Is the Federal Home Loan Banking System at Risk?

It's lent billions to smaller banks like IndyMac. And if it fails, taxpayers are on the hook

By Peter Coy

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Raymond Biesinger

Fannie Mae (FNM) and Freddie Mac (FRE) were controversial for years before they fell into government conservatorship this year. But few people have considered the risks posed by the Federal Home Loan Bank System (FHLB), even though it occupies the same gray area between the public and private sectors.

Created by Congress in 1932 to bolster mortgage finance, the system, with its 12 member banks, lends to financial institutions of all sizes, with more than $900 billion in outstanding loans as of midyear, up 43% since 2006. Like Fannie and Freddie, the system can borrow cheaply because of the assumption that the federal government won't let it fail. As private cooperatives, the 12 banks make profits and pay dividends to their owners—more than 8,000 financial institutions.

Here's the problem: The system has weak restraints against overlending. Its stated mission is to make loans, and by law it's not responsible for monitoring or controlling what those loans are used for. That's the job of the borrowers' primary regulators. In addition, if a bank with an FHLB advance goes under, the FHLB is at the head of the line to get repaid, so it has little reason to lend cautiously. And in a potential conflict of interest, the FHLBs are lending to their owners—the member banks. The result: Bountiful funding from the FHLBs could allow some banks to "gamble for salvation," getting into even deeper trouble.

OVERSIGHT

True, the home loan banks don't go unscrutinized. Following a July 29 reorganization, they are regulated by the new Federal Housing Finance Agency, which also oversees Fannie and Freddie. Administrator James B. Lockhart III told BusinessWeek in an interview that the home loan banks are working effectively with the Federal Deposit Insurance Corp. and other regulators to make sure that financial institutions have access to funds. "They have provided a tremendous service to the banking industry and therefore probably to the banking regulators," says Lockhart. In addition, the home loan banks say they have an incentive to make loans that will be repaid. "The idea that we would lend recklessly just doesn't make good sense," says Alfred A. DelliBovi, president of the Federal Home Loan Bank of New York.

Still, concerns about the federal home loan banks' role grew after the July 11 failure of IndyMac Bancorp (IDMCQ). The FDIC predicts it will cost $9 billion to work out, making it the costliest takeover in the agency's history. The bank's finances were so plainly precarious that, by the end, depositors were pulling out their money in droves.

Yet IndyMac increased its borrowings from the Federal Home Loan Bank of San Francisco more than 500% from the end of 2004 through early 2008. At the time it folded, loans of $10 billion from the San Francisco bank accounted for nearly a third of IndyMac's liabilities. Amy Stewart, a spokeswoman for the home loan bank, declined to comment on why it helped keep IndyMac afloat but said that, generally speaking, it doesn't like to pull the plug on borrowers. "It is not our role to cause a liquidity problem for a member institution," she said.

The IndyMac failure came on the heels of the near-collapse of the nation's biggest mortgage lender, Countrywide Financial (BAC), which had borrowed even more heavily. As Countrywide spiraled downward in 2007, CEO Angelo Mozilo arranged for its banking unit to borrow $51 billion from the Federal Home Loan Bank of Atlanta. Senator Charles E. Schumer (D-N.Y.) charged that Countrywide was using the Atlanta lender as its "personal ATM." Bank of America (BAC) acquired Countrywide this past summer, assuming all of its liabilities.