The dangerous role of America’s weird lenders-of-next-to-last resort

Stephen Cecchetti is professor in international finance at Brandeis International Business School. Kim Schoenholtz is clinical professor emeritus at NYU’s Stern School of Business. Lawrence White is professor of economics at NYU’s Stern School of Business, and was a regulator of the FHLB system in 1986-89.

Some government financial institutions strengthen the system; others do not. Nowhere is that clearer than with the tangled mess of the Federal Home Loan Bank system.

In the US the Federal Reserve plays a critical role in financial stabilisation as the lender of last resort. In contrast, the FHLB system — government-sponsored enterprises that currently in practice act as a lender of next-to-last resort — plays a destabilising role, keeping dying institutions artificially alive and increasing the ultimate costs of their failures.

But first, a quick primer on this uniquely weird aspect of the US financial system. Please stay with us, as their discreet but important role is often under-appreciated.

Into the FHLBiverse

The regional Federal Home Loan Banks are part of the Federal Home Loan Bank system — an ür-government sponsored enterprise, predating better-known cousins like Fannie Mae and Freddie Mac. Created by federal law in 1932, the FHLB system was designed to provide wholesale lending in support of residential mortgage finance.

Here is a map of today’s 11 FHLB districts:

At its founding, the system’s eligible members were savings and loan institutions (S&Ls) and life insurance companies (which, in the 1930s, originated a significant portion of all residential mortgages). The circumscribed nature of the membership meant that the FHLB loans were highly likely to be used for residential mortgage finance.

Legislation broadened both the eligible membership and the mission in the 1980s and 1990s: Commercial banks, credit unions, and non-depository community development financial institutions (CDFIs) were also allowed to become members and tap the FHLBs for funding.

Large banking members are required to devote at least 10 per cent of their assets to residential mortgage finance; insurance companies and CDFIs are required to devote at least 5 per cent of their assets to residential mortgage finance; and small depositories must be involved in community lending (including residential mortgage finance).

Super-lien me

In theory, their loans are very safe. FHLB advances to members are always over-collateralised. It is up to each FHLB to establish a credit limit for each borrower — with limits typically in the range of 20-60 per cent of the borrower’s assets — even if it’s possible to exceed the limit with management or board approval.

In the event that the borrowing member becomes insolvent and goes into receivership, the lending FHLB has a (statutory-based) super-lien on the borrower’s assets — and thereby subordinates all other claimants, including the Federal Reserve and the FDIC.

Today, the FHLBs are basically large interconnected wholesale banks that lend to their members — around 6,000 banks and around 500 insurance companies — and their importance has risen sharply since the 1990s. Together, they now hold about $1.5tn of total assets, of which over $1tn are loans to their members.

The FHLBs raise their funds in debt markets through their common Office of Finance. They are jointly and severally responsible for their issuance. Because they are GSEs, investors assume that FHLB debt has an implicit federal guarantee, even if the system itself stresses that:

Federal Home Loan Bank consolidated obligations are not obligations of the United States and are not guaranteed by the United States. No person other than the Federal Home Loan Banks will have any obligations or liability with respect to consolidated obligations.

However, one sign of their special status is that federal government-only money market funds are authorised to hold FHLB debt. Another indication is that FHLB debt counts as a high-quality liquid asset for satisfying bank liquidity requirements.

Reflecting these legislative and regulatory advantages, the FHLBs can borrow at privileged rates that are only modestly above the rates paid on US Treasury bonds. The FHLBs are expected to pass these favourable borrowing rates through to their members in the form of lower interest rates on the funding they use.

The role of the FHLBs as lenders of next-to-last resort first became prominent during the financial crisis of 2007-09. In that period, FHLB advances rose by nearly two-thirds by lending to large, poorly capitalised banks — some of which, such as Washington Mutual, Countrywide and Wachovia — eventually failed.

Why those terms are systemically risky

We saw this dangerous pattern again over the past year when loans from FHLBs tripled to a record of more than $1tn, helping postpone the inevitable reckoning for Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank.

While their mission is to promote residential mortgage finance and community development, the FHLBs’ include in their routine wholesale lending loans to banks that are highly vulnerable to runs. These loans have several extremely undesirable properties.

1. They come with a “super-lien”: If the borrowers fail, the FHLBs get paid first, before everyone — including the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC).

2. There is little timely disclosure about who borrows or the amounts that they borrow.

3. Reflecting the super-lien, the over-collateralisation of their loans and the implicit federal guarantee of their (GSE) liabilities, the FHLBs appear utterly unconcerned about the viability of their borrowers.

This is why FHLBs have lent large amounts to troubled banks. From their own narrow and distorted perspective, the combination of over-collateralisation and the super-lien made these loans extremely safe — even though the loans elevated the risk that the borrowers would fail.

If SVB, Signature, and First Republic had instead been forced to face market discipline during 2022, their borrowing costs would have been far higher. These expenses likely would have motivated the banks to have addressed their losses at an earlier stage, so that the banks might have survived (or at least could have been absorbed by other banks at lower public cost than actually occurred).

But it’s easy to understand why SVB, Signature Bank, and First Republic therefore turned to the FHLBs to stay afloat when large unrealised losses eroded (or even wiped out) their capital.

In addition to avoiding greater market scrutiny — or the regulatory scrutiny that would have accompanied lender-of-last-resort borrowing from the Fed — FHLB loans allowed these banks to delay asset sales that would have forced the recognition of losses and compelled them to raise equity earlier or to shrink. Instead, the banks gambled for resurrection supported by the FHLBs’ mispriced government-sponsored financing.

It was a gamble that failed.

Here’s how we can fix things (a little at least)

To improve the resilience of the US financial system, policymakers should eliminate the FHLB system’s unofficial and destabilising role as the lender of next-to-last resort by:

1. Eliminating the super-lien.

2. Requiring that bank regulators — including the Federal Reserve and the Comptroller of the Currency — approve their supervised banks’ borrowings (advances) from the FHLBs beyond a normal level.

3. Requiring full and immediate public disclosure by the FHLBs of their loans (or, at least of advances beyond some size threshold), including the lending conditions, the collateralisation and the borrowers.

Eliminating the super-lien would encourage the FHLBs to actually consider the viability of their borrowers, helping reduce lending to zombie banks. Giving regulators of vulnerable banks a say in limiting their access to low-cost government-subsidised debt would reinforce the discipline that the Fed — as the official lender-of-last-resort — is supposed to impose on weak and failing banks. The same goes for increasing transparency: Improved disclosure would focus counterparty and regulatory attention where it belongs — on the weakest banks.

Yes, some of these proposals require legislative action. But the FHLB overseer (the Federal Housing Finance Agency) and bank regulators should act quickly to implement what is feasible even without legislation.

There also are other reform possibilities, such as capping the scale of FHLB borrowing, but these three changes would go far towards limiting the role of the FHLBs as sources of liquidity to floundering banks without undermining their legislative purpose: to support residential mortgage and community finance.

Arguments that meddling with the FHLB system would be like “removing a storm barrier that for 90 years has successfully protected a fragile coastline” are, well, pretty weak sauce.

As it stands, the FHLBs are a clearly destabilising force in the US financial system by providing subsidised loans during periods of stress and undercutting the actual lender-of-last resort, the Federal Reserve. Fixing this would improve financial resilience by creating greater incentives for banks to manage their risks.