CHICAGO - Federal Home Loan banks seemed to be headed for extinction when the U.S. thrift crisis was at its peak.
But these wholesale banks, which borrow in the public markets and issue long-term advances to mortgage lenders, got a fresh start under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.
Stripped of regulatory and insurance responsibilities, the 12 district Home Loan banks began focusing tightly on housing finance.
And, significantly, they gained limited authority to sell wholesale funds to commercial banks and other nonthrift housing lenders, expanding the potential market for their services.
Perhaps the Federal Home Loan Bank of Chicago best illustrates the progress that can be made in the new environment.
Until fairly recently, it played a trivial role, at one point accounting for less than 2% of systemwide advances outstanding.
Over the last three years that ratio rose to a more meaningful 5.3% as the Chicago Home Loan Bank more than tripled its advances outstanding, to $61 billion at Sept. 30.
Even with the expansion, concedes Alex J. Pollock, president of the Federal Home Loan Bank of Chicago, government-sponsored enterprises such as the Federal National Mortgage Association, are gaining most of the new business in the housing finance market.
But he contends that myriad individual housing lenders, acting with the support of the Home Loan banks, will remain indispensable in assuring a vibrant market.
In an interview with American Banker, Mr. Pollock predicts Federal Home Loan banks will continue growing beyond the confines of the thrift industry, and he proposes legislative changes that would bolster the system's health and evolution.
Q: How is business? POLLOCK: Business is very good, thank you, and the growth we've seen over the past three years is continuing.
Q: What are the dimensions of this growth? POLLOCK: The financial institution membership of this bank has roughly doubled to more than 500 since 1991. Borrowings, or advances to members, have nearly tripled to more than $6 billion.
And the share of advances held by the 25 most active borrowers has fallen by 13 percentage points to 72%, indicating greater diversification in our portfolio of advances.
Q: What is the profile of the typical new member? POLLOCK: The typical new member is a commercial bank. It ranges in size all the way from $10 million to more than $5 billion in assets, but the average newcomer has between $150 million and $200 million of assets.
It either has a significant residential lending business, or it wants to become active in residential lending.
These institutions want to manage the interest rate risk that attends long-term mortgage assets.
Home Loan Bank advances offer a sound mechanism, which banks haven't historically had, by which long-term assets can be funded with long-term, liabilities. When we survey new members, an ability to access long-term financing tops the list in explaining why they joined.
Q: As reflected on your own income statements, some of your clients have found themselves suddenly not needing some of this funding, incurring prepayment penalties in order to return portions of it.
And there are other issues, such as extension and prepayment risk, that crop up when you are juggling assets and liabilities of longer durations.
How skillfully are borrowers employing Home Loan Bank advances, and what are you doing to assure that clients handle funds productively? POLLOCK: You touched on prepayment fees, which raise an important point: The owner of a mortgage is long the bond and short the option.
That means he's got to hold the instrument on its contractual terms as long as the customer wants, but also stand ready to sell the mortgage back to the customer who wants to prepay.
Thus, the lender has to manage the interest rate risk of the bond, and also manage the option risk of the prepayment.
We can not only finance at maturities, which the average member couldn't get on its own, but we can also finance with embedded options - calls, for example - which can help the institution manage both interest rate risk and prepayment risk.
We also offer a yield on the financing that is much more attractive than what individual institutions could obtain on the own. That is why advance demand is brisk, because of that combination of risk reduction and very favorable rates.
We don't want to run the balance-sheet positions and risk-management strategies of our members. That is their management problem.
But we would like to help them understand their positions and give them ideas. We think it is our responsibility to maintain a top-flight analytical ability within the bank and make it available to members.
Q: What effect, if any, does your growing bank clientele have on your core thrift clientele? Based on what you are saying, there's a growing amount of wholesale funding being supplied to banks.
You could even say banks are entering -mortgage lending with the help of the Federal Home Loan Bank. How much farther down this road do you see this institution going, and to what consequences? POLLOCK: You have to go back to the mission of the Home Loan banks. The mission is to promote economical housing finance. So whichever institutions are making those loans and are committed to that business, it is our mission to help them all of them.
Now, the real competition in the mortgage business, seen in large scale, isn't between banks and thrifts. It is between two systems of mortgage finance.
Under the securitization system, you create the mortgage and sell it to Fannie Mae or Freddie Mac. They either sock the instrument into their own portfolio or place it in a specific pool funded by publicly traded securities.
Under the portfolio system, by contrast, the institution makes a loan to its customer as a private transaction. It holds that loan, manages and services it, and finances it via private transactions with depositors and Home Loan banks.
Q: Government support, to varying degrees, is intertwined in both systems. So the terms of that competition, the degrees of freedom accorded each player, hinge on the attitude of the government.
If you agree, do you then perceive that the government has a preference as to which mortgage finance system ultimately wins this competition? And how does that preference manifest itself? POLLOCK: Clearly, over the last decade, market share has shifted to the securitized system, as evidenced by the growth of the securitized markets and the really amazing portfolio growth at Fannie Mae and Freddie Mac.
Most people don't realize that the two together hold a quarter of a trillion dollars worth of assets in their own portfolios.
If you strip away the layers of governmental support, I think it is fair to say that the Home Loan Bank System has better intrinsic credit quality. To the extent that Fannie Mae and Freddie Mac compete with lesser intrinsic credit quality, you could say the government favors these entities.
Q: Do you see both of these systems continuing to coexist? POLLOCK: Yes. It is the Home Loan banks' specific mission to make the private transaction system work, to make it stronger.
Q: Why should we make it stronger" Mortgages have some pretty serious risk management issues that go with them. Why not shift most of this risk to the public markets, and. away from entities which essentially are taking stabs at interest rate risk management with the backing of the federal government and deposit insurance? POLLOCK: I would rather have lots of institutions afl over the country making and holding mortgage loans. Lots of players and competitors.
Dealing with customers directly. Managing credit. Deciding on terms and conditions. This serves the housing market better than a massively centralized and highly controlled home finance system.
Q: Are you suggesting thrifts and banks can expand residential portfolios and prove able to weather some potentially severe rate shock in markedly better fashion than what we witnessed in the disastrous 1980s? POLLOCK: The Home Lean Bank System is a key tool in helping portfolio lenders do it right. And in terms of management, control, and measurement of interest rate risk, there have been huge advances in the last 15 years. We really did learn the lessons of the last war.
That doesn't mean there won't be future mistakes. There is always some new sort of risk surfacing, and emerging problems will not be prevented by regulation. But on a systemic basis, there has been an enormous, positive shift.
Q: As you know, the government commissioned a number of studies of the Home Loan Bank System, with a view towards quote, reform, unquote. And next year, Congress might revisit the structure of the Home Loan Bank System.
What, if anything, do you believe should be done to facilitate the mission of the system and further assure its continued soundness? POLLOCK: The first thing is to put afl members on the same basis: the same requirements for stock holding, the same rights and privileges, the same authority for borrowing.
This would free thrifts from mandated membership, and it would remove constraints on the borrowing ability of commercial banks.
Of course, when you make all members equal and voluntary, you need to think about ways to create permanent capital for the Home Loan bum and I think there are ways to do that.
One thing has to be made clear, and that is that all of the capital belongs to the shareholders. Twice in history, we have had notable takings of the retained earnings of the Home Loan banks by the government.
It should be made unambiguous and indubitable that all the capital, including retained earnings, belongs to shareholders.
Q: Is the future of the Federal Home Loan Bank wedded to the future of the thrift industry, and are there risks if it remains firmly wedded to thrifts? POLLOCK: The Home Loan Bank System's future is wedded to the future of residential mortgage finance done in private transactions between financial institutions and their customers.
It is hardly an original observation to note that thrifts and banks progressively are looking more alike. I think it is a fair guess that notions of separateness win have passed by the turn of the century, and there will be one big depository institutions industry.
Within that big depository industry, there will be a very big business called mortgage financing. Residential mortgages still comprise the biggest class of financial asset in this country, and in the world, and residential lending will remain a huge business, no matter what.
And if you believe, as I do, that a private transactions component is essential if residential lending is to be vibrant and competitive, then there is going to be a very important and interesting role for Home Loan banks.