Banking November 6, 2008, 5:00PM EST

Is the Federal Home Loan Banking System at Risk?

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The problem for taxpayers is that if a bank that has borrowed from an FHLB fails, the home loan bank gets fully repaid, even if the collateral it holds proves insufficient. That raises the cost for the FDIC, which has to protect depositors by reaching deeper into its insurance fund—and, if necessary, tapping the Treasury.

Concerned that her agency is getting squeezed, FDIC Chairman Sheila C. Bair has taken shots at the home loan bank system recently. In an interview for an in-depth analysis in the November issue of Bloomberg Markets magazine, she said: "We really get a double whammy," adding that the agency has "a beef with excessive reliance on Federal Home Loan Bank advances." The FDIC is proposing to increase its premiums for deposit insurance on banks that rely more than average on home loan bank advances and on brokered deposits—another big source of concern. (Brokered deposits come from wealthier customers who parcel out their money among many banks so they can qualify for FDIC insurance on the entire amount.)

Several economists share Bair's worries. "My concern is that there is not enough oversight by the [FHLBs] of the risk that the commercial banks take when they use advances," says Timothy J. Yeager, a former economist at the Federal Reserve Bank of St. Louis who is now a finance professor at the University of Arkansas Sam M. Walton College of Business.

In theory, home loan bank advances needn't be destabilizing. Home loan banks should open and close their funding spigots in consultation with the borrowing banks' primary regulators, such as the FDIC or the Office of Thrift Supervision. Some of that may be happening: Advances that appear unwise could have been made at the request of a regulator that wants to tide a bank over a rough spot or ease it gently into receivership.

Still, the credit bubble was all about bad loans overlooked by bankers and regulators. In the rush to revive the U.S. economy, it's important to watch out for the FHLBs funding banks that really shouldn't get the money.

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Delayed Reaction

A November 2008 Bloomberg Markets story examines the possibility of a taxpayer bailout of the FDIC if housing defaults cause a wave of regional bank failures. Regional banks, says the story, have waited longer than Wall Street firms to write off their bad mortgages. "It's not going to be Armageddon," says one economist quoted in the story, "but it's going to be bad."

To read the story, go to http://bx.businessweek.com/financial-services-industry/reference

Is the Federal Home Loan Banking System at Risk? incorrectly stated that a Federal Home Loan Bank gets fully repaid in the case of a borrowing bank's failure even if the collateral it holds proves insufficient. While the FHLBs' secured loans have priority over depositors' claims, an FHLB could still lose money if the value of its collateral dropped enough.

Coy is BusinessWeek's Economics editor.