Eye on Washington

Like many financial institutions trapped with private-label securities on their balance sheets, the Federal Home Loan Banks are trying to hold on and ride it out.If they sell these illiquid assets now, the banks would incur huge losses. So they are holding them to maturity even though the mortgage-backed securities will be a drag on earnings for years to come.But unlike other financial institutions, the 12 FHLBs have an ace up their sleeve.Since 1989, the FHLBs have diverted a large chunk of their earnings to pay off $30 billion in Resolution Funding Corp. bonds the federal government issued to cover the costs of the old savings and loan cleanup.It now appears the FHLBs are on track to pay off their Refcorp obligations as early as April 15, 2012, which would free up 20% of their income.So it is just a matter of holding out for a few more years until that income stream can be tapped to rebuild retained earnings and capital.Or the FHLBs could go to Congress and ask for a temporary reduction in the Refcorp contribution, say to 15% of income, to ease some of the financial strain caused by current economic conditions and the private-label MBS. But that is not desirable and FHLB officials hope it won’t be necessary.Either way, the FHLBs seem to have the resources to get through the current financial turmoil without a government bailout like their fellow government-sponsored enterprises, Fannie Mae and Freddie Mac.American Bankers Association executive vice president Bob Davis noted the FHLB System will be more secure once the Refcorp obligations are finally satisfied.“We need to start planning now for how we are going to use those funds,” he said, “and how some of those funds can be used to make the FHLB System more competitive and effective in carrying out its mission.”In the first quarter of 2009, FHLBs reported $434 million in earnings, but six of the banks posted a loss.Earnings jumped to $1.1 billion in the second quarter and only two FHLBs reported losses.Nevertheless, the FHLBs’ investments in $63.3 billion in private-label MBS are taking their toll.The banks absorbed $953 million in impairment charges related to those private-label securities over the first six months of 2009, including $437 million in the second quarter.These impairment charges have hit some banks harder than others and several have suspended dividends as they try to rebuild retained earnings.FHLB officials tend to minimize the impact these investments are having on the banks. They like to claim that private-label MBS, which were originally AAA-rated, make up only 5% of the 12 regional banks assets.In addition, they say the securities have performed as expected in terms of interest and principal payments. They have not lost a nickel yet. The credit losses booked so far are based on models of future performance — and some real losses are expected.“We don’t like losing money,” an FHLB executive said. But with $46 billion in capital, “the system can withstand these losses,” the executive said.The private-label securities are backed by $35.4 billion in prime loans, $27.8 billion in alt-A loans and $22 million in subprime mortgages.The delinquency rate (based on 60 days or more past due) is 6.6% for the prime loans, 22.8% for the alt-A loans and 25% for the subprime loans.Half of these AAA-rated securities have been downgraded and 33% of the MBS are now below investment grade, according to the GSE regulator.The Federal Home Loan Banks also are experiencing low demand recently for advances, which is the wholesale banks’ bread-and-butter business.During the first half of this year, banks and thrifts have reduced their borrowings from FHLBs by nearly $190 billion or 20% to $739 billion.It appears banks and thrifts are flush with deposits and able to fund their mortgage pipelines and other lending needs. “As of the end of June, deposits funded 67.8% of the industry’s assets, the highest proportion since March 1998,” the Federal Deposit Insurance Corp. said.Part of the drop in advances could reflect the suspension of dividends, which are an important source of income for FHLB stockholders — banks, thrifts, credit unions and insurance companies.Members have to purchase stock in the banks when they borrow. And the suspension of stock dividends makes borrowing more expensive.This drop in demand could make it tough for some FHLBs to earn their way out of current difficulties.But the banks still have their ace in the hole. The 40-year Refcorp bonds don’t mature until 2028. So Congress could easily stretch out the payments to maintain the capital levels of the banks, if necessary.