The Federal Home Loan Bank System has found itself abandoned as the mortgage market moves forward. When it was first proposed, the concept of a government-sponsored enterprise seemed like the perfect wave.
Government would prime the pump for desired social investments-initially in residential real estate. Then the putative discipline of financial markets would take over, ensuring the government a good return on its investment and improving mortgage markets to boot.
There is little question that the idea made a great deal of sense and worked very well for many years. Thrifts would not have been able to make homeownership a middle-class reality without the long-term liquidity provided by the Federal Home Loan banks in the decades after World War II.
Similarly, efficient secondary markets for mortgage-backed securities would never have developed without Fannie Mae's and Freddie Mac's leadership. However, this partnership between social mission and private profit appears to be coming apart, in large measure the result of the basic incompatibility between the public mission of expanding affordable housing and the inexorable drive by shareholders for quarter-over-quarter return.
The Home Loan Bank System is a particularly problematic government- sponsored enterprise. Although they do not have public shareholders as Fannie and Freddie do, the Home Loan banks have members that are private institutions. Though this insulates the banks from some of the more quixotic demands of analysts and investors, it does not remove them from the discipline of the market.
Members of the Home Loan banks have made investments in these institutions, and they are prepared to see these investments earn a below- market return only if their funds are safe and if they receive services rendered for dollars contributed. In recent years, that rather reasonable demand by Home Loan bank members has become harder and harder for the system to meet. A large amount of the system's membership base was blown away in the savings and loan debacle of the late 1980s, and attempts to fill the gap with community banks have failed to provide the Home Loan Bank System with enough revenue to offset this loss.
Forays into fancy structured notes bumped return up a bit, but only at the cost of caustic congressional criticism. Last year some of the Home Loan banks tried to fix their problem with legislation that would have transformed them into "Enterprise Resource Banks."
This year the provisions in financial reform legislation - at least so far - are a more modest response to the push by some in the Home Loan Bank System for a new mission. The bill includes provisions that would permit the Federal Home Loan banks to support lending by small banks for small- business, agriculture, or "community development" purposes. Interestingly, the bill also would allow any entity-including large banks, insurance companies, cities, etc.-to obtain Home Loan bank advances to support affordable housing loans without the onerous stock-purchase requirements that now burden such advances.
To allay fears about this dramatic expansion, the legislation also gives the Federal Housing Finance Board new powers to govern the Home Loan banks.
It remains to be seen if this new formula for the Federal Home Loan banks will work. However, the more immediate question is whether it should even be tried. Quite simply, if the Federal Home Loan banks cannot survive now because their job is done, then why should they not be shut down?
This could be accomplished in three ways. First, the banks could simply be closed. Members would be given their capital back, with a sale of Home Loan bank assets contributing to any shortfall to the greatest degree possible.
After the Home Loan banks are closed, their members would simply fund themselves from core deposits and the capital market, like any other bank or thrift. There is no reason to expect any marked change in mortgage rates or credit availability if this policy were pursued.
An alternative would be to cede the Home Loan banks over to the other housing government-sponsored enterprises, Fannie Mae and Freddie Mac. Much as this might appeal to the other government-sponsored enterprises, it is not likely to get anywhere. One of the biggest selling points those advocating Home Loan bank expansion have put forth is the argument that a third government-sponsored enterprise is needed to control the other two.
The third way would be to devolve the banks into fully private enterprises. Interested members might buy their bank or a group of banks from the federal government and other members, restructuring the resulting venture into something like a bankers' bank for mortgage lending and other purposes.
The federal government would kick in by taking over the system's Resolution Funding Corp. obligation, which would have been a cheaper way to fund the savings and loan cleanup in the first place.
This last alternative sounds the most appealing of a tricky lot, but it, too, is not likely to succeed. The problem with privatizing the Home Loan banks is precisely the problem with keeping them going: There is simply no apparent reason for a captive mortgage-funding facility.
In the 60 years since the system was created, capital markets have become so efficient and mortgage securitization so effective that even the smallest bank or thrift can fund itself with a flick of a computer key.
Unless the Home Loan banks are expanded, they will have to be shut down. Congress is proposing the first alternative, but private companies that will own stock in this expanded government-sponsored enterprise will need to consider some others. They could end up owning a stake in a government- backed entity that puts them out of business, or in an enterprise going nowhere but down.