Home Loan Banks Criticized For Issuing Structured Notes

WASHINGTON - As the Federal Home Loan Bank System negotiates with bankrupt Orange County to buy back some of its complex debt, critics inside and outside the system are asking whether the banks should be selling structured notes in the first place.

Eleven of the system's 12 banks are now in talks with Orange County, which last week held $1.63 billion in system debt, most of it in structured notes. The Chicago and New York banks have already repurchased their debt, paying a total of $170 million to the troubled California county.

The $225 billion-asset bank system was founded to provide a steady source of cash for home mortgage finance. Its supporters argue that the banks further their mission of financing home ownership by selling derivatives, which they say lowers the cost of funds to thrifts and banks.

But critics of the system argue that many investors assume that their holdings are risk-free because the system is a government-sponsored entity.

While the agency's debt carries little credit risk, its structured notes have high liquidity and market risk. Some say the Federal Home Loan Bank System obtains this cheap funding by unfairly trading on its relationship to the government.

The Dallas Home Loan Bank stopped selling the structured debt altogether at the beginning of last year. It is the only one of the system's 12 banks that has said it will not buy back its debt from Orange County.

Early on, "structured notes really did end up in the hands of sophisticated investors," said Dallas bank president George M. Barclay.

"As structured notes became more complex and as funding through structured notes became more costly, that coupled with a lack of any earth- shattering need for funding at the time just made discretion the better part of valor," he said.

Walker F. Todd, a former Federal Reserve bank staffer, said, "Unsophisticated investors buy these notes not fully understanding what they are." For the Federal Home Loan Bank System to continue selling them "is unseemly."

Bank regulators issued warnings last year when volatile structured notes crept into the portfolios of community banks. Many incorrectly believed the instruments had low risk because they were issued by the bank system.

Mr. Todd believes the system should either stop selling structured notes or should go fully private, dropping its status as a government-sponsored enterprise. "They are hiding behind the . . . appearance that the Treasury supports what they do," said Mr. Todd, an attorney at Buckingham, Doolittle & Burroughs in Cleveland.

But others point to the advantages for the system and its member thrifts and banks.

"Derivatives have been very useful for funding at the federal Home Loan banks, particularly by enabling us to bring our costs down, which in turn allows our customers to be able to provide mortgage money less expensively to their customers," said James R. Faulstich, president of the Seattle bank.

Structured notes have so lowered the funding costs that a homebuyer borrowing $100,000 with a 30-year, fixed-rate loan would save $5,000 over three decades, Mr. Faulstich said.

Paul B. Spraos, publisher of Swaps Monitor, a New York-based newsletter, said, "Structured notes have been a vehicle which has enabled the Home Loan banks to save a significant amount of money in their borrowings."

Of the $147 billion in bonds the system has outstanding, nearly a third issued - $44 billion - are structured notes.

The thrift industry's major trade group opposes the bank system buying back its debt from Orange County.

"We don't want the admittedly unfortunate circumstances here to create a precedent," said Brian P. Smith, policy director at the Savings and Community Bankers of America.

The SCBA is concerned because many of its brood are required to own stock in the bank system. The expectation that the system would bail out other holders of its debt "would cost our members money," Mr. Smith said.

The debate over the bank system's use of structured notes arises in part because of its unique standing as a government-sponsored enterprise. The negotiations with Orange County highlight how the system straddles public and private status.

The county turned for help unwinding its money-losing portfolio to GSEs, but not to other issuers, demonstrating that the system is often expected to bear a special responsibility that other issuers escape.

"They are in this no man's land between government and private, and that does give rise to these questions," said Securities and Exchange Commissioner Richard Y. Roberts.

Nonetheless, he thinks the system should issue the kinds of securities the market demands.

However, James D. Roy, president of the Pittsburgh bank, said, it is the American homebuyer who is the ultimate beneficiary when the system issues derivatives.

"We think (that), if not fully understood, any investment can become quite risky," Mr. Roy said. "On the other hand, we know that structured transactions can provide significant advantage" by lowering bank system member institutions' borrowing costs.

The system has rules designed to keep complex securities from the portfolios of unsophisticated investors. They include large minimum purchase amounts and suitability agreements with underwriters. But Mr. Roy acknowledged that "at the secondary market level, there is more of a concern."

And some say any savings for homebuyers now carry too high a price.

"You are robbing Peter to pay Paul," said Mr. Todd, the attorney. "You are robbing Orange County taxpayers to pay the funders of the Home Loan banks."

Pittsburgh's Mr. Roy counters, "These transactions are not engineered by the Home Loan banks. They are typically brought to us by the investment banking community."

"Certainly the securities that were held in the Orange County portfolio were presented first to us by Wall Street," Mr. Roy said.

The blame really lies with Orange County's treasurer, Robert Citron, several sources said.

"He had a basic borrow-short, lend-long attitude," SCBA's Mr. Smith said. "Lord knows there have been plenty of savings institutions that went down that road 15 years ago and lost money. We don't do that now."

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