Although FHFA’s “advisory” to the Home Loan Banks about funding troubled banks drew little notice, our analysis shows clearly just how consequential this de facto rule will prove.  Last year, the Home Loan Banks smugly funded high-risk banks secure in their super-lien, stiffed the FDIC even on pre-payment penalties, and even told the Federal Reserve to stand back when one possibly-salvageable bank sought discount window access.  If FHFA has its way – and that’s never a sure thing – faltering banks now need new funding sources, the FDIC is at considerably less risk of loss, and Home Loan Banks will defer to the Fed when it comes to the discount window, not the other way around.

Home Loan Bank advances now stand at $780.8 billion, down about $100 billion from the huge draws in the midst of the 2023 crisis but more than double what they were just a few years ago.  This is an after-effect of the March crisis, when the very largest banks experienced unprecedented deposit inflows as funds fled high-risk banks.  Most of these deposits have since stayed put.  As a result, banks regional and small, shaky and sound, have turned to the Home Loan Banks, using the securities they cannot liquidate due to unrealized losses as collateral backing the Home Loan Bank advances on which many banks have come to rely as deposits remain scarce and costly.

Whether this does any good for housing is a debate for another time.  What is clear is that Home Loan Banks have been happy to become not just housing lenders, but lenders’ lenders, bolstering profits for the lender-owned system and salaries for those who run the Banks on their behalf.  I also will not revisit the question of whether Home Loan Banks enjoy a taxpayer subsidy – the Banks stoutly say no and pretty much everyone else says yes.  The indisputable point is that Home Loan Banks are government-sponsored entities regulated as such by a federal agency to ensure that Home Loan Banks serve the public good along with promoting member profit.

Now, FHFA is demanding that the Banks serve the public good as taxpayer risk defines it, earning no more than their keep warranted by core activities such as providing advances to members who are willing and able to pay them back.  And lending now must come without resorting to forcing the FDIC to pay billions for feckless, but profitable, lending to faltering insured depositories or robbing the Fed of the collateral needed for the discount-window draw that might just save a troubled bank and thus avoid not only FDIC resolution costs, but also the harm done to a bank’s community, employees, and even borrowers.

FHFA’s advisory also means that Home Loan Banks aren’t the only entities that now need to redesign their strategic plans.  All of the members drawing all of the hundreds of billions from Home Loan Banks also need to reckon with a tough new funding reality.

As was all too clear last year, all of the banks that failed had borrowed billions from their Home Loan Banks, often doing so urgently to replace uninsured deposits running for the exit.  Many of the twenty-two or more banks that came close to failing also beat the reaper with dollars from the Home Loan Banks.  The System takes pride in this emergency-liquidity role, but it allows banks that should have had far more prudent funding strategies to draw on government funds that put taxpayers – not their own shareholders – at risk. Now that Home Loan Banks cannot continue to lend to a bank showing signs of severe trouble, banks need to understand that they cannot run close to the rim by over-leveraging their asset portfolios secure in the knowledge that, if depositors take fright, the FHLBs will bail them out up to the point of unavoidable failure thanks to the FHLBs’ expectation that the FDIC will in turn bail them out.

As matters now stand at the Home Loan Banks, their sanguine view of their right to insouciant finance allows high-risk banks to garner out-size profits until they can’t.  This is moral hazard squared, and the FHFA is right to divide and, I hope, conquer.