Full text of "The future of the Federal Home Loan Bank System : hearing before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundred Third Congress, second session, on the need for a comprehensive legislative package to update and to strengthen the Federal Home Loan Bank System's mission, structure, capital requirements, and regulatory oversight, June 15, 1994"

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S. Hrg. 103-902

^ ^ THE FUTURE OF THE FEDERAL HOME

LOAN BANK SYSTEM

Y 4, B 22/3: S, HRG. 103-902 ~

The Future of the Federal Hone Loan. . .p j-^ j^

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED THIRD CONGRESS

SECOND SESSION

THE NEED FOR A COMPREHENSIVE LEGISLATIVE PACKAGE TO UI'DATE
AND TO STRENGTHEN THE FEDERAL HOME LOAN BANK SYSTEM'S
MISSION, STRUCTURE, CAI^ITAL REQUIREMENTS, AND REGULATORY
OVERSIGHT

JUNE L5, 1994

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

'"'"'•-"imM,

'^'^'iimr^'m,^'

U.S. GOVERN.MENT PRI.NTING OFFICE
86-560 CC WASIII.NGTON : 1994

For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
ISBN 0-16-046839-6

S. Hrg. 103-902

\^ ^ THE FUTURE OF THE FEDERAL HOME

LOAN BANK SYSTEM

Y 4. B 22/3: S. HRG. 103-902

The Future of the Federal Hone Loan. . .p j-vj/^

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED THIRD CONGRESS

SECOND SESSION

THE NEED FOR A COMPREHENSIVE LEGISLATIVE PACKAGE TO UPDATE
AND TO STRENGTHEN THE FEDERAL HOME LOAN BANK SYSTEM'S
MISSION, STRUCTURE, CAPITAL REQUIREMENTS, AND REGULATORY
OVERSIGHT

JUNE 15, 1994

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

APtf » f J93S

U.S. GOV.ER.N.ME.\T PRINTING OFFICE
86-560 CC WASHINGTON : 1994

For sale b\ the U.S. Government Pnnting Office
Superintendent of Documents, Congressional Sales Office, Washington. DC 20402
ISBN 0-16-046839-6

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

DONALD W. RIEGLE, JR., Michigan, Chairman

ALFONSE M. D'AMATO, New York
PHIL GRAMM, Texas
CHRISTOPHER S. BOND, Missouri
CONNIE MACK, Florida
LAUCH FAIRCLOTH, North Carolina
ROBERT F. BENTSIETT, Utah
WILLIAM V. ROTH, JR., Delaware
PETE V. DOMENICI, New Mexico

PAUL S. SARBANES, Maryland
CHRISTOPHER J. DODD, Connecticut
JIM SASSER, Tennessee
RICHARD C. SHELBY, Alabama
JOHN F. KERRY, Massachusetts
RICHARD H. BRYAN, Nevada
BARBARA BOXER, California
BEN NIGHTHORSE CAMPBELL, Colorado
CAROL MOSELEY-BRAUN, Illinois
PATTY MURRAY, Washington

Steven B. Harris, Sta/f Director and Chief Counsel

Howard A. MenELL, Republican Sta/f Director

Patrick J. Lawler, Chief Economist

Cindy Lasker, Professional Staff Member

Emily L. Frydrych, Professional Staff Member

Edward M. Malan, Editor

(II)

CONTENTS

WEDP^SDAY, JUNE 15, 1994

Page

Opening statement of Chairman Riegle 1

Opening statements, comments, or prepared statements of:

Senator D'Amato 2

WITNESSES

Frank N. Newman, Under Secretary for Domestic Finance, Department of

the Treasury, Washington, DC 3

Prepared statement 23

Summary 23

Introduction 23

I. Recent reports point to the need for comprehensive restructuring

of the Bank System 24

II. Restructuring System capital should strengthen the System's
long-run safety and soundness 27

III. Comprehensive reform is needed because of the interrelationships
among the various issues 31

Response to written questions of Senator Murray 58

Nicolas P. Retsinas, Assistant Secretary for Housing, Department of Housing

and Urban Development, Washington, DC 7

Prepared statement 32

Mission 33

Capital structure 34

Membership 35

Effects of FIRREA on Federal Home Loan Bank System 36

Governance and regulation 37

Conclusion 37

Response to written questions of:

Senator D'Amato 59

Senator Murray 63

Michael T. Crowley, Jr., Chairman, Federal Home Loan Bank Stockholder

Study Committee, Milwaukee, WI 12

Prepared statement 38

Introduction 38

Housing finance mission 39

Community development 40

I'roducts and services 41

Capital: Adequacy and reform 41

Governance 42

Membership recommendations 42

Appendix A — Stockholder committee 44

Appendix B — Contacts with organizations 46

Mary IjCC Widener, Chairman of the Board, Federal Home Loan Bank of

San Francisco, San Francisco, CA 15

Prepared statement 48

I. Introduction 48

II. Importance of Federal Home Loan Bank System 48

III. The need for comprehensive reform 49

IV. GAO is correct: The REFCorp allocation formula is unwise public
policy 50

V. HUD as program regulator 51

(III)

Page

Mary Lee Widencr, Chairman of the Board, Federal Home Loan Bank of
San Francisco, San Francisco, CA — Continued
Prepared statement — Continued

VL Targeted lending: AHP and CIP 51

VII. Membership requirements and terms of access for advances 52

VIII. Taxpayer exposure to the FHLB System: The issue of perma-
nent capital 53

IX. Summary of views on HUD study 53

X. Conclusion 54

Alfred A. DelliBovi, president. Federal Home Loan Bank of New York, New

York, NY 19

Prepared statement 54

Response to written questions of Senator D'Amato 63

THE FUTURE OF THE FEDERAL HOME
LOAN BANK SYSTEM

WEDNESDAY, JUNE 15, 1994

U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,

Washington, DC.
The Committee met in room 538, of the Dirksen Senate Office
Building at 10:05 a.m., Senator Donald W. Riegle, Jr. (Chairman
of the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN DONALD W. RIEGLE, JR.

The Chairman. The Committee will come to order.

Let me welcome all those in attendance this morning. We're
meeting here today to consider the future of the Federal Home
Loan Bank System.

I want to say, on behalf of Senator D'Amato, that he had in-
tended to be here, but is presently engaged on a matter on the Sen-
ate Floor. If time permits, he'll be joining us. He wanted me to in-
dicate that it was his intention to otherwise be here.

Today, we have two panels of witnesses whom we'll be hearing
from. The first will be Treasury Under Secretary Frank Newman
and HUD Assistant Secretary Nicolas Retsinas, who also serves as
the Acting Chairperson on the Federal Housing Finance Board, the
Home Loan Bank's regulator.

The second panel will include Mary Lee Widener, the chairman
of the Board of Directors of the San Francisco Federal Home Loan
Bank; Michael Crowley, who is Chairman of the Federal Home
Loan Banks Stockholder Study Committee; and Alfred DelliBovi,
who is president of the New York Federal Home Loan Bank.

The twelve Home Loan Banks were established in 1932 to help
deal with that era's thrift crisis and to help assure a steady source
of funding for home mortgages. Home Loan Banks, as Government-
Sponsored Enterprises, are able to borrow funds in capital markets
at rates close to those paid by the U.S. Treasury. They lend those
funds to member institutions that put up mortgages and other
housing related assets as collateral.

In the past 5 years, resolution of our more recent thrift crises
brought many changes to the Home Loan Bank System. During
that period, the number of thrift members, most of which are re-
quired to join, has fallen by one-third, and advances or loans to
thrift members have fallen by nearly one-half. Furthermore, to help
repay the costs of the thrift cleanup, legislation required the Home
Loan Banks to contribute virtually all of their retained earnings,

(1)

some $2.8 billion, plus an additional $300 million each year. These
changes clearly have been stressful to the System.

To maintain dividend levels, Home Loan Banks have expanded
their traditional role to include large investments in mortgage-
backed securities as a source of extra earnings. They've also wid-
ened their membership, as permitted by the 1989 thrift legislation,
to include commercial banks. Bank members are now as numerous
as thrift members.

Recognizing that it is time for reevaluation of the role and struc-
ture of the Home Loan Bank System, Congress, in 1992, asked for
comprehensive studies by HUD, the Congressional Budget Office,
the General Accounting Office, and the Federal Housing Finance
Board, an especially formed committee of stockholders.

The legislation also recognized Treasury's role by asking for its
comments on the studies.

The studies, of course, are now complete, and they call for wide-
ranging changes in the System's membership rules, capital require-
ments, and regulatory structure.

Today, we have officials from both Treasury and HUD here to
outline the Administration's proposal in more detail. It's fair to say
that these are complicated proposals with carefully interrelated
component parts.

The Administration will not be ready to offer specific legislative
language within a timeframe that would enable us to act upon it
this year, but I think it's important to have this hearing now. Sen-
ator, that we put in place a solid foundation for further consider-
ation of the future of the thrift industry and the Home Loan Bank
System.

With that, I'll ask unanimous consent that any statements other
Members may wish to make be put into the record at this point.

PREPARED STATEMENT OF SENATOR ALFONSE M. D'AMATO

Senator D'Amato. Mr. Chairman, I want to join you in welcom-
ing our witnesses to this hearing on the future of the Federal
Home Loan Bank System. We will hear useful and interesting tes-
timony from Administration witnesses, representatives of several
Federal Home Loan Banks, and on behalf of the stockholders.

Mr. Chairman, the Federal Home Loan Bank System has been
a mainstay in our Nation's housing finance system for over 60
years. While Congress has periodically reviewed and refined the
role of the System, by the late 1980's it became clear that a com-
plete analysis and comprehensive modernization of the System was
necessary. Other factors underscored the need for change: the
plight of the thrift industry; the need to finance the savings and
loan bailout; and changes in housing finance and mortgage mar-
kets, to mention only a few. In view of these developments. Con-
gress, in 1992, requested a number of studies to examine the Sys-
tems purpose, functions, and structure.

Mr. Chairman, these hearings serve as the backdrop for this
hearing and I want to commend all of the contributors — HUD, the
Federal Housing Finance Board, the GAO, the CBO, and others.
They are thoughtful reports and will assist Congress in considering
and determining the System's future.

Mr. Chairman, I especially want to acknowledge the participa-
tion in the hearing of Alfred A. DelliBovi, president and chief exec-
utive officer of the Federal Home Loan Bank of New York. Mr.
DelliBovi has unique experience in this area. In addition to his du-
ties at the Federal Home Loan Bank, he served as Deputy Sec-
retary at HUD in the Bush Administration. As a result, he has a
special appreciation for the role of portfolio lenders in our housing
delivery system.

Mr. Chairman, although we do not have time in the current ses-
sion to consider legislation to reposition the Federal Home Loan
Bank System for the future, I am pleased that you have started the
process with this hearing.

The Chairman. Let me now welcome our Under Secretary, Frank
Newman, from the Treasury Department, and Nicolas Retsinas.
We'll start with you, Mr. Newman. We'd like your statement. We'll
make your full statement a part of the record, and you may sum-
marize as you wish, then we'll go to Mr. Retsinas.

OPENING STATEMENT OF FRANK N. NEWMAN

UNDER SECRETARY FOR DOMESTIC FINANCE

DEPARTMENT OF THE TREASURY, WASHINGTON, DC

Mr. Newman. Thank you, Mr. Chairman. Thank you for the op-
portunity to be here to present these views and for taking the ini-
tiative to lay this foundation for future action, which we believe is
very important and really is called for, before the System goes
much further into the future.

The reports being discussed today all show that the Bank System
remains a healthy and important part of our housing finance sys-
tem. They also point out the need for comprehensive updating of
the System's mission, structure, capital requirements, and regu-
latory oversight. Together with the reports, today's hearing should
help provide a map for the Administration and the Congress in de-
veloping a comprehensive legislative package. On behalf of the Ad-
ministration, we look forward to introducing such a legislative pro-
posal by early next year.

The Bank System continues to operate largely as it was initially
structured, as you just noted, Mr. Chairman, and remains oriented
toward depository institutions that originate and hold mortgages in
their own portfolios.

It was 1989 when FIRREA introduced the first major structural
changes to the Bank System by opening System membership to
commercial banks and credit unions that met threshold tests for
mortgage lending. Today, as you noted, more than half of all Sys-
tem members are commercial banks. FIRREA added two new pub-
lic policy goals to the Bank System, the Affordable Housing Pro-
gram and the Community Investment Program. The Act directed
the Bank System to capitalize the Resolution Funding Corporation,
REFCorp, and required the System to pay $300 million a year for
40 years toward interest payments on REFCorp bonds.

The Act you just mentioned called for five studies. The reports
generally conclude that the System continues to serve an important
function and that it operates in a safe and sound manner. Most of
the reports also urge that comprehensive changes be made to keep
the System vital and healthy. Let me briefly summarize some of

the important conclusions from these reports and offer our assess-
ment of these conclusions.

By permitting commercial banks and credit unions to join the
System, FIRREA fundamentally altered the System's membership
structure. All the reports aCTee that this particular structure of two
membership classes, mandatory and voluntary, is unfair to the
mandatory members and may result in differing risk-management
incentives between the two groups.

We concur with the recommendations that System membership
should be voluntary for all eligible members.

Consistent with that, we believe that the same rules of access
should apply to all members.

Also, as recommended in the reports, we believe that member-
ship eligibility should not be extended beyond the currently eligible
group of depository institutions and insurance companies. In fact,
we believe that eligibility requirements should be somewhat tighter
than they are today. We agree with HUD's conclusion that member
institutions should have at least 10 percent of their assets in whole
residential mortgages and that this should be an on-going require-
ment, compared to the current rules where there's only an initial
requirement and an institution might have a smaller and smaller
proportion of its assets in mortgages over time and still be eligible
for advances.

This raises an important concern in formulating changes to the
System's mission and membership rules. We do not want to see
"Home Loan" taken out of the Federal Home Loan Bank System.

We believe that the program regulator should be able to increase,
but not decrease, the statutory threshold test defining an institu-
tion's commitment to housing finance in order to be eligible for Sys-
tem membership. A higher threshold would strengthen the nexus
between membership and mortgage lending.

Finally, it's crucial that collateral rules retain their focus on
mortgage loans, both to maintain the System's safety and sound-
ness and to uphold the link between advances and housing finance.
Therefore, we join in HUD's recommendation that collateral rules
not be changed.

FIRREA imposed two fixed financial obligations on the System,
the REFCorp obligation and the Affordable Housing Program.
Taken together, they take about $400 million a year of the Sys-
tem's annual earnings.

The problems with the fixed nature of these obligations are well
documented in the reports. We believe the overall strength of the
System would be improved by altering the internal allocation of the
REFCorp obligation. Therefore, we're looking at the possibility of
altering the current formula as part of the overall structural re-
form package.

Treasury is also concerned with the added risks being under-
taken by Federal Home Loan Banks in order to meet these fixed
obligations, especially the reliance on a large portfolio of mortgage-
backed securities to generate the earnings needed to satisfy these
payments, as well as to pay dividends to members. While we appre-
ciate the earnings pressure created by these obligations, we are dis-
turbed by the arbitrage between one type of a GSE security and
another GSE security.

At a minimum, we believe that such investments should continue
to be subiect to strict limits established by the safety and sound-
ness regulator. It should not be permitted beyond the level dictated
by the earnings required from the fixed obligations. We also note
that this kind of an activity does not add to the overall pool of
funds financing home mortgages and transfers interest rate risk
from the private sector market to a Government-Sponsored Enter-
prise.

Turning now to capital, as the reports note, the Bank System, as
a whole, may well have more capital than it needs, given its cur-
rent risk profile, but it also has the unusual characteristic that its
capital lacks permanence. Voluntary members may elect to leave
the System and redeem their capital stock.

The basic goal in establishing a regulatory capital structure for
the System is to ensure that taxpayers are protected from any
losses incurred by the System and from any problems that might
arise from a shrinking membership base. The second goal is to pre-
serve the System's cooperative nature, and the third is to promote
the economic efficiency of System operations.

While the five reports offer a number of approaches to restruc-
turing Bank System capital, there is general agreement among
them as to the basic risks undertaken by the Federal Home Loan
Banks. First, credit risk associated with collateralized advances is
minimal.

A relatively new area of credit risk exposure for the System,
however, is in off-balance sheet activities. As the System relies in-
creasingly on structured debt financing, it incurs credit risks in the
derivative transactions that are integral to such financing.

Home Loan Banks incur interest rate risk in both the advances
they make and the investments they hold. Finally, as with any fi-
nancial institution, operations risks are also important.

The reports each suggest that the Home Loan Bank capital re-
quirements be restructured in some way. In general, there's been
a call for more permanence in the capital base and a closer connec-
tion between risk-taking and required capital.

Rather than describe all the merits and limitations associated
with the various capital proposals, I would like to voice the Treas-
ury's concerns about problems that would be presented if publicly
traded stock were issued by the Bank System. Then I would like
to outline the Treasury's thoughts on appropriate capital structure.

We have a number of concerns with any capital restructuring
proposal that calls for publicly traded stock in the System. Perhaps
the most significant concern is how publicly traded stock would
change the incentives underlying bank management. Moving to
publicly traded stock would mean that the System would be ex-
pected to pay explicit returns to shareholders, which would be in
the form of dividends and stock price appreciation. Currently, how-
ever. System members receive substantial implicit returns in addi-
tion to the explicit dividends paid on their redeemable stock. With-
out the ability to benefit from these implicit returns, public share-
holders might encourage the banks to accept greater risks in an at-
tempt to increase profits. Generally, public shareholders might en-
courage the banks to maximize any subsidy that's inherent in their
Government-Sponsored Enterprise status, which would run counter

to the public policy interests of keeping the System low-risk and fo-
cused on specific types of financing that support the public interest.

Many of the capital structure proposals are actually refinements
of the existing structure. A strong yet flexible capital structure can
be developed simply by strengthening the existing capital's perma-
nence combined with a more rational risk-based approach for set-
ting the required level.

Permanent capital, as we use it here, means ensuring that there
is sufficient time resiliency to redeemable member stock so that it
is unlikely that too much capital would drain out of the System as
members shrink or withdraw. As noted earlier, the basic goal for
the Government is for capital to be sufficient, at a minimum, to
protect taxpayers and ensure payment of the fixed FIRREA obliga-
tions. This can be accomplished by retaining the existing redeem-
able common stock structure but by making that redemption sub-
ject to more stringent conditions than exist today.

With clearly defined rules governing redemptions, including
prompt corrective action rules, members should be otherwise free
to enter and leave the System.

It is also important to select an appropriate formula for deter-
mining the minimum amount of capital for each Home Loan Bank.
The Banks should have sufficient capital to ensure payment of the
fixed FIRREA obligations and to avoid any direct or indirect tax-
payer expense. This suggests that a minimum capital requirement
should be equal to the present value of the REFCorp obligation
plus some risk-based amount. The risk-based amount could be con-
structed as the sum of two elements; one for credit risk, both on-
and off-balance sheet, as well as management and operations risks,
and the other element for interest rate risk.

Establishing and enforcing capital rules requires a safety and
soundness regulator, obviously.

Most of the reports describe the problems associated with the Fi-
nance Board's conflicting roles as governor-manager for the Sys-
tem, safety and soundness regulator, and programmatic regulator.

We agree that the Finance Board's current responsibilities are in
conflict. We further believe that it is essential that the Bank Sys-
tem have a strong, independent safety and soundness regulator,
able to handle the kind of sophisticated transactions that the
Banks are increasingly getting into, to implement the regulatory
reforms of the Bank System that will be part of the comprehensive
reform package.

In conclusion, the five reports on the System, mandated by the
Act, point the direction for comprehensive reform and updating of
the System. It is important to note that in the broad areas I've de-
scribed this morning, there is general agreement across the five re-
ports. We think this is good news, Mr. Chairman, for it suggests
that a consensus on comprehensive reform is achievable.

To summarize, the reports generally agree that:

— Membership rules should be made consistent for all eligible
members.

— The Bank System should be able to continue meeting its
FIRREA obligations, although the burden of those obligations
is adding risk to the System and has certain perverse incen-
tives.

— The Bank System capital needs to be restructured with greater
permanence. The capital levels should be risk-based.

— The current responsibilities of the Finance Board, to be both
manager and regulator, need to be separated.

The Treasury Department concurs with each of these conclu-
sions.

The reports also agree on one other key point. That is, that
achieving these changes and improvements to the Bank System re-
quires comprehensive, not piecemeal, legislation. For example,
moving all savings associations from mandatory to voluntary mem-
bership status must be done in conjunction witn reforming tne Sys-
tem's capital structure and membership rules.

Mr. Chairman, with the release of the final mandated study of
the Bank System by HUD, the Treasury Department is working
with HUD and others in the Administration to develop such a com-
prehensive package. As noted earlier, we expect to complete our
work by this fall, and present the legislative proposal by early next
year. We look forward to working with this Committee for the pas-
sage of Bank System reform legislation during the next year.

Thank you, Mr. Chairman.

The Chairman. Thank you very much.

Mr. Retsinas, we'll make your statement a part of the record, and
we'd like your comments now.

OPENING STATEMENT OF NICOLAS P. RETSINAS
ASSISTANT SECRETARY FOR HOUSING, DEPARTMENT OF
HOUSING AND URBAN DEVELOPMENT, WASHINGTON, DC

Mr. Retsinas. Thank you, Mr. Chairman. Let me join my col-
league. Under Secretary Newman, in thanking you for the oppor-
tunity to come here and for your leadership on what is a very, very
important issue.

As you noted, I come here in two capacities; one as the Assistant
Secretary for Housing in the Department of Housing and Urban
Development, and also as the designated representative of Sec-
retary Cisneros on the Federal Housing Finance Board.

I would like to acknowledge, if I could, Mr. Chairman, the other
Director of the Federal Housing Finance Board, Larry Costiglio,
who's also here this morning.

I have prepared and submitted to your office, to your staff, the
written statement.

What I would like to do, if I could, Mr. Chairman, is summarize
the major points, summarize the study undertaken by the Depart-
ment of Housing and Urban Development that I believe will lay the
kind of foundation that Under Secretary Newman was referring to.
As you know, the legislation asked each of the study entities to an-
swer 14 questions. Rather than go through the 14 questions, I'd
like to focus on six that I think are the core issues as you look to
the future of the Federal Home Loan Bank System.

As you pointed out in your opening statement, the System was
created in 1932. It was one of many agencies created, at that time,
to help take this country out of the Depression. Its primary mis-
sion, in 1932, was to support housing finance. The first and essen-
tial conclusion of the HUD study is that mission ought to be

reafTirmed. That mission ought to be reaffirmed and codified. There
remains an important role in the support of housing finance.

We further beheve that mission can be prudently expanded.
While continuing to focus on housing finance, we think it's appro-
priate to contemplate an expansion of that mission with new devel-
opment lending. We qualify that, of course, to note that that mis-
sion ought to be expanded in a safe and sound manner, but we be-
lieve the capacity of the member institutions can add real value to
community development lending.

In looking at the mission and role of the Federal Home Loan
Bank System, one of the first questions that we address is the con-
tinuing importance of portfolio lending. As you know, Mr. Chair-
man, better than anyone, there has been a substantial growth in
the role of the secondary market in housing finance and mortgage
lending generally, so it is a fair question to ask what role continues
to exist for portfolio lending. We believe there is an important role,
and we believe that the Federal Home Loan Bank System can pro-
vide an important source of capital for that role. It is the 4,600
member institutions who are very often closest to the needs within
their communities.

With my capacity at HUD, I understand that there are certain
kinds of loans and certain kinds of lending that do not lend them-
selves to the secondary market. Multifamily lending and small
business loans come to mind. It appears to us that portfolio lending
is an important way of addressing those needs.

Again, our first conclusion is a reaffirmation of the mission of
supporting housing finance, and a prudent expansion of that mis-
sion into community development lending.

Clearly, as Under Secretary Newman noted, the second issue
that we addressed that is fundamental to the future of the System
is the issue of capital and the need for an appropriate amount and
type of capital to support and undergird the System. While we be-
lieve there appears to be, at least under current rules, an adequate
amount of capital, we too, are concerned about the lack of a perma-
nent capital base. We suggest, in the report, alternative ways of
crafting a capital structure that will attend to that issue.

I might note that the individual banks and the regional banks
are now undertaking a maior study in this regard. We expect that
study to be completed by the end of the summer, and that will be
an input into these deliberations. We need to look not only at the
capital structure as outlined by the participants, but also the ap-
propriate capital structure that can protect the fiduciary interests
that we have a responsibility for. We certainly have an open mind
on what some of those alternatives may be. We will come to a con-
clusion when we present our legislation to you early next year.

The capital structure, of course, is related to many other issues.
Another one that I want to bring to your attention is the issue of
membership. If you believe, as we do, that the System is ultimately
dependent on its ability to attract and retain private capital, we be-
lieve that over time membership must be voluntary. If there is
going to be an efficient investment of capital, the membership
ought to be voluntary and open, on equal terms to all members. We
are proposing that as our conclusion. We are aware, however, of
the transitional nature of that recommendation.

There are, as Under Secretary Newman pointed out, obligations
of the System, obligations as it relates to the REFCorp payment,
and obligations as it relates to the Affordable Housing Program.
We believe those are obligations that must be met. As we make
this transition to a full voluntary system, we need to make sure we
don't undermine those commitments and those obligations.

The fourth conclusion of that report is the need to expand the
products and services offered by the System. While we stop well
short and suggest that it is not an appropriate role for the System
to engage in securitizing loans and being another secondary mar-
ket, we think there are some opportunities for an expanded role.
I believe that many of these expanded products and services can
take place without legislation. We have certainly challenged the re-
gional banks to think through how they can reach out and be more
actively supporting of housing finance and community development
lending.

I have not yet received a complete report on their activities, but
some preliminary information indicates there is a fair amount of
imagination and creativity. We need to make sure that that's done
prudently but in a way that's responsive to local needs.

The fifth major issue I would like to summarize for you, Mr.
Chairman, is the issue of System governance and regulation. As
you know, currently the System has three obligations. It has a
safety and soundness regulatory responsibility. Second, it has what
we would call a program regulation responsibility to ensure that its
mission is kept, and third, it has a responsibility to oversee the
business operations, the raising of capital for the System. We be-
lieve that the continued marriage and joining together of those re-
sponsibilities is inhibiting the growth, development, and potential
of that System. Therefore, our report recommends a separation of
those responsibilities in this way.

We would suggest that consideration be given to the delegation
of the safety and soundness regulatory responsibility to the new Of-
fice of Federal Housing Enterprise Oversight.

As you know, Mr. Chairman, this was an office created by this
Committee and the Congress as an independent office within the
Department of Housing and Urban Development. We believe it's
appropriate to have a centralized GSE regulator, and we believe
this would be an appropriate home. We do, however, in the report,
acknowledge this office is literally just getting off the ground. It is
just in its first year and we certainly need to look at that closely
to judge its capacity to carry out that responsibility.

As it relates to program regulation, that is, to ensure that the
housing mission is undertaken, we suggest that we follow the
model of this Congress in its regulation of the GSE's. Therefore, we
are recommending, for your consideration, that the program regu-
latory responsibility be transferred to the Secretary of the Depart-
ment of Housing and Urban Development, not the operation of its
housing mission, but really oversight to ensure that mission is
being met.

Third, as it relates to business operations, we believe that there
can be a continuing decentralization of business operations to those
that are putting up the capital. We think there is a continued role
for a Federal Housing Finance Board by defining its board and

overseeing those business operations, but we believe a continuing
decentralization to the level that is closest to where the money
comes from is an appropriate way to move forward.

The sixth issue I'd like to bring to your attention is the REFCorp
obligation. We, too, join the concern of Treasury in terms of the im-
pact of this obligation and the kinds of investments that result as
a consequence of this obligation.

In all candor, Mr. Chairman, we wrestled with an alternative
way to meet that obligation. Our preliminary conclusion is that we
haven't found it yet. That doesn't mean that we're still not working
on it. We believe it's an important obligation, one that cannot be
put aside. It does have some unintended results as it relates to the
investment decisions of member banks. We're trying to find a way
that we can eliminate the unintended results and still meet that
obligation. We have some thoughts, some preliminary thoughts, but
we've not been able to get through the budget scoring system here
in a way that's able to give you, at this point, a clear recommenda-
tion.

Last, the issue of System consolidation. While we believe that,
over time, there may in fact be consolidation of the System, there
may be a more efficient array of the member banks, we believe it
is inappropriate for us, for we here in Washington, to try to align
that System. We think that if we make the System responsive to
a capital structure that encourages the efficient use of capital, the
System will align itself in a voluntary way, over time, in a way
that's efficient and effective.

In summary, Mr. Chairman, we believe the System continues to
have value. We believe the System, today, is safe and sound. We
also believe it is our obligation to take those steps that are nec-
essary to ensure its safety and soundness in the carrying on of its
mission over time.

We certainly are looking forward to working with Treasury and
other parts oi the Administration in putting together comprehen-
sive legislation, that we can bring to the Committee's attention
next year, that we believe will set the ground work for the future
safety and soundness of the System.

Thank you, Mr. Chairman.

The Chairman. Thank you very much.

Let me pose this question to both of you. Right now, as you
know, we're in conference with the House on the Community De-
velopment Financial Institutions Bill. I've taken the position that
we should not deal with amendments to the Home Loan Bank Sys-
tem until we have a comprehensive proposal from the Administra-
tion.

I particularly oppose raising, from 30 percent to 40 percent, the
maximum principal share of Home Loan Bank advances to mem-
bers who do not meet qualified thrift lender tests.

I'm wondering, what is the Administration's position on these is-
sues? Let me ask you first, Mr. Newman.

Mr. Newman. Fine, Mr. Chairman.

We agree with you wholeheartedly. As a matter of fact, we won-
der if there may be some misunderstanding about the facts here
because, after taking a closer look, it turns out that only about 8
percent of that 30 percent is being utilized at the moment.

The definition does not apply to commercial banks, which are 16
percent, but to non-QTL members, as you mentioned, and that's
only 8 percent, so there's quite a bit of leeway already left in the
30 percent.

Some people are also under the misimpression that the 30 per-
cent applies to each individual bank, and that's not correct either.
It applies to the System as a whole, so there just isn't any need
to do it.

Second, these members that we're talking about are members
who would be voluntary members. To increase the risk of the Sys-
tem without having a solution to the permanence of the capital just
doesn't make sense from the Government's perspective. We have to
keep in mind that the only way that these institutions are able to
provide low-cost financing is by capitalizing on their status as a
Government-Sponsored Enterprise, and there is implicit or explicit
risk to the Government involved here, especially if we undertake
to increase the risk without first assuring that the capital structure
is proper. We've been through that before, Mr. Chairman. You
know all about that. You've had to solve problems after that has
happened in similar environments.

The third thing is that to start picking on pieces of this without
seeing all the pieces fit together — as you suggested, it just doesn't
make sense. There's a great danger of one piece or another seeming
like it makes sense independently, which this one doesn't, I don't
believe, but when you look at the context of everything, you then
conclude that it doesn't make sense to do one piece at a time.

Mr. Retsinas. We agree with that conclusion.

Just for emphasis, there is — one of the things that we learned,
in undertaking our study — there is a Rubik's Cube quality to the
System in terms of the interrelationships of the pieces. We believe
it is appropriate to look at it comprehensively, so we concur with
that.

The Chairman. Let me ask you, another provision in the House
CDFI Bill would exempt Community Investment Program loans
from existing collateral requirements of Home Loan Banks. Ques-
tions of timing aside, do you think it's necessary or desirable to
eliminate collateral restrictions for these loans?

Mr. Newman. Again, Mr. Retsinas will comment from some more
direct experience, but our view is that it's not necessary, there's no
demonstrated need for that. The collateral system is working quite
well. It is essential that this System, in order to provide its fun-
damental function in the future, continue to be low-risk, and we
need to be very careful about taking on new risks. The System is
providing important community services right now without taking
on undue risk, and should be able to continue to do so.

Mr. Retsinas. Mr. Chairman, prior to my joining the Adminis-
tration, I was with a housing finance agency that was a borrower
from Federal Home Loan Bank System, so I am certainly aware of
the collateral requirements. While they are appropriately stringent,
the key word is appropriately. Right now, the collateral require-
ments are really a fundamental back-up of the safety and sound-
ness of the System.

The Chairman. Mr. Newman, let me ask you this. It's our under-
standing that the RTC spending on thrift losses is coming in on the

low side of the expectations, at least thus far, and that sounds like
good news. Some are suggesting that, as a result, we should reduce
the amount of money we made available to the RTC last year.
Would you agree with that? What would be your view?

Mr. Newman. The first thing that occurs to me, Mr. Chairman,
is when will we ever learn.

The one thing that we know in common about all the estimates
that have ever been made about the costs associated with this is
that they've all been wrong. One of the reasons the structure that
was put in the bill, that I know you supported, was put there was
to allow some degree of reality to the estimation process.

These estimates that are being talked about now are just that;
they're only estimates. There's still about $50 billion worth of prob-
lem assets that need to be sold out of the RTC. Nobody knows for
sure what prices they will bring, and nobody will know until the
sales are actually made.

The structure now calls for none of that $18 billion to be spent
unless it needs to be spent. There is an approval structure, where
the RTC goes to the Oversight Board, that is chaired by Secretary
Bentsen, any time it believes that it needs another block of funds
and demonstrates, to the satisfaction of that Board, that, in fact,
it needs the block of funds.

We would be delighted, and I know Secretary Bentsen, person-
ally, is very hopeful that we'll be able to report back to the public
at the end of the RTC that, in fact, much less than the $18 billion
was needed, but it would be highly premature and unnecessary to
take an action at this point in time. We would hate to see the RTC
in a situation where, once again, it has to come back to Congress
for more funds, and the mechanism to make sure that it doesn't
spend more than it needs to is already in place.

The Chairman. Very good.

Gentlemen, we have other questions for the record that we're
going to ask you to respond to, and there'll be questions from other
Members as well, but I'm going to excuse you now and call our next
panel. Thank you very much for your testimony.

Mr. Newman. Thank you.

The Chairman. Let me again introduce our witnesses on the sec-
ond panel. Mr. Michael Crowley is the Chairman of the Federal
Home Loan Banks Stockholder Study Committee, Mary Lee Wid-
ener is chairman of the Board of Directors of the Federal Home
Loan Bank of San Francisco, and Alfred DelliBovi is serving as the
president of the Federal Home Loan Bank of New York.

We'll put your full statements in the record, and we'll take you
in the order that I've just cited your names, if we may.

Mr. Crowley, we're going to start with you, and we'd like you to
summarize. We'll go right on down the table.

Thank you.

OPENING STATEMENT OF MICHAEL T. CROWLEY, JR.

CHAIRMAN, FEDERAL HOME LOAN BANK STOCKHOLDER

STUDY COMMITTEE, MILWAUKEE, WI

Mr. Crowley. Thank you, Chairman Riegle. Members of the
Committee, on behalf of the Federal Home Loan Banks Stockholder
Study Committee, of which I am Chairman, I'd like to thank you

for this opportunity to testify on our views of the Federal Home
Loan Bank System. My name is Mike Crowley and I'm the presi-
dent of Mutual Savings Bank of Milwaukee, WI.

The original request from Congress in the Housing and Commu-
nity Development Act of 1992 for a report on the Federal Home
Loan Bank System and its stockholders provided representatives of
the System's owners with a unique opportunity to assess and de-
bate the structure of the System and reach a consensus on the fu-
ture evolution of the System.

Congress, as we've heard, has now received the full complement
of reports on the Bank System, including the recently filed report
from the Department of Housing and Urban Development. Al-
though others will contribute to the assessment of the Bank Sys-
tem, no other group has our perspective interest and commitment
to the Bank System. The stockholders of the Federal Home Loan
Banks are the owners, members, and users of the System. Their
Federal Home Loan Bank membership is an integral part of their
institution's operations.

As we've heard and seen in the reports, no, the System is not
broke, and ves, it does need some fixing, but those repairs do not
have to be clone on an emergency basis.

We join with the Administration in opposing the piecemeal
changes to the Federal Home Loan Bank Act that would be affected
by sections 220, 221, and 222 of the House version of the Commu-
nity Development Financial Institutions Bill, H.R. 3474. Savings in-
stitutions, such as my own, hold about 75 percent of the stock of
the Federal Home Loan Banks. We have the greatest stake in their
health and are vigorously opposed to tinkering with the highly
interrelated mechanism that is the Federal Home Loan Bank Act
to satisfy special constituencies in advance of comprehensive re-
form.

The areas of the mission of the System and products and serv-
ices, I believe, were well covered in the written statements that
were provided by others here today. I'm going to just ask that my
comments be referred to in my written statement.

I would like to point out that our group also studied the relative
affordable housing contribution of each of the housing sector Gov-
ernment-Sponsored Enterprises. We note that the Bank System is
the only one of three with an objective dollar subsidy requirement
soon to reach $100 million per year. Both Fannie Mae and Freddie
Mac have specific targets for low-, moderate-, and central-city lend-
ing. They expect to show a profit margin on those loans that is not
significantly different from the rest of their book of business.

The hard dollar financial commitment of the Federal Home Loan
Banks and their members to affordable housing is already in place.
Thus, the goals established for those other GSE's are not relevant
to the Federal Home Loan Banks.

Our position on these issues was developed while Congress was
in the very early stages of drafting the important CDFI legislation.
We support the thrust of this legislation. I'd also like to, personally,
add a thank you to Congress for the inclusion of a measure of regu-
latory relief within that pending legislation.

The application of formal percentages of low- to moderate-income
mortgage loans, or other designated assets, against Federal Home

86-560 - 95 - 2

Loan Bank advances outstanding can never be a workable ap-
proach to ensuring appropriate use of those funds. Many institu-
tions are occasional borrowers from the System, but their commit-
ment of funds to these uses is ongoing, stable, and even increasing.
The Community Support regulations and the CRA process is better
suited to assure mission fulfillment.

Today, I've heard the Treasury's testimony with great interest,
and I'm sure the System stockholders will consider it very care-
fully.

The question of System capitalization is a complicated one, given
the twin constraints of REFCorp and the AHP. They need not, and
underline the word not, drive away voluntary members through
low dividends or otherwise. The Administration and Congress thus
should proceed very cautiously and deliberately in this capital area,
and not attempt to get too specific too quickly lest unintended and
damaging consequences occur. The current work of the Federal
Home Loan Bank System's Capital Study Task Force, in studying
and developing recommendations on capitalization, certainly will be
very important in determining how we proceed.

It is my hope that your Committee will hold future hearings that
will focus on the results of the Capital Study Task Force and those
industry groups, such as Savings and Community Bankers of
America, that are developing recommendations on System reform.
Involvement of the equity holders in any reconfiguration of a cap-
ital base is vital. At this point, virtually all of the capital in the
System is represented by the holdings of redeemable common by
the member institutions. Their reaction to any proposed overhaul
will be critical to its feasibility and success.

I believe the critical component will be legislatively assuring that
the System's permanent capital is not again subject to confiscation
as occurred in 1989. This said, we would note, however, that the
capital investment in the Bank System is higher than needed for
safety and soundness purposes under any risk-assessment method.
The stockholders' contribution to capital should be reduced, of
course, subject to the ability of the Bank System to pay its
REFCorp assessment and its Affordable Housing Program obliga-
tions.

The Stockholder Committee recommends that minimum safety
and soundness capital standards for the Federal Home Loan Banks
in the Bank System should be based on risk and overall financial
condition, similar in purpose to the stress test developed for the
other two GSE's.

Then again, even higher capital adequacy standards for the Bank
System may be required from time to time to assure the ability of
the System to maintain its triple A credit rating and to cover the
REFCorp and the Affordable Housing obligation, as well as to pro-
vide a reasonable dividend to stockholders.

The Bank System should have the necessary tools available to
address capital adequacy, including the authority to permit the
Banks to issue different classes of stock to members, to build per-
manent capital, and to retain earnings without fear of confiscation.

Since the members are the providers of the System's entirely pri-
vate capital, they deserve a serious review of their role in govern-

ance. In fact, and as we've heard today, several of the studies rec-
ommended a separation between regulation and management.

Here again, the Bank System currently is undertaking an effort
system-wide to recommend and to study delegation of governance
back to the individual local Federal Home Loan Bank Boards of Di-
rectors.

Voluntary membership on a uniform basis must be extended to
all members of the Federal Home Loan Banks. Access to member-
ship in the Federal Home Loan Banks should continue to be avail-
able only to thrifts, commercial banks, credit unions, and insurance
companies, as under the current rules, since these are the Nation's
portfolio lenders.

Consistent with uniform rules for membership, the stock pur-
chase requirement for all members should be equalized when a sin-
gle class of voluntary members is created.

The committee's recommendations were unanimous, in part be-
cause of the careful balancing of the individual items within the
overall package.

To quote directly from our report:

The issues facing the Federal Home Loan Bank System are significantly inter-
related and cannot be addressed in isolation. It is so important not to deal with the
issues facing the System on a piecemeal approach.

We are aware that Congress is unlikely to adopt every provision
in our report, or in any other report, for that matter, without some
adjustment. Even so, we urge careful consideration of the connec-
tions between individual components of any package of System re-
form amendments.

In that regard, we commend to your attention one final and very
difficult issue that hangs over the System since FIRREA. That is
the inflexible first-dollar call on System earnings for the REFCorp
contribution.

We are intrigued by the approach outlined in the GAO report
whereby any shortfall or surplus from the 20 percent tax yield
could be debited or credited to an interest bearing account to
equate to the same present value burden and maintain the flexibil-
ity of the System. We did not offer that solution in our report but
I have discussed it with many members of our committee, and we
agreed that it would be an equitable way to restore flexibility to
the System's operation.

I'd be happy to answer any questions on our study or on any
other studies that have been submitted to you. Thank you for this
opportunity to express our views.

The Chairman. Thank you very much.

Ms. Widener, I'll take you next.

OPENING STATEMENT OF MARY LEE WmENER

CHAIRMAN OF THE BOARD, FEDERAL HOME LOAN BANK OF

SAN FRANCISCO, SAN FRANCISCO, CA

Ms. Widener. Thank you, Chairman Riegle and Members of the
Committee, for inviting me to testify. My name is Mary Lee Wid-
ener, chairman of the Board of Directors of the Federal Home Loan
Bank of San Francisco. I also serve as president of Neighborhood
Housing Services of America. My comments will reflect views de-
veloped from both of these perspectives.

My relationship with the Federal Home Loan Bank System dates
back to 1971 when I was employed to promote effective urban lend-
ing strategies, and in 1977, was appointed to be a director of the
San Francisco Bank.

The Neighborhood Housing Services organizations grew out of
that work. Wearing my NHS nat, thank you for your steadfast sup-
port over the years for that work.

All of this has given me an opportunity to witness the dramatic
changes in housing finance in the last two decades. As we address
the issue of reforming the System, I see our challenge as one of
working for a consensus on changes that will ensure the long-term
capacity of the entire System to support its housing mission
through its service to portfolio lenders. Portfolio lenders are crucial
to this country's most difficult housing and economic development
needs, and play a preeminent role in ^stering the work of commu-
nity development organizations through the Affordable Housing
Program and Community Investment Program of the Banks.

The Federal Home Loan Bank System, acting through its mem-
bers, is a vital link between the financial community and the low-
income neighborhoods of this country. As one example, South
Central Los Angeles is a community with well-known social and
economic problems, yet one with prideful volunteers and credit-
worthy borrowers.

The members of the Federal Home Loan Bank are the most sig-
nificant source of private financing that fiows into South Central
Los Angeles, originating 65 percent of all mortgage loans made
there. Of this $895 million, $726 million went to minority appli-
cants. Throughout California, our members' ratio of mortgage loans
originated in the low-income neighborhoods of California was 50
percent higher than the ratio of all other mortgage originators in
the State. This kind of lending is feasible for our members because
the Federal Home Loan Bank System has accomplished its primary
mission for the past 62 years: supporting lenders who make home
loans.

Providing our members with liquidity from the Federal Home
Loan Banks gives them an incentive to hold otherwise illiquid
home mortgage loans that do not qualify for the secondary market
and to be proactive in more difficult lending environments than
otherwise would be feasible.

The Administration has indicated that it will submit comprehen-
sive legislation to Congress addressing Federal Home Loan Bank
issues. Comprehensive reform is needed to strengthen the System's
capacity to excel in meeting its social and its financial obligations.
In that regard, I believe that reform must be comprehensive, not
piecemeal, in nature. As a result, we cannot support the adoption
of the cluster of amendments in the House version of the Commu-
nity Development Financial Institution legislation affecting the
Home Loan Banks at this time, or in their current form. Such is-
sues, however, should not be precluded from being adopted as part
of a comprehensive package of reforms on capital, governance, and
other issues.

The System, including community interest directors who are rep-
resentatives of community development organizations, is working
toward development of solutions on all these issues. The group is

the Governmental Affairs Committee of the Federal Home Loan
Banks. Our objective is to speak on these issues with one diverse
voice. We look forward to a continuing dialog with the Administra-
tion and Congress in arriving at the most productive actions pos-
sible.

One topic in need of attention is the current distortion of the pri-
mary mission of the Federal Home Loan Banks by the obligation
to make interest payments on the bonds issued by the Resolution
Funding Corporation, also known as REFCorp, and by the manner
in which those payments are allocated among the Federal Home
Loan Banks. The Federal Home Loan Banks are required by law
to make a fixed annual REFCorp payment of $300 million. As the
Government Accounting Office has noted, this fixed obligation has
caused the Federal Home Loan Banks to greatly increase their in-
vestment in mortgage-backed securities. The GAO found that this
investment has increased both the interest rate risk and the man-
agement risk in the System, thereby raising the possibility that
meeting the fixed obligations could conflict with the System's safety
and soundness. The GAO is correct.

The GAO also states that the shortfall allocation penalizes lend-
ing and could disrupt the System. The Congressional Budget Office
concludes that the REFCorp payment subverts a Federal Home
Loan Bank's incentive to make advances to savings and loans, the
very institutions that have capitalized the System. Both the GAO
and CBO conclude that the formula penalizes the Federal Home
Loan Banks for fulfilling the purpose for which they were char-
tered: to safely support lending, primarily through advances to its
members.

Another key issue in reforming the System is the function of its
regulator.

The HUD study states that safety and soundness regulation
should be separated from the Federal Housing Finance Board's cur-
rent managerial responsibilities. Everyone agrees on that point. We
believe that the Boards of Directors of the Banks should be respon-
sible for managing the Banks, and that the safety and soundness
regulator should be responsible for examining and supervising the
Banks in a manner consistent with other regulators.

Another critical issue facing the System today is its membership
structure.

The GAO has stated that the System would be more stable and
effective if membership were voluntary for all insured depository
institutions. We agree.

Also, any reform of the stock purchase requirements should not
discourage shareholders from borrowing from a bank. Members
that borrow from the System are the main source of revenue for
the System.

The two principles for constructing sound membership rules
enunciated in the GAO study make a great deal of sense. First, the
rules should equalize the benefits and burdens of membership for
all members, irrespective of charter type. Second, the rules should
give more control of the System to the shareholders of the Federal
Home Loan Banks as an incentive for their use of the System and
its growth in meeting public policy objectives.

The issue of System capital, its appropriate amount and form, is
a complex matter.

We've not had time yet to analyze the proposals made by the
Treasury Department today, though I have to admit I cheered
throughout my quick reading of Mr. Newman's testimony.

We look forward to a continuing dialog with Treasury on rede-
sign of the System's capital in a manner that will ensure the safety
and soundness of the System while recognizing that the capital
issue cannot be divorced from the REFCorp issue.

In closing, systematic reform is necessary in order to increase our
efforts to help portfolio lenders, and through them, to help low-in-
come communities. We need to attract new members and to retain
our existing members. The REFCorp assessment, the membership
requirements, the capital structure, and the governance structure
need to be reformed.

Addressing the REFCorp issue is the most difficult challenge.

As GAO noted. Congress could change the fixed $300 million as-
sessment to 20 percent of System income and require the Federal
Home Loan Banks to continue paying the Grovernment past the
maturity date of the REFCorp bonds if the present value of such
variable payments was less than the present value under the cur-
rent assessment. Although this proposal is budget neutral over the
37 or more years that payments would be made by the banks, we
recognize that it may not be budget neutral over the 5-year time
frame used for scoring proposed legislation, so it would require a
budget waiver. It seems, however, that if ever a budget waiver
would be warranted, it should be when GAO recommends it as a
measure to reduce the long-term risk to the taxpayer in a manner
that is, in the long run, budget neutral.

These reforms, Mr. Chairman, would enhance System strength
and each bank's ability to back the efforts of citizens to improve
home ownership and the quality of housing in their communities
across America.

Thank you very much, and thank you for all your work on this.

The Chairman. Thank you.

Mr. DelliBovi.

OPENING STATEMENT OF ALFRED A. DELLIBOVI, PRESIDENT,
FEDERAL HOME LOAN BANK OF NEW YORK, N^W YORK, NY

Mr. DelliBovi. Good morning, Chairman Riegle. I'm Al Delli-
Bovi, president of the Home Loan Bank of New York, and I appre-
ciate this opportunity to appear before you to comment on this
study. I also appreciate your including my full written testimony
in the record, so I'll just say a few words in summary.

The New York Bank is in full agreement with the two central
conclusions of the HUD study: One, that portfolio lending in sup-
port of mortgage financing is critically important; and two, that
support for mortgage portfolio lenders should remain the core func-
tion of the Home Loan Bank System.

The System works well, and the HUD study tells us it is needed
and, more importantly, it's not broken. While we look forward to
working to develop comprehensive legislation in the future, we do
remain in business today. Today, we and the local lenders that we
serve should enjoy the benefits of the few legislative changes that
we believe common sense and reason dictate are needed now.

To that end, the Board of Directors of the Home Loan Bank of
New York has adopted a legislative agenda which is included in my
full written testimony.

During deliberations on these legislative objectives and other
comprehensive legislation that may be considered in the future, it
is critical, we believe, to ask one question, the 15th question, if you
will, that wasn't asked in the five studies. That question is: How
do the portfolio lenders, with the support of the Home Loan Bank
System, do their business?

These studies tell us that they do business, that they're worth
having in business. The question I think that wasn't asked that
needs to be answered is how do they do that business?

Portfolio lenders are in business for the long haul. They are often
located in the very heart of their communities. The community
lender is there to help finance a loan for his or her neighborhood.
He or she is there to take deposits and offer savings accounts.
They're there to cash checks, to make car loans or personal loans,
and to keep valuables safe. In short, they serve to meet many of
the diverse financial needs of their communities.

The ability to accept, as collateral, many types of mortgages, has
enabled the Home Loan Banks to offer a unique foundation, a foun-
dation from which local lenders can play their key role of building
neighborhoods. With our flexible policies, we can lend against a
wide variety of creditworthy, mortgage-related collateral. This flexi-
bility has, in turn, enabled portfolio lenders to meet their cus-
tomers' varying financial needs.

A great many of our local member lenders holding mortgages in
the New York district hold them on l-to-4 family residences, resi-
dences with a small business, maybe a health care facility or a dry
goods store, attached. These types of l-to-4 family properties typi-
cally do not fall into the standards and guidelines of the secondary
mortgage agencies.

I give a number of examples in my written testimony of the
kinds of businesses that I'm talking about, the kinds of houses, and
the kinds of community lending that our members make, and they
make everyday. These are the nonconforming loans.

Let me also point out that our community housing lenders don't
just make nonconforming l-to-4 family loans. Basic multifamily
residential mortgage in this country is a key part of the business
strategy of many of the members of the New York Home Loan
Bank. Because of the special housing requirements of our metro-
politan communities, our members have developed special expertise
in multifamily lending. This is especially important in this sector
of the residential market because it is so clearly underserved by
the secondary market. In fact, if you look at multifamily mortgages
that banks and thrifts hold in their portfolios, you'll see that they
total 3V2 times all of the multifamily mortgage securities outstand-
ing. I think that's important enough for me to try to repeat in an-
other way.

If you look at the entire amount of securitized multifamily mort-
gages, you will find that the commitment of thrifts and banks to
multifamily lending is 3V2 times as great. The ability to pledge
these loans at the Federal Home Loan Banks is the major factor,
I believe, in maintaining the flow of mortgage funding to this vital
sector of the housing market.

Mr. Chairman, we believe this is community development lend-
ing. This is what our members do everyday. The portfolio lenders
who do this kind of lending have relied on the Federal Home Loan
Bank System to serve as an integral partner for over 60 years.
Through our programs, we ensure a flow of capital from Wall
Street to Main Street.

Without question, the Home Loan Bank System serves an impor-
tant role in our economy. This fact is underscored in each of the
five studies mandated by Congress in 1992. There is another im-
portant fact that all of the studies agree on as well, that is, that
the System is well capitalized. This position of capital strength is
reflected in the results of a special analysis to evaluate the stand-
alone credit rating of the housing GSE's by Standard and Poor's.

Standard and Poor's gave the Federal Home Loan Bank System
a triple A credit rating on a stand-alone basis, that is, without any
implicit Government backing. The Bank System is the only housing
GSE to receive this high ranking. Furthermore, the Bank System
is among a handful of banking institutions in the entire world with
a triple A stand-alone rating.

The CBO, the GAO, and HUD have each put forth ideas on how
the basic nature of the capital in the System could be improved.
To respond to these ideas, the 12 District Banks are conducting a
coordinated and comprehensive analysis of the System's capital
structure and possible alternatives.

The objective of this study is to recommend viable alternatives
for the capital structure of the System that address the concerns
of the Government regarding the permanency of capital while pre-
serving the value of our existing shareholders' investment.

This System's study is being conducted by a committee consisting
of Federal Home Loan Bank executives, thrift and commercial
bank shareholders, public interest directors of the banks, and has
the help of an investment banker, outside legal counsel, and ac-
counting counsel as well. Three representatives from the Finance
Board, Director Retsinas, Director Costiglio, and Acting Managing
Director Fair, serve ex officio on this committee.

Because the System is well capitalized currently, and there is no
danger, not even a cloud on the horizon, we should, in a measured
and considered manner, thoroughly explore all options in this com-
plicated question on the future structures of the System's capital.
In my written statement, I list many of the questions that are
being asked as part of that capital study.

The study's modeling and stress testing exercises are going to ad-
dress the points contained in the Government studies, and will
touch on the issues raised in Treasury's comments today.

The capital study is just getting underway. It should be con-
cluded by late summer or early fall, and any decision to restructure
the System's capital, prior to the completion of the System's capital
study, could be unnecessarily premature because it will have been
made before the options have been weighed and their ramifications
understood. I was delighted to hear you say, in your opening state-
ment, that legislation will not be submitted until the next Con-
gress.

Mr. Chairman, let me conclude my remarks by emphasizing our
eagerness to work with Congress to help ensure that the financing
needs of all American home buyers are met.

We look forward to working with you, and thank you for this op-
portunity today.

The Chairman. Thank you all.

Let me raise a couple of matters with you, and I'm going to go
right down the table in the same order, so we'll start with you, Mr.
Crowley, but I'm asking all of you. Do you think that the Adminis-
tration s proposals, as we heard them outlined today, can form the
basis for comprehensive legislation next year?

Mr. Crowley. I think they certainly have all of the elements
that are involved, that we've studied over the last year, and so on.

I'm sure, at this point, they aren't specific enough for all of us
to understand exactly what the details might be, but I think they
start at a good point in forming a platform upon which consensus
could be built.

The Chairman. What's your view, Ms. Widener?

Ms. Widener. Yes. I was pleased with all the testimony that I
heard, both from Secretary Retsinas and Mr. Newman. It's detail
that we've got to work out on the capital study, and on the govern-
ance structure. I mention only those two items because I believe
there is consensus that the REFCorp obligation should be changed
to 20 percent of System income and that membership should be one
class and voluntary.

The Chairman. Mr. DelliBovi?

Mr. DelliBovi. I would agree. I think we form a basis on a plat-
form of all of these studies, including the testimony today.

The Chairman. The Community Development Financial Institu-
tions Bill that we now have in the House/Senate Conference, the
House bill, as you know, includes provisions affecting the Home
Loan Bank System. What would your position be on adopting those
provisions this year? Let me start, Ms. Widener, with you on that.

Ms. Widener. I am in total favor of comprehensive legislation.
I just think it would be a mistake to do anything ahead of a com-
prehensive package. I support the notion of the subject areas in the
bill but, again, they have to be looked at comprehensively.

Let me make one comment, for example, on the Community De-
velopment Bank accessing the banks without stock purchase re-
quirements.

I feel that everyone should access the System on equal stand-
ards, and that if anyone can't meet those standards, then we need
to do what's needed to help them meet them. It's that kind of detail
that I'd like to be able to work out.

The Chairman. Mr. DelliBovi?

Mr. DelliBovi. We support both the Baker amendments and the
comprehensive legislation. We think it's going to take a while to de-
velop comprehensive legislation, so it's our position that passage of
the Baker amendments will enhance the System's mission in a
small way. Most importantly, it will provide additional time to de-
velop comprehensive legislation in a rational manner.

The Chairman. We have some difference of opinion on that, but
I think we've heard a lot of common thinking today. I think it's
been a constructive discussion and I think it lays out the — Mr.
Crowley, let me hear from you on that, too.

Mr. Crowley. I stated in my remarks that the stockholders are
not in favor of any piecemeal legislation. I think, for reasons that
Under Secretary Newman mentioned on specific issues in the
amendment, there's good reason not to consider those issues, even
in comprehensive legislation. In that regard, I'm speaking about
the nature of access to the System and the collateral requirements.

As far as the issue about raising the limit on non-QTL borrowers,
in a total comprehensive package, as our Stockholder Study Com-
mittee has indicated in its report, we have no objection to that. We
do not see it as being a crisis right now. It's a definite issue that
I think should be put on the back burner until next year.

The Chairman. Am I correct, then, in gathering from what you
just said, that you think we ought to hold off on any changes now
and put them in a comprehensive package?

Mr. Crowley. There's no question about it. Yes, I would agree.

The Chairman. That would be the view of the group that you've
worked with?

Mr. Crowley. That's correct.

The Chairman. Again, let me thank you all. I think we've cov-
ered some good ground today. I think we now have this issue fully
out on the table, with the respective points of view out there for
public review and discussion.

We will have some additional questions for the record from other
Members of the Committee who could not be here. Again, I thank
you for your participation.

The Committee stands in recess.

[Whereupon, at 11:10 a.m., Wednesday, June 15, 1994, the Com-
mittee was adjourned, subject to call of the Chair.]

[Prepared statements and response to written questions follow:]

PREPARED STATEMENT OF FRANK N. NEWMAN

Under Secrettary fx)r Domestic Finance, Department of the Treasury,

Washington, DC

June 15, 1994

Summary

• The testimony discusses the Treasury's views on the findings of five reports on
the Federal Home Loan Bank System mandated by the Housing and Community
Development Act of 1992.

• The Treasury agrees with the reports that the System needs significant reform
and that the interconnectedness of major issues involved — capital, membership,
regulation and governance, mission, REFCorp — requires comprehensive, not piece-
meal, legislation.

• Besides protecting taxpayers. System capital structure and capital requirements
should preserve the System's cooperative nature. Capital requirements should be
risk-based and easily implemented. There should be sufficient time resilience to
redeemable member stock so that it is unlikely that too much capital will drain
out of the System at any one time. The possibility that a member could not re-
deem all of its stock investment if the FHLBank were facing serious financial dif-
ficulties should provide members with a strong incentive to ensure that such con-
ditions are avoided through prudent risk-management practices.

• Difierent capital options are being explored. There are a number of concerns with
any capital structure that calls for publicly traded stock. Fixing the weaknesses
with the System's capital structure does not necessarily require a complete over-
haul of the current structure. The Administration will develop comprehensive leg-
islation which will include capital recommendations early next year.

• The Bank System's regulator, the Federal Housing Finance Board (FHFB), cur-
rently has three sometimes conOicting responsibilities — program oversight, safety
and soundness regulation, and governance. The Administration is examining how
the Bank System's safety and soundness regulation can best be strengthened and
how the rest of the FHFB's current responsibilities should be distributed.

• Membership in the System should be voluntary for all eligible members and mem-
bership rules should apply equally to all System members. All members should
have the same incentives with regard to the System and share the benefits and
obligations of membership equally. Member institutions should have at least 10
percent of their assets in whole residential mortgages to strengthen the nexus be-
tween membership and mortgage lending.

• The System's public mission should be to support mortgage lending and commu-
nity development lending in a safe and sound way. The collateral requirements
for advances should remain unchanged because the current collateral require-
ments minimize the credit risk in making advances and preserve the link between
advances and mortgage lending.

• The overall strength of the Bank System could be improved by altering the inter-
nal allocation of the REFCorp obligation. With voluntary membership, equalized
access to the Bank System, and restructured capital rules, a change in the alloca-
tion formula may be both appropriate and acceptable to the majority of System
members.

Introduction

Chairman Riegle, Senator D'Amato, and Members of the Committee, thank you
for the opportunity to discuss the Treasury's views on the recently completed reports
on the F^ederal Home Loan Bank System and to offer the Treasury's thoughts on
developing a comprehensive legislative proposal to modernize the Bank System. We
are happy that the Congress and the Administration are working together to review
systematically the purposes, operations, and safeguards of the Bank System.

The reports being discussed today all show that the Bank System remains a
healthy and important part of our housing finance system, yet they also point to
the need for comprehensive updating of the System's mission, structure, capital re-
quirements, and regulatory oversight. Today's hearing will be an important supple-
ment to the reports and is the appropriate next step in the process. Together with
the reports, today's hearing should help provide a map for the Administration and
Congress in developing a comprehensive legislative package to update and strength-
en the Bank System to keep it a vibrant source of housing credit into the 21st Cen-
tury. On behalf of the Administration, the Treasury Department looks forward to
introducing such a legislative proposal by early next year.

I. Recent Reports Point to the Need for Comprehensive Restructuring
of the Bank System

Since its inception in 1932, the Federal Home Loan Bank System has been an im-
portant source of mortgage credit for home buyers. Federal Home Loan Banks sell
bonds in the securities market at rates only slightly higher than Treasury's and
lend the proceeds (in the form of advances) to their thrill and bank institution
owner-members, who in turn are able to lend this money to home buyers. Debt secu-
rities of the Bank System, like those of other Government-Sponsored Enterprises
(GSE's), trade in the market at yields that reflect a perception of an implicit Gov-
ernment guarantee although no such guarantee, either expressed or implied, exists.
Also, interest earned on Federal Home Loan Bank debt securities is exempt from
State and local income taxes.

The housing finance market has changed dramatically since 1932. Two other
housing-related GSE's, the Federal National Mortgage Association (Fannie Mae)
and the Federal Home Loan Mortgage Corporation (Freddie Mac), as well as the
Government National Mortgage Corporation (Ginnie Mae) and various private firms
now provide means for depository institutions to sell the mortgages they originate
into tne secondary market.

At the same time, the Bank System continues to operate largely as it was initially
structured and it remains oriented toward depository institutions that originate and
hold mortgages in their own portfolio. As of April 30, 1994, the Bank System had
about $187 billion in assets, of which $101 billion was advances outstanding and
$83 billion was investment securities (including about $27 billion in mortgage-
backed securities).

The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of
1989 introduced the first major structural changes to the Bank System by opening
System membership to commercial banks and credit unions that met threshold tests
for mortgage lending. As of April 30, 1994, the System had added 2,524 commercial
bank members and 62 credit union members, which together with the 2,139 thrift
members and 19 insurance company members brings total membership to 4,744 in-
stitutions. Thus, more than half of all System members are now commercial banks.
FIRREA added two new public policy goals for the Bank System. It required each
Federal Home Loan Bank to establish an Affordable Housing Program (AHP) in
which the Bank makes subsidized advances and grants for qualifying affordable
housing ventures. FIRREA also made the Community Investment Program (CIP) a
statutory requirement in which the Banks make at-cost advances for qualifying
mortgages and community development purposes. FIRREA required the Bank Sys-
tem, which at the time was owned primarily by savings and loan associations, to
help pay for the cost of the thrift cleanup. The Act directed the Bank System to con-
tribute $2.5 billion of its retained earnings to capitalize the Resolution Funding Cor-
poration (REFCorp) and required the System to pay $300 million a year for 40 years
toward interest payments on bonds issued by REP"'Corp. (This is known as the
REFCorp obligation.)

The Housing and Community Development Act of 1992 called for five comprehen-
sive studies o? the Federal Home Loan Bank System. These studies, prepared by
the Department of Housing and Urban Development (HUD), the Federal Housing
Finance Board (Finance Board), the General Accounting Office (GAO), the Congres-
sional Budget (JfTice (CBO), and the Federal Home Loan Banks Stockholder Study
Committee, provide us with an assessment of the System's current structure, includ-
ing the changes made in F'IRREA. The reports generally conclude that the System
continues to serve an important function and that it operates in a safe and sound
manner, yet most of the reports also urge that comprehensive changes be made to
keep the Bank System vital and healthy. Let me briefiy summarize for you some
of tne important conclusions from these reports and offer the Treasury's assessment
of these conclusions. I will begin with the future role and structure of the Bank Sys-
tem, and then discuss how to ensure its continued safety and soundness.

A. The Bank System's Public Mission Should Be To Support
Mortgage Lending and Community Development Lending

Most of the reports noted the lack of an explicit statement of public purpose, or
mission, for the Bank System and several offered possible mission statements. There
was a general consensus among the reports that the primary purpose of the Bank
System should continue to be facilitating the provision of housing credit through
low-risk, collateralized advances to home lenders. The HUD and Finance Board re-
ports each recommend that this current purpose be broadened to encompass commu-
nity development lending.

The Treasury Department agrees with the need for an explicit mission statement
for the Bank System and endorses the statement of purpose in the HUD report:

The Federal Home Loan Bank System is a profit-making enterprise whose pur-
pose is to support residential mortgage lending (including mortgages on housing
for low- and moderate-income families), as well as community development lend-
ing, throughout the Nation, safely and soundly, primarily through a program of
collateralized advances to System members. The System facilitates such lending
by increasing the liquidity and improving the distribution of investment capital
available through its member institutions.

We believe that this statement of purpose afTirms the important role played by
the Bank System in making mortgage credit available while also recognizing the ap-
propriate use of advances to finance community development activities for targeted
areas and populations. The statement of purpose also recognizes the need for the
System to be a profit-making enterprise and the fundamental need that the System
of)erate safely and soundly. Importantly, we also strongly affirm the recommenda-
tion in the HUD report that collateral requirements remain unchanged. These re-
quirements serve two critical purposes: (1) they serve to minimize tne credit risk
in making advances, and (2) they preserve the link between advances and mortgage
lending.

This statement of purpose also limits the possible new products and services that
could be offered by the Federal Home Loan Banks. We believe that is appropriate,
since any GSE should be limited to a well-defined line of business. We concur with
the conclusions reached in the reports that permitting Federal Home Loan Banks
to securitize mortgages or make construction loans would be an inappropriate ex-
pansion of System activities because these activities are already established in the
marketplace. Also, we generally concur with the strict criteria developed in the GAO
and Stockholder Study Committee reports that could be used by the regulators to
assess the appropriateness of possible new Bank System activities.

B. Membership Rules Should Consistently Apply To All System Members

By permitting commercial banks and credit unions to join the Bank System,
FIRREA fundamentally altered the System's membership structure. Prior to 1989,
nearly all Federal Home Loan Bank members were required by statute or regulation
to be System members. Today, over half of all System members are voluntary mem-
bers; that is, they have freely chosen to join the System and, with certain limita-
tions, they can also freely exit the System. In addition, State-chartered, Savings As-
sociation Insurance Fund (SAIF')-insured savings associations, which are currently
mandatory members, will become voluntary members next April. This will leave just
federally-chartered, SAIF-insured savings associations as mandatory members. All
the reports agree that this particular structure of two membership classes — manda-
tory and voluntary — is unfair to the mandatory members and may result in difTering
risK-management incentives between the two groups.

We concur that System membership should be voluntary for all eligible members.
Voluntary membership has several attractive features. First, it provides a clear
market signal as to whether the Bank System provides economic value to its mem-
bers. If the System no longer provides value, now or in the future, members would
be expected to leave the System, thereby sending a clear message that this GSE
may no longer be needed. Second, it gives all members the same incentives with re-
gard to the System. Since all members could request to leave the System if their
Bank began to experience financial difilculty, voluntary members would no linger
be able to "put" their share of the Home Loan Bank's embedded losses to the man-
datory memoers. Third, voluntary membership creates better incentives for Federal
Home Loan Bank managers to operate their Banks efficiently and to be responsive
to their member/shareholders. Wliile important transitional issues exist witn mak-
ing membership fully voluntary, we believe that this change can be done in a way
that actually improves the System's safety and soundness by putting all members
on the same footing.

Consistent with making membership voluntary for all eligible institutions, we be-
lieve that the same rules of access should apply to all members. Membership rules
should not differentiate either stock purchase requirements or access to advances
based on whether or not a member satisfies the qualified thrift lender (QTL) test.

Finally, as recommended in the reports, we believe that membership eligibility
should not be extended beyond the currently eligible group of depository institutions
and insurance companies. In fact, we believe that eligibility requirements should be
somewhat tighter than they are today. We agree with HUD's conclusion that mem-
ber institutions should have at least 10 percent of their assets in whole residential

^U.S. Department of Housing and Urban Development, Report to Congress on the Federal
Home Loan Bank System, April 19, 1994, page 21.

mortgages and that this should be an ongoing requirement that members should
satisfy.

This raises an important concern in formulating changes to the System's mission
and membership rules. We do not want to see "Home Loan" taken out of the Federal
Home Loan Bank System. This means that the System's activities should not ex-
pand beyond housing finance and conununity development. It also raises the ques-
tion of the linkage between advances and members' support of housing finance.

There needs to be a continual evaluation of whether the System is satisfying its
public policy purpose of supporting housing finance. One test of this needs to be
members' minimum commitment to housing finance. Members that satisfy the QTL
test demonstrate a serious commitment to housing finance. It is less clear that a
depository institution with only 10 percent of its assets in mortgages has the same
relative commitment. At a minimum, we believe that the program regulator should
be able to increase, but not decrease, the statutory threshold test defining an insti-
tution's commitment to housing finance in order to be eligible for System member-
ship. A higher threshold would strengthen the nexus ^tween membership and
mortgage lending.

Finally, it is crucial that collateral rules retain their focus on mortgage loans both
to maintain the System's safety and soundness and to uphold the link between ad-
vances and housing finance. Therefore, we join in HUD's recommendation that col-
lateral rules not be changed in order to control the System's risks and preserve the
System's basic orientation toward residential lending.

C. Fixed FIRREA Obligations Impose a Heavy Financial Burden
ON THE Federal Home Ijoan Banks

FIRREA imposed two fixed financial obligations on the Federal Home Loan Bank
System that must be considered in any assessment of the System. The REFCorp ob-
ligation, which I mentioned earlier, obligates the Bank System to pay $300 million
annually toward the cost of protecting federally-insured deposits in savings and
loans that have failed over the last 5 years. This $300 million is allocated among
the 12 Home I^oan Banks in two steps. First, each Bank must pay up to 20 percent
of its net income. Should the total of the Banks' initial assessment be less than $300
million, the Banks are assessed for the remainder on the basis of their outstanding
advances to members with deposits insured by SAIF. The second FIRREA obligation
is AHP. This year, the Bank System must pay the greater of $75 million or 6 per-
cent of its preceding year's income toward AHP. In 1995 and in subsequent years,
the Bank System must pay the greater of $100 million or 10 percent of its preceding
year's income. Taken together, the fixed FIRREA obligations absorb $400 million or
more of the System's annual earnings.

The problems with the fixed nature of these obligations are well documented in
several of the reports. The GAO report, in particular, provides a complete descrip-
tion of the problems associated with the fixed nature of the REFCorp and AHP obli-
gations, and the allocation formula used to assess the REFCorp obligation.^ Still,
As the reports each describe, budgetary considerations impede any obvious solution
to the current formulas outside of reallocating the REFCorp burden within the Bank
System.

We believe the overall strength of the Bank System would be improved by altering
the internal allocation of the REFCorp obligation. Therefore, we are looking at the
possibility of altering the current REP Corp allocation formula as part of our overall
structural reform package. That is, with voluntary membership, equalized access to
the Bank System, and restructured capital rules, a change in the allocation formula
may be both appropriate and acceptable to the majority of System members. For ex-
ample, the 20 percent first-round assessment could be increased over time or the
basis for the second-round allocation could be modified. Ideally, any such change
could allow for a reduction in, or eventual phase-out of. Federal Home Loan Banks'
holdings of mortgage-backed securities.

The Treasury is concerned with the added risks being undertaken by Federal
Home Loan Banks in order to meet the fixed FIRREA obligations, especially the re-
liance on a large portfolio of investment securities (including mortgage-backed secu-
rities) to generate the earnings needed to satisfy these payments. While we appre-
ciate the earnings pressure created by the FIRREA obligations, we are disturbed by
the arbitrage between one type of GSE debt security and another GSE debt security
currently taking place.

While the approaches to this arbitrage take many specific forms, a general exam-
ple would be a Bank purchasing a mortgage-backed security that yields, say, 90

^U.S. General Accounting OfTice, Federal Home Loan Bank System: Reforms Needed to Pro-
mote Its Safety, Soundness, and Effectiveness, GAO/GGD- 94-38, December 8, 1993, pp. 33-48.

basis points over a comparable duration Treasury security, and funding it with a
System debt security of equal duration on which the Bank pays, say, 30 basis points
over a comparable Treasury security. In this relatively simple example, the Bank
would earn a spread of 60 basis points. Thus, a $5 billion investment like this could
yield about $30 million per year. However, the realized yield is likely to be different
than this because market interest rate movements could have substantially different
impacts on the durations of the Bank's liabilities and the mortgage-backed securi-
ties. Also, in practice, a Federal Home Loan Bank will likely fund a group of mort-
gage-backed securities with a group of debt securities of various maturities and
other characteristics.

The primary reason a spread exists at all is the interest rate risk inherent in the
mortgage-backed security, including the risk that mortgage prepayment speeds may
change as interest rates change. As this risk is mitigated through various hedging
strategies, the spread actually earned will fall. While the Finance Board has restric-
tive policies to limit the risks that may be undertaken, and the Federal Home Loan
Banks each actively manage the interest rate risk embedded in their mortgage-
backed securities portfolio, there are no perfect hedges in this type of activity.
Therefore, at a minimum, we believe that such investments (and, in fact, the entire
investment securities portfolio) should continue to be subject to strict limits estab-
lished by the safety and soundness regulator and in any event should not be per-
mitted beyond the level dictated by the earnings pressure resulting from the fixed
obligations. We should also note that this activity does not add to the overall pool
of funds financing home mortgage loans, and transfers interest rate risk from the
private sector market to a GSL.

n. Restructuring System Capital Should Strengthen the System's
Long-Run Safety and Soundness

As the five Federal Home Loan Bank reports note, the Bank System, as a whole,
may well have more capital than it needs, given its current risk profile, but it also
has the unusual characteristic that its capital lacks permanence. Currently, 65 per-
cent of System members are voluntary members, and another 8 percent of mem-
bers— State-chartered savings associations — will be voluntary members beginning in
April 1995. Voluntary members may elect to leave the System and redeem their cap-
ital stock upon exiting the System.

Most of the reports note that the Finance Board has confiicting responsibilities
as the System's governor, safety and soundness regulator, and program regulator.
Ensuring the System's long-run safety and soundness requires both an appropriate
capital structure and regulatory capital requirements, and a strong, independent
safety and soundness regulator.

A. Goals and Criteria for Restructuring Bank System Capital

The basic goal in estabHshing a regulatory capital structure for the Bank System
is to ensure that taxpayers are protected from any losses incurred by the System
and from any problems associated with a shrinking membership base. For example,
failure to make the annual REFCorp payment would likely increase taxpayer out-
lays. Thus, one implication of this goal is that the System must have sufiicient cap-
ital to fund the assets needed to pay the fixed FIRREA obligations each year.

Besides protecting taxpayers, we believe that a second appropriate goal in estab-
lishing a capital structure and capital reauirements for the Bank System is to pre-
serve the System's cooperative nature. We believe the cooperative nature of the
Bank System is worth preserving because it: (1) aligns the interests of members and
shareholders because the members are the shareholders (in particular, it reduces
the moral hazard problems associated with divorcing ownership risks from the bene-
fits and obligations of borrowing advances); and (2) keeps the benefits of the Bank
System that derive from its status as a GSE with housing lenders and their cus-
tomers.

A third goal is to have a regulatory capital structure that promotes the economic
efilciency of System operations.

Combined with these goals, we believe the following criteria should be used in as-
sessing alternative capital structures for the Bank System:

• Capital requirements should be risk -based;

• Capital structure should allow individual Home Loan Banks to grow and shrink
over time (this is especially important given the cyclical nature of the demand for
advances);

• Capital structure should not impede future consolidation among Home Loan
Banks; and

• A new capital structure should be easily implemented.

B. The Reports Offer Several Options for Restructuring
Federal Home Loan Bank Capital

While the five reports offer a number of approaches to restructuring Bank System
capital, there is general agreement among them as to the basic risks undertaken
by the Federal Home Loan Banks. F'irst, credit risk is minimal. Advances are
overcoUateralized loans (that is, loans that are secured by a members' assets where
the assets posted as security substantially exceed the value of the loan) and, beyond
that, the Home Loan Banks have a priority interest in the assets of failed members.
With respect to investments, the F'inance Board's Financial Management Policy ap-
pears to limit the securities eligible for investment to only those with minimal credit
risk.

A relatively new area of credit risk exposure for the System is in off-balance sheet
activities. As the System relies increasingly on structured debt financing, it incurs
credit risk in the derivatives transactions that are integral to such financing. For
example, a Bank could provide a member with adjustable rate funding by issuing
a fixed rate bond and entering into a swap agreement with a third party where the
fixed rate cash fiow is exchanged for the aesired variable rate cash fiow. In this ex-
ample, the Bank has credit risk in that the failure of the third party could disrupt
or cancel the swap agreement.

Home Loan Banks incur interest rate risk in both the advances they make and
the investments they hold. Interest rate risk from advances is mitigated, but not
eliminated, by prepayment penalties assessed when an advance is prepaid. With re-
gard to investment securities, the F'inance Board limits the amount of interest rate
risk a Bank may undertake. However, the current capital rules are unrelated to a
Bank's interest rate risk. Furthermore, the large holdings of medium- and long-term
investments, particularly mortgage-backed securities, remain a concern because of
the interest rate risk associated with funding such assets. Finally, as with any fi-
nancial institution, management and operations risks are also important.

The reports each suggest that Home Loan Bank capital requirements be restruc-
tured in some way. This restructuring involves both the amount and type of capital
required. In general, there has been a call for more permanence in the capital base
and a closer connection between risk-taking and required capital. A number of alter-
natives were suggested including:

• Establishing a core (minimum) capital requirement equal to that set for Fannie
Mae and Freddie Mac (2.5 percent of assets plus 0.45 percent of off-balance sheet
obligations).

• Developing a risk-based capital requirement modeled after that used for banks
and thrifts. Federal Home Loan Banks could be required to hold appropriate lev-
els of risk -based capital, with advances weighted at 20 percent.

• Using stress tests like those being developed by the Office of Federal Housing En-
terprise Oversight for Fannie Mae and Freddie Mac. Specific proposals regarding
stress tests included using them to monitor interest rate risk or requiring the
Banks to hold retained earnings sufficient to pass an interest rate risk stress
test.^

• Issuing stock to the general public.

• Changing the weight used for Home Loan Bank stock in the bank and thrift risk-
based capital requirements to that appropriate for an equity investment.

Other capital structures we have explored include establishing a permanent cap-
ital base through a required membership fee. Under another option, the Bank Sys-
tem could be encouraged to establish a larger permanent capital base in the form
of retained earnings, while reducing the amount of redeemaole capital as well as
total capital. The Federal Home Ijoan Banks could be encouraged to retain earnings
by clarifying that such earnings were the private property of tne System's members
with appropriate constitutional protections. Finally, we understand that the Bank
System has recently formed a committee of stockholders, public interest directors,
and Bank presidents to consider alternative capital structures. The committee ex-
pects to have a proposal by this fall and we look forward to considering the results
of its work as well.

Rather than describe all the merits and limitations associated with each of these
proposals (most of which may be found in the reports), I would like to voice the
Treasury's concerns about problems that would be presented if publicly traded stock

^Because the Federal Home Ix>an Banks undertake minimal credit risk, a credit risk stress
test may not be meaningful. See Congressional Budget OITice, The Federal Home Loan Banks
in the Housing Finance System, July 1993, p. 42-43, for an explanation of the technical difficul-
ties in applying a credit risk stress test to the Banks.

were issued by the Bank System, then I would like to outline the Treasury's
thoughts on an appropriate capital structure.

C. Publicly Traded Stock Could Introduce a Number of Problems

We have a number of concerns with any capital restructuring proposal that calls
for publicly traded stock in the Home Loan Bank System, whether that stock is is-
sued on a System-wide basis or Bank-by-Bank. Perhaps the most significant concern
is how publicly traded stock would change the incentives underlying Bank manage-
ment. Moving to publicly traded stock would mean that the System would be ex-
pected to pay explicit returns to shareholders, which would be in the form of divi-
dends and stock price appreciation. Currently, however. System members receive
substantial implicit returns in addition to the explicit dividends paid on redeemable
stock. (There is no price appreciation on redeemable stock; it is always carried at
par.) The implicit returns to members include immediate access to liquidity (which
permits members to maintain fewer liquid assets on their balance sheets) and struc-
tured financing. Without the ability to benefit from these implicit returns, public
shareholders may encourage the Banks to accept greater risks and to seek out new
activities to increase profits. Generally, public shareholders may encourage the
Banks to maximize any subsidy inherent in the Banks' GSE status, which would
run counter to public policy interests in keeping the System low-risk and focused
on specific types of financing that support the public interest.

Publicly traded stock also may be inconsistent with most of the criteria described
above for System capital. For example, publicly traded stock could make it difficult
for Home Loan Banks to shrink and may inhibit consolidation if the stock is issued
on a Bank-by-Bank basis. Moreover, implementing such a radical change would be
very complex, especially given the fixed FIRREA obligations. It might also lead to
numerous unintended consequences such as:

• The amount of publicly traded stock that could be successfully sold would depend
on the market's forecast of future System income rather than the value the Sys-
tem has for its members. Furthermore, public ownership could give the System
an incentive to stretch its powers to take on more risk and increase profits.

• If publicly traded stock were preferred stock, thereby having priority over mem-
bers' common stock, then the dividends required for the preferred stock could be
so high that in some Banks little or no income would be left for dividends to hold-
ers of the common stock. All the reports note the earnings strain created by the
fixed FIRREA obligations; adding required dividends on preferred stock would in-
crease the System's fixed obligations.

• If members' redeemable stock were made preferred stock, thereby having priority
over the publicly traded common stock, then without additional measures to im-
prove System income it is unclear that the Banks would be able to sell the com-
mon stock. If common stock were sold to the public, the members could conceiv-
ably exit the System, leaving the public shareholders with responsibility for the
REFCorp obligation. In such a structure, shareholders would discount what they
would be willing to pay for such stock.

• Publicly traded stock would change the cooperative nature of the System.

D. The Existing Capital Structure Can Be Strengthened

AND Capital Levels Set Based on Risk

As I have already noted, the five reports suggest a variety of possible improve-
ments to the System's capital structure, all of which we are considering. Many of
these proposals are actually refinements of the existing structure. This suggests
that fixing the weaknesses with the System's capital structure does not necessarily
require a complete overhaul of that structure. Rather, a strong yet flexible capital
structure can be developed simply by strengthening the existing capital's perma-
nence, combined with a more rational, risk-based approach to setting the required
level of capital.

We are still working out the specifics of what changes would need to be made for
such an approach and how they would be implemented. Let me outline for you some
of our general thinking at this point. 'Permanent" capital, as we use it, means en-
suring there is sufficient time resiliency to redeemable member stock so that it is
unlikely that too much capital will drain out of the System as members shrink or
withdraw. As noted earlier, the basic goal for the Government is for capital to be
sufficient, at a minimum, to protect taxpayers and ensure payment of the fixed
FIRREA obligations. This can be accomplished by retaining the existing redeemable
common stock structure but making redemption subject to more stringent conditions
than exist today. The possibility that a member could not redeem all of its stock
investment if its Home Loan Bank were facing serious financial difficulties should

86-560 - 95 - 3

provide members with a strong incentive to ensure that such conditions are avoided
through strong risk-management practices in the Home Loan Banks.

Today, a voluntary member may withdraw from the System and, upon 6 months
notice, have its Bank stock redeemed at par unless the Finance Board finds that
the Bank's paid-in capital is, or is likely to be, impaired. In that event, the Finance
Board may make a pro rata redemption. Additional limitations on redemption could
be established. For example, a limit could be placed that did not allow capital to
fall below a regulatory required level. Similarly, prompt corrective action rules could
be developed tnat would specify limits on dividend payments and capital redemp-
tions in specified situations. Redemptions might not take place in a lump sum, but
rather could be done using two or tnree payouts over a fixed period, witn some al-
lowance for accelerated redemptions if a Bank sufficiently exceeds its minimum cap-
ital requirements.

With clearly defined rules governing redemptions, including prompt corrective ac-
tion rules, members should be otherwise free to enter and leave the System. Pro-
vided a Home Loan Bank meets its capital requirements and related rules, there
should be no further impediments to a member withdrawing from the System and
redeeming its capital stock in an orderly fashion according to a predetermined
schedule. Of course, transition rules would need to be carefully developed if such
changes to System capital rules were introduced concurrent with the introduction
of full voluntary membership. Also, we believe that the existing 10 year moratorium
on rejoining the System afler withdrawing from it should be retained.

It is also important to select an appropriate formula for determining the minimum
amount of capital each Federal Home Loan Bank should have for regulatory pur-

foses. The Banks should have sufficient capital to ensure payment of the fixed
ERREA obligations and to avoid any direct or indirect taxpayer expense. This sug-
gests that a minimum capital requirement for Home Loan Banks should require
capital at least equal to the present value of the REFCorp obligation plus some risk-
based amount. The risk -based amount could be constructed as the sum of two ele-
ments, one element for credit risk — both on- and off-balance sheet — as well as man-
agement and operations risks, and the other element for interest rate risk.

For the first element, as suggested in several of the reports, the risk -based capital
rules for commercial banks could be applied to the Home Loan Banks. Although the
Home Loan Banks have minimal credit risk in the advances themselves, they have
credit risk in off-balance sheet obligations and they have management and oper-
ations risks. Because of the low credit risk in Home Loan Banks, we expect that
it may be possible to set this requirement slightly lower than it is set for commercial
banks.

The larger measurable risk in the Bank System, and ont that we believe must
be carefully measured and controlled, is interest rate risk, including the interest
rate risk implicit with off-balance sheet liabilities. Therefore, the second risk-based
element we propose would require each Home Loan Bank to have sufficient capital
to withstand significant interest rate shocks of various types. The exact approach
for such stress tests and the determination of how much capital would be needed
to pass them remain open questions at this time. While quite preliminary, our ini-
tial estimates suggest that current System capital is more than sufficient to meet
the overall capital requirements suggested here, as long as the System's mix of as-
sets and liabilities stays approximately as it is now and interest rate risk is ade-
quately hedged.

While changes are needed in the statutory requirements governing System cap-
ital, the safety and soundness regulator should also be given authority to adjust the
Banks' capital requirements over time. For example, the System's safety and sound-
ness regulator should have the authority to establish minimum requirements for re-
tained earnings.

As with any GSE, one of Treasury's primary concerns is the GSE's safety and
soundness. We believe that the steps outlined here can strengthen System capital,
make the level of required capital sensitive to the amount of risk undertaken by a
Bank, continue to give member/shareholders a strong incentive to control risk-tak-
ing by Bank management, and make System membership economically beneficial for
depositories that have a focus on home mortgage lending.

E. Strong, Independent Safety and Soundness Regulator Also Needed
TO Ensure the Bank System Remains Safe and Sound
Most of the reports described the problems associated with the Finance Board's
confiicting roles as governor/manager for the System, safety and soundness regu-
lator, ana programmatic regulator. The HUD, GAO, Finance Board, and Stockholder
Study Committee reports each recommended that the management function be sep-
arated from the regulatory functions. The HUD and GAO reports recommended

merging the Finance Board's safety and soundness function into OFHEO while as-
signing programmatic oversight to the Secretary of HUD.^ This would put Federal
oversight of all three housing GSE's — the Bank System, Fannie Mae, and Freddie
Mac — in the same places.

We agree that the Finance Board's current responsibilities are in conflict. We fur-
ther believe that it is essential that the Bank System have a strong, independent
safety and soundness regulator to implement the regulatory reforms of the Bank
System that will be part of our comprehensive reform package. We recognize that
OFHEO is a new agency and that its stafT is working diligently to discharge their
responsibilities with respect to Fannie Mae and Freddie Mac. Given HUD's rec-
ommendation, we are examining how the Bank System's safety and soundness regu-
lation can best be accomplished and how the rest of the Finance Board's current re-
sponsibilities should be distributed.

m. Comprehensive Reform is Needed Because of the Interrelationships
Among the Various Issues

The five reports on the Federal Home Loan Bank System mandated by the Hous-
ing and Community Development Act point the direction for comprehensive reform
and updating of the Bank System. These studies each covered 13 broad Questions
concerning the System. It is important to note that in the broad areas I nave de-
scribed this morning, there is general agreement across the five reports. This is good
news, Mr. Chairman, for it suggests that a consensus on comprehensive reform is
achievable.

To summarize, the reports generally agree that: (1) the Bank System serves an
important function in making credit available to housing lenders; (2) membership
rules need to be made consistent for all eligible members; (3) the Bank System
should be able to continue meeting its FIRREJA obligations, although the burden of
those obligations is adding risk to the System and has certain pjerverse incentives;
(4) Bank System capital needs to be restructured, with greater permanence given
to System capital, and capital levels should be risk-based; and (5) the current re-
sponsibilities of the Finance Board, to be both manager and regulator, need to be
separated. The Treasury Department concurs with each of these conclusions.

The ref)orts also agree on one other point; that is, that achieving these changes
and improvements to the Bank System requires comprehensive, not piecemeal, leg-
islation. Each report describes the interconnectedness of the various issues. For ex-
ample, moving all savings associations from mandatory to voluntary membership
status must be done in conjunction with reforming the System's capital structure
and rules. Otherwise, we risk a large exodus of mandatory members and possible
disruption of the REFCorp payment.

Mr. Chairman, with the release of the final mandated study of the Bank System
by HUD, the Treasury Department is working with HUD and others in the Admin-
istration to develop such a comprehensive reform package. As I have noted in my
testimony, we do not yet have a completed proposal. We expect to complete our work
bv this fall and present a legislative proposal by early next year. Working with the
Committee, we look forward to the passage of comprehensive Bank System reform
legislation.

■•The GAO report also suggested that OFHEO could be merged into the Finance Board, there-
by making the combined regulator responsible for all hoiising-related GSE's but independent of
HUD.

STATEMENT BEFORE THE SENATE COMMITTEE
ON BANKING, HOUSING AND URBAN AFFAIRS

FEDERAL HOME LOAN BANK SYSTEM

JUNE 15, 1994

^^AENTq^

^^N deV^^

NICOLAS P. RETSINAS

ASSISTANT SECRETARY

FOR HOUSING-FEDERAL HOUSING COMMISSIONER

Thank you, Chairman Riegle and Members of the Committee, for inviting me to
testify this morning on the Department of Housing and Urban Development's
(HUU's) recently released study of the Federal Home Loan Bank System. I am here
not only in my capacity as Assistant Secretary of HUD, but also as Secretary
Cisneros' designated representative on the Federal Housing Finance Board (Housing
Finance Board).

The Housing Finance Board is the safety and soundness regulator of the Federal
Home Loan Bank System, and ensures that the System fulfills its public policy role
as a primary source of funding for housing finance and also carries out its statu-
torily mandated Affordable Housing Program and Community Investment Program.

As you know, the Housing and Community Development Act of 1992 required the
Department of Housing and Urban Development to study 14 specific questions re-
garding the Federal Home Loan Bank System and to submit a report containing any
recommendations for legislative action to the Congressional Banking Committees.
The Act also required reports on the same 14 topics from the General Accounting
Office, the Housing Finance Board, the Congressional Budget Ofiice, and a commit-
tee representing members of the 12 Federal Home Loan Banks. The HUD report
reflects our effort to form a consensus through a cooperative, consultative process
within the Administration. We believe it will pay dividends later as we work with
the Treasury Department and others in the Admmistration to develop a comprehen-
sive legislative proposal to m.odernize the Federal Home Loan Bank System.

While HUD's report provides answers to all 14 questions, today I would like to
focus on the five most important topics raised by the study: (1) mission; (2) capital
structure; (3) membership; (4) the effects of the financial obligations placed on the
Federal Home Loan Bank System by the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989; and (5) governance and regulation.

Mission

The Federal Home Loan Bank System was created in 1932 in response to the Na-
tion's need for a secure, dependable source of housing finance lending. To date, the
System has remained safe and sound — never once suffering a credit loss in its 62-
year history. That is a message worth noting. The Federal Home Loan Bank System
is not broken, nor is it facing apocalypse, but we need to examine how it is posi-
tioned going forward, and the studies have provided this opportunity.

It is also important to note that the Federal Home Loan Bank System ooerates
in a very different market environment today than it did 60 years ago or, for that
matter, 5 years ago. The "wholesale" housing finance market has changed signifi-
cantly in the past few decades as securitization has come to be the predominant fi-
nancing mechanism, involving Ginnie Mae, Fannie Mae, Freddie Mac, and private
conduits. The securitization process gives retail lenders a source of liquidity in ex-
change for their mortgages, enabling them to originate additional mortgages.

Despite the tremendous growth of the secondary market, the Federal Home Loan
Bank System, through its over 4,600 member financial institutions, continues to
serve an important support role for community -based lenders involved in the pri-
mary mortgage market. That is. Federal Home Loan Bank System advances (loans)
make it more feasible for lenders to originate and hold loans that do not conform
to secondary market underwriting standards but are nonetheless responsive to local
needs and conditions. A Federal Home Loan Bank does this by accepting a mem-
ber's pledge of home mortgages, other real estate-related collateral, or Government
securities in return for an advance. It is this support of "portfolio lending" and the
System's unique role in support of community-based lenders that sets the Federal
Home Loan Bank System apart from the other wholesale sources of housing finance.
At the outset of our study of the Federal Home Loan Bank System it was important
to recognize this.

This led us to consider constructive change to enhance the underlying strength
of the System and to ensure that it satisfies its mission. First, it is necessary to
reaffirm and codify the public purpose of the Federal Home Loan Bank System —
that the Federal Home Loan Banks should continue to specialize in collateralized
advances to portfolio lenders. Further, we recommend that the System's mission
statement include support for community development lending, multifamily lending,
and lending for low- and moderate-income housing consistent with safe and sound
operating practices. While the HUD report does not make any prescriptions or re-
quirements for engaging in community aevelopment lending, we believe the strength
of the System is in the potential of its community-based members. The Federal
Home Loan Bank System, through its community-based members, is uniquely situ-
ated to affect and influence community lending.

With the essential purpose of the Federal Home Loan Bank System defined, we
then sought to determine whether the System was making full use of its potential

in terms of its public purpose. We believe that while it is important that the Federal
Home Loan Bank System assist community lenders, we should be able to dem-
onstrate that the Federal Home Loan Bank System facilitates community lending.

The Federal Home I^oan Banks' most visible initiatives in the area of community
lending, to date, have been the Affordable Housing Program (AHP) and the Commu-
nity Investment Program (CEP). The AHP is often cited as a national model of a
successful housing program, having subsidized 63,000 units with $237.4 million in
subsidies leveraging $3.3 billion in development costs. CEP advances are made to
member institutions at the FHLBank's cost of funds plus administrative expenses.
Since 1989, the CU' has experienced dramatic growth, having financed $4.5 billion
in community development loans including $150 million for economic development
projects. These are relatively new programs that are already achieving success and
show promise for the future.

The HUD report recommends that the objectives of these programs be extended
more generally to the overall advances program to further expand lending for hous-
ing for low- and moderate-income families, multifamily lending, and community de-
velopment lending. An appropriate definition of community development lending, for
this purpose, is loans that serve: (1) investment areas that meet objective distress
criteria, or are located in designated empowerment zones or enterprise communities;
or (2) targeted populations identified as being underserved by existing financial in-
stitutions whose purpose is to develop or support:

• Commercial facilities that enhance revitalization, community stability, or job cre-
ation and retention efforts in targeted areas.

• Business creation and expansion efforts that create or retain jobs for low-income
people, enhance the availability of products and services to low-income people, or
create or retain businesses owned by low-income people or residents of a targeted
area.

• Community facilities that provide benefits to low-income people or enhance com-
munity stability.

• Home ownership opportunities that are afTordable to low-income households.

• Rental housing that is principally affordable to low-income households.

• Activities of community development loan funds that support any of the above
purposes.

To control operational costs to the Federal Home Loan Banks from nonresidential
lending, eligible non-real estate community development loans should be supported
by Fecferal Home Loan Banks in the same manner in which such loans may oe sup-
ported in CIP; that is, they should count as authorized uses of advances, but tradi-
tional forms of collateral would be required to be pledged against these advances.
It is not recommended that the categories of loans eligible to be pledged as collateral
be altered. Consistent with this emphasis on controlling the risKs tnat may accom-
pany broadened programs, the 30-percent limit on use of other real estate-related
collateral should oe retained.

Our report also identifies several new initiatives for the Federal Home Loan Bank
System to support multifamily lending within the scope of their existing lending au-
thority. Already some innovative projects are using equity financing from AHP and
debt financing from CEP.

For example, the Federal Home Loan Banks could serve as a clearinghouse to fa-
cilitate the sale of multifamily mortgages from one member to another. By facilitat-
ing the transfer of associated risks among members, the Federal Home I^oan Banks
could help increase the capital invested in multifamily housing development. In ad-
dition, the multifamily risk-sharing demonstration program authorized under sec-
tion 542(b) of the Housing and Community Development Act of 1992 offers new pos-
sibilities for the Housing Finance Board, the Federal Home Loan Banks, and their
member institutions to expand activities in the multifamily field. The demonstra-
tions under this section are to involve partnerships, reinsurance, risk-sharing agree-
ments, and other types of formal relationships between the Federal Housing Admin-
istration (FHA) and other organizations such as the F'ederal Home Loan Bank Sys-
tem, Fannie Mae, Freddie Mac, and other qualified financial institutions. In this
case, risk would be shared between FHA and depository institution members of the
Federal Home I^an Bank System, with coordination through the Federal Home
Loan Banks and the Housing Finance Board. Like community lending, expanded
support for multifamily lending should be accomplished while maintaining tradi-
tional forms of collateral to control risk.

Capital Structure

As we look to the future of the Federal Home Loan Bank System, a core issue
is the capital structure. Capital must provide the Federal Home Loan Banks with
a financial cushion adequate to protect against the various risks in their operations.

The HUD report agrees with the other studies that strongly suggest the need for
a permanent capital base. Further, we believe that appropriate levels of regulatory
capital should be determined using both risk -based and minimum capital standards.

Despite these issues, it should Be made clear that the Federal Home Loan Bank
System is not currently undercapitalized. In fact, the most recent study of housing
GSEs' risk ratings by Standard & Poor's gave the Federal Home Loan Bank System
a AAA credit rating without any implicit Government backing.

Currently, the federal Home Loan Banks raise capital by means of mandatory
stock purchases by members, in accordance with statutory requirements. In addi-
tion, tne Federal Home Loan Banks must comply with a 20-to-l maximum debt-to-
capital ratio and a maximum interest rate risk requirement estabhshed by the
Housing Finance Board.

However, there are concerns that Federal Home Loan Bank System capital may
be subject to what may be termed "membership risk," which is depletion of capital
by members that can withdraw from the System and redeem their stock. This risk
has been a factor since 1989, when the passage of the Financial Institutions Reform,
Recovery, and Enforcement Act (FIRREA) provided membership for commercial
banks and credit unions for the first time in tne Federal Home Loan Bank System's
history. These new members of the System can opt to voluntarily withdraw their
membership and redeem their investment at par value. Prior to FIRREA, State-
chartered savings banks and insurance companies were the only voluntary mem-
bers. The gi-owth in voluntary membership since FIRREA has steadily increased. At
the end of 1989, voluntary members represented 8.8 jjercent of total System mem-
bership and accounted for 8.5 percent of total System capital. As of March 31, 1994,
voluntary members represent 65 percent of total Federal Home Loan Bank System
members and account for 36 percent of total Federal Home Loan Bank System cap-
ital. The upward trend in voluntary membership continues as the Federal Home
Loan Bank System is now adding approximately 100 voluntary members a month —
up from a monthly average of 75 in 1993. Membership risk will increase further in
1995 when State-chartered savings associations become voluntary members.

The HUD repwrt discusses several alternative approaches for creating permanent
capital to protect against financial risks. The report notes that the issuance of non-
refundable, tradable stock could improve the System's protection against financial
risks, including membership risk, at a lower capitalization than at present. To pre-
serve the System's cooperative management structure, voting rights could accom-
pany stock whose ownership is restricted to members. Issuance of certain financial
instruments to private shareholders (i.e., other classes of common stock, preferred
stock, or subord.inated debt), or requiring that members that increase their use of
advances purchase additional stock, could enable the Federal Home Loan Banks to
increase and decrease capital cyclically with changes in advances. In any case, mar-
keting of securities to the public would be viable only if the System is expected to
be sufficiently profitable.

The report also notes that the Federal Home Loan Bank System could be required
to build permanent capital through retained earnings. Since approximately $2.5 bil-
lion of F'ederal Home Loan Bank retained earnings were taken to assist in funding
the Resolution Funding Corporation (REFCorp), it would be important for the stat-
ute to provide assurances that Federal Home Loan Bank retained earnings are the
property of the System's members and are protected from confiscation. Capital
structures that combine elements of these two approaches may be possible.

The Federal Home Loan Bank System, recognizing the need for creating a perma-
nent capital base, has formed a committee representing Federal Home Loan Bank
System leaders to explore the various options to achieve this important objective.
This committee includes representatives of the Federal Home Loan Banks, share-
holders, and appointed public interest directors. We are pleased by this development
and look forward to reviewing their report and recommendations along with receiv-
ing input from many other sources. It is critical to have the views of all afTected
parties, particularly those whose investment is at risk, in order to measure the via-
bility of any proposal and to protect against regulatory uncertainty.

The Treasury Department is developing the Administration's proposal for restruc-
turing System capital. HUD will work with the Treasury Department as options are
developed. As indicated in our report, we expect that any capital restructuring pro-
posal for the System will include risk-based capital and minimum capital require-
ments.

Membership

The Federal Home Loan Bank System thrives on its ability to attract and retain
capital. Evidence of this ability is the over 2,500 new voluntary members (commer-
cial banks and credit unions) that have joined the System since 1989. We are con-

fident in the fact that the System offers value to its members. In that spirit, and
in the interest of fairness, the HUD report recommends that membership be vol-
untary for all Federal Home Loan Bank System members regardless of charter. It
is important to note that HUD conditions its endorsement of voluntary membership
on the establishment of permanent capital and risk -based capital standards for the
System that ensures the System can handle the additional risks of voluntary mem-
bership while maintaining its capacity to meet its ongoing obligations. Specifically,
HUD is committed to ensuring that the AHP and Resolution Funding Corporation
(REFCorp) obligations are not undermined as the System moves toward fully vol-
untary membership.

Another membership issue involves the Qualified Thrift. Lender (QTL) status of
the System's members. To obtain advances, a savings association must meet the
QTL requirement, which requires them to have mortgage-related assets equal to 65
percent of total assets. Also, Federal Home Loan Bank advances to non-QTL mem-
oers — mostly commercial banks — are limited to 30 percent of aggregate System-wide
advances. HUD believes the QTL test and the 30 percent limit should be eliminated
as a condition of access to advances. The cap on oystem-wide advances to non-QTL
members is an unnecessary potential deterrent to voluntary membership and may,
in the future, constrain overall System support for housing finance and community
development. It should be noted that the percentage of home mortgage loans held
in portfolio by commercial bank members of the Federal Home Loan Bank System
grew at an annual rate of 22 percent during 1992 and 1993, while non-member com-
mercial banks increased their holdings of home mortgage loans at an annual rate
of only 4 percent over the same period.

HUD's research indicates that a degree of concentration in mortgage-related as-
sets (if properly managed) can be an eitective profit-making strategy for a local port-
folio lender. Thus, there remains an incentive for depository institutions to continue
to specialize in mortgage lending, even if QTL rules governing advances are relaxed.
In addition, the orientation of Federal Home Loan Bank members toward mortgage
finance would be maintained through restrictions on collateral and use of advances.

Commercial banks and credit unions that do not qualify as QTL's face disincen-
tives to borrow advances once they are Federal Home Loan Bank members since
stock purchase requirements for non-QTL's are more costly than for QTL members.

We believe that equalizing the stock purchase requirements for all Federal Home
Loan Bank members and removing the QTL test as a condition for access to ad-
vances will assist the Federal Home Loan Banks in fully realizing their potential
in housing finance and community development lending.

Furthermore, HUD supports the current requirement that institutions must have
at least 10 percent of their assets in residential mortgage loans to be eligible for
Federal Home Loan Bank membership, but our recommendation goes further to rec-
ommend that, in keeping with the System's portfolio lending role, only whole loans
(not mortgage-backed securities) be counted toward this requirement.

Effects of FIRREA on Federal Home Loan Bank System

FIRREA placed several financial obligations on the Federal Home Loan Bank Sys-
tem. First, $2.5 billion in Federal Home Ix)an Bank System retained earnings were
used to defease the principle of the REFCorp bonds — a funding mechanism for the
Resolution Trust Corporation.

Second, the Federal Home Loan Bank System was required to contribute $300
million annually to help pay the interest on debt securities issued by REFCorp. Up
to 20 percent of each Federal Home Loan Bank's annual earnings are allocated for
REFCorp. If, after this initial 20 percent allocation, the total does not meet $300
million, the shortfall is apportioned according to each Federal Home Loan Bank's
share of the preceding year s advances to SALF-insured members. It is important to
note that, to date, the 20 percent allocation has not satisfied the total REFCorp obli-
gation in any year, with the total obligation representing 34 percent of System earn-
ings in 1993. In addition, there is a legislatively mandated contribution to the AHP
which began at 5 percent of annual net income (with a minimum of $50 million),
and increases to 10 percent of annual net income (with a minimum of $100 million)
by 1995 and thereafter.

The REFCorp payments represent a statutory assessment on the Federal Home
Loan Bank System and its member institutions which will continue until the year
2030. The AHP obligation will continue in perpetuity.

The annual REFCorp assessment of $300 million was identified in 1989 as a fair
share assessment on the Federal Home Loan Banks based on System earnings of
$1.5 billion in that year — significantly higher than current earnings. This burden,
in our view, should be reduced. However, due to Federal budgetary procedures, this
Federal Home Loan Bank System annual obligation cannot be reduced without find-

ing another available revenue source to make up the shortfall. The prospects for this
seem unlikely, but we continue to explore and discuss any and all suggestions for
resolving the REFCorp problem as we consider overall structural reform, including
equalized membership access and restructured capital rules.

Governance and Regulation

When FIRREA created the Housing Finance Board, the four following co-equal ob-
jectives were established for its operation:

• To supervise the Federal Home Loan Banks.

• To ensure that the Federal Home Loan Banks carry out their housing finance
mission.

• To ensure that the Federal Home Loan Banks remain adequately capitalized and
able to raise funds in the capital markets.

• To ensure that the Federal Home Loan Banks operate in a safe and sound man-
ner.

The Housing and Community Development Act of 1992 prioritized these objectives
by designating the safety and soundness role as the Housing Finance Board's "pri-
mary duty." However, a structural problem exists by virtue of the fact that the
Housing Finance Board also performs a coordinating and leadership role for the
Federal Home Loan Bank System. This arrangement is contrary to the principle
that the roles of regulator and regulatee should be administratively separated. The
Housing Finance Board also recognized this potential conflict of interest in its report
to Congress on the Federal Home Loan Bank System.

With regard to the Housing Finance Boards reg^ilatory role, HUD recommends
that the Ouice of Federal Housing Enterprise Oversight (OFHEO) become the finan-
cial safety and soundness regulator for tne Federal Home Loan Bank System. While
this is HUD's current recommendation, we may be willing to revisit this issue as
the legislative process proceeds.

In addition, program regulation should be administratively separated from pro-
gram management and coordination activities to ensure appropriate objectivity. Pro-
gram regulation functions include administration of community support require-
ments, monitoring, reviewing any new program for consistency with tne stated pur-
pose of the Federal Home Loan Bank System, the appointment of the non-elected
directors of each Federal Home Loan Bank, and oversignt of rules such as those gov-
erning collateralization and use of advances. Program regulation should be assigned
to the Secretary of HUD, who has this responsibility with respect to Fannie Mae
and Freddie Mac. The program regulator would have to seek the approval of the
safety and soundness regulator for any actions that could have a major financial im-
pact on the System or any individual Federal Home Loan Bank.

HUD also believes that the current program management and coordination re-
sponsibilities of the Housing Finance Board unnecessarily constrain Federal Home
Loan Bank business decisions, thereby limiting potential Federal Home Loan Bank
System growth and its ability to provide maximum support for housing and commu-
nity development. The Housing Finance Board is taking interim steps to determine
within the current statute which of these non-regulatory roles do not require central
coordination and may be delegated to the Federal Home Loan Banks themselves.
However, to fully realize the System's potential, we suggest that the Federal Home
Loan Banks assume those non-regulatory roles currently performed by the Housing
Finance Board, including the administration of the AHP and other strategic plan-
ning and central administration activities.

Conclusion

HUD is convinced that the Federal Home Loan Bank System is fiscally sound and
its role in support of residential mortgage financing continues to be critically impor-
tant today. Nearly all market trends suggest favorable growth prospects for the Fed-
eral Home Loan Bank System. After several years, the trend of declining advances
appears to be reversing itself with average advances above $100 billion for the first
quarter 1994, and up 25 percent over the first quarter of last year. As of March 31,
1994, total membership is 4,668 — 1,813 more members than at year-end 1990.

The AHP and CEP are well recognized as successful programs that encourage tra-
ditional financial institutions to increase their commitment to community lending.
The Federal Home Loan Banks, through their Community Investment Ofiicers and
Affordable Housing Councils, are playing an ever increasing and important role in
facilitating member institutions' compliance with the Community Reinvestment Act
and its objectives by providing programmatic initiatives and technical assistance to
their member institutions.

The HUD report seeks to build on the Federal Home Loan Bank System's
strengths. We affirmatively state our continued belief that the support of portfolio

mortgage lending should remain the core function of the Federal Home Loan Banks.
However, this report outlines specific reforms needed to improve F'ederal Home
Loan Bank support of mortgage lending for low- and moderate-income housing and
to expand Federal Home Loan Bank support of lending for community development.
Just as importantly, the report details several measures that are necessary to con-
tinue to strengthen the safety and soundness of the Federal Home Loan Bank Sys-
tem and refine its membership and governance structure.

All of our recommendations are mterrelated and interwoven. We do not believe
any singular recommendation should be undertaken on a piecemeal basis, and that
a comprehensive approach to Federal Home I>oan Bank System modernization is re-
quirea. HUD believes that with the completion of the five reports on the Federal
Home Loan Bank System, this is the appropriate time to begin developing com-
prehensive legislation. It is my hope that today's hearing is yet another step toward
that goal.

Again, thank you for calling this hearing today.

PREPARED STATEMENT OF MICHAEL T. CROWLEY, JR.

Chairman, Federal Home Ix)an Banks Stockholder Study Committee,

Milwaukee, WI

June 15, 1994

Introduction

Mr. Chairman, Members of the Committee, on behalf of the Federal Home Loan
Banks Stockholder Study Committee (Stockholder Committee), I would like to thank
you for this opportunity to testify on our views on the FHLBank System. My name
is Mike Crowley. I am the president and chief executive officer of Mutual Savings
Bank, Milwaukee, Wl, and Chairman of the Federal Home Loan Banks Stockholder
Committee.

The Stockholder Committee was statutorily established by the Housing and Com-
munity Development Act of 1992 * (HCDAct). The members of the Stockholder Com-
mittee formally presented our report, "The Future Direction of the Federal Home
Loan Bank System," in July 1993.

The original request from the Congress provided representatives of the Bank Sys-
tem's owners with a unique opportunity to meet for tne first time to assess and de-
bate the structure of the Banlc System and to reach a consensus on the future evo-
lution of the System. We gave the request particularly serious consideration, first,
because of the importance of the System mission, and, second, because of the signifi-
cance of our financial investments in the Bank System.

The Stockholder Committee consisted of 24 members — two stockholder represent-
atives from each of the 12 Federal Home Loan Bank (FHLBank) Districts. (A list
of the members of the Stockholder Committee is attached as Appendix A.) They
were selected by the Board of Directors of each FHLBank. All are executive officers
of their institutions and most are currently directors of their FHLBanks. As a for-
mal matter, the main work of the Stockholder Committee was completed when we
submitted our report last year, but we believe that the formation of the Stockholder
Committee was instrumental in developing an across-district dialog that continues
to this day and that has continued to shape System decisionmaking.

The Stockholder Committee's first meeting was on December 14, 1992, and we
held seven additional meetings, the last on June 2, 1993. We also had extensive dis-
cussions with interested parties on the issues in the questions outlined in the
HCDAct. (A list of the parties is attached as Appendix B.) We greatly appreciate
their cooperation and willingness to share their views with us and we know that
Congress will also be seeking their views directly. We would emphasize, however,
that the Study Committee does have a unique stake in the outcome of the policy
debate on the role of the System since we represent the providers of the System's
capital and the bearers of the System's risk.

The Stockholder Committee also collected, reviewed, and assessed information
prepared by others regarding the Bank System, including studies prepared in 1990
ancl 1991 by the Department of the Treasuir (Treasury), the Congressional Budget
Office (CBO), and the General Accounting OfTice (GAO). We reviewed information
prepared by the Federal Housing Finance Board (FHFB) in conjunction with its
strategic plan for the Bank System (System 2000) and met on numerous occasions
with VHVB members and staff. We held a briefing with directors of the Bank Sys-

Public Law No. 102-550, 106 Stat. 3672 (1992).

tem in Washington, DC, on March 9, 1993, to discuss the process of the Stock-
holder Committee at that time. Further, I testified at the FHFB hearings on the
future of the Bank System held in Washington, DC, on March 26, 1993. On May
26, 1993, we also met with the presidents of the FHLBanks to exchange views about
the Bank System's challenges and opportunities.

Congress has now received the full complement of statutory reports about the
Bank System. Although others will contribute to the assessment of the Bank Sys-
tem, no other group has our perspective, interest, and commitment. The stockhold-
ers of the FHLBanks are the owners, members, and users of the System: Their
FHLBank membership is an integral part of their institutions' operations.

The Bank System was created by Congress in 1932. Since that date it has served
as an important part of this Nation's housing finance mission. In 1989, the Finan-
cial Institutions Reform, Recovery, and Enforcement Act (FIRREA) made fundamen-
tal changes in the Bank System. The studies of the Bank System mandated by the
HCDAct are particularly relevant because significant changes in the Bank System's
operating environment since FIRREA has made many of the key assumptions un-
derlying the passage of FIRREA ripe for review.

For example, the imposition of the FHLBanks' obligation to provide $300 million
annually to the Resolution Funding Corporation (REFCorp) and the taking of $2.5
billion of retained earnings from the FHLBanks on the initial formation of REFCorp
were considered justified on the assumption that these were financial contributions
of FHLBank members that had precipitated the thrift financial crisis. In fact,
thrills, which are still members of the Bank System, in 1993 were not the
precipitators of financial crisis: To the contrary, they are most responsible for the
thrill industry's restored financial stability.

Projections during the drafting of FIRREA, regarding future earnings of the
FHLBanks, also proved to be overstated. In 1989, the $300 million REFCorp obliga-
tion approximated 20 percent of the FHLBank's 1988 earnings. Congress, in creat-
ing this obligation, expected that earnings of the Bank System would continue at
1988 levels, or even grow. However, that nas not been the case for various reasons.

to half of their 1988 level of $150 billion, have recovered substantially, and, passing
the $100 billion mark, seem destined to grow for the foreseeable future.

The System is not "broke," but it does need some fix-up. Reoairs do not have to
be done on an emergency basis. This important power source helping to drive the
portfolio lending process is actually working far better than it was 2 years ago.
These encouraging trends afibrd us an opportunity to consider the strategic issues
facing the System.

Housing Finance Mission

The most basic topic to be decided for the System is updating and clarifying the
mission statement. Definition of the public purpose for the System will highlight the
areas where reform is most needed.

As stockholders and members of the FHLBanks, we believe the Bank System has
made a significant contribution to housing finance throughout its history. More re-
cently, the FHLBanks have been given additional responsibility for affordable hous-
ing, the major sector where housing credit Hows remain constrained. We support the
Bank System and depend on it in our day-to-day business. In our view, the mission
of the Bank System is:

1. To promote the availability of housing finance to households of all income lev-
els throughout the country in widely varying financial and economic cycles
through the provision of advances and other services to member institutions.

2. To operate in an efficient, safe, and sound manner through the prudent man-
agement of risk to provide the Federal Home Loan Banks' members with ac-
cess to competitively priced funds; liquidity; and high value financial, cor-
respondent, and management services so that members, particularly those
holding home mortgage portfolios, can more effectively compete and respond
to the requirements of their markets.

3. To preserve stockholders' capital while simultaneously fulfilling the Federal
Home Ijoan Banks' public trust and providing an acceptable rate of return to
stockholders.

4. To provide members with the funds and programs necessary to expand afford-
able housing, thereby significantly enhancing the development of communities
throughout the United States.

As with any brief mission statement, a set of assumptions and implications is em-
bedded in the text. The first and last points of the language that the Stockholder

Committee offers for your consideration emphasizes the housing role of the System.
The System's center of gravity must rest on the expertise of its professional staff
and member institutions in this area.

The System functions on the "wholesale" level of financial services intermediation.
It truly is a 'Taankers' bank." In most cases, the individual mortgage or business de-
velopment borrower is completely unaware of the assistance that the System has
provided. The access to the virtually unlimited liquidity of the System enables an
institution to make far more loans within any given balance sheet total. This source
of liquidity is actually more flexible than secondary market securitization since the
loans do not have to meet this market's standardization criteria. Accordingly, the
System ofTers this support to the overall portfolio lending efforts of its members but
does place particular emphasis on the affordable housing segment for low-to-mod-
erate income borrowers. The most effective assistance that the System can ofier in
neighborhood revitalization is housing credit, but we appreciate that the Community
Investment Program (CIP) can be put to broader use and we can see real potential
for that line of Business when a local lender or Government body sees a good fit.

As these public policy goals are pursued consistent with that mission, the Stock-
holder Committee also feels that preservation of the financial integrity of the Sys-
tem is vital. The Stockholder Committee spent a great deal of time discussing ways
to enhance the System's contribution to community development without raising
safety-and-soundness concerns. As community -based lenders, we want to be involved
in the measures that Congress is directing to enhance access to credit and economic
development for neighborhoods that have taken a back seat on the national agenda
for too long.

Community E)evelopment

The Bank System and its members intend to continue to be major participants
in community development banking and in any discussion relating to expansion of
community development banking. We have developed the following recommenda-
tions for System activities to assist in that overall eftort.

The Affordable Housing Program (AHP) could be more effectively administered if
approval for program subsidies for individual projects is transferred from the FHFB
to the local FHLBanks. We appreciate the thrust of the proposed regulation to that
efiect still pending at the FHFB, but many member institutions are concerned that
the proposed regulation remains far too complex. This feeling is shared by many
not-for-profit partners in the AHP. We are gratified that the HUD report confirms
our views on tnis point.

The Stockholder Committee also suggests that, in the event of a merger of individ-
ual FHLBanks, branches or other types of local offices should be maintained to en-
sure that the effectiveness of the auordable housing and community development
programs is not reduced. Again, the HUD report is consistent with our own views
on this topic.

Our group also studied the relative affordable housing contribution of each of the
housing sector GSE's. We note that the System is the only one of the three with
an objective, dollar subsidy requirement, soon to reach $100 million per year.
Thougn Fannie Mae and Freddie Mac have specific targets for low-to-moderate and
central-city lending, they expect to show a profit margin on these loans that is not
significantly different from the rest of their book of business.

The financial commitment of the FHLBanks and their members to afTordable
housing substantially exceeds that burden. Thus, the goals established for these
other GSE's are not relevant to the FHLBanks.

Our position on these issues was developed while Congress was in the very early
stages of drafting the important Community Development Financial Institutions
Bill^ H.R.3474. We support the thrust of this legislation. Personally, I would like
to thank Congress for the inclusion of a measure of regulatory relief within that
pending legislation.

I believe that I can speak for all of the Stockholder Committee members when
I emphasize that we are committed to performance over paperwork and to the en-
hancement of real community credit access. Portfolio lenders have voiced concerns
that well-intentioned regulatory revisions under the Community Reinvestment Act
will be very counterproductive. We hope that we can achieve real simplification and
real upgrades in performance.

I do believe that, consistent with the basic mind-set of the stockholder reoort, the
application of formal percentages of low-to-moderate mortgage loans (or other des-
ignated assets) against F'HLBank advances outstanding can never be a workable ap-
pioach to ensuring appropriate use of these funds. Many institutions are occasional
borrowers from the Sy.stem, but their commitment of funds to these uses is ongoing,
stable, or increasing. The Community Support/CRA review regime is better suited

to assurance of mission fulfillment because of the difficulty of such asseL^iability
linkage caused by the fungibility of liability issuance proceeds.

Products and Services

A more effective way to enhance the community development activities of the Sys-
tem is by seeking new business uses for its funding and credit enhancement capac-
ity.

The expansion of the product menu for the System in support of community devel-
opment or for other reasons must be carefully handled. Four basic criteria must be
met before any new housing-related credit product or service should be offered by
the FHLBanks to their members. New housing-related credit products and services
must:

• Promote the Bank System's mission of housing finance;

• Be primarily an extension of credit for housing and housing-related finance for
which the Bank System has the greatest amount of experience and expertise;

• Neither change the risk profile nor result in significant additional risk to the
FHLBanks;

• Not duplicate housing-related credit products and services already offered by
members.

After consideration of these four criteria, the Stockholder Committee concluded
that the Bank System should not purchase unsecuritized housing-related assets or
make direct loans for housing or housing construction. These recommendations were
the same as those on this topic within the HUD report.

The Stockholder Committee did feel that the current limitation (30 percent of
each member's capital) on the amount of residential real estate-related assets, other
than fully disbursed first mortgages or MBS, that can be accepted by the FHLBanks
as collateral for advances should be removed. It should be replaced by uniform limi-
tations and guidelines to be monitored by the individual FHLBanks.

To maintain proper risk control procedures for reasons of safety-and-soundness,
the stockholders, through their local Boards of Directors, should have final approval
of any new product or service, and access to existing or new products and services
should be available only to those currently eligible for access to FHLBank products
and services. As a means of expanding their community development efforts, the
FHLBanks should continue to offer credit enhancement services related to housing
finance.

Furthermore, the FHLBanks should also be able to act as facilitators or clearing-
houses for the syndication of loans that may be too large for individual members,
but only at the request of members.

To address the financial exposure from these new activities, the Stockholder Com-
mittee suggests that pilot programs to test new concepts and minimize risk may be
an appropriate way to enhance feasibility of product alternatives. The FHLBanks
should have the ability to establish limited purpose subsidiaries for this purpose.
The operation of any pilot program(s) should be limited to the geographic district
of the sponsoring FHLBank(s).

Capital: Adequacy and Reform

The above suggestion of using special purpose subsidiaries or pledged capital to
manage the risk of new activities indicates the substantial attention that the Stock-
holder Committee paid to safety-and-soundness. The appropriate balancing of the
countervailing forces to expand activities and to enhance capital was a major factor
in the rewriting of the rules for Fannie Mae and Freddie Mac. Similar attention is
necessary for the Bank System.

We would note, however, that capital investment in the Bank System is higher
than needed for safety and soundness purposes under any traditional assessment
of risk, including the ability to survive a risk -based capital stress test similar to the
one required for Fannie Mae and Freddie Mac. The stockholders' contributions to
capital should be reduced, subject to the ability of the Bank System to pay its
REFCorp assessment and AHP obligation.

The minimum safety and soundness capital standards for the FHLBanks and the
Bank System should be based on risk and overall financial condition, similar in pur-
pose to the "stress tests" developed for these other two GSE's.

Ongoing capital adequacy standards for the Bank System should also reflect the
ability to:

• Maintain the AAA credit rating;

• Cover the REFCorp assessment and Affordable Housing obligation; and

• Provide a reasonable dividend to stockholders.

The Bank System should have the necessary tools available to address capital
adequacy, including the authority to permit the FHLBanks to issue different classes
of stock to members, build permanent capital, and retain earnings without fear of
confiscation.

The Stockholder Study Committee is pleased that these recommendations on cap-
ital, which were developed and delivered in our final report last July, began the con-
sideration of the topic of provision of "permanent" capital for the System. This
theme was expanded in the CBO and GAO reports that were completed afler our
work. The HUD report addresses the issue in somewhat greater detail, but does not
give any specifics on the capital instruments that might be employed.

A great deal of discussion took place within our Stockholder Committee last year,
and / would emphasize that the involvement of the equity holders in any reconfigura-
tion of the capital base is vital. At this point, virtually all of the capital in the System
is represented by the holdings of redeemable common by the member institutions.
Their reaction to any proposed overhaul will be critical to its feasibility and success.

Governance

Since members are the providers of the System's entirely private capital, they de-
serve a serious review of their role in governance. The studies that have addressed
the issue in depth, those presented by the GAO and HUD, have recommended a sep-
aration between regulation and management. This issue was, however, first seri-
ously raised by the Stockholder Study Committee.

This enhanced stockholder control should be accompanied by even greater Federal
attention to safety and soundness via a single purpose regulator patterned afler the
Office of Federal Housing Enterprise Oversight, the overseer of Fannie Mae and
Freddie Mac. The HUD report actually recommends a merger of the FHFB and
OFHEO.

Our report was not so specific, but the committee discussed a range of alter-
natives for the location of this regulatory authority, including the Treasury, since
fiscal soundness was the suggested focus for this operation.

The committee also recommended the creation of a central policy entity with a
small staff and a Board of Directors to be responsible for Systemwide principles and
policies, such as joint and several liability issues, capital, and risk management. In-
dividual FHLBanks' Boards of Directors should elect one member to the Bank Sys-
tems' central policy entity. With that coordinating body in place, to the maximum
extent feasible, local policymaking and governance decisions should be vested with
the local FHLBanks' Boards of Directors. Management of the local FHLBanks
should be, in turn, vested with local management responsible to their respective
Boards of Directors.

The Stockholder Committee encourages consideration of consolidation among the
FHLBanks. Concern for both shareholder control and a local presence requires that
any consolidation among individual FHLBanks should be recommended by their re-
spective Boards of Directors and approved by their stockholders. Legal impediments
to consolidation should be reviewed and modified, or removed, as appropriate.

As part of that process, the Bank System's central policy entity should conduct
a thorough study of the issues relating to consolidation of the FHLBanks, including,
but not limited to, cost savings and the function, structure, and efficiency of the
F'HLBanks. These recommendations are again broadly consistent with the HUD
study.

Since our committee was intimately familiar with the management of the individ-
ual FHLBanks, we did make two further recommendations on governance. First, the
chairmen and vice chairmen should be elected by the local Boards of Directors. The
presidents of the local P"'HLBanks should be selected and appointed by the local
Boards of Directors.

Second, the terms of elected directors of the local Boards of Directors should be
established at 4 rather than 2 years to be consistent with terms of the appointed
directors. Directors should not be permitted to serve more than 2 consecutive terms.

Membership Recommendations

Voluntary membership on a uniform basis must be extended to all members of
the P^HLBanks. A two-class membership, with different obligations and rights, is di-
visive, inefficient, and unsustainable. Access to membership in the FHLBanks
should continue to be available only to thriRs, commercial banks, credit unions, and
insurance companies, as under current rules, since these are the Nation's portfolio
lenders.

Because of that orientation toward portfolio lenders, the current statutory mini-
mum requirements for eligibility, including the requirement that insured depository

institutions have at least 10 percent of their total assets in residential mortgage
loans, should continue to apply.

Consistent with uniform rules for membership, the stock purchase requirement
for all members should be equalized when a single class of voluntary members is
created. A two-pronged approach under that new uniform standard for members
still continues to make sense, with some modest adjustment.

The stock purchase reauirements should be determined by the Bank System's
central policy entity, basea on financial need and computed as follows:

• The initial stock purchase requirement should be based on a percentage of total
assets rather than mortgage assets; and

• The stock purchase requirement for members to obtain advances should be based
on a uniform percentage of advances.

FHLBank members that are currently required to meet the QTL test should be
eligible to obtain advances without the QTL test qualification, and limitations on
the amount of advances the Bank System may extend to non-QTL members should
be eliminated.

Since members should be free to leave if they so desire, some constraint is nec-
essary to prevent "revolving door" memberships. Thus, a member who voluntarily
withdraws from the Bank System should not be permitted to rejoin for 5 years.

These recommendations are consistent with those contained in the other studies,
but we emphasize that it is important to proceed with these changes in concert.

To quote directly from the text of our report: These issues "are significantly inter-
related and cannot and should not be addressed in isolation. The Stockholder Com-
mittee is presenting interdependent recommendations that should be considered in
their entirety. If they are not considered in their entirety, our positions on specific
issues may be different."

The Stockholder Committee's recommendations were unanimous, in part because
of the careful balancing of the individual items within the overall package. We are
aware that Congress is unlikely to adopt every provision in our report, or in any
of the others, without adjustment. Even so, we urge careful consideration of the con-
nections between individual components of any package of System reform amend-
ments.

Naturally, Congress is experienced in weighing competing arguments as legisla-
tion is crafted. That is the very nature of the legislative process. In that regard, we
commend to your attention one final and diiticult issue that hangs over from
FIRREA.

That is the infiexible, first-dollar call on System earnings for the REFCorp con-
tribution. We suggested a move to the fiat 20 percent "tax rate" originally con-
templated in FIKHEA as a continuation of the old 20 percent transfer to the so-
called legal reserve. We were, however, seriously concerned by the potential short-
fall that such a switch might create.

We are intrigued by the approach outlined in the GAO report whereby any short-
fall or surpluses from the 20 percent "tax yield" could be debited or credited to an
interest bearing account to eauate to the same "present value" burden but maintain
the Hexibility of the System. We did not offer that solution in our report, but I have
discussed it with the members of our committee and we all agreed that it would
be an eauitable way to restore fiexibility to the System's operation.

If nothing else, the range of analysis that has been presented to Congress from
the individual perspectives of these five studies shows the wisdom of commissioning
them in the first place and digesting their contents before moving legislation.

I would be happy to take any questions on the study that we submitted or on
those presented by the other entities. Thank you for this opportunity to express our
views.

APPE>JDIXA

FEDERAL HOME LOAN BANK SYSTEM
STOCKHOLDER COMMIITEE

Chairman

Michael T. Crowley, Jr.
President & CEO
Mutual Savings Bank

Vice Chairman
San Frandsco

James F. Montgomery

Chairman

Great Western Bank

Allanla

Richard E. Funke
Chairman & President
Atlantic Federal Savings Bank

Lynn W. Hodge

President & CEO

United Savings Bank, FSB

Boston - -

Cincinnati

Larry A. Caldwell

President

Cambridge Savings Bank

Tony D. Whitakcr

President

Hrst Federal Savings Bank

Chicago

John A. Becker
Chairman & President
Charter Bank, FSB

Dallas

Skip Martin

President <

Pocahontas FS&LA

Manuel J. Mehos

Chairman & CEO

Coastal Banc Savings Assoc.

David F. Holland
President &. CEO
Boston Federal Savings Bank

Hcrben W. Cununings
Vice Chairman
Citizens Savings Bank

Pes Moines

Etonald A. Glas

President

First State FS&LA

Michael J. Gorman

President

United Postal Savings Assoc.

A.1

Indianapolis

•Garry G. Carley
Executive Vice President
Standard Federal Bank

C. Gene Marling

Chairman & CEO

First Federal of Michigan

New York

Kenneth H. Van Saders

President

Clifton Savings Bank, SLA

•George L. Engelke. Jr.

President

Astona FS&LA

Pittsburgh

Norman L. Keller
President & CEO
Pcnnview Savmgs Bank

Edward J. Molnar
President & CEO
Harleysville Savings Bank

JsmsiiA

♦Richard T. Ponrrf
President & GEO
Mid-Continent FS&LA

•Frank C. Sidles
President & CEO
Provident Federal Savings Bank

SanFrandsco

Herbert M. Sandler

Chairman &CEO

World Savings and Loan Association

•H. Brent Becsley .
Chairman & CEO
Heritage Savings Bank

GJ. Pittcnger

President. Washington Division

Great Western Bank

(•) Subcommittee Chairman

A.2

VPPENDKB
CONTACTS WITH INTERESTED ORGANIZATIONS

The Stcxkholder Comraiaee has held extensive meetings with individuals representing
both public and private sector organizations. We have considered all viewpoints and
perspectives on the various issues confronting the Bank System. We have also met with
other interested organizations on a continuing basis.

Wherever possible we have followed up preliminary contacts, met with them, and
exchanged documents to understand, to the fullest extent, the impact of our
recommendafj^ns on ether organizations and interests involved in the Bank System.

The following individuals, agencies, and institutions have met with FHLBank
stockholder representatives:

Agency /Institution

/ ConUcts

Amcncan Biokcn Auooaucm

Kenneth Oayion, Senior Federal Legislauve
Counsel and Gail Bolcar. Senior Policv Analvst

CongrcssioaaJ Budget Office

Douglas HanultoQ, Pnocipal Analyst. Fiscal
Analysis Division

Congressman Rjchard Bakers
Office

Duane Duncan, Lepslanve Director & Counsel
and Paul Sawyer. Lepslanve Assmant

Deparrmeni of Housing and
Urban Dcvclopmcnl

Ben Laden. Director. Financial Intntuuons
Re^auoo Staff: John Ross. Director. Economic
and Public Finance Division; and John Gardner,
Senior Ecormmist

Depanmeni of the Treasury

Mart Kjnsey and Margaret Nilson. Financial
Economists

Fcacral Home Loan Bank
Housine Advisorv Councils

Chairpersons

Federal Home Loan Bank
Svsiem

Presidents and Ehrectors of the FHLBanks

Federal Home l,oan Mortgage
Corporation

Mitch Delk, Vice President Government and
Industry Relations: Ed Golding. Director. Policy
and Planning. Financial Research Department; and
Dick Prati, Consultant

Federal Housing Finance
Board

Board Members and Staff

Federal National Mongage

A^^nclallon

Annene Fnbourg. Vice President. Regulatory
Activiiies. and Mark Obnn? v. Senior Economist

General Accounting Office

Bill Kxuvant. Assistant Director. Financial
Institutions and Markets; Ed DeMarco. Senior
Economist; and Patrick Docrmng. Opcrauons
Research Analvst

Independent Bankers
Association of Amenca

Diane Casey. Execuuve I!>uector, Karen Thomas,
Regulatory Counsel; and Ann Grodiala. Director
of Bank Operations

B.l

Mortgage Bankers Associauon

Phylhj Slesmger. Senior Director, and Viaoru
VidaL Associate Direcior. ResidenuaJ
FinanceAjovcmmeai Aygxry Reliooos.

NaDooal Associanoo of Home
Buildcn

Neigh bortiood
Corporation

Rem vestment

Office of Thnft Supcrvisioo

Savings and Community
Bankers of America

Krffl ColtDO. Executive Direnor. David Ledford,
Stiff Vice Pitsidenc David Sodeis, Chief
EcoDomisc ind Kjtby Geiladi. Legislanve
Dnecujr

Geor^ Knigbu EiecuDve Director

Jcoatfaoo Fiechier. Acting Director, and
Price. Actiin Assigant Director for Policy

John

Manm Regaiia. Director,
Reseaicii moi Alfred
Oovermncnt Relanons

Ecoooimrs and
PoUard, Director.

Senaie Banking Comn-jnee

Pai Lawler. Chief Economist

PREPARED STATEMENT OF MARY LEE WIDENER

Chairman of the Board, Federal Home Loan Bank of San Francisco,

San Francisco, CA

June 15, 1994

I. Litroduction

Good morning. Chairman Riegle, Members of the Committee, thank you for invit-
ing me to testiiv. My name is Mary Lee Widener. I am the chairman of the Board
of Directors of the F'ederal Home Loan Bank of San Francisco. I also serve as presi-
dent of Neighborhood Housing Services of America. My comments will reflect views
developed from both these perspectives.

My relationship with the Federal Home Loan Bank System dates back to 1971
when I was employed by the Federal Home Loan Bank Board to help lead the thrift,
industry into productive and effective urban lending programs. That relationship
deepened with my appointment in 1977 to be a director of the San F'rancisco Bank.
I served in that capacity until 1982. In 1990, I became a member of the Afibrdable
Housing Advisory Council to the San PVancisco Bank and served as chairperson of
the Affordable Housing Advisory Council from 1990 to 1993.

n. Importance of Federal Home Loan Bank System

My service in the Federal Home Loan Bank System and through non-profit hous-
ing services to distressed neighborhoods has given me an opportunity to witness the
dramatic changes in housing finance in the last two decades. As we address the
issue of reforming the System, I am keenly aware that our challenge is to work for
a consensus that will bring about changes that will ensure the long-term capacity
of the entire System to support its housing mission through its service to the port-
folio lenders. Tney are crucial to this country's most difficult housing and economic
development needs, and play a preeminent role in fostering the work of community
development organizations through the Affordable Housing Program and Commu-
nity Investment Program.

The Federal Home Loan Bank System, acting through its members, is a vital link
between the financial community and the low-income neighborhoods of this country.
The Home I^oan Banks and their members perform this function through several
mechanisms: (1) general loans that support community -based portfolio lenders that
make market rate loans in economically disadvantaged areas; (2) special loans that
are targeted with below market rates for such areas; (3) direct subsidy grants
through the Affordable Housing Program; and (4) human capital through their local
leadership.

Some have questioned the continued need for the Home Loan Banks largely be-
cause of the success of Fannie Mae and Freddie Mac, in the secondary market, in
helping millions of Americans obtain home loans. As we acknowledge this important
success, we must also acknowledge that many families are not served by these
GSE's. By their nature, Fannie and Freddie must have national uniform underwrit-
ing criteria. Homogeneous mortgage loans are what allow the secondary market to
function so effectively. For the millions of mortgage applications, and millions of
people whose home ownership dreams do not fit within this homogeneous loan cri-
teria, another resource is needed. Just because a potential borrower does not fit
within that mold docs not mean that such a person does not represent a good credit
risk; it just means that he or she is an individual, different in some manner from
a statistical composite.

Part of America's strength is its diversity. Having a broad network of community-
based lenders, with local standards, helps promote that diversity. The Home Loan
Banks have successfully accomplished their primary mission for the past 60 years:
Supporting lenders who make home loans. IVoviding our members with liquidity
from the Federal Home I>oan Banks gives them an incentive to hold otherwise il-
liquid consumer home mortgage loans that do not qualify for the secondary market
and to be proactive in more difficult lending environments than otherwise would be
feasible.

Access to Federal Home I^oan Bank advances gives lenders the confidence that
they will be able to hold loans that they cannot sell at full value and still meet ei-
ther seasonal or cyclical demands from their depositors. In effect, access to Federal
Home Ivoan Bank advances takes the liquidity risk out of lending to the families
with the fewest financial options. The way to expand that access is by increasing
the financial success of the System.

I want to state, in the strongest possible terms, that the members of the Federal
Home Loan Bank of San Francisco have a positive effect on the lives of people in
the communities in which they operate. South Central Los Angeles, for example, is

a community with well-known social and economic problems. Years of inadequate
Federal and local support have been compounded by a State-wide recession, that
was larger in scope than any recession since the Great Depression of the 1930's, and
by an unprecedented string of natural disasters. The recession, which still lingers
on in California, has caused a drastic cut-back in State services. This area needs
new sources of private financing and Federal aid, but we also need to ensure that
the existing public and private financial resources that are flowing into the region
are not reduced.

The financial institutions that are members of the Federal Home Loan Bank of
San Francisco are the most significant source of private financing that Hows into
South Central Los Angeles. According to the most recent Home Mortgage Disclosure
Act data. Federal Home Loan Bank members make 39 {percent oi tne mortgage
loans in California; but in the low-income areas of South Central Los Angeles, Bank
members make 65 percent of the mortgage loans. Home Loan Bank members made
loans of $895 million in South Central LA in 1992, of which $726 million went to
minority applicants. Our members' efforts in South Central Los Angeles are not an
aberration. State-wide in California, Bank members do a disproportionately larger
share of the lending in low-income neighborhoods. Bank members' ratio of mortgage
loans originated in the low-income neighborhoods in California is 50 percent higher
than the ratio of all other mortgage originators in California.

Mr. Chairman, let me emphasize, this lending is above and beyond the very suc-
cessful Affordable Housing Program and Community Investment Program. These
statistics represent the ongoing day-to-day business operations of private financial
institutions in low-income communities. I believe we can, and must, do more. In de-
signing new programs, we must be careful to nurture and preserve our base, and
develop our capacity to grow stronger, not weaker, in addressing affordable housing
needs.

I concur in the succinct statement of purpose for the Federal Home Loan Bank
System, found on page 125 of the HUD study, which reads as follows:

I think this mission statement reflects the balance between the profit-making na-
ture of the System and its social mission, which can only be accomplished through,
and by the actions of, its members.

One issue that has resurfaced in the HUD study of the Federal Home Loan Bank
System is the question of whether there is actually a cause and effect link between
Federal Home Loan Bank advances and specific mortgage loans made by our share-
holders. This question suggests to me an interest in tracing dollars that I believe
would create cost and grief beyond comprehension with no benefit to anyone.

It is clear, beyond all doubt, that advances do play an important role in extending
housing opportunities to more families by increasing the availability, and reducing
the cost, of mortgage credit. It is not merely the funding of an advance that encour-
ages our shareholders to extend credit to low- and moderate-income families not
served by the secondary market. Rather, it is the knowledge that, as a member of
the Bank System, the lender can take an otherwise illiquid loan to the Federal
Home Loan Bank when it needs cash. In other words, a member's potential borrow-
ing capacity at the Federal Home Loan Bank removes the liquidity risk from other-
wise illiquid loans.

HI. The Need for Comprehensive Reform

The Administration has indicated that it will submit comprehensive legislation to
Congress addressing Federal Home Loan Bank issues. I applaud and encourage
such an effort. Comprehensive reform can increase the effectiveness of the System.
In that regard, I believe that reform must be comprehensive, not piecemeal, in na-
ture. We do not support the adoption of the cluster of amendments in the House
version of the Community Development F'inancial Institution legislation affecting
the Home I^oan Banks in their current form. Such issues, however, should not be
precluded from being adopted as part of a comprehensive package of reforms on cap-
ital, governance, and other issues. The System, including representatives of inter-
ested community development organizations, is working toward development of so-
lutions to all of these issues and we look forward to a continuing dialog with the
Administration and Congress.

We believe that to reform the Federal Home Loan Bank System in a proper man-
ner, one must understand the balance that is critical to the success of the System.
This balance has, on the one side, the Banks' business operations and, on the other,
the central social missions they currently perform, and the challenge is to under-
stand and maintain the link between the financial performance of the Banks and
their ability to achieve the public purposes set forth by Congress.

The Federal Home Ixian Bank System has functioned well in the past because it
has maintained this balance between meeting the legitimate expectations of its
shareholders for a reasonable return on their investment in the Banks, and fulfilling
the public policy mission as set out by Congress. The System's shareholders have
valued the System for the liquidity and lending functions it has performed, and for
the dividend they receive on their capital investment in the System. It is investment
of private capital in the Federal Home Loan Banks that enables the System to meet
its public policy purpose without Federal tax dollars. That balance has been upset
recently, and it could deteriorate further if changes are not made or if the wrong
changes are made. The delicate balance between private interest and public purpose
must be restored.

rV. GAO is Correct: The REFCorp Allocation Formula is
Unwise Public Policy

Currently, the primary mission of the Federal Home Loan Banks is being dis-
torted by their obligation to make interest payments on the bonds issued by the
Resolution Funding Corporation (also known as REFCorp), and by the manner in
which that obligation is allocated among the Federal Home Loan Banks. The Fed-
eral Home Loan Banks are required by law to make a fixed annual REFCorp pay-
ment of $300 million. As the GAO has noted in its report on the Federal Home Loan
Bank System, this fixed obligation has caused the Federal Home Loan Banks to
greatly increase their investment portfolios, particularly their investments in mort-
gaged-backed securities. The GAO found that this investment "has increased both
the interest rate risk and management risk in the System, thereby raising the possi-
bihty that meeting the fixed obligations could confiict with the System's safety and
soundness." The GAO is correct.

The Federal Home Loan Banks continue to hold large investment portfolios and
soon will have mortgage-backed securities portfolios equal to three times their cap-
ital. Let there be no mistake about our position on this issue. We are not pleased
to be in the business of investing in mortgage-backed securities, but the current
drain on our funds is so significant that we find ourselves with no choice if we want
the System to continue to function. As the CBO has noted, without these invest-
ments, the System could be in financial trouble. We believe that, after the System
is reformed, the Federal Home Loan Banks should only hold short-term invest-
ments, and only enough of those investments to meet any temporary surge in de-
mand for advances.

The other problem I wish to draw attention to, with respect to the REF'Corp pay-
ments, is the formula for allocating the $300 million among the 12 Banks. The
REFCorp payment is allocated in two steps. First, each Bank pays 20 percent of its
net income. Second, to the extent that aggregate amount does not equal $300 mil-
lion, each Bank pays an additional amount based on its share of total System ad-
vances outstanding to savings associations insured by the SAIF. This allocation
method is unrelated to a Bank's ability to pay, which is the foundation for most Fed-
eral taxes. More importantly, the allocation actually discourages a Bank from mak-
ing advances to its members in support of its primary housing mission. Ironically,
the better job a Bank does at meeting its mission, the greater its portion of the as-
sessment. The GAO and CBO make this point in their studies of the Federal Home
Loan Bank System.

The GAO states that "The Shortfall Allocation Penalizes Lending and Could Dis-
rupt the System," and the CBO reaches the conclusion, in its report on the System,
that the REFCorp payment "subverts" a Federal Home Loan Bank's incentive to
make advances to savings and loans. Both the GAO and CBO conclude that the for-
mula penalizes the F'ederal Home Loan Banks for fulfilling the purpose for which
they were chartered: Lending money to savings associations.

Let me illustrate the degree to which it does so. Whenever any Bank makes an
advance to a SAIF-insured institution, its share of the REFCorp shortfall in future
years increases. In the San Francisco Bank's case, increasing advances by $1 billion
will increase the Bank's share of the REFCorp assessment by nearly one full per-
centage point (90 basis points). Today, this means that more than $1 million of the
profit on these advances is paid in additional assessments.

In contrast, arbitrage investments, including those that have nothing to do with
housing, have no effect on a Bank's share of the REFCorp shortfall. As a result, at

the San Francisco Bank, an investment with a spread of 11 basis points is as profit-
able on an after-REFCorp basis as an advance with a spread of 25 basis points.
Both will produce net income of 8.6 basis points after REFCorp. Thus, the Bank is,
in effect, encouraged to buy securities and it is discouraged from doing what it was
chartered to do: Promote housing by lending to savings associations.

This discrepancy is even more apparent at a Federal Home Loan Bank, such as
the Boston Bank, that pays a very small share of the shortfall. The Boston Bank
is able to pass on more money to its shareholders from an arbitrage investment
yielding 2 basis points than from an advance to a SAIF-insured member yielding
25 basis points. In sum, the shortfall allocation formula encourages all Federal
Home Ijoan Banks to prefer lower-yielding investments to higher-yielding advances
to SAIF-insured members, notwithstanding the fact that such investments may earn
less money for the System as a whole. This hurts housing bv increasing the short-
fall, making less money available to finance home ownership/rental housing, and by
making less money available for the Federal Home Loan Banks' Affordable Housing
Programs.

V. HUD as Program Regulator

Before I begin my analysis of HUD's recommendations on what it calls "program
options" for the P'ederal Home Ijoan Bank System, let me indicate my general dis-
comfort with that term. I suggest that we need to think of these issues and frame
them in terms of business opportunities and social responsibilities. Program ootions
are something that a Government regulator administers through its regulatory
power.

As you know, Congress established the Banks to perform a social mission as a
provider of liquidity to promote housing finance. This social mission can only be ac-
complished, however, ifmembers choose to remain in the System. We cannot force
our members to take a loan from us. We do not operate by regulatory edict; we oper-
ate by offering our members access to loans that encourage lending for housing and
home ownership.

I am concerned by HUD's recommendation that an "additional mechanism" be cre-
ated to require the commercial banks and thrifts that borrow funds from a Federal
Home Loan Bank to use a portion of those advances for housing for specified pur-
poses. The HUD report suggests that specific collateral targets would have to be
met, and a new reporting system established. This approach not only will fail to
achieve HUD's objectives; it will be counterproductive. Such targets and require-
ments will discourage members from joining the System and from borrowing from
the Banks.

The HUD study states that safety and soundness regulation should be separated
from the Federal Housing Finance Board's current managerial responsibilities. All
observers of the System agree on that point. We believe that the Boards of Directors
of the Banks should be responsible for managing the Banks, and that the safety and
soundness regulator should be responsible for examining and supervising the Banks
in a manner consistent with other regulators.

Much discussion has occurred over the topic of who the regulator should be. The
HUD proposal is that the Office of Federal Housing Enterprise Oversight be given
responsibility for safety and soundness regulation, and that HUD be designated as
the program regulator. It further leaves in place a potential governance role by the
Federal Housing Finance Board. I am troubled by this possible three-party regula-
tion of the Federal Home Loan Banks. The Afibrdable Housing Advisory Councils
are unanimous in their opposition to the direction this suggests. We are opposed to
the establishment of a program regulator that might encroach upon the ability of
local community groups to participate, through the Community Reinvestment Act
process, in the eflorts of financial institutions to meet the credit needs of their local
communities. Community development organizations place a high value on the pri-
vate nature of the Federal Home Loan Banks. Clearly, there is a need for a safety
and soundness regulator, but there is no such need for a separate and distinct pro-
gram regulator. The core business of the Federal Home Ijoan Banks, lending to
other financial institutions, should be administered by the individual Federal Home
Loan Banks under the guidance of their Boards of Directors. The AHP- and CEP-
targeted lending business has been, and can continue to be, effectively administered
by the regional Home Ijoan Banks within national guidelines.

VI. Targeted Lending: AHP and GIF

In addition to supporting community-based lenders that originate and hold il-
liquid mortgage loans, the Federal Home Loan Banks also link the financial commu-
nity and the low-income neighborhoods of this Nation through two targeted seg-
ments of our lending operations, the Affordable Housing Program and the Commu-

nity Investment Program. The contribution of the Federal Home Loan Banks to the
Affordable Housing Program will increase another $25 million this year to $100 mil-
lion per year. Community groups are universal in their acclaim that the Affordable
Housing Program and the Community Investment Program are effective, targeted
means of supporting the development of low-income communities.

The Affordable Housing Program provides Federal Home Loan Bank members
with below-market-rate loans or direct subsidies to finance the construction or reha-
bilitation of projects to meet the needs of low-income communities. The Banks have
provided about $234 million in afTordable housing subsidies since the program was
initiated, assisting over 62,000 units of affordable housing, and another $75 million
has been set aside for subsidies to be awarded in 1994. The rate of contribution
going forward is 10 percent of net income,'with a minimum of $100 million p)er year.
Comprehensive reform of the System can enable it to earn more income and in-
crease this contribution. Our AfTordable Housing Advisory Council shares our strong
desire to position the System to far exceed the current $100 million flow of funds
into AHP.

Advances under the CIP are made at a discount from the Banks' regular ad-
vances. These loans are priced to just cover direct costs; the Banks do not quite
break even on the loans when indirect costs are added in. Our share of the REFCorp
assessment, for exaniple, increases each time we make a CIP loan to a savings and
loan in our district. Thus, a Bank actually incurs losses on CIP loans because the
REFCorp assessments are not calculated as a direct expense.

The purpose of the CIP is to encourage member institutions to make special ef-
forts to increase their involvement in community revitalization and development.
CIP advances may be used to support financing the construction, rehabilitation, or
acquisition of residential or commercial property that benefits low- and moderate-
income areas or families. Over $5 billion in subsidized advances had been made
under this program through March 31, 1994, funding over 137,000 housing units
and $170 million in economic development projects.

I would like to contrast our targeted lenaing business to the requirements for the
other housing GSE's. FNMA and FHIJVIC have requirements to acquire loans made
to families oi moderate income, but Federal law states that they must earn a rea-
sonable return on such investments. The Federal Home Loan Banks are housing
GSE's required by law to subsidize loans; that is, the Banks must make these loans
at a loss.

These targeted segments of our business have received support from the local
communities that they serve because they are flexible, non-bureaucratic, and de-
monstrably improve the lives of people in the community. The staff at our Bank
works hard to promote partnerships between non-profits and mainstream financial
institutions.

The Community Investment Program has been used to support mostly housing ac-
tivity. That is because most of our borrowers are specialized housing lenders. They
do not do a lot of business lending, but our members that do engage in small busi-
ness lending find the CD-* to be very helpful. East-West Federal Bank received a
$4 million CIP advance in 1993 to support the permanent financing for a small
shopping center in IjOS Angeles' Chinatown district. That particular community has
a median income that is 44 percent of the area median income. The shopping center
not only provides economic opportunity, it helps maintain the area as a focal point
of the local community. To the extent we can encourage institutions that have the
expertise in making tnese types of loans to join the System, we can expand these
types of economic opportunities.

Vn. Membership Requirements and Terms of Access for Advances

The membership requirements of the Federal Home Ivoan Bank Act are a product
of history, and a result of a compromise between the House and Senate in the
FIRREA legislation passed in 1989. Prior to 1989, commercial banks and credit
unions were not allowed to become members of a Federal Home I^oan Bank. When
FIRREA was adopted. Congress recognized the changing nature of the home mort-
gage lending industry, as commercial banks and credit unions began increasing
their share of the home mortgage lending business. The Senate proposed letting
commercial banks and credit unions join the System if they satisfied the same
Qualified Thrift Ixjnder, or QTL, test that applies to savings and loans; the House
proposed letting all commercial banks and credit unions join. A compromise was
reached whereby commercial banks and credit unions could join if they had at least
10 percent of their assets in mortgage loans, but lending was restricted so that no
Federal Home Loan Bank could lend more than 30 percent of its advances to insti-
tutions that did not satisfy the QTL test. In the Housing and Community Develop-
ment Act of 1992, that restriction on lending was further liberalized to permit an

individual Federal Home Loan Bank to exceed the limit of 30 percent of loans to
institutions that did not pass the QTL test, so long as the System, as a whole, did
not exceed the 30 percent limit.

One of the provisions of the House version of the CDFI Bill would raise the
threshold for loans to non-QTL borrowers from 30 percent to 40 percent. The Fed-
eral Housing Finance Board reports that only 8 percent of System advances out-
standing as of December 31, 1993, are to non-QTL borrowers. There obviously is no
pressing need to increase that threshold now. While the provision's sponsor has dis-
played a true concern for comprehensive reform, not all of the provision's proponents
are similarly motivated. There are some who will be opposed to comprehensive re-
form of the System.

The GAO has noted that the current structure of two classes of members, some
voluntary and some mandatory, increases the risk to the System. The GAO has also
stated that the System would be more stable and efTective if membership were vol-
untary for all insured depository institutions. We agree. As part of comprehensive
reform, for the long term, we think stock purchase requirements among all share-
holders should be equalized. The two principles for constructing sound membership
rules enunciated in the GAO study make a great deal of sense. First, the rules
should equalize the benefits and burdens of membership for all members, irrespec-
tive of charter type. Second, the rules should give more control of the System to the
shareholders of the Federal Home Loan Banks. This would allow them to operate
their business in a manner that assures the System's responsiveness and, therefore,
attractiveness to voluntary members.

VlJi. Taxpayer Exposure to the FHLB System:
The Issue of Permanent Capital

Some have suggested that the Federal Home Loan Banks pose an indirect risk
of loss to the taxpayers because most members of the System are institutions with
deposits insured by the FDIC. Any fair assessment of the actual risk of loss borne
by the insured deposits of Bank members must take into account the actual risk
profile of the Bank System. Given the current operations of the Bank System, the
chance of a default of the magnitude necessary to afTect the insured deposits of a
member is so unlikely that the overwhelming amount of the expected risk of loss
(which itself is minimal) is borne by the members' capital, not their insured depos-
its. During the past 60 years, no Federal Home Loan Bank has ever experienced
a credit loss on a loan. Moreover, during the past 60 years, each Federal Home Loan
Bank has reported positive earnings in every fiscal year. The stand-alone AAA rat-
ings of 10 of the 12 Federal Home Loan Banks are a matter of public record.

The issue of Federal Home Loan Bank System capital, its appropriate amount and
form, is a complex matter. I currently serve on a task force within the Federal Home
Loan Bank System that is in the process of gathering and analyzing the latest fi-
nancial data on this issue. It is important to note the interrelationship of the many
issues confronting the Bank System. One of the primary objectives of the San Fran-
cisco Bank in participating in a design of the System's capital structure is to ensure
the safety and soundness of the System. Also, capital issues cannot be divorced from
the REFCorp burden, so fixing REFCorp should be addressed as part of the reform
of the capital structure of the Bank System.

IX. Summary of Views on HUD Study

The HUD study makes three basic recommendations regarding the Federal Home
Loan Bank System. First, it suggests establishing a new mandate for allocation of
credit to Bank shareholders. Second, it endorses the creation of permanent capital
and a statutory capital standard. Finally, it calls for equal access and stock pur-
chase rules for all snareholders.

Let me briefly summarize our points of agreement with HUD. First, we agree that
the overall focus of the System snould remain on supporting community -based port-
folio lenders. The Federal Home Loan Bank System needs to remain strong and fi-
nancially sound.

Second, we agree that there is no need for the development of new products and
lines of business that would increase risk in the System, and the System does not
require expansion of membership outside the regulated financial institutions that
are currently allowed to join. Securitizing loans is not a good idea; it would eventu-
ally lead to three housing GSE's in that business. Direct lending, as in construction
lending, is an area in which those with experience suffer regular losses that would
endanger the System's credit rating. There is no reason to think the System would
do any better than its members, and as a start-up business, the System would un-
doubtedly do worse. Instead of new lines of business, we need to create more public/
private partnerships that build on the existing strengths of the participants.

Third, we agree that the Federal Home Loan Banks need to have a statutory risk-
based capital requirement, as other financial institutions do. The Federal Home
Loan Bank System currently operates without a statutory capital standard require-
ment in terms of capital to assets. The only statutory standard related to capital
is the minimum stock purchase requirements for Bank members.

Fourth, we agree that all potential members should have equal access to the Sys-
tem, and the same stock purchase rules. There should be no distinctions based on
the type of charter held by an insured depository institution.

Finally, we agree that voluntary membership is necessary and inevitable.

There are, however, a number of points of disagreement with the HUD study.

First, we disagree with the concept of credit allocation formulas or the concept of
placing limits on advances. The Federal Home Loan Banks are not designed to con-
trol the loans that their members make. Any efTort to do so will discourage potential
members from joining the System and encourage existing members to leave. We are
wholesale lenders; our members do the retail lending. Ketail lender activities need
to be addressed directly so the disadvantages and advantages of the various ap-
proaches can be fully developed in open debate.

Second, we do not believe a program regulator is necessary. One regulator, fo-
cused on safety and soundness, will suffice.

Finally, we note that HUD did not address the REFCorp issue. We agree with
GAO that the REP^Corp contribution should be rationalized in order to minimize the
risks in the System and remove the disincentive to make loans for housing and
home ownership.

X. Conclusion

Systematic and comprehensive reform is necessary in order to increase our effec-
tiveness in helping portfolio lenders meet the credit needs of the communities they
serve, especially low-income communities. We need to attract new members and to
retain our existing members, which requires us to return the Federal Home Loan
Banks to a higher level of profitability and pay a fair return on our members' in-
vestment in the Bank without the artificial boost from investing in mortgage-backed
securities. The REFCorp assessment, the membership requirements, the capital
structure, and the governance structure need to be reformed.

The REFCorp assessment appears to be the most difficult issue to address politi-
cally. There is a solution, if Congress and the Administration are willing to take a
long view. The REFCorp assessment lasts for another 37 years, when the last
REF'Corp bonds are retired, but the pay-as-you-go rules measure the budget impact
for only 5 years.

As the GAO noted. Congress could change the fixed $300 million obligation to 20
percent of income and require the Federal Home Loan Banks to continue paying the
Government past the maturity date of the REFCorp bonds to the extent the present
value of such variable payments was less than the value under the current fixed
$300 million assessment. This reform would require a budget waiver because, al-
though it is budget neutral over the 37 or more years that payments would be made
on the REFCorp bonds, it is not budget neutral over the 5-year time frame used
for scoring proposed legislation. It seems, however, that if ever a budget waiver
would be warranted, it should be when GAO recommends it as a measure to reduce
the long-term risk to the taxpayer in a manner that is, in the long run, budget neu-
tral. REFCorp reform, along with changes to the System's membership and capital
requirements and to its governance structure, will enhance the Banks' ability to suc-
cessfully perform their housing finance mission.

PREPARED STATEMENT OF ALFRED A. DELUBOVI

Presidknt, Fkderal Home Loan Bank of New York, New York, NY

June 15, 1994

Good morning. Chairman Riegle. I'm Alfred DelliBovi, president of the Federal
Home Loan Bank of New York. I am grateful for the opportunity to comment on
the HUD study and possible legislation impacting the Federal Home Loan Bank
System.

I believe the HUD study is a solid, thoughtful report. It, as well as the reports
of the CBO, GAO, FHFB, and the Stockholders' Study Committee, should be thor-
oughly considered by Congress.

The New York Bank is in full agreement with the two central conclusions of the
HUD study: One, that portfolio lending in support of mortgage financing is critically

important and, two, that support for mortgage portfolio lenders should remain the
core function of the Home Loan Bank System.

For over three generations, the Home Loan Bank System has successfully served
the public policy mission Congress has given it through the efforts of our private
sector members who own the System. Providing our members with financial incen-
tives has helped ensure the economic well-being of the communities and the people
served by these local lenders. Through our 267 community-based shareholders, the
New York Bank plays a key role in nundreds of communities in our district which
includes New Jersey, New York, Puerto Rico, and the U.S. Virgin Islands. Similar
economic contributions are being made by the other 11 Home Loan Banks, with
local, member lenders, in thousands of communities across the Nation.

The System works well, and as the HUD study tells us, it is needed, and it is
not broken. There are a few changes that potentially will make it work better, but
we should be careful not to create problems in the process. Some will say that these
changes should only be made as part of a comprehensive package, and we would
likely support such a comprehensive legislative proposal. However, because the 2-
year HUD study has just been completed, and because the key capital study is just
getting underway, it is highly unlikely that a comprehensive proposal will, or
should, be considered by Congress this session. While we look forward to working
to develop comprehensive legislation in the future, we are in business today. Today,
we and local member lenders should enjoy the benefits of a few legislative changes
that common sense and reason dictate should be made.

To this end, the Board of Directors of the New York Home Loan Bank, last month,
adopted a 1994 Home Loan Bank lx;gislative Agenda.

Specifically, the New York Bank's Board of Directors supports:

• Allowing the Home Loan Banks to incur daylight overdrafts under the Federal
Reserve Bank's daylight overdraft rules.

• Allowing members that opted out of the System in 1989 and 1990 a 3-month "win-
dow of opportunity" to rejoin.

• Stating in statute that all management duties reside with the District Bank
Boards.

The New York Bank hopes the nominations for the vacant FHFB seats are made
in time for your consideration and Senate confirmation before the sine die recess
of this Congress.

• If that is not possible, the New York Bank supports allowing the two existing
members of the Federal Housing P"'inance Board to constitute a quorum until the
existing vacancies are filled or a comprehensive change in the Finance Board
structure is enacted by Congress.

• Supporting the Baker Amendment contained in the Community Development
Banking and F'inancial Institutions Bill passed by the House, and a proposal that
would calculate and apply a 40 percent non-QTL advance cap on an individual
Bank basis.

• Amending section 2901 of the Community Reinvestment Act of 1977 which would
encourage and recognize, for compliance purposes, lending by institutions who
help meet the credit needs of the local communities in which they are chartered,
or in such targeted low- and moderate-income neighborhoods designated by the
appropriate State authority consistent with the CRA.

We believe these changes can be made during this session of Congress. These
changes will help guarantee the continued significant contributions oi our Afford-
able Housing IVogram, our Community Investment Program, and our payment of
REFCorp assessments. They will ensure that we are better able to conduct business
and meet our mission; a mission, highlighted by the HUD study, which is totally
directed to supporting mortgage portfolio Tenders.

During deliberations on these six specific points and other general issues of a
comprehensive legislative package on the Home Loan System, it is critical to ask,
if you will, the "filteenth question" that the HCDA might have asked: "How do port-
folio lenders, with the support of the Home I^oan Bank System, do their business?"

First and foremost, local lenders conduct their business with complete knowledge
of, and thorough commitment to, their communities. Portfolio lenders are in busi-
ness for the long haul, and they are oflen located in the very heart of their commu-
nities. They are not merely temporary store front operations which only originate
loans for housing units and close up shop if the market looks like it might turn.

The. community lender is there to help finance a home for his or her neighbor.
He or she is there to take deposits and offer savings accounts. They are there to
cash checks, to make car or personal loans, and to keep valuables safe. In short,
they serve to meet many of the diverse financial needs of their communities.

The ability to accept, as collateral, many types of mortgages, has enabled the
Home Ijoan Banks to ofTer a unique foundation from which the local lender can play
its key role in neighborhood building. With our flexible policies we can lend against
a wicfe range of creditworthy, mortgage-related collateral. This flexibility has, in
turn, enabled portfolio lenders to meet tneir customers' varying financial needs.

A great many of our local member lenders hold in portfolio a mortgage on a one-
to-four family residence with a small business, such as a health care facility, a dry
goods store, or a restaurant — the kinds of buildings located in every community —
that is attached to the home. Other examples are a home with 21 boat slips in Suf-
folk County, NY, or a bed and breakfast in Upstate New York. These types of family
properties typically do not fall within the guidelines of the secondary mortgage mar-
ket.

Some of our portfolio lenders serve culturally diverse communities with different
standards and practices for loan documentation. As a consequence, the mortgage
documents do not conform to those of the secondary mortgage market, but do rep-
resent sound business.

Another significant area of support from the Home Loan Bank is for mixed-use
multifamily properties. Let me just mention a few typical examples we have in our
collateral vaults. In the Bronx, we accepted Oliver Gardens as collateral pledged for
advances. This is a mixed-use building with 43 co-op apartments and, like so many
other buildings in New York City, with small businesses on the ground floor.

In Ulster County, NY, we have as collateral a property with a non-conforming
blanket mortgage covering a three-story building with eight apartments, one family
cottage, and two garage buildings with nine bays.

Similarly, in Orange County, NY, we have as collateral a five-unit apartment
building with documentation that would not comply with the cookie cutter require-
ments of the secondary mortgage market.

This fiexibility in the types of collateral we accept allows the local lenders we
serve in I'uerto Kico to pledge 720 home loans originated under various housing pro-
grams sponsored by the Commonwealth.

Our community housing lenders don't make only unusual mortgages. The basic
multifamily resiaential mortgage is a key part of the business strategy of many of
the members in our district. Because of tne special housing requirements of our
metropolitan communities, our members have developed special expertise in multi-
family lending. This is especially important in this sector of the residential mort-
gage market, oecause it is so clearly underserved by the secondary market. In fact,
the multifamily mortgages that banks and thrifts hold in their portfolios total more
than SVIj times all multifamily mortgage securities outstanding. The ability to
pledge these mortgages at the Federal Home Loan Bank is a major factor in main-
taining the fiow oimortgage funding to this sector.

The traditional role ofthe banks in supporting home ownership through collateral
lending was expanded by FIRREA through the Affordable Housing Program and the
Community Investment Program. The subsidies on"ered by these programs are im-
portant tools to portfolio lenders in their efforts to help revitalize neighborhoods,
maintain property values, and meet the credit needs of their communities.

Simply stated, the portfolio lender can count on the Home Loan Banks as a valu-
able and reliable source of funds to support mortgage lending operations. We serve
as an important source of liquidity. A resource that enables a member to deploy a
greater percentage of assets into mortgages or mortgage investments, thus increas-
ing the availability of mortgage funds. Further, this access to ensured liquidity has
been an important reason why over 2,500 community commercial banks have volun-
tarily joined the System.

Without question, the Home Loan Bank System serves an important role in our
economy. This fact is underscored in each of the five studies mandated by Congress
in 1992. There is another important fact that all ofthe studies agreed on: The Sys-
tem is well capitalized. This position of capital strength is reflected in the results
of a special analysis to evaluate the stand-alone credit rating ofthe housing GSE's
by Standard & Poor's. Standard & Poor's gave the Federal Home Loan Bank System
a AAA credit rating on a stand-alone basis; that is, without any implicit Govern-

ment backing. The Bank System is the only housing GSE to receive this high rank-
ing. Furthermore, the System is among only a handful of banking institutions,
worldwide, with a AAA stand-alone rating.

The Sy.stem received this rating because of robust earnings, pristine asset quality,
minimal interest rate risk, a vibrant customer base, and strong management. Noth-
ing suggested in the five studies or in the System's own strategic framework will
alter the System's fundamentally conservative operating philosophy.

As with all systems, the Home Loan Bank System is not absolutely risk free, but
the risk in the System is not a risk of loss, rather, it is confined to the variability

in reported net income. This variability is largely associated with the cyclical move-
ment of the economy and interest rates, due to the earnings capacity of our capital,
and the changing prospects for funding increases in mortgage demand for our mem-
bership.

One of the strengths of the System is derived from the stock held by its member
institutions. The U.S. Treasury does not own any stock in the System. Although
Treasury provided the System's initial capitalization in 1932, the System retired all
Treasury-owned stock by the early 1950's. For more than 40 years, the System has
been capitalized entirely by private sector funds from private sector financial insti-
tutions.

It is for that reason that we strongly concur with Assistant Secretary Retsinas'
statement last month to the House BanJting Subcommittee that any proposal for re-
structuring the System's capital must involve the providers of the System's capital.
As the Assistant Secretary said, restructuring capital cannot be "done behind closed
doors."

The CBO, the GAO, and HUD have each put forth ideas on how the basic nature
of the capital in the System could be improved. To respond to these ideas, the 12
District Banks are conducting a coordinated and comprehensive analysis of the Sys-
tem's capital structure and possible alternatives.

The objective of the study is to recommend viable alternatives for the capital
structure of the System that address the concerns of the Government regarding the
permanency of the capital while preserving the value of existing shareholders' in-
vestment.

The System's study is being conducted by a committee consisting of FHLB execu-
tives, thrift and commercial bank shareholders, and public interest directors of the
Banks with the help of an investment banker, and outside legal and accounting
counsel. Three representatives from the Finance Board — Directors Retsinas and
Costiglio and Acting Managing Director Fair — serve ex officio on the committee.

Because the System is currently well capitalized and there is no danger — not even
on the horizon — we should, in a measured and considered manner, thoroughly ex-
plore all options in this complicated question on the future structures of the Sys-
tem's capital. Some of the questions the capital study will address are:

• Should the System's capital structure be based on a holding company model, on
the 12 separate Bank structures, or on a hybrid?

• Will there be multiple classes, such as common equity and preferred stock, and
who will own the retained earnings?

• Can interests in the permanent capital component be transferred to other mem-
bers or non-members?

• Is there a role for subordinated debt?

• What are the appropriate amounts of required capital subscriptions relative to
mortgage assets, total assets, and advances?

• What changes can be accomplished within existing legislated authorities of the
Federal Housing Finance Board?

This study's modeling and stress testing exercises will address the points con-
tained in the Government's studies and Treasury comments today.

The capital study is just getting underway and should be completed by late sum-
mer or early fall. Any decision to restructure the System's capital prior to comple-
tion of the System's capital study would be unnecessarily premature, because it will
have been made before the options have been weighed and their ramifications un-
derstood.

In conclusion, let me point out that the portfolio lender has relied on the Federal
Home Loan Banks to serve as an integral partner for over 60 years. Through our
programs, we ensure a flow of capital from Wall Street to Main Street. We are eager
to work with Congress to help ensure that financing needs of all American home
buyers are met.

Thank you.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR MURRAY

FROM FRANK N. NEWMAN

Q.l. Under current law, institutions that have withdrawn from the
Federal Home Loan Bank System may not rejoin for 10 years. Per-
haps at the time of its adoption, this provision may have seemed
necessary in view of the uncertainties surrounding not only the
FHLB System but also the entire banking system. Isn't it time to
repeal this statute in order to encourage the highest possible vol-
ume of consumer-based lending by making the System accessible to
the highest number of institutions?

A.1. We believe that, in a voluntary cooperative system, a morato-
rium on rejoining is essential to ensure membership stability, and
thereby ensure financial stability. As described in our testimony
and in the recently published reports on the FHLBank System, one
weakness in the current System is that voluntary members are
largely free to withdraw their capital on demand. The 10-year mor-
atorium on rejoining the System after leaving it provides an incen-
tive for members to examine the long-run value of the FHLBank
System before deciding to leave.

As we described in our testimony, we believe that the problem
with the lack of permanence with System capital can be handled
by strengthening the rules governing capital redemptions when a
member leaves the System. In an all-voluntary System, the mora-
torium on rejoining is integral to this approach to structuring Sys-
tem capital.

Without a moratorium, institutions would be free to enter and
leave the System at will, making the financial management of a
FHLBank subject to sudden increases and decreases in capital.
This would also make the System less stable during periods of
short-term economic turbulence or short-term financial problems
within a FHLBank because members could withdraw their capital
until the uncertainty was resolved. Thus, we conclude that a mora-
torium on rejoining is essential to the System's financial stability.

Finally, we do not believe that the moratorium should be waived
for members that departed the System after FIRREA. By depart-
ing, these institutions avoided the risks and costs associated with
System membership the past few years. It would be unfair to those
institutions that remained in the System to now permit departed
members to rejoin by waiving the 10-year moratorium in place at
the time they elected to leave the System.

Q.2. The Administration has made a major effort to build public-
private partnerships to help meet our Nation's housing and com-
munity development needs. I understand that some of the Federal
Home Loan Banks would be interested in receiving enhanced dis-
cretionary authority to help meet those needs we see in our rural
and urban areas.

As I understand the Administration's view in the HUD report,
you argue that you would like the Banks to do more in the commu-
nity development area, but you oppose allowing community devel-
opment loans to be accepted as collateral. How can we expect our
community banks to do more when we will not allow the Federal
Home Loan Banks to be their partners?

What additional discretionary authority in the housing and com-
munity development areas would the Administration support for
the Bank System?

A.2. The Administration has consistently encouraged depository in-
stitutions to strengthen their focus on community lending. Adding
community development lending to the FHLBanks' mission is con-
sistent with this policy. However, we also wish to retain the basic
orientation of the System toward residential lending, and this is ac-
complished, in part, through the restrictions on eligible collateral.

For most members, the current collateral restrictions are a non-
binding constraint on their advances borrowing. Also, existing col-
lateral rules, including the allowance of other real estate-related col-
lateral up to 30 percent of a member's capital, already permit cer-
tain community development loans to serve as collateral.

The FHLBanks are not equipped, at this time, to analyze the
credit risk in most nonmortgage loans, including nonmortgage com-
munity development loans. Keeping collateral requirements as they
are today is integral to maintaining the safety and soundness of
the System. This is a practical solution as well because, if collateral
rules were expanded to include all community development lend-
ing, the FHLBanks might have to increase the cost of those ad-
vances to factor in the uncertainty associated with that collateral.

Finally, FHLBanks are well equipped to serve as partners with
their members in community development lending, not only
through the Affordable Housing Program (AHP), the Community
Investment Program (CIP), and the traditional advances program,
but also through the technical assistance and outreach responsibil-
ities of each FHLBank's Community Investment Officer.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR D'AMATO
FROM NICOLAS P. RETSINAS

Q.l. How has the absence of a quorum affected the workings of the
Federal Housing Finance Board? Put another way, what percent-
age of the Finance Board decisions have been put off due to the
lack of a quorum?

A.1. As of this time, none of the necessary decisionmaking and vir-
tually none of the decisions of the Federal Housing Finance Board
(Board) have been postponed due to the absence of a quorum.
Under the operative principles of quorum law, the Board, acting
without a quorum, may continue to carry out the day-to-day oper-
ations of the agency, functions prescribed by statute and regula-
tion, and implementation of existing policy, which may include the
exercise of professional judgment or discretion under the statute,
regulation, or policy. This has allowed the Board to carry out agen-
cy business and to do all things necessary to the continued over-
sight, supervision, and governance of the FHLBank System.

For example, the Board has taken the following actions without
a quorum:

• Approved AHP applications;

• Approved membership applications;

• Approved FHLBank dividend distributions;

• Conducted elections for elective directors of the FHLBank
Boards;

• Designated vice chairs to fill vacancies in such positions on the
FHLBank Boards;

• Approved FHLBank presidents' compensation and incentive
awards under the existing Compensation Plan; and

• Approved an amendment to the Office of Finance 1994 Budget.

Further, the agency has been able to continue to conduct all nec-
essary business due to actions that were taken by the Board acting
with a quorum last fall, including the adoption of appropriate dele-
gations of authority, which actions and delegations survive the loss
of a quorum. For example, pursuant to the 1994 Strategic Plan of
Examinations for the Federal Home Loan Banks (FHLBanks) that
was adopted by the Board acting with a quorum last fall, examina-
tions of all 12 of the FHLBanks and the Office of Finance are being
conducted according to schedule. In 1994, seven examinations have
been conducted, two are in process, and all 13 examinations will be
completed by year-end.

Another important example was the adoption by the Board last
fall, acting with a quorum, of a delegation of authority to the Sec-
retary of HUD — "in the event that there is no Chairperson or Act-
ing Chairperson" of the Board — of "all authorities, powers, and re-
sponsibilities of the Board necessary to effect the overall manage-
ment, functioning, and organization of the [Federal Housing] Fi-
nance Board." This delegation, as well as another existing sub-dele-
gation to the agency's Managing Director with respect to the day-
to-day administration of the agency, also has facilitated the smooth
functioning of the agency in the absence of a quorum.

However, absent a quorum, the Board will not be able to adopt
or amend rules, regulations, or policies. Thus, for example, while
agency staff continue to analyze the comments received in response
to a proposed rulemaking on the Affordable Housing Program
(AHP) adopted by the Board acting with a quorum, the adoption of
a final rule will have to await a quorum. Similarly, other rule-
makings that were initiated by the Board acting with a quorum,
and rulemakings and changes to policy that currently are being de-
veloped by agency staff, will not be able to proceed when ready in
the absence of a quorum. In each such case, however, considerable
staff work is required before any of those rulemakings or changes
to policy are ready for Board action.

Thus, while the Board, to date, has been able to conduct all nec-
essary business — and should be able to continue to do so into the
foreseeable future — the agency will be unable to adopt or revise ex-
isting rules or policies until it once again has a quorum.

Q.2. How has the absence of a quorum affected the workings of the
General Counsel's Office? Put another way, what percentage of the
General Counsel's work consists of deciding what actions the cur-
rent quorum-less Finance Board can and cannot take?
A.2. The absence of a quorum has had minimal affect on the work-
ings of the General Counsel's Office. While difficult to quantify, on
average the amount of time that the General Counsel's Office has
devoted to quorum and quorum-related matters would be in the
range of 15 percent to 25 percent.

Certainly, considerably more time was devoted to quorum mat-
ters at the conclusion of 1993 and the inception of 1994 than is re-

quired on an ongoing basis, since at that time the agency was gear-
ing up for, and first starting to operate under, the absence of a quo-
rum. While on an ongoing basis specific actions contemplated by
the Board necessitate legal analysis of the appropriateness of the
actions absent a quorum, often such determinations dovetail with
the legal review customarily and ordinarily undertaken with re-
spect to any matters going to the Board for action.

Q.3. How has the absence of a quorum affected the personnel deci-
sions of the Federal Housing Finance Board? Put another way, how
many vacancies are there currently at the Federal Housing Finance
Board?

A.3. The absence of a quorum has not really affected personnel de-
cisions at the Finance Board, except as might be expected when it
relates to the immediate Office of the Board of Directors.

We have delayed filling staff positions in the immediate Office of
the Board of Directors since there are only two Board positions cur-
rently filled (one of which is the Secretary of HUD, an ex-officio po-
sition). We fill only the most critical positions to ensure that the
mission of the agency is carried out.

Staff reductions have resulted due to careful management deci-
sions reflecting recommendations from the Vice President's Na-
tional Performance Review agenda, where appropriate. In addition,
we are in the process of determining those authorities that may be
most appropriately conducted by the FHLBanks without involve-
ment of the Finance Board, thus reducing agency staff needs.

There are 22 vacancies currently at the Federal Housing Finance
Board. The Board approved 109 full-time permanent and 19 other-
than-full-time permanent positions for 1994. At the present time,
the agency has 89 full-time permanent employees and 17 tem-
porary employees, of which seven are summer interns. Aside from
the vacant positions in the immediate Office of the Board of Direc-
tors, the reason we are 20 full-time positions below the approved
level is because of the emphasis placed on streamlining agency op-
erations.

Q.4. Given all of the above, what percentage of the Federal Hous-
ing Finance Board's maximum operating capacity has been dimin-
ished due to the absence of a quorum?

A.4. The Federal Housing Finance Board is continuing to operate
at almost full capacity, even without a quorum. The agency contin-
ues to carry out the legislative requirements to supervise the Fed-
eral Home Loan Banks, ensure that the Banks are operated in a
safe and sound manner, carry out their housing finance mission,
and remain adequately capitalized and able to raise funds in the
capital markets. The remaining Board Directors hold monthly
Board Briefings, open to the public, and continue to visit the 12
FHLBanks, as necessary. Both of these activities were initiated by
the present Board's preaecessors.

Q.SA. Recently the Board of Governors of the Federal Reserve Sys-
tem imposed new regulations concerning posting times for debits
and credits to accounts maintained at Federal Reserve Banks. In
addition, explicit charges for so-called daylight overdrafts (DOD's)
have been established. Have these changes affected the capacity of

the FHLBanks to disburse the proceeds of its loans to community
lenders?

A,5A. The funding of FHLBank loans (called "advances") to com-
munity lenders is done through accounts established by the Federal
Home Loan Bank ("FHLBank") for this purpose. In many in-
stances, the member draws down the balance on its account when
the funding is needed by requesting that the FHLBank transfer the
proceeds via Fedwire.

However, the Fed's funds transfer regulations do not provide the
FHLBanks access to the Fedwire on the same terms as other users.
Generally, Fedwire users are permitted to overdraw their Fed ac-
counts, intraday, up to a limited amount, called the net debit cap,
which is based on an evaluation of the user's creditworthiness.
While the Fed acknowledges that the FHLBanks pose no credit
risk, it does not grant them access to a net debit cap. The Fed's
position is that the FHLBanks should not incur any DOD's at all.

Maintaining sufficient excess balances at the Fed, to prevent
DOD's entirely, is prohibitively expensive due to the loss of interest
income on funds that would otherwise be invested. The Fed regula-
tions clearly recognize this, and grant some latitude to all other
frequent users of the Fedwire system.

We believe that the national payment system would not be jeop-
ardized by allowing the FHLBanks net debit caps like other
Fedwire users. No public policy benefit would accrue to the na-
tional payment system by denying equal access to the FHLBanks.
In fact, tne system may suffer from denying such access to the sys-
tem's largest net seller of Fed funds.

Therefore, we strongly favor legislation to clarify that the Fed-
eral Home Loan Banks use of the Fedwire should be under the
same FRB Payment System Risk Policy guidelines applied to other
Fedwire users.

In addition, recent Federal Reserve discussions have focused on
extending the daylight overdraft restriction and fees to the book-
entry debt issued by GSE's. This would act directly to increase the
advance funding costs of the FHLBanks, and negatively impact
housing affordability. We also would favor a specific statutory ex-
emption from the daylight overdraft rules for book-entry GSE debt
operations.

Q.5.B. Have these changes affected the capacity of the Home Loan
Bank System to provide correspondent services to community lend-
ers relative to Automated Clearing House (ACH) transactions?
Would this be an example of the type of service you think the
Home Loan Banks should or could be offering in support of their
mission regarding community and economic development?
A.5.B. Prior to the implementation of the new regulations on Octo-
ber 14, 1993, daylight overdrafts related to ACH transactions were
excused by the Federal Reserve System ("Fed"). The new regula-
tions treat ACH overdrafts the same as all other DOD's. The Fed
granted a 6-month grace period until April 14, 1994, before it
would charge fees for DOD's. The Fed has since extended that
grace period until October 14, 1994.

The Fed's initial fee structure for DOD's is fairly benign and does
not pose a financial penalty that would prohibit the FHLBanks

from continuing to provide correspondent services to institutions
engaged in community and economic development activities. How-
ever, absent access to net debit caps, the FHLBanks may re-evalu-
ate their roles as providers of such services as DOD penalties in-
crease.

Q.5.C. What other products or services do you recommend the
Home Loan Banks should offer in support of community and eco-
nomic development that are dependent on equal access to the na-
tional payment system?

A.5.C. It is anticipated that recommendations for other FHLBank
products or services will be contained in a comprehensive legisla-
tive package for the FHLBank System to be considered during the
next Congress. Equal access to the national payment system would
allow the FHLBanks to provide these and other products and serv-
ices more effectively and efficiently to community development
lenders.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR MURRAY
FROM NICOLAS P. RETSINAS

Q.l. There is broad agreement that the Bank System's Affordable
Housing Program has been so successful in large part because it
is focused on a community level. As part of your effort to decentral-
ize a number of bank functions, do you support giving the banks
additional authority over the Affordable Housing Program?

A,l. I am strongly supportive of decentralizing many of the func-
tions (specifically the governance functions) currently performed by
the Board and vesting such functions, instead, in the Federal Home
Loan Bank System (System). One of the areas that I believe par-
ticularly appropriate to be undertaken by the System, directly, is
the approval of Affordable Housing Program (AHP) applications
and modifications to approved AHP awards. In fact, the Board, last
December, in adopting for public comment proposed amendments
to its AHP regulation, specifically proposed decentralizing these
functions.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR D'AMATO
FROM ALFRED A. DELLIBOVI

Q.l. How have these changes affected the New York Federal Home
Loan Bank's eligibility for, and access to, the Fedwire?
A.1. The Federal Home Loan Bank of New York is eligible for
Fedwire and continues to have access, but the evolution of the
Board of Governors' Payment System Risk Policy has formally nar-
rowed the Bank's access to daylight overdrafts, and raised the pos-
sibility of imposing "penalty" rates of interest on daylight over-
drafts. In addition, the most recent development suggests that even
the GSEs' congressionally mandated book-entry debt issuance and
redemption may be restricted, fundamentally cnanged, or subjected
to fees, including penalties, in the name of payment system risk re-
duction.

These changes place the Bank at a significant disadvantage in
utilizing the Nation's payment system because, in contrast to the
flexibility accorded to other financial institutions, the Bank has no
leeway in originating or receiving payments through the system.

The Board of Governors' interpretation imposes a requirement
that, during each minute of the business day, the Bank's payments
may be made only when a positive balance exists in its account at
the Fed. In contrast, other users of the payment system are per-
mitted to incur such "daylight overdrafts" in amounts that range
as high as 2V4 times capital.

As a result of this disparate treatment, the Bank must rely on
receipts from financial institutions that are allowed to incur day-
light overdrafts before it may make payments for itself or its cus-
tomers. If daylight overdrafts do occur, the FRB System has noti-
fied us that out-going wire activity would be restricted. Such action
would effectively preclude us from servicing community lenders
who depend on us to facilitate many of their core business activi-
ties.

Q.2. How has your mission — the mission of the Home Loan
Banks — to provide support for home mortgage lending, and the
more recent mission to provide funds for affordable housing, been
affected by the Fed's action?

A.2. Any undue restriction of the Bank's ability to meet its cus-
tomers' liquidity requirements, even though it may be of very short
duration, clearly is contrary to the Bank's mission. Further, any in-
crease in the Bank's cost of funds is reflected in higher interest
rates for advances to member institutions degrading the Bank's
support of housing and, especially, affordable housing where every
funding advantage is important. Less obviously, the Bank supports
the daily operations of its home-lending customers through the pro-
vision of correspondent services, such as securities safekeeping,
electronic funds transfer, coin and currency and settlement serv-
ices. These services generate substantial activity in our Federal Re-
serve account, much of it posted at times that cannot be simply
forecasted. As a result, we regularly must delay sending out-going
wires, the bulk of which represent funds available in support of
housing finance and the liquefaction of portfolio mortgage assets.

Q.3. In your opinion, does use of the Fedwire system by the Fed-
eral Home Loan Banks cause undue exposure to the Federal Re-
serve System?

A.3. Not at all. The scope and nature of the Banks' use of Fedwire
is modest compared with the flows of funds through the payment
system. We think that the Banks' activities offer no particular risk
to the Federal Reserve System.

The Federal Reserve has based its position that the Banks may
not incur daylight overdrafts, in part, on the possibility that day-
light overdrafts may become "overnight" or "real" overdrafts that
pose a risk to the Federal Reserve. The Banks are recognized
worldwide as a triple-A credit. Our obligations are accorded a 20
percent risk weighting by international risk-based capital stand-
ards. The Banks nave never incurred a credit loss in their 62-year
history, have ample capital, superior asset quality, and have a stat-
utory borrowing facility of $4 billion at the United States Treasury.
In fact, the Federal Reserve Bank of New York, in its conduct of
open-market operations, has been a frequent buyer of the Banks'
long-term debt issues, so we think that the Banks themselves pose
no credible risk to the Federal Reserve System.

Q.4. Has your use of the Fedwire caused any losses to the Fed in

the past?

A.4. Our use of the Fedwire has never caused any losses to the

Fed.

Q.5. How can Congress provide the Federal Home Loan Banks
with continued use of the Fedwire without exposing the system to
undue risks in order to support your important housing mission in
the same manner and to the same extent as before the Fed's recent
overdraft regulations?

A.5. The Federal Reserve believes it has no statutory authority to
extend credit to the Federal Home Loan Banks at its discount win-
dow. According to the Federal Reserve Board's recent policy state-
ment, daylight overdrafts ". . . will begin to appear more and more
like overnight extensions of credit by Reserve Banks. . . ." Thus,
the Federal Reserve believes that it has no choice but to deny the
Federal Home Loan Banks the daylight overdraft facility that it
routinely grants to other users of Fedwire, because of its perception
that this may appear to be non-authorized lending.

Congress can amend the Federal Reserve Act or the Monetary
Control Act of 1980 to clarify the status of intraday credit, and to
clarify the status of the Federal Home Loan Banks with respect to
permitting their use of the payment system within the existing
framework of the Federal Reserve's Payment System Risk Policy.
This would include the establishment of a net debit cap and the im-
position of fees for any daylight overdrafts that do occur, calculated
in the same manner as fees for other users. Congress can also spe-
cifically exempt the Banks' book-entry debt operations from the
provisions of the Payment System Risk Policy. These two actions
would alleviate the legal concerns of the Federal Reserve without
exposing the payment system to undue risks. Moreover, we believe
the potential for payment system gridlock would be substantially
reduced by these legislative actions.

Q.6. Have you discussed this with the Federal Reserve?
A.6. The Banks' conversations with the Federal Reserve have al-
ways come back to the statutory interpretation identified in our
previous answer.

Q.7. Has the Federal Housing Finance Board taken a position on
this issue affecting the System?

A.7. We are not aware of any position that the Finance Board has
taken on the issue itself The Federal Housing Finance Board staff
has assisted the Federal Reserve in working with the Banks to pre-
vent daylight overdraft occurrence.

BOSTON PUBLIC LIBRARY

3 9999 05705 7992

ISBN 0-16-046839-6

9 780160

468391

90000

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