November 5, 1997

Thank you very much, and congratulations to Norwest for its leadership in sponsoring this luncheon, but more importantly, its leadership in the areas that this conference is about. I think this is an example that we would like to see all of the banking institutions in this country following, with emphasis on investment in both housing affordability and economic development.

I also want to thank and congratulate the ABA for its co-sponsorship of this event, and in particular to commend Scott Jones on the marching orders he is giving, that this activity of community development is a growth industry for the banking institutions and ought to be a center of profitability for the future of banks. I think that’s a very welcome message, and I am glad to hear it given.

I appreciate very much being invited to be here by the Comptroller of the Currency, my friend and former law school classmate, Gene Ludwig. I know that you’re all looking forward to his words this evening. He certainly has been in the forefront of making community reinvestment not just a regulatory matter, but a challenge in finding opportunities to do good business in the communities where the banks that he regulates operate. And I think that is the very best performance of a regulator.

I’d also like to mention, being here in Louisiana, that I’m pleased to be in the home state of Congressman Richard Baker. I’m the chairman of something called the Federal Housing Finance Board, and almost no one in the world knows what that is. But Congressman Baker, as the chairman of the Banking Committee Subcommittee with jurisdiction over us, has done more that actually learn the name of the agency. He has, in fact, mastered the important issues affecting the future of the Federal Home Loan Bank system.

And he, with his ranking Democratic colleague, Paul Kanjorski, have labored mightily over the last four years to try to bring forward modernization legislation for the Bank System. And so, being here in Louisiana, I just want to mention to everyone that Louisiana is represented by someone who cares about the issues that I’m about to talk about.

The Federal Home Loan Bank System is a tool not well known by many, but very much appreciated by those who are using it, appreciated for its relationship to that industry of which it’s a critical part. The Federal Home Loan Bank system has a very proud and important history that’s important to understand when thinking about the value of this System to you in economic development work in the future.

The Federal Home Load Bank System was created in the ‘30s. Like many of the institutions created in the ‘30s, it was uniquely well-suited to solve some of the most difficult economic circumstances that have ever been faced by this country.

The Federal Home Loan Bank System was created to tie the thrift industry, which was then a very localized group of institutions that needed to be in the business of making housing affordable to the capital markets. These institutions had just learned, with the onset of the Depression and the bank closings and runs on deposits, that they were not really set up to provide long-term finance that was key to the access to housing.

We are all very much spoiled now on the issue of how easy it is to gain access to housing. The fact is, of course, that today we’re pushing the frontiers in terms of affordability, we’re pushing the frontiers in terms of access to groups and communities that have not shared in the American Dream in that way.

But the truth is that the 66 percent of American families that we have now achieved homeownership owe that ability to be a homeowner to the payment of regular monthly mortgage payments that are affordable to average working people. That very wonderful ability for local institutions to tap the capital markerts for long-term funding in order to provide amortizing long-term mortgages for high loan to value amounts was a creation of the FHL Banks in the ‘30s. And America was changed by that.

A lot of development has come since then. FHA, VA mortgages, Fannie Mae, Freddie Mac, development of the secondary market, all of that was built upon this initial foundation of the Bank System. But the important point that I like people to think about when they think about where the Federal Home Loan Bank System fits in the future of the banking industry is the connection that is at its very roots, which is bringing Wall Street to Main Street; providing the kinds of credit, funding and liquidity tools to local banking institutions to allow them to fashion products that would not otherwise be available for their customers; and, as a result, to change projects that don’t work, that don’t have cash flow to support themselves, into projects that do work.

It is very easy to miss the fact that there are a lot of profitable projects to be financed in communities that fail not because they’re not good credit risks, not because there isn’t a viable market, but because the structure of financing, the way in which the debt will be paid over time, is not properly provided to the project.

If you don’t believe that, just ask whether working people could by houses in the 1930’s, before the invention of long-term amortizing mortgages. Those people who were just as credit-worthy then as they are now, didn’t have a structure by which they could finance home purchase.

That same kind of mismatch of the kind of financing available with the kind of financing that will work – that will make the numbers come out at the bottom line – is a persistent problem today with many community development activities.

That is the contribution that I hope you will think about when you think about the Federal Home Loan Bank System.

The System is famous for one of its particular products in an audience like this, and that is the Affordable Housing Program. The Affordable Housing Program has been a uniquely flexible tool for affordable housing development. We’re very proud of what has been done in that regard. I think AHP is a model for subsidy programs generally.

It has been subsidy that has been able to act in many ways like equity. It’s been able to be a first-in funding source, with the flexibility to be used to build other funding around it. Weve just completed a regulatory revision that we hope will enhance the flexibility of the Affordable Housing Program. We have divested ourselves of initial approval responsibility and given it to the 12 Federal Home Loan Banks.

We have increased flexibility of the rules that the Federal Home Loan Banks can use in making funding decisions. And we hope that we have made the program even more user-friendly than it was. But in talking about the Affordable Housing Program, I want to emphasize two things. It's only 100 + million dollars a year and it’s a subsidy program. The Federal Home Loan Bank System is not primarily a subsidy vehicle.

So AHP is, I suppose, the loss leader of the system. This gets people in the door, but I hope as people think about the System and what it can do to support the work of depository institutions in their communities, they will not stop at the idea that it's merely a source of affordable housing subsidies. I don't want people to think of it as a System that deals with housing, but as one that deals with housing and targeted economic development. And I don't want people to think of it as useful if you can get a subsidy, but also as a very flexible tool for enhancing the different ways in which credit can be extended by member institutions.

There's been a lot of discussion in Washington, and a lot of debates about whether the mission of the Federal Home Loan Bank System needs to be changed. And yet, for the most part, that’s a distracting debate, a false debate, because the Congress has actually given the Federal Home Loan Bank System a mission that is wholly adequate to the challenge that the members of the System face: that is, to support housing finance and to support targeted community investment activities. What are those? They include development work in communities that do not have adequate access to purely private capital sources. That describes an awful lot of the communities in the country, rural and urban. No one in this audience needs to think, "If only legislation would pass, the Federal Home Loan Bank System could respond to the needs that we have."

The Federal Home Loan Bank System may or may not be able to fit its capacity into the demands that you have for the work that you want to do. But if it’s not fitting into those needs, it’s not because of any legislative problem. There’s a different problem, and one that I want the System be a part of the solution to, with you.

When I got this job I made one commitment, and that was that the Finance Board as a regulator would not stand in the way of innovative activities of our Banks that would enhance credit availability in this country, that we would facilitate that activity, and that we would never – whether at the member institutions, or at the bank level, or in Washington – accept the answer to a new idea to be, "The Finance Board won’t allow it."

It is our job to respond to demonstrated needs that can be met by our Banks, and find ways to facilitate those programs. We’ve made some progress in that regard, but we have a long way to go, and it’s important for you to understand our predicament. The Federal Housing Finance Board is a regulator. We have no checkbook, we don’t make loans, we don’t make grants. We regulate the people that make these decisions.

We’re in a responsive mode. But we don’t want to see opportunities that are out there in the communities not responded to. So my challenge to you is to be aggressive, whatever role you are in, with respect to this System. I’m going to tell you about a few projects in more detail to give you some ideas. But I don’t want you to think that because I list A, B and C, that there isn’t a D, E and F that I haven’t thought of.

Our view is not that we in Washington have some magic idea about the kinds of programs and activities that the Federal Home Loan Banks should develop, but rather that you out in the communities as borrowers and lenders, know what isn’t getting done and what ought to be done, and how a program might be changed, how the funding might be structured so that things might work differently.

What I need from everyone who’s working in the field is a commitment to "knock on the door". If you are a member of an institution, you should be challenging the Federal Home Loan Bank of which you are a member to be responsive. If you are not a member, you should ask the question of whether you could or should be. And if you are a community developer, you should be asking member institutions in your community for more flexibility. And when they say they don’t think they have it, ask them whether they’ve asked the Federal Home Loan Bank about ways that they might innovate in order to respond to those needs.

Unless that happens – unless this is a demand-driven situation – we can think great thoughts and write great ideas in Washington, but we can’t make a single deal happen. We cannot order or cajole any one to do a deal. Deals are done between borrowers and lenders, and that is the way the System works. And it is very important that people see this as part a bag of tools that that they may use.

Now, let me say a little about some of the things that we have done, and are doing, and hope to do, to make the System more available. First we have created pilot programs. Why pilot programs? Well, I have a degree in chemistry, and what I learned from getting my degree was finding out if something will work by doing an experiment.

When I got into politics, I found out that the Washington way of doing an experiment is to vote on something; the majority rules. So, if the proposition were moved that the sun goes around the earth, all in favor would say "aye". Build a rocket and you might end up in the wrong place if the vote comes out wrong.

The point is, we do have a habit in our Democratic processes of actually thinking we can vote what’s true, vote on whether things will work and how they should be done. Obviously, we should vote on policies and choices we should make, but the question of whether something’s viable and whether or not its risks can be managed is often better answered by actually trying things in a controlled environment and learning where the problems are, rather than letting the nay-sayers stop it from ever happening or having over-enthusiasts set it running off track before it ever gets a chance to work.

So we’ve developed pilot programs to use the investment authority of the Federal Home Loan Banks to do things in a different way. We have three pilots that have been approved, and one that is pending.

First, the New York Bank has been approved to do participations, including in economic development projects. It recently participated in the Pathmark Shopping Center Project in Harlem, one of the first shopping center projects ever to come to Harlem, unbelievable as that may seem.

The New York Bank participated in two ways in that project. First, by making what’s called a CIP loan – that is, a below standard price loan, because of the target population. Second, by taking a participation interest in some of the lending for the project. That participation interest is an investment that we authorized as part of a pilot program intended to assist institutions to make loans larger than they want to carry on their own books because of liquidity issues and the like.

The idea behind that pilot is to allow the leverage, the portfolio capacity of Federal Home Loan Banks, to contribute to the liquidity of economic development lending by local institutions. We all know that one of the reasons that loans don’t get made is not just that people are worried about the credit risks, but that an institution is concerned about too many illiquid assets on their books. And regulators – like the OCC, for instance – often raise questions about the balance sheet with respect to liquid verses illiquid assets.

This can be a burden, and it’s especially a burden for smaller institutions rather than large institutions both just because of the size involved and also because larger institutions have greater ability to package loans and move them into the capital markets. Smaller institutions often find that very difficult.

Secondly, at the Atlanta Bank, we have approved a pilot program that allows participations in multifamily affordable lending being done by a consortium of banks and thrifts in North Carolina. What happens with affordable housing loan consortia? There’s lots of interest, perhaps CRA driven, and you get a pool of funds together from a number of institutions and a lot of good projects come in. The projects get funded, everybody’s very happy, but then the consortium stalls because it can’t grow.

They’ve made the loans; now they’re hold these amounts. When people are asked for more, they’re told, "Well, this is our commitment. This is the amount that we’re comfortable with holding. We’ll grow six percent a year and we’ll put six percent more into the pool." But the demand is much more than that, so you get stalled out on these kind of projects. Once again, we’re using the capacity of the Federal Home Loan Banks to take some of the product off the books of the individual institutions and recycle the funds to increased product.

Third, in Chicago, there is a pilot program we’re being sued over – I knew we were doing something right when we were sued!

This pilot program is about a new way to handle conventional single-family mortgages. Your first reaction is going to be, "Well, that’s not what we’re here to talk about. We’re talking about that and economic development."

But I wanted to talk about this pilot because I think buried in here is some conceptual information for a role that the Federal Home Loan Bank System can play.

You are all familiar with the two main ways in which we handle single-family mortgage products in this country. On the one hand, institutions hold them in portfolio, take all the risks, get all the profits. Or, they sell them to the secondary market, primarily Fannie and Freddie, and get the organization fees and maybe the servicing, but give up all of the profit associated with managing the market risk and the credit risk. Well, the Chicago pilot is a test for a third way.

The third way is to break up the risks differently, to move the market risks to the Federal Home Loan Bank, the capital markets player, and to keep the credit risk with the local institution. How is this done? It’s basically done by credit enhancement, so that the asset held by the Federal Home Loan Bank is the equivalent of an AA pass-through MBS. The credit risk on an AA MBS is very, very low. The investor loss on that has been essentially zero over the last 10 years. This third choice solves a whole lot of problems that are inherent in those two other choices. It allows institutions to avoid market risk management. There are large institutions for whom that’s no problem, they have easy access to the capital markets and can do it every bit as efficiently as Fannie and Freddie.

But many, many institutions are burdened with having to manage the option risks and the interest rate risks that are inherent in single-family mortgages. Federal Home Loan Banks are primarily capital markets players; they have all the powers that GSE’s have to be very, very effective in the options markets and to be able to manage many of the risks more easily than many of the member institutions.

As far as the credit risk goes, the secondary market has absolutely nothing special to offer with respect to credit risks. If there’s anything really special to offer, it’s in the underwriting process. You can get some diversification of credit risk across the country by pooling these, but you also get concentration. In this test that we’re doing, we’re essentially aligning the incentives that come with underwriting. The better your underwriting, the more profitable it is to manage the credit risks and to take the profits from that. The more there’s an alignment of servicing and underwriting, the more likely it is that that will be a "virtuous circle" that will improve the performance of the loans, and improve the profitability for the institutions.

When you keep the credit risks with the originating institution, you don’t have nearly as stringent rules as far as acceptability to the secondary market; because you’re not sending the credit risk to the secondary markets, conformity rules are really much less important. The risk continues to reside with the underwriting institution, and you don’t have the moral hazard that you have when the originator, who’s doing the underwriting, assigns the risk over to the secondary market.

This means that while this product is starting very much in mainstream of the conventional single-family market, it has the capacity to expand in many different directions. It is essentially able to work on pricing risks, on keeping the credit risks with the originators, and thereby allowing the originators to be significantly more flexible. All of this is for fixed rate mortgages.

Many institutions deal with this problem by offering only adjustable rate mortgages to non-conforming customers and to non-conforming projects. That often means the most vulnerable lower-income borrowers are the ones who are asked to absorb the interest rate risk – that risk that the institution doesn’t want to manage, is assigned to the only person less well able to manage it than they, namely the customer.

Most people who work for a living really can’t manage interest rate risk. We’re all spoiled right now because we had a period of very low interest rates and no real spikes. But, if we think back to times not so long ago, with two percent a year increase in your interest rate, that’s a burden on a $1000-a-month mortgage payment that becomes $1200 or $1400 over a period of a year.

So bringing fixed rate product to the non-conforming market is a very important issue about real affordability over time and keeping default rates down, and this is something that this product can do if it works. But there’s more to what this approach can do than just the single-family mortgage market.

The concept here is important, which is thinking separately about funding, liquidity, market risk issues and credit risk issues, separating them out and trying to solve them in two different places. I find that when people talk about the lack of available funds for community development projects, multifamily housing, economic development projects, they are talking at cross purposes.

Borrowers say, "There’s no money for this kind of activity." And the lenders say, "We have got tons of capital looking for someplace to go." They talk past each other. I’ve been at I don’t know how many conferences where that seems to be going on. What’s really happening is borrowers saying, "We need loans and we can’t get them," and lenders saying, "We’re happy to make loans, but there’s all kinds of risks we can’t manage. We don’t underwrite those kind of risks. We can’t carry that."

Well, the Chicago pilot is the model of looking for ways to handle credit risk in one pot, in one category, starting with underwriting institutions, but thinking beyond that to other insurance options that may exist, and about how government at various levels needs to play a role – not so much the role of writing big checks to finance big pieces of projects, but rather taking a guarantee role that reduces the credit risks. In that way, most of the money comes from the private sector, but underwrites the critical credit risk. That can give much greater leverage to any given public dollar than you get from big grants to write down the project.

People have talked for years about a better development of a secondary market with respect to multifamily and community development assets. Maybe someday we’re going to get to a well-developed market there, but I think there are lots of barriers to it – centralizing the credit risks is a problem, and standardization of cash flow and predictability of cash flows is a much more difficult matter with respect to community development activities than it is with single-family housing, which has such a well-developed database that allows securitization. And besides that, securitization is a costly process and doesn’t necessarily fit many of the projects of the size that actually need the funding help.

Right now, the Federal Home Loan Banks have about $150 billion of portfolio capacity, based on their current capital, which is being used on arbitrage activities, investing in things that somebody else already created, investing in MBS and short-term money market funds. There’s nothing evil about those investments, but there’s no value added. Think about investing $150 billion worth of portfolio capacity in economic development and multifamily projects. It would be a very different world.

So I think that what we’re doing in Chicago has more to it than just single family market. I think it’s a concept: finding ways to wed the market risk management and liquidity power of the Federal Home Load Banks to the underwriting and insurance possibilities at the local level to make a lot more projects viable, a lot more fixed-rate interest projects possible, which would make a world of difference in a lot of multifamily and economic development projects that don’t happen today.

The pilots, which are coming along at their own pace, are not all that’s going on. We have proposed a change in the rules about who can join the Federal home Loan Bank System and what they can use for assets as collateral. We’re required by statute to require that institutions have a certain amount of residential mortgage assets, both to join and to use these as collateral.

The Finance Board has defined a residential property such that 50 percent of the value of such property has to be in a residence. That’s not a problem in a standard situation, but it’s a terrible problem in rural areas where there may be a farm property that’s mixed use, partially residential and farm. It may be a problem in both rural and urban areas with mixed use properties that are partially residential and partially commercial.

What we’ve proposed is to allow the definition of residential mortgage assets to include and property where there is a residence used as a residence, regardless of how small the residential portion of the property is compared to the value as a whole. We think this will open the door to institutions to become members who do not now pass the asset test, and more than that, will allow more collateral flexibility for those institutions to do more borrowing.

There’s a proposal in HR-10, amendments related to the Federal Home Loan Bank System, which would open the door to membership in the System and use of collateral that is broader still. It would allow institutions of $500 million or less to use small business assets and agriculture assets as well, beyond what we can do under our rules now, to qualify. And we’re very supportive of that, and we hope that that kind of change will be made. But we’re going to push the envelope now, regardless of what happens legislatively.

We also have had under consideration, and we intend to continue work on, expansion of the program that is now known as CIP, or the Community Investment Program. Actually, in that statute, the Community Investment Program is one mandated statutory economic development lending program. It has been thought of as the only program, but in fact the statute says that the existence of this mandated program is not to be taken to mean that other community investment cash advance programs cannot be created as well.

We want to encourage the Banks to develop other targeted produces that will reach into the economic development sphere. The reason that this is important is that the ability of the Federal Home Loan Banks to support economic development is limited in a way that their work in housing is not limited; they must pass certain tests are far as targeting before they can fund community investment activities.

Therefore, we are working on, and will continue to work on and hope to create, a series of safe harbor rules so that the banks will be more innovative and more flexible and more aggressive in terms of creating alternatives to the program we have right now, which is CIP. What’s wrong with CIP is that it has one set of targeting rules; a community has to have 80 percent of median income characteristics in order to qualify for CIP.

But there are many other instances of communities that don’t fit into that particular category and can’t get access to the kind of capital market support for this kind of product. This is especially true in rural areas where every community is at 100 percent of median. So you never make this kind of loan in a rural area, for instance.

Our banks have been doing economic development lending, but not nearly enough. There have been some very good projects, but not nearly enough. These are harder things to do, and therefore they will take more pushing from the customers, and that is the kind of pushing that I am asking you to do.

We’re also encouraging the Banks to develop a technical assistance capacity. Now, some of them have done this already to various degrees. But the idea is this: it’s one thing to have a product available: it’s another thing to teach the members of the Bank how to manage risks by using those products.

The marketplace does not have perfect information; that’s on of those economist’s assumptions. Many deals go unfunded because people haven’t figured out how to manage the risks. There may be very good products available for risk management, but the people who are being asked to do the deal don’t have information about the risk management product.

We think it is uniquely appropriate for a cooperative like the Federal Home Loan Bank System, in addition to offering products, to be offering services that build the capacity of members to use their products to manage the risks that are coming in the door.

So that’s the perspective that I have on what we can do – innovation on a different level, with more creativity and much more sparing and targeted use of public resources is the order of the day, and of the future. The old idea of the Federal Home Loan Bank System as a capital markets partner for local depository institutions is about to see its rebirth as a critical too in how we do things today. Public/private partnerships are something we think we invented in the ‘90s, but we’ve had them, at least in the Bank System, since the ‘30s.

I would hope that you take an aggressive view about your half of the partnership, and push on the Federal Home Loan Banks to respond to the kinds of needs, the kinds of opportunities that you see in your community. The one thing that I can promise you is that if somebody at a Federal Home Loan Bank says to you, "Wed love to do that, but our regulator won’t let us," you call me and I’ll answer.

Of course we look at the risks. But the one thing we will not do is allow a hard and fast rule, rather than an analysis, to govern the decision on whether something is a viable and legal and appropriate this to do. So please, knock on the door and keep knocking on the door until you get a fair and decent and appropriate answer.

Thank you very much.

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