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There are plenty of bad guys in the current banking collapse, but I want to introduce you to some unsung villains: the executives running little-known, federally chartered bankers' cooperatives called Federal Home Loan Banks. The FHLBs — known to insiders only half-facetiously as "Flubs" — like their cousins, Fannie Mae and Freddie Mac, helped throw gasoline on the 2000s mortgage bonfire.
Flub executives personally profited from stoking the crisis because their compensation was structured so that officials such as Dean Schultz, the CEO of the Federal Home Loan Bank of San Francisco, were awarded rich bonuses for loaning more money to banks, even reckless ones such as the recently failed IndyMac. Last month, these bankers won a hard-fought regulatory battle to soften rules that, had they been in force when proposed earlier this decade, might have discouraged the irresponsible lending that got us into the mess we're in now.
The FHLBs are 12 regional megabanks created by President Herbert Hoover to allow mom-and-pop mortgage lenders to weather temporary storms with cheap, subsidized loans. Like Fannie and Freddie, the Flubs operate in a regulatory no-man's land between the public and private sectors. They borrow on the open market, but with an implicit belief among investors that the federal government would never allow the Flubs to fail. This faith in the Flubs' security means they can sell their debt at a low interest rate, creating a subsidy they pass on to private banks in the form of cheap, plentiful loans.
That's fine for good banks in good times. But during the current mortgage crisis, the banks with the biggest appetite for this kind of no-questions-asked cash were the irresponsible ones. They put their mouths to the multibillion-dollar Flub cash spigot so they could continue making troubling loans long after deposits and other funding sources had run dry. The result of this Flub-funded night-of-the-living-dead banks was to worsen the impact of bad lenders' eventual collapse.
The San Francisco FHLB has become a poster child for this type of lending. During the go-go mid-2000s, critics say, it pumped billions of dollars' worth of cheap, few-questions-asked credit into large, unsafe lenders. One such bank, IndyMac, was previously the California king of a type of loan requiring scant documentation of income or assets, known during the boom as "alternative documentation loans," and in hindsight as "liar loans." As of last July, IndyMac was the biggest bank failure in U.S. history, with more than $10 billion in outstanding loans, known as advances, from the San Francisco FHLB.
Schultz rejects any blame. It wasn't FHLB lending, but banks' judgment in making home loans, which separated winners from losers in the mortgage crisis. And he insists it's the role of federal regulators, not of the FHL Banks, to supervise banks.
"The reason an institution fails is not because of the composition of its funding sources, but because of the quality of its assets," he wrote in an e-mail last week. "Some institutions made poor credit underwriting decisions, or were unprepared for the housing market disruption and severe economic downturn of the last few years, and subsequently failed."
While the fortunes of banks and depositors sank, Schultz' apparently soared. According to an executive incentive program detailed in the San Francisco FHLB's public financial filings, he receives bonuses based in large part on how much he can increase lending to member banks (without any regard for whether those banks are behaving prudently). In 2007, as irresponsible lenders attempted to cling to their business plans by taking out billions of dollars in additional loans, the San Francisco Flub was an eager enabler. At the end of December 2007, three member banks made up 70 percent of the San Francisco FHLB's lending, accounting for $174 billion of outstanding loans. The biggest borrower as of last December was Citibank, with $81 billion. Citi is currently seen as posing such a huge risk to the financial system that the Wall Street Journal cited former federal officials calling it the Death Star.
Now the S.F. Flub holds rotten assets as collateral, and recently announced it would halt dividends in order to save up a war chest to fend off insolvency.
As reward for his performance during the FHLB loan explosion, Schultz received more than $600,000 in cash bonuses for a total 2007 pay package worth $1.8 million.
When asked whether he thought it fair to ask whether a bank executive's pay package helped worsen the mortgage crisis, Schultz responded in the negative. "FHL Bank advances enable member financial institutions to lower their cost of funds, manage interest rate risk, and reduce liquidity risk, which may lead to lower costs for consumers," he wrote. "So it's patently unfair to criticize the San Francisco FHL Bank's executive compensation program for having a component that encourages providing liquidity to members, when that is the San Francisco FHL Bank's congressionally mandated mission."
It didn't have to turn out this way. In 2002 and 2006, the Federal Deposit Insurance Corporation attempted to take steps that might have discouraged the kind of excessive borrowing from FHLBs we've seen during the mortgage bubble and collapse. The agency proposed charging higher premiums of the heaviest borrowers.
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.