidyscope review of the banks' annual reports found that in the first three months of 2009 alone, several FHLBs saw the ratings of a large portion of these securities decline from AAA to junk status, most notably the Boston, San Francisco and Seattle banks. A downgrade to junk doesn’t mean the securities are worthless, and an improvement in the market could increase their value. Still, the downgrades were numerous. The San Francisco bank, for example, saw $7 billion of its private mortgage-backed securities go to junk (see graphic below).

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Over the past week, new financial reports have come out that confirm trouble at the Federal Home Loan Banks -- and the biggest news comes from the Seattle bank. In the wake of the downgrades to its securities, the Seattle FHLB reported nearly $1,374 million in unrealized losses. That’s almost one-and-a-half times the $960 million the bank held in capital on March 31. Other banks announced similar, though less extreme, trends; San Francisco’s unrealized losses were equal to 71 percent of its capital buffer, while Boston’s, Chicago's and Indianapolis's were 30 percent (see graphic below).

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A TEMPORARY SETBACK?

Representatives of the FHLBs maintain that the system as a whole has enough capital to recover from any future losses. And they say the potential losses are never likely to be realized, because the banks intend to hold the securities to maturity. By then, spokespeople predict that the economy will have improved and their holdings will have recovered some or all of their value.

The Federal Home Loan Banks already maintain a thinner capital margin than is typical for commercial banks, however. Because they have an implicit government guarantee—investors believe the federal government won't let them fail—they're able to maintain slimmer reserves.

Last fall, the FHLBs' private mortgage-backed securities had already run into enough trouble to raise concerns about capital levels. In January, Moody's reported that in the worst-case scenario, if their securities never regained their former value, eight of the 12 home loan banks would fail to meet capital requirements.

Home loan bank representatives defend their smaller capital margin. As their 2008 combined financial report shows, the majority of FHLB assets—about 70 percent—are made up of advances, or loans to member banks. Those advances are extremely secure for investors: when a member institution takes out a loan, it must put up more collateral than the loan is worth. And the FHLBs are first in line to be paid back if a member bank fails. In fact, in their 77-year history, the home loan banks have never lost a penny on an advance.

Private mortgage-backed securities, however, don't enjoy these extra safeguards—and they're much riskier than advances.

Moreover, the measure that the FHLBs’ regulator must use by law to determine if the banks are adequately capitalized may make them appear healthier than they are. For example, the Seattle FHLB had only $960 million of capital on March 31, 2009, according to generally accepted accounting principles. For regulatory purposes, however, the Seattle FHLB was allowed to state that its capital was almost $3 billion (see graphic below).

For this review, Subsidyscope used the measure of capital that accountants use, in part because regulatory capital doesn’t count the losses a bank suffered on its mortgage-backed securities and can be potentially misleading. For example, the regulatory capital of the Seattle, San Francisco and Boston banks actually went up when accounting capital went down.

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THE ROAD AHEAD

If a home loan bank suffered large losses that it couldn't recover, what would the road ahead look like? Before it ever reached insolvency, the bank could take internal steps to save money: it could suspend dividends to its members and temporarily forbid them from withdrawing stock, among other remedies. Indeed, six of the 12 banks have announced since December 2008 that they are suspending dividends.

Moreover, all the FHLBs are responsible if one runs into trouble. The home loan banks are subject to "joint and several liability"—meaning that if one bank were to fail, the others would be liable. The other FHLBs may also provide capital if a bank simply needs additional funds, but is still solvent. Just how they would accomplish this is far from clear, however. The individual FHLBs are used to a high degree of independence, so any bailout of one by the others is likely to be contentious and take time to resolve. The worry for taxpayers is that if the entire FHLB system still fell short of required capital, it might have to turn to Congress for extra funds.

There is some evidence that confidence in the Federal Home Loan Banks among investors has eroded in recent months. Subsidyscope has obtained information on the price of credit default swaps on FHLB bonds (see graphic below). One way the home loan banks fund their loans to members is by selling bonds. Credit default swap prices are a measure of how expensive it is to buy insurance against the possibility that the FHLBs would default on their bonds. The data show that it has become increasingly expensive to buy this insurance, suggesting that investors' confidence in the health of the FHLBs has been waning of late.