Flubbers

How Federal Home Loan Banks and their execs exacerbated the banking meltdown.

The idea was simple: Normal insurance companies charge higher premiums when more money is at greater risk, so why shouldn't the FDIC? During the current mortgage crisis, a bank with a large appetite for FHLB loans has been the equivalent of a Ferrari driven by a teenager.

"Institutions that borrow funds from the Federal Home Loan Banks place the FDIC and taxpayers at greater risk of loss," says William Black, former general counsel to the Federal Home Loan Bank of San Francisco, and associate professor of economics and law at the University of Missouri.

"If you look at some of the firms whose names have been in the headlines, some of them were the largest borrowers in the FHLB system," adds Mark Flannery, a finance professor at the University of Florida. "It suggests, with hindsight, that the ability to borrow that money might have been a factor" in the current wave of bank failures.

But previous efforts were thwarted by the political might of the FHLBs. There are member banks in most congressional districts that can conjure up hundreds of letters of protest when needed. Throughout the 2000s, the FDIC repeatedly yielded to protests, including a 2006 letter from Schultz, and backed off efforts to charge higher premiums. When the FDIC again proposed the higher charges last year, Schultz and his fellow bankers sent 1,100 letters of protest.

Last month, the FDIC finally issued a watered-down version of its long-sought rule. The agency had originally sought to charge banks whose ratio of FHLB loans and other "secured liabilities" to local deposits exceeds 15 percent. In the end, the FDIC all but capitulated to the Flubs: The only banks charged higher premiums will be those whose ratio of FHLB loans and other similar debt to deposits exceeds 25 percent.

"The 25 percent threshold is set so high that I don't think it is effective," says Tim Yeager, a University of Arkansas professor who studies the FHL banks. "Most banks, even the ones that rely heavily on advances, have ratios well below this. ... So no, I don't see this as an effective deterrence to heavy reliance on advances."

Unless Congress and the president untangle the perverse incentives driving the FHLB system, it appears poised to make matters worse the next time a banking crisis rolls around.

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