While other lenders said no, this one said yes

The Federal Home Loan Banks heftily increased lending in the third quarter. Can they sustain those loans amidst the credit crunch? Fortune's Peter Eavis investigates.

By Peter Eavis, Fortune senior writer

NEW YORK (Fortune) -- As the credit crunch hit hard in the third quarter, most banks were forced to cut back their lending. But one group of banks increased lending by an incredible $182 billion. Who were these deep-pocketed lenders -- and are they capable of handling such a large rise in loans, especially at a time when credit markets are unsettled and mortgage defaults on the rise?

The lenders in question were the 12 Federal Home Loan Banks, set up under a government charter during the Great Depression to provide support to the housing market by advancing funds to over 8000 member banks that make mortgages. In the third quarter, loans to member banks, also called 'advances," totaled $822 billion, a 28% leap from $640 billion at the end of June.

As the credit markets seized up, banks found it hard to carry out short term borrowing in, for example, the commercial paper market. As a result, they found a large alternative source of short-term funds in the FHLB system. "The FHLBs have provided a massive liquidity injection into the banking system," says Gary Gordon, banks analyst for brokerage Portales Partners.

"By anybody's standards, that increase was immense. But, having said that, we are in business to respond to the funding needs of our member banks," says Richard A. Dorfman, president and CEO of the Federal Home Loan Bank of Atlanta.

The $182 billion rise in FHLB funding - over ten times the dollar increase reported in the second quarter - raises a range of questions that will be hotly debated if the credit markets continue to be weak. First, because the FHLB increase is so big, it would seem to remove the need for a big increase in mortgage purchasing by the better known government-sponsored entities, Fannie Mae and Freddie Mac, which buy mortgages from banks. Combined, Fannie and Freddie increased their overall loan portfolios by $62 billion in August, according to Gordon at Portales. That's much lower than the $110 billion increase in funding to banks that the FHLB system reported for that month.

On the other hand, even a liquidity injection as large as $182 billion is not going to provide much support to the mortgage market, where, before the credit crunch, $12 billion of mortgages were being originated every business day, according to research firm Inside Mortgage Finance.

Still, it is big enough to increase scrutiny of the FHLB system. A broad range of market pundits and politicians are calling for Fannie and Freddie's regulator to allow the two mortgage buyers to substantially increase home loan purchases, but the regulator has so far resisted the removal of growth limits that were put in place after both companies went through accounting scandals and showed serious operating deficiencies. Now similar questions may be asked of FHLB itself. When any lender aggressively expands its loans, it's important to ask whether the lender has the internal controls in place to avoid losses from borrowers defaulting and from changes in interest rates.

And in the case of FHLB, this is not an idle concern. The FHLB system restated its financials for 2002 through 2004, due to changes in the way the banks accounted for derivatives (financial instruments used to bet on price movements of underlying securities). In 2004, after some harmful interest rate bets, the Seattle FHLB agreed to some far-reaching reforms in an agreement with the FHLB regulator, the Federal Housing Finance Board. The Chicago FHLB also agreed to changes with the regulator in 2004, because of shortcomings in bookkeeping and the way balance sheet risks were managed.

Brian Harris, analyst at Moody's Investors Service, says that the FHLB banks are capable of handling the increase in lending to banks. In part, that's because the FHLB banks demand collateral - for example, mortgages - that exceeds the value of the advance they make to the borrowing banks. In addition, the FHLB banks have shown themselves very good at assessing the credit quality of the collateral, he says. Debt issued by the FHLB system carries a triple-A rating from both Moody's and Standard & Poor's.

The other question is whether the FHLB banks can raise the money in the markets to lend to the banks that need the liquidity. "Funding has not been a problem," says Dorfman, of the FHLB of Atlanta. The FHLB banks, like Fannie and Freddie, benefit from the market's perception that their debt has a government guarantee, or that the government would step in and provide assistance if any of them ran into trouble. That not only translates into lower borrowing costs, but it also means investors flock to buy FHLB debt for perceived safety when bond markets get jittery. As a result, the FHLBs can borrow cheaply even in tough times.

Could anything potentially make FHLB debt less attractive? Theoretically, any repetition of problems similar to those that occurred at the Seattle and Chicago FHLBs could spook some investors. In addition, buyers of FHLB would curtail purchases if there were indications that the FHLB was going too far in its attempts to provide liquidity to mortgage lenders. For example, if the downturn in the housing market deepens, investors would want to be comforted that the FHLB was not being used in any way to bail out banks and homeowners. Any hint of that could cause the lower borrowing costs from the perceived government guarantee to evaporate.

So far, there is no evidence that any FHLB banks are experiencing internal problems again and there doesn't seem to be any top-down pressure on the FHLB to effectively bail out mortgage lenders that got themselves into trouble. But when any lender grows its biggest loan portfolio by 28% in one quarter, these kinds of questions should be asked and answered.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.