Mr. Chairman, members of the committee, it is a privilege to be here to give the views of America's Community Bankers on S.1423, the Federal Home Loan Bank System Act. ACB represents the nation's community banks, savings banks, and savings and loans that have been the traditional base of the Bank System and still hold a preponderance of the System's capital stock, though no longer making up the majority of its membership by number.
I am Curtis Hage, Chairman, President & CEO of Home Federal Savings Bank in Sioux Falls, South Dakota. I am currently Vice Chairman of the FHLBank of Des Moines and a member of ACB's board of directors. I am also a member of the System-wide Federal Home Loan Bank Council but I am appearing here today strictly as a representative of ACB.
Need for Both Existing Role of System and Modernization Amendments
It is a pleasure to testify about the System, and ACB deeply appreciates the interest shown by the introduction of this bill and the conduct of this hearing. On behalf of ACB and the shareholders of the System, Mr. Chairman, thank you for holding this very important hearing. ACB strongly supports Senator Hagel's and the cosponsors' efforts and urges the committee to proceed to a mark-up of FHLBank legislation in the few remaining legislative days of this Congress. S.1423 provides a sound foundation for tying up some loose ends in the process of opening up the System, begun back in 1989, beyond its traditional base of thrift institutions. Perhaps because of the then recent date of the 1989 membership changes, the System was not included in the regulatory restructuring that was performed on the other two, higher-profile housing sector government sponsored enterprises, Fannie Mae and Freddie Mac, shortly thereafter in 1992. The Congress, the Administration, and, importantly, the System's stockholders and stakeholders must at some point review how to reconfigure the System for the new millennium. Ideally, this can be a real financial modernization initiative with a chance of success.
Though less familiar to many Americans, and even to members of Congress not on the Banking Committees, the Bank System has played -- and still plays -- a crucial role as a part of the nation's housing finance infrastructure. The System provides a steady liquidity source for traditional mortgage products and is fulfilling the crucial function of providing liquidity to loans that do not meet the standards of the secondary market GSEs. The System is doing well while it is doing good. The System is presently performing well, but some changes will be needed to maintain, even enhance, its role.
The System is best served, both for now and for the future, by the considered and targeted approach that this bill, S.1423, takes in dealing with the range of issues that should be addressed. ACB considers that the most efficient way to handle System issues is by considering all of the proposed changes to System structure and operations in one measure such as S.1423. Accordingly, when we testified this very week on S.1405, the Shelby-Mack regulatory relief package, we recommended that two of the three, relatively technical, changes in System procedures in that measure be incorporated in this bill, S.1423, to maintain the balance of the entire System update package.
Current Unequal Membership Rules Distort System
That balance in overall System changes is all the more necessary because System membership is currently on a decidedly uneven footing. A minority of Federal Home Loan Bank stockholders, the federal savings banks and savings and loans such as my own institution, are required to be members of the System. The compulsory nature of their investment in the System violates both basic fairness and the basic structure of the FHLBanks as a user-cooperative working off the capital base of its member/stockholders and member/borrowers. It is the community of interest of the members that acts as an incentive for the FHLBanks to develop innovative programs for the "wholesale" FHLBanks to support the operations of their "retail" bank members. The FHLBanks should always work through, not around, their members.
That user-cooperative structure also acts as a brake on any well-intentioned but potentially hazardous new initiatives that would impede the soundness of the System or take it into inappropriate activities. The combination of "spur and reins" works best when each member has the same proportionate stake in the System: captive capital has no place.
Consensus Among Previous Studies and Current Stockholders
S.1423 wisely addresses this basic issue on which all stakeholders agree. Though the 1992 Housing and Community Development Act that made changes to the Fannie Mae and Freddie Mac regulatory structure did not itself make any such changes to the FHLBank Act, the 1992 legislation did mandate a set of studies of the System, studies that reached very similar conclusions on most topics and a unanimous conclusion about uniform voluntary membership status.
Legitimate questions have been raised by legislators and policy analysts from all points along the political spectrum about the appropriate scope and in-depth focus of the activities of GSEs in general and of the Bank System in particular. Even so, virtually all System stockholders and the U.S. Treasury (across administrations from both parties) have agreed that is easier to police the range of Systems activities, the profit and mission "drivers" of the System, and the potential displacement of private sector activities if the System remains in its existing user-cooperative format.
This immediately raises a question about the capital base of the System as a whole and of the 12 individual FHLBanks. (In fact, all the topics this testimony raises today are recognized by S.1423 as being intimately interrelated.) ACB, as one of its first items of business on its formation by the merger of two predecessor industry trade associations, adopted in 1992 a comprehensive Statement of Principles on FHLBank legislation. That overall approach, with only very minor modifications: still remains ACB's basic overall position (the current version is appended to this testimony).
Revising the Capital Structure
A great deal of useful work was done on the capital structure of the System within the reports mandated by the 1992 legislation. This topic was studied in great detail by the report of the Stockholder Study Group and by the Federal Housing Finance Board report. The user stock format inherent in the cooperative structure is sometimes alleged to have a potential weakness because of the possibility of a stampede for the exits in the event of System or even individual FHLBank asset impairment. Because of the joint-and-several nature of the System's consolidated obligations, a significant problem at any individual FHLBank could and would affect the entire System.
That is not a wholly theoretical concern as shown by the unfortunate experience of the Farm Credit System a decade ago. Of course, the FHLBanks lend on a fully secured, overcollateralized, and priority-lien basis so that even the high depository institution failure rate of the late 1980s and early 1990s did not produce a single dollar of credit risk loss for any FHLBank. Maintenance of the cooperative format with appropriate discipline on credit risk and activities actually provides more effective control of risk to the public purse than reconfiguring the capital base to public shareholder ownership and then stretching for a competitive rate of return on that equity.
The analysis within those congressionally-mandated studies, most particularly that by J. P. Morgan for the Stockholder Study Group, indicates that a competitive rate of return will never be earned by the System on a publicly-traded capital base from the existing lines of the System business or from any modest natural extension of those lines. Furthermore, that prior analysis did raise the question of the "accounting risk" to the par carrying value of any remaining user stock from the inevitably fluctuating market value of a tradable stock component.
Accordingly, ACB is sympathetic to the approach within S.1423 of adding stability to the System's capital base by creating another class of stock with a significantly longer notice period than the current six-month "put-able" common. That approach adds "permanence" to the capital base without the complexity of crafting a strategy that will supply "permanent" paid-in capital in substantial volume on a short time-line. Mandatory members tend to be somewhat concerned by the possibility that somehow their currently captive capital might play an unwanted leading role in the act of creation of a permanent capital tranche. All members should be treated alike in both the new uniform membership regime and in the transition to that structure.
Since existing user-cooperative members can be expected to remain, even if all on a voluntary basis -- and the possibility of exit will serve as a valuable discipline on System regulation, management, and activities -- there is little need for complex investment banker analyses of market receptivity to various alternative capital instruments. The five year putable class that is authorized in S.1423 has the great merit of simplicity in its enhancement of capital base stability.
The legislation also sensibly addresses the regulatory flexibility of enhancing that "Class B" stock's voting and dividend rights by enabling the individual FHLBank to propose and the Finance Board to approve such enhancements. The stock also gets "superweighting" status in the determination of the FHLBank's capital adequacy. Again, this is very reasonable.
One adjustment to that provision should be considered for the sake of smooth transaction to the new regime. Various "superweights" have been considered for that Class B stock, ranging from 1.5 to 1.75. The precise calibration should perhaps consider the status of an existing commercial bank member, one which does not meet the Qualified Thrift Lender test and has a relatively small percentage of total assets invested in mortgage assets Under current rules, that bank must buy FHLBank stock "as if" it had mortgages as 30% of total assets. The stock purchase requirement is 1% of that 30%, or in other words 30 basis points of total assets.
If the stock purchase requirement is moved to a total assets basis and a value of 0.5% of that broader asset base is set as the purchase requirement, then giving a 1.67 or higher weighting to that Class B stock would mean that no institution would actually have to purchase any additional stock under the new rules. They could all, at worst, meet the requirement by converting some or all of their existing holdings to the longer lived Class B stock.
It would be possible for this Class B stock to build up to a significant fraction of the System's capital base in a relatively short time. For example, the FHLBanks could simply pay dividends for a time exclusively in Class B stock. With roughly $1 billion in annual dividends, in five years the Class B stock, not counting any member purchase of Class B stock, would reach about $5 billion, a value which would substantially address the stability issue. Institutions could still redeem stock since their entire existing holdings are on six months' notice and that stock could be readily redeemed. This is by no means a policy recommendation, but only an observation that substantial stability can be quickly added with this simple approach.
It is certainly possible to build up truly permanent risk capital in the System by other means. The most straightforward method is by the accumulation of retained earnings. That component of capital had reached fairly healthy levels over the life of the System before almost all retained earnings were used to defease the principal of the FICO and REFCorp bonds from 1987 to 1990. Though statutory assurances can be given that this type of resource transfer will not happen again, and certainly the need for such assistance to the federal deposit insurance funds has seldom seemed more remote, only limited reliance may be placed by stockholders on such assurance without complex and untested mechanisms for delivering a vested interest in retained earnings to the stockholders.
Of far more practical importance is the financial impossibility of generating sufficient System income to provide both an adequate dividend yield, somewhere in the neighborhood of open market yields on short term Treasury or agency debt, and significant additions to retained earnings. The financial arithmetic here is merely another way of looking at the inadequacy of the earnings stream, at least from the family of existing lines of business and its close relatives, to facilitate the conversion of the System to operating on a widely-held, publicly-traded capital base.
This caveat about permanent capital should, however, certainly not be taken as a blanket dismissal of the formation of a "Class C" tranche of permanent risk capital, merely that it would be a slow process via retained earnings. A forced conversion of current stock to permanent form on a faster timeline would present a whole set of different problems. It took many years for the 20% earnings retention rate via transfers to the so-called "legal reserve" to build up the sizable retained earnings used for FICO and REFCorp defeasance. The ongoing $300 million annual REFCorp debt service contribution, while approximately equal to the amount that would have been transferred to the old legal reserve at current earnings levels, disappears from System capital rather than adding to it.
ACB is certainly happy to entertain all reasonable suggestions of alternative approaches. For example, perhaps a publicly-traded subordinated debt tranche could play a role in stabilizing the base of the System.
Need for Legislative Guidance
In the event, however, that a "Class C" permanent capital tranche is also authorized by statute in addition to, or as a replacement for, the Class B stock of S.1423, ACB believes that it would be useful for the legislation to give the Finance Board and the boards of the 12 FHLBanks some guidance on how this capital component is to be created and its contribution to meeting the minimum capital requirement for the FHLBanks. For example, it would be helpful if the Finance Board were to be authorized, by explicit statutory language or by report language, to place a "super-weight" of 2 on any permanent capital support, including retained earnings. Since elsewhere in S.1423 the Finance Board is directed to impose on the FHLBanks a minimum leverage requirement equal to that for well-capitalized status for an insured depository, currently 5% of assets, a double weighting for this capital component would be consistent with the separate statutory 2.5% leverage ratio applied to Fannie Mae and Freddie Mac. It would also give a reasonable spectrum of treatments of the Class A, B, and C capital instruments.
Besides the appropriate weight of capital components, guidance on any significant capital base reformulation, for example by redemption and reissuance of existing for replacement capital instruments, should be provided to the Finance Board and the boards of the FHLBanks. Above, ACB noted concerns about the treatment of mandatory members. But, ACB is also concerned about the transition and treatment of currently voluntary members.
Among the nationwide trade associations in the banking sector, only ACB has significant membership segments in both voluntary and mandatory FHLBank status. ACB is acutely aware of the delicacy of balance within any set of changes in the transition to uniform rules. The comment above on how to avoid imposing an additional stock purchase requirement on many voluntary members indicates our sensitivity to this issue.
ACB suggests that any fundamental reconfiguration of an individual FHLBank's capital structure, under approval authority of the Finance Board, should previously be approved by not only the board of directors of the FHLBank before submission to the Finance Board but also by the stockholders of the FHLBank, here casting their ballots on a one-share, one-vote basis.
Admittedly, the movement to a universal voluntary system would enable those opposing the capital base reconfiguration to "sell" the stock of this entity moving in a disfavored direction by exiting the System but this would not solve the problem of any stockholder with a position in the 5-year notice Class B stock. Requiring stockholder approval would be consistent with normal corporate governance procedures for such recapitalization plans, even though, as we discuss below, special rules may be retained for the election of "industry directors" to the FHLBanks' boards of directors.
Before moving to these governance issues, let me stress that ACB is completely committed to removing, within a uniform membership regime, all traces of differential treatment as regards access to FHLBank advances or other System services whether based on charter type or QTL status. ACB strongly supports the removal of these counterproductive restrictions, but fairness demands that elimination of restrictions on voluntary, non-traditional members be accompanied by the elimination of the most basic limitation of all, mandatory membership.
Governance and Mission Revisions
On the topic of governance, S.1423 makes very worthwhile changes in the separation of management and oversight of the System. To its great credit, the Finance Board has made significant efforts in delegating authority to the boards of the regional FHLBanks to the extent permitted by the current statute, but ultimate responsibility cannot be so easily shed, nor can the process be made immune to reversal by future Finance Boards.
ACB appreciates that, under the Federal Home Loan Bank Act as revised, the Finance Board will continue to have both a mission and safety-and-soundness oversight role. Though these functions are strictly separated in the supervision of Fannie Mae and Freddie Mac by two independent offices of the Department of Housing and Urban Development (with the Department of the Treasury also devoting some attention to the prudential aspect of oversight), their combination within the Finance Board is certainly workable and perhaps more efficient, especially if the Congress supplies appropriate guidance on the desired scope of System activities.
To some extent, such guidance is unmistakable, though implicit, in the expansion of eligible collateral and the elimination of any mortgage asset test for small (below $500 million) depositories. ACB certainly appreciates the difficulties that small rural depositories (of all charter types) may be encountering in raising deposits for deployment in local lending at a time when consumers/investors are increasingly attuned to national and global investment options.
While ACB has concerns about creating dual citizenship in the System, we understand the rationale for this significant expansion of System activities and membership eligibility as part of an overall balanced package. It is vital, however, that this new collateral type be treated appropriately from a safety-and-soundness perspective. The FHLBanks supply liquidity, not risk capital. Accordingly, these new items, which at least initially and perhaps permanently carry somewhat more risk than the familiar housing-related assets, should include only secured debt and be subject to appropriately higher over-collateralization rules. While statutory language would be preferable, at a minimum report language should be supplied to ensure that the valuable liquidity that the System can provide is not confused with risk capital for well-intentioned "social engineering" via rural, small business, or infrastructure lending. The credit risk should remain with the FHLBank-member-institution, not be transferred to the FHLBank itself.
Senator Bennett's draft proposal providing a pilot secondary market participation and securitization program for rural credit would dove tail nicely with this expansion of FHLBank activities. Coordination of these legislative approaches would generate some real synergies.
In dealing with this expanded collateral, each FHLBank should be encouraged to set up a review committee of both staff and directors to develop the requisite over-collateralization rules. The approach taken by the FHLBank of New York in crafting its pilot program for multifamily loan participations could serve as a model for this task. Naturally, the FHLBanks have considerably more familiarity with the expanded-eligibility construction lending collateral that is also covered by S.1405, the Shelby-Mack bill, under a provision that should be rolled into S.1423.
In general, we would hope that any legislation will include sufficient guidance on any mission expansion that implementing regulations from the Finance Board do not become the subject of procedural disputes and expensive and contentious litigation over the scope of Finance Board and FHLBank authority. That outcome is clearly undesirable.
One other technical point and one major philosophic point is appropriate here as regards expanded membership eligibility. The first is that it would be more consistent with the legitimate desire to assist small entities if the $500 million threshold were to apply to total assets within depository subsidiaries of a holding company. Multibillion dollar entities with a string of separate subsidiaries that happen to fall below this cutoff should not be offered this targeted exemption. In addition, and this is the substantive philosophic point, any loosening of eligibility standards for depositories should not be taken to presage expansion or extension of eligibility for other types of entities.
It is understandable that mortgage banking operations might seek to become members of the FHLBank System by arguing that it is unfair for a housing sector GSE to exclude them. Of course, mortgage bankers dominate the customer base of Fannie Mae and Freddie Mac, while the distinguishing feature of the FHLBanks is their support of portfolio lending. Besides, at least as measured by origination volume, the majority of mortgage bankers already have indirect access to the FHLBank advances window via a depository affiliate: many major mortgage banking operations reside within bank or thrift holding companies. In addition, it would be inevitable that mortgage banker access would put pressure on the standard over-collateralization value of 120% since equity cushions in small, independent mortgage banking operations are typically thin and a higher "cash-out" percentage from pledged assets would be sought. Since these are entities not subject to the regular examination of depositories and their affiliates, this pressure would come from entities that would impose a disproportionate supervisory burden on the credit officers of the FHLBanks to the disadvantage of existing members. Without adequate oversight by state and federal regulators, it would be most unwise to extend eligibility in this way and ACB supports the stance of S.1423 in this regard.
To make this point completely clear, it would be useful to state explicitly, in report language or otherwise, that any authorization to the Finance Board and to the FHLBanks to assess fees for advances lines-of-credit or other services as a flexible partial substitute for capital stock purchases must not be confused with a direction or grant of authority to expand membership beyond currently eligible groups. ACB supports the pricing flexibility of a fees/capital trade-off for any FHLBank that has met its capital requirement and is seeking to avoid adding to earnings pressure to generate a return on a needlessly large capital base: that does not imply ACB support for open-door access to System products and services.
It may also be helpful to clarify that the FHLBanks may choose to impose either a modest fee or added spread on products or advances used by housing finance agencies that use the System without contributing to its capital base, but these charges would be allowed only as an offset for the lack of that capital contribution. The discussion on this point among the Finance Board, the FHLBanks, and the System's stockholders/
stakeholders indicates that it is certainly useful for any statutory expansion of activities of the System to be accompanied by operating guidance from the legislation's drafters.
Composition of Board of FHLBanks
On occasion, detailed legislative drafting becomes so overwhelmed by complexity and special cases that only general guidance is possible. This has been the case with the treatment of the size and composition of the boards of the regional FHLBanks. The various drafts that culminated in S.1423 made an intensive and good-faith effort to address the adequacy of representation across size and geographic boundaries by the complement of industry-elected directors on each FHLBank's board. The relative composition from appointed, outside, public interest directors and industry-elected directors has been set at a perfectly reasonable three-to-two ratio.
The difficulty arises in those FHLBank districts composed of many states, such as the FHLBanks of Atlanta and Seattle. Here, special provision is made in the current statute for an industry director from each state. That is indeed sensible. On the other hand, representation across asset sizes is also an issue. At one point, a suggested approach was to mandate size class representation and make the geographic representation an ancillary but desirable goal. This immediately raised concern in those multi-state districts.
ACB has worked with the Finance Board and legislative staff to devise comprehensive approaches that would cover both the size and state dimensions of representation. After considerable effort, all parties concluded that the resulting structure was so complex that it made more sense to retain the current rule, but allow each FHLBank to develop a different approach to be approved within the district and brought to the Finance Board for final approval. That approach offers valuable flexibility. Some additional legislative refinements may, however, be in order to guide the Finance Board approval process.
First, it makes sense to provide that, to the extent possible, the alternative composition maintains the three-to-two composition of the appointed/elected director slots. Second, it should be the rule that Finance Board approval, once granted, is irrevocable until that FHLBank reapplies for a different board composition. This necessary approval should not be an annual or periodic bargaining chip in any disputes between the Finance Board and the FHLBank. Third, the existing option of the individual FHLBank to accord the president of that FHLBank director status should be preserved and should not use up either an industry or appointed slot: this should be an optional add-on to the board's numbers.
Limitations on Shares' Voting Rights
The discussion about industry elections within asset classes, the practice for the boards of the Federal Reserve Banks, does raise a further, very real issue in corporate governance. This is the limitation on the shares that can be voted for industry directors to the average institution's shareholdings within the FHLBank. If any FHLBank succeeds in attracting a sequence of new, small members, the proportion of stock that can be voted by existing members spirals downwards.
Above, a recommendation was made that the voting for major recapitalization initiatives should be on the basis of one-share, one-vote. It is likely that, absent the creation of directorships by size classes, this simplest procedural rule will not be acceptable for the election of industry directors, It would probably represent too radical a shift from the existing limitation. Other middle-ground approaches could be considered, e.g., that any institution, notwithstanding any other limits, could always vote at least x% of its holdings. Obviously, setting an acceptable value for "x" might be a challenge but this may be an issue that could, with benefit, be considered within the next stages of processing S.1423 into final legislation.
Revising the Annual REFCorp Debt Service Obligation
Finally, let me turn to another key component of legislation, the topic of revising the way that the System-wide annual contribution of $300 million is allocated across the 12 FHLBanks. Fortunately, this has become a somewhat less contentious issue as the System's earnings have now allowed that amount to be collected from the flat-tax 20%-of-earnings tranche of the FHLBanks' obligation. That has pushed into the background, at least temporarily, the difficult issue of the disincentive to make or take advances to and by SAIF-insured institutions under the allocation formula for any shortfall from the required $300 million annual figure from the uniform 20% of FHLBank earnings component. The original stumbling block to revising the approach originally adopted in the 1989 legislation, besides the perceived zero-sum disagreements among the individual FHLBanks, had been the unacceptably high completely flat-rate equivalents generated by the budget scoring analyses performed by the Congressional Budget Office under the procedures mandated by the Budget Enforcement Acts.
More recently, as the earnings performance of the System has improved, the break-even flat-rate tax values indicated by those CBO estimates have dropped closer to the uniform 20% level that was extracted from all of the 12 FHLBanks with less complaint about the fairness of the imposition. On the other hand, it is increasingly clear that the $300 million value under current rules serves as both a floor and ceiling on the REFCorp contribution. Over time, as the System resumes "organic" growth, in even a continuation of the current non-inflationary environment, this is indisputably a case where the dollar revenue yield from the truly flat-rate tax, even at the most recent CBO calibration of 21.75%, will exceed that from the current rule by an ever-increasing amount.
This is not a matter of predictable eagerness to avoid paying any more in taxes than necessary but simply another reflection of the earnings impact of the restriction of the lines of business of the System for sound public policy reasons. The Finance Board has been developing ways to avoid penalizing the System for the removal of an admittedly distorting approach, while securing the full present-value equivalent of the resource stream promised under the 1989 legislation, and maintaining the required budget neutrality necessary for any System legislation to pass the Budget Enforcement Act filter. That certainly is a consensus item for all System stakeholders.
Perhaps consideration could be given to the contribution of any "reverse shortfall", defined as any positive excess of 20% of System and individual FHLBank earnings over the $300 million level, to a reconstituted legal reserve of retained earnings that could not be paid out in dividends without the express prior approval of the Finance Board. Eventually, this would materially assist in the development of an enhanced cushion of regular capital protection.
ACB would welcome the opportunity to continue to discuss the topics that have been outlined
above, as well as a variety of other issues too technical to discuss in even this lengthy
submission. Again, ACB appreciates the work that has been done to advance to this stage in the
legislative process and we hope to see this effort through to completion. Thank you for this
opportunity to testify and I would be happy to respond to any questions that you may have.
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