FHLBs = toast

Though you may have never heard of them, 3/4s of the Federal Home Loan Banks may implode, adding billions more to the Fannie/Freddie bailout tab.  Bloomberg:

The Federal Home Loan Banks face potentially “substantial” losses on mortgage bonds, and in a worst-case scenario only four of the 12 would remain above regulatory capital minimums, Moody’s Investors Service said.

The FHLBs, government-chartered cooperatives owned by U.S. financial companies, hold about $76.2 billion of “private- label” mortgage securities that may cause losses under accounting rules, the New York-based ratings firm said in a statement today. Moody’s said it is unlikely to lower the system’s Aaa debt ratings because of their government support.

What does this have to do with the Fannie/Freddie bailout?  Well, few people noticed when that bailout announcement was made, but when Treasury agreed to bail out Fan and Fred, it also backstopped the Federal Home Loan Banks:

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

The Federal Home Loan Banks are “government sponsored enterprises” like Fannie and Freddie.  Like Fan and Fred they have always benefited from an implicit government guarantee of their debts.  That guarantee enables them to obtain low cost funding, which they pass on to member banks in the form of cheap loans.  They are also quasi-private in that, like Fan and Fred, they are owned privately.  Fan and Fred were owned by their individual shareholders.  The FHLBs are owned by banks themselves, which contribute equity to the FHLBs so that the FHLBs can in turn provide cheap funding back to member banks.

It’s all a scam designed to provide low cost funding to favored borrowers.  In the case of Fan and Fred, folks borrowing to finance home purchases are favored.  The ultimate source of the capital used to finance mortgages are the investors that buy Fan and Fred debt, the proceeds of which are funneled into home loans.  Fan and Fred were, of course, obnoxiously overleveraged.  Typically, that would discourage investors from purchasing their bonds.  But because of their taxpayer guarantee, investors figured all was copacetic and bought the bonds anyway, confident that if the sh*t ever hit the fan, Treasury would ride to the rescue.  Which it did.

The banking system at large is also a favored borrower.  Their source of cheap cash is the FHLBs, which obtain it courtesy of their own taxpayer guarantee.  Instead of funneling the money directly into home loans, however, the FHLBs funnel the cash to banks.

In practice, when private sources of capital evaporated last year, many troubled banks had to increase borrowings from FHLBs in order to keep operating.  In this way, the FHLBs acted as a lender of penultimate resort, one step ahead of the Fed.  As I wrote in my last op-ed:

At this point, much of the U.S. financial system would be out of business without taxpayer support. Banks need credit to operate, and Uncle Sam has stepped in as creditor of last resort. In addition to the trillion dollars of bailout money on the way, taxpayers have pumped another trillion-plus into the banking system via the Federal Home Loan Banks and the Federal Reserve.

Before the credit crisis, the Fed only accepted the highest quality paper as collateral for its loans. Now it accepts risky mortgage-backed securities and even equities, exposing taxpayers to significant risk. The FHLBs - off-balance-sheet entities of the federal government like Fannie and Freddie - have advanced more than $900 billion to banks, up nearly $300 billion since the credit crisis hit.

Private investors weren’t willing to lend to troubled banks because the collateral on offer was banks’ toxic assets. Would you have lent money to Countrywide knowing that their assets were collapsing in value?  Nor would anyone else.  So the FHLB system, of which Countrywide is a member, rode to the rescue.

Besides Countrywide, other banks that turned to the FHLB for loans back in 2007 and 2008 included IndyMac and WaMu.  These were some of the largest originators of toxic mortgages like Alt A liar loans and pay option ARMs.  According to an informed source, in many cases, these assets were the the collateral turned over in exchange for FHLB loans.  And the FHLB treated these loans as “prime AAA collateral,” requiring only a 10% haircut at the time.  Losses on such loans are likely to be far higher than 10%.

Private investors knew how toxic these banks’ assets were, and so weren’t willing to lend to them directly.  At the same time many were perfectly willing to lend to the FHLBs, even though they knew the FHLBs were in turn lending the cash to troubled banks.  Why?  Because of the government guarantee.

The logic seems foolish, but all across the financial world, government guarantees are perverting investor incentives. Why would anyone put their savings at GMAC Bank, knowing full well it is on the brink of bankruptcy?  Because GMAC is offering stupid-high deposit rates and as a member of FDIC, GMAC’s depositors are protected by a government guarantee.  “Who cares if GMAC collapses?  My money is safe because I have FDIC insurance.  Might as well take advantage of that high interest rate while I can.”

This is remarkably short-sighted from a macro perspective.  As I’ve noted recently, the FDIC has only $35 billion in cash insuring deposits and other debt worth $4-$5 trillion.

And this is the larger point.  The government, via various bailout facilities, has guaranteed upwards of $8-$9 trillion.  That doesn’t include any of the $5 trillion of deposits guaranteed by FDIC, by the way.  The CBO yesterday estimated that the fiscal ‘09 budget deficit will be $1.2 trillion.  And that’s BEFORE the $800 billion stimulus Barack wants to pass.

The government doesn’t have the money for any of this.  So what happens if the government actually has to make good on these guarantees?

Uncle Sam’s balance sheet goes kaboom is what.

Posted in Economy, GSE, bailout, banking, debt, taxpayer issues |