“Shadow Fed” Casts a Shadow Over the Solvency of the U.S. Banking System

It's called the "Shadow Fed."

And it's the next potential hot spot in the ongoing financial crisis. But few outside the Federal Home Loan Bank system, the Federal Deposit Insurance Corp. (FDIC) the U.S. Federal Reserve and the U.S. Treasury Department are remotely aware of the problems that are smoldering.

The Federal Home Loan Bank system, a government sponsored enterprise like Fannie Mae (FNM) and Freddie Mac (FRE), has been called a shadow Fed, and is another part of the"shadow financial system" that's been a central player in the ongoing financial mess we're continuing to battle.

With several of the 12 Federal Home Loan Banks now losing money, their impaired ability to lend to their member banks or pay dividends may increase financial-system stress and insolvency. That has the Fed and the FDIC very worried.

And with good reason.

The FHLB system allows member banks to borrow cheaply, to use proceeds for purposes other than originally intended, to mask regulatory capital inadequacy, and ultimately to leverage U.S. taxpayers by adding to the burdens of central bank and the FDIC.

Questions regarding government backing, moral hazard, conflicts of interest and whether the Home Loan Banks inadvertently abetted the banking crisis need to be addressed immediately.

The Blueprint of the Home Loan Banking System

The Federal Home Loan Bank system, established by Congress in 1932, is a wholesale cooperative of 12 regional banks with locations in Atlanta, Boston, Chicago, Cincinnati, Dallas, Des Moines, Indianapolis, New York, Pittsburgh, San Francisco, Seattle and Topeka. It was designed to address several specific problems.

In 1932, for instance, there was no secondary market for residential mortgages, thrifts originating mortgages had to hold them until maturity. If a thrift was "loaned up," meaning there was no more depositor funding available for mortgage lending, potential borrowers were turned away. The Home Loan Banks were chartered to make loans, known as "advances," to member banks, after taking in their existing mortgages as collateral.

Originally, only thrifts, savings-and-loan associations, savings banks and insurance companies were allowed to be members of the Home Loan Bank system. The Financial Institutions Recovery Act of 1989 opened the FHLB system to commercial banks, credit unions and other depository institutions with involvement in the mortgage business. In 1999, the Gramm-Leach-Bliley Act increased membership reach by loosening participation criteria and lifting the cap on the amount of other real estate assets - such as commercial real estate loans - that members could post as collateral.

As of September 2008, according to the latest figures available on the FHLB's Web site, the system has 8,154 member institutions, $1.429 trillion in assets, and has extended $1.012 trillion in advances - which has resulted in $88 billion in mortgage loans. The fact that the FHLB hasn't updated its assets and advances to reflect activity through the end of the year may be more a failure to be timely than it is a hint that there are problems afoot. Still, given that we're in the midst of the worst financial crisis in modern history, updated data on membership, assets, advances and mortgage creation, should have been a priority.

The Hidden Costs of Cheap Money

The problem begins with the FHLB's easy ability to raise the money it lends to members.

The FHLB funds itself by issuing debt instruments across the world's capital markets. But because the FHLB is a government-sponsored enterprise (GSE), the debt it raises is not only a joint obligation of the regional Home Loan Banks, it is also considered an obligation of the United States government. The de facto government backing means an investment grade AAA rating from all the major rating agencies. And that means that the FHLB can borrow at a very narrow spread over Treasuries - in other words, cheaply.

Perhaps if FHLB members just used borrowed capital to facilitate mortgage lending in their respective regions, the fallout would've been localized. But in a 2007 U.S. Federal Reserve report, "Federal Home Loan Advances and Commercial Bank Portfolio Composition," authors W. Scott Frame, Diana Hancock and S. Wayne Passmore determined that the banks were, relatively speaking, no longer fulfilling their primary purpose. The authors concluded that:

  • Capital advanced by the Home Loan banks is "just as likely to fund other types of bank credit as to fund single-family mortgages."
  • Unexpected changes "in all types of bank lending are accommodated using FHLB advances."
  • Some banks "appear to have used FHLB advances to reduce variability in commercial and industrial lending in response to macroeconomic shocks."

There are two problems with members borrowing cheaply and easily from the system:

The first issue is one of moral hazard. Not having to rely on core deposit growth or pay higher fees to attract deposit capital through CDs, member banks, able to borrow freely, are less constrained in their efforts to grow. The lack of any "risk premium" imposed by the FHLB on members doesn't differentiate good borrowing members from suspect borrowers and actually may incentivize some banks to take greater portfolio risks.

The second problem is that many banks may actually be using these loans to mask capital inadequacy. There have already been some egregious examples of FHLB advances propping up sick institutions.

From the end of 2004 to the end of last year, IndyMac Bancorp Inc. (OTC: IDMCQ) increased its borrowings from the San Francisco Home Loan Bank to more than $10 billion, an increase of 500%. At the time IndyMac failed, that money accounted for a third of IndyMac's liabilities. In November, when asked why the Home Loan Bank helped keep IndyMac afloat, FHLB spokesperson Amy Stewart told MSNBC.com that "it's not our role to cause a liquidity problem for a member institution."

Not one to be denied a place at the FHLB trough, Countrywide Financial Corp., as it was reeling from mortgage losses in 2007, borrowed $51 billion from the Atlanta Home Loan Bank branch, which U.S. Sen. Charles E. Schumer, D-N.Y. accused CEO Angelo Mozilo of using like a "personal ATM." But the winner, so far, has been Washington Mutual Inc., which the FDIC says tripled its FHLB advances to $58.4 billion - or almost 20% of its assets - before it collapsed.

Problems Looming?

At a time when global financial leaders are working hard to end the banking crisis and restore confidence in the still-functioning institutions, insolvent banks that are actually being propped up by FHLB advances pose a devastating possible threat to these objectives. Potentially insolvent banks pose an overwhelming threat to the FDIC, and virtually none to other member banks that may inadvertently be abetting insolvency.

The FHLB has never suffered a loss on any advance. Because advances are "collateralized claims," they have a senior position under U.S. bankruptcy law. FHLB claims are repaid before other claims, including those of the FDIC.

In its November cover story, "Banks on the Edge," Bloomberg Markets magazine quotes Tim Yeager, a former Fed economist who is now a finance professor at the University of Arkansas at Fayetteville, as saying: "The Federal Home Loan Banks cannot effectively control or monitor the risks that are in these institutions."

That's not a problem for the FHLB, according to John von Seggern, president of the Council of Federal Home Loan Banks, a lobbying group for the FHLB.

"We're not the regulator, our role is to be the liquidity provider," he told the magazine.

But liquidity loans are a big problem for the FDIC. According to that same Bloomberg article, FDIC Chairman Sheila C. Blair said "we really get a double whammy. We have a beef with excessive reliance on Federal Home Loan Bank advances."

It stands to reason that if FHLB advances spell trouble for the FDIC, they spell even more trouble for the Fed and the U.S. Treasury Department, which will inherit the problem and be forced to bail out the FDIC when its dwindling deposit-insurance fund is exhausted.

In fact, the government is not only worried about funding the FDIC, it is so worried about the potential solvency of Federal Home Loan Banks that on Sept. 7 - the day after then-U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. announced the bailout of Fannie Mae and Freddie Mac - he quietly extended a secured line of credit to the FHLBs - "if needed."

The time of "need" may be nearing. At the end of February, the Federal Home Loan banks of San Francisco, Pittsburgh, Boston and Chicago reported write-downs on heavy losses on mortgage securities, and some banks had net losses. The Pittsburgh bank reported a loss of $187.9 million for the fourth quarter; the Boston bank reported a loss of $73.2 million; and the San Francisco bank reported a loss of $103 million for the quarter - a major swing from the net profit of $231 reported in the comparable quarter the year before.

Just last Wednesday, according to The Seattle Times, the Federal Home Loan Bank of Seattle announced it took a fourth-quarter net loss of $241.2 million, and said it took a $304.2 million charge for impaired securities on its balance sheet. In addition to its statement that full-year results will be posted by March 31, the bank said it failed to meet a regulatory capital requirement at the end of last month and that because of its capital deficiency it is disallowed from paying a dividend or repurchasing its capital stock from members. Members rely on dividends and their ability to sell back capital stock to their district banks to additionally bolster their own balance- sheet capital. The F ederal H ome L oan banks of Atlanta, Pittsburgh and Indianapolis have already suspended or delayed dividends, the newspaper reported.

No one really knows what might happen if all of the system's financial dirty laundry is aired, given how many banks are being propped up by FHLB advances. For the member banks reliant on that capital, the graver concern is what might happen if FHLB funding dries up. If that's the next shoe to drop in this ongoing financial crisis, the worry is that an entire leg - the banking system - comes with it.

New and stronger regulations - and absolute transparency - are necessary to wean banks off these "easy-money loans" from the Federal Home Loan Banks and "hot money" from brokered deposits, the FHLB's other evil twin.

Like a flash-fire in an untouched part of the woods, just as fire crews have finally gotten a series of deadly wild fires under control after months of battling, a crisis and scandal in a heretofore untouched portion of the U.S. financial sector could have a demoralizing and devastatingly damaging impact on the long battle to subdue the financial crisis - just as it seems some gains have been made.

With the opportunity to act before this fire really gets started, let's not waste weeks or months in debate. The time to act is now. We need to "Just Do It."

[Editor's Note: Money Morning Contributing Editor Shah Gilani is a retired hedge fund manager and an internationally recognized expert on the credit and financial crises that continue to sweep the globe. More than 2 million readers have perused his analyses of deregulation, problems with the debt-rating process, and the bailout and stimulus plans put forth by the Bush and Obama administrations. Indeed, Gilani recently unveiled a banking-system repair plan that he says would fix the U.S. financial system - and at a much lower cost than the government bailout plan now being proposed.

Gilani is also the editor of The Trigger Event Strategist, which identifies profit plays that continue to be created by "aftershocks" from the financial crisis. Uncertainty will continue to be the watchword for at least the first part of the New Year. Little wonder, as the global financial crisis continues to whipsaw the U.S. financial markets in a manner that hasn't been seen since the Great Depression. It's almost enough to make you surrender and give up the investment game forever.

But what if you knew - ahead of time - what marketplace changes to expect? Then you'd be in the driver's seat right? You'd know what to anticipate, could craft a profit strategy to follow, and could then just sit back, watching and waiting and finally profiting from the very marketplace events you anticipated.

That's just what Gilani, a nationally known expert on the U.S. credit crisis, attempts to do with the Trigger Event Strategist. He has predicted five key "aftershocks" of the financial crisis that he says will create substantial profit opportunities for investors who know just what to look for, and how to play the. In the Trigger Event Strategist, Gilani uses these "trigger events" as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the profit strategy they feed into, check out our latest offer.]

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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