Earlier this week, the Wall Street Journal reported that the trillion-dollar Home Loan Bank System might soon be opened to nonbanks such as mortgage real estate investment trusts (MREITs).  New members, no problem – or so advocates say based on the System’s seemingly pristine record.  It’s indeed true that the System didn’t lose a nickel in the 1980s despite the billions it lent to S&Ls without capital or collateral beyond the silver french-fry forks in the executive dining room.  It’s equally true that the FHLBs sailed through the 2008-2010 great financial crisis.  The reason, though, isn’t risk-management acumen of awesome perspicacity.  Instead, it’s because Home Loan Banks have a prior lien ahead of the FDIC.  As a result, whenever a bank member fails, Home Loan Banks swoop in to get all the collateral and whatever else is on hand to make themselves whole.  If MREITs or other nonbanks become FHLB members, the System is on its own, making it essential to be sure they could withstand losses for which their current capital and prudential structure leaves them ill-prepared.

The System’s prior-lien is little-noticed when critics worry about a GSE-crisis redux for the Home Loan Banks.  These worries are unsurprising given the System’s implicit guarantee and ambitions not only to supplant Fannie and Freddie in mortgage securitization, but even to buy Freddie Mac, or so the Journal tells us.  However, Fannie and Freddie never had a direct, explicit line to the federal government.  The FHLB’s prior lien is just that.

In practice, the prior lien means that, even the failure of a very big member means nothing to the System if that very big member is an insured depository, as virtually all of those to date have been.  The case of IndyMac in 2008 makes this all too clear.  When the FDIC closed this high-flying California thrift, its resolution losses were increased by $6.3 billion to pay off outstanding FHLB advances.  Given that IndyMac had only $32 billion in assets at the time of failure, that’s a lot, making IndyMac the costliest FDIC rescue ever.  Had the FDIC not taken this loss, the Home Loan Bank of San Francisco surely would have and then have been no more.

One might argue that more revenue from new members would buttress flagging FHLB earnings, but this is a get-paid-from-Peter-ultimately-to-rob-Paul solution.  More earnings don’t mean more safety and soundness and, even if they did, MREITs are not the place from which to expect more earnings under stressed-market conditions.

After the financial crisis, federal regulators were so worried by MREITs that they contemplated systemic designation for the sector as a whole.  It’s hard to know if FSOC demurred because it took two-and-a-half years for the SEC to do at least a bit of what FSOC wanted in terms of systemic rules for money-market funds, if the lack of a federal regulator for MREITs made it hard to see what systemic designation would mean, or if MREITs somehow assuaged FSOC’s worries. 

These worries were founded on MREIT liquidity risk derived from the sector’s penchant for funding short to lend long.  FHLB advances would do nothing to reduce liquidity risk; indeed, MREIT risk might lever up still higher if System advances only replace increasingly scarce short-term wholesale funding from big banks at lower cost. Collateral backing advances doesn’t ameliorate this liquidity risk because collateral is meant to protect FHLBs from credit risk but only to the extent of each advance, not to the degree necessary to protect an FHLB from counterparty default.  That’s where the FDIC stepped in, but MREITs don’t have a federal deposit insurer with unlimited lines of credit from the Treasury to comfort Home Loan Banks. 

One could argue about the current prior lien – I surely would – but it’s at least there to protect the System against risks from regulated banks.  New members must be judged against this backdrop and, if the System’s mission could meaningfully be advanced by one or another class of unregulated members, additional safeguards need to be an ex ante price, not a post hoc regret.