Former Fed Gov. Tarullo sees systemic danger in ‘irrelevant’ Federal Residence Mortgage banks

Former Federal Reserve Gov. Daniel Tarullo and two Fed economists are calling for more oversight of the Federal Home Loan banks, claiming the banks have expanded into activities that pose risks to financial stability and have become “irrelevant” in housing finance markets. 

In a new white paper, Tarullo and the economists argue that the Home Loan banks’ hybrid public-private business model needs to be reexamined. The 11 regional banks, the authors argue, have moved beyond their primary mission of supporting housing into activities that could trigger systemic stress. 

Daniel Tarullo, former chair of the Federal Reserve’s supervisory committee, said in a paper released in June that the Federal Home Loan Bank system could pose systemic risks in times of stress in the housing market.

Ron Antonelli/Bloomberg

The authors suggest that in the absence of Congressional action, the Federal Housing Finance Agency, which oversees Fannie Mae, Freddie Mac and the Home Loan banks, should determine if the banks are working in the public interest.

“There is not a well-defined role for FHLBs to justify their public privileges,” Tarullo wrote along with co-authors Stefan Gissler and Borghan Narajabad, both economists at the Fed. “In the absence of a well-defined mission, the FHLBs crop up in unexpected parts of financial markets as they pursue profitable opportunities.” 

The pointed criticism from Tarullo, a Harvard Law professor who served as the chair of the Fed’s supervisory committee during the Obama administration, may reinvigorate debate about the Home Loan banks’ purpose and relevance. The 54-page white paper was published June 23 by SSRN, an academic research publisher.

The Federal Home Loan Bank System was created in 1932 during the Great Depression to spur homeownership and provide liquidity as a “lender of last resort” to member institutions. 

But critics have alleged for many years that the Home Loan banks have expanded far beyond their core mission in housing and now operate primarily for the financial benefit of members at the expense of taxpayers.

“The original motivation for their creation during the Great Depression is essentially irrelevant in today’s housing finance market,” the authors wrote. 

Kris Williams, president and CEO of the Federal Home Loan Bank of Des Moines, responded to the criticism by reiterating that the system has provided stable liquidity to its members for 90 years. In addition, since 1990 the Home Loan banks have provided roughly $7.3 billion in affordable housing subsidies. 

“For nine decades, the Federal Home Loan Banks have played a vital role to its approximately 6,500 member institutions, comprised primarily of  community banks, credit unions and insurance companies,” Williams said in a statement. “By providing a stable source of funding to meet their members’ liquidity needs in any operating environment, the Federal Home Loan Banks help bring stability and equilibrium to the financial markets.”

Still, it remains unclear whether FHFA Director Sandra Thompson plans to take action on the Home Loan banks. In April, Thompson said she supported the idea of creating an advisory committee to take a deep dive into the banks, but has not yet created such a committee.

Each regional bank is subject to a monthlong exam by the FHFA, which has a division devoted to the Home Loan banks and releases an annual report on their activities. 

The Home Loan banks “welcome a discussion on how best to further fulfill its responsibilities as a” government-sponsored enterprise, said Sheila Owens, a spokeswoman for the Council of Federal Home Loan Banks. 

The Home Loan banks provide liquidity in the form of advances to its members. Last year, advances dropped 20% to $350 billion, the lowest level in 15 years. One of the authors’ core concerns is whether the banks would be able to continue providing liquidity if the number of advances continues to decline. 

“The inability of the FHLBs to roll over advances could exacerbate liquidity shortfalls during periods of stress,” the authors wrote.

Some critics also suggest that there is little transparency into whether financial institutions are investing funds in housing. 

“The problem is that when a home loan bank makes an advance, there is no assurance that the funds will be used for housing. So that nexus with housing has been lost over time,” said Cornelius Hurley, an adjunct professor at Boston University School of Law and a former independent director of the Federal Home Loan Bank of Boston. 

In December, Hurley wrote an article in American Banker, with William M. Isaac, the former chairman of the Federal Deposit Insurance Corp., advocating ways to modernize the  system. 

The hybrid structure of the Home Loan bank system has contributed in the recent past to systemic stress while also undercutting financial regulation, Tarullo and the Fed economists wrote.

Among the activities the authors cite is that the banks have become dominant players in the federal funds market, changing borrowing terms and providing advances to help large banks meet regulatory liquidity requirements. The banks also have helped money market funds meet portfolio requirements by the Securities and Exchange Commission. 

“The FHLB system now provides various services to financial firms, but few of them appear to be linked to promoting economical housing finance,” the authors note. 

Another core criticism is that the Home Loan banks are receiving hefty public subsidies while engaging in activities that have less to do with housing and more with ratcheting up profits for its member institutions, including banks, credit unions and insurance companies. 

“What the authors point out is that the FHLBs get half of their funding from money market mutual funds, and at any time you could have a freeze-up in the credit markets where either the funding or the advances became a problem,” Hurley said.

The Home Loan banks’ structure also appears to be causing conflicts between their private incentives and public goals.

“The dominance of the private members in the corporate governance of FHLBs has predictably led to the Banks using their public privileges to opportunistically seize profitable opportunities that may bear only an attenuated relationship to expanding the pool of resources available for mortgage financing,” the authors wrote. “In the absence of a well-defined mission for a public-private hybrid, chances increase that private incentives to leverage public privileges will lead to activities that do not promote the public interest.”

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