I want to thank Senator Faircloth and the members of the Financial Institutions Subcommittee for their initiative in holding this oversight hearing on the Federal Housing Finance Board (Finance Board). I welcome the opportunity to testify before you on the condition and mission of the Federal Home Loan Banks (FHLBanks) and to present my views of pending legislative proposals regarding the Federal Home Loan Bank System (FHLBank System). I wish to emphasize that the views that I express here today are my own, and that they do not necessarily represent the views of the Administration nor of the other directors of the Finance Board.

When I became Chairman of the Finance Board in mid-1995, on one side were many critics who said that the FHLBank System was obsolete, searching for a new mission. On the other side were many who wondered why anything had to change at all. I have always advocated a third position: that the mission remains as defined by Congress, but that the means need to be updated. There is always room for change, for innovation and for improvement in how the Banks meet their mission. My goal as Chairman, beyond ensuring the safety and soundness of the FHLBanks, is to promote both innovation and structural reform that will over time result in more of the System's assets being devoted to mission-related activity. Today I am pleased to report progress on that front -- progress that, during a time of such scarce resources for housing and community development, makes the FHLBank System particularly relevant and valuable.

The Finance Board, charged by Congress with the statutory duty of regulating the Banks for safety and soundness and ensuring the achievement of their housing finance mission, has been encouraging and fostering the evolution of the System into the 21st century, equipped with the tools to be a financial services provider serving a unique public policy purpose. And I can state unequivocally that a combination of pending legislation with pilot programs and regulatory initiatives currently underway represents the ideal way to improve the structure of the System and assure fulfillment of mission as we move forward.

MISSION OVERSIGHT

In order to look toward the future, let me start with a brief historical perspective. The statutory mission of the FHLBank System is clear: it is a government-sponsored enterprise charged with using its agency-status borrowing advantage to increase the supply and availability of finance for the nation's housing and community development needs. And for 65 years the System has been a consistent and reliable source of liquidity and funding for this purpose.

When most of the member/lenders were traditional thrifts -- with their balance sheets largely limited to housing assets -- it was easy to say that the System supported housing finance. There was no debate. But the world has changed since 1932 -- and since the passage of FIRREA in l989. First of all, the way housing is financed has changed. The dramatic growth of securitization -- and of Fannie Mae and Freddie Mac -- has produced effective, competing sources of funds for standardized mortgage loans. Second, depository institutions have changed -- and Congress expanded membership in the System beyond thrifts to commercial banks and credit unions -- such that few financial institutions have a single-minded housing orientation. What used to be the direct connection between the FHLBank System and housing lending has been attenuated.

Under these circumstances, many have questioned the System's usefulness as a source of wholesale funding. Where is that money going? How is the System's borrowing advantage being used to serve its public purpose? And how can we better measure how the mission of housing and community investment finance is being achieved without damaging the flexibility that has proven to be such a source of System strength? These are legitimate questions.

My response has two parts. First, there are some things that do not have to change. We know that over 85 percent of advances are to members whose portfolios satisfy the QTL test. And the System does its work even when members don't borrow, because access to advances allows lower balance sheet liquidity and higher loan to deposit ratios. In other words, as a safe and sound substitute for balance sheet liquidity, FHLBank advances permit more lending for housing and community investment than would otherwise be the case.

On the other hand, some things without a doubt do have to change. The System must more fully use its borrowing advantage for things that are value-added. The balance sheet, a reflection of how the Banks are using that benefit, shows that 55 percent is in advances, which provides direct assistance to member lending. The remainder is in investments, about a third of which is in mortgage-backed securities. The other two-thirds is in agency debt and money market instruments. These latter assets, while generally without safety and soundness problems, do not support the mission of the System other use arbitrage to enhance System earnings. There is a need to replace these assets, we believe, with more mission-related ones, preferably assets which help members provide community credit, as advances do.

Again, let me bring some historical perspective to the problem. The FHLBanks' investment portfolio is an artifact from 1989, when, following FIRREA, the System was given some enormous challenges under difficult circumstances. In the years following 1989, the System experienced a dramatic reduction in membership, and the advances portfolio declined from about $140 billion to about $70 billion. At the same time, the Banks were charged with meeting a $300 million annual interest payment on the REFCorp bond obligation, and contributing what now exceeds $100 million annually to the Affordable Housing Program. Meeting these obligations required assets that would generate greater earnings than was possible from the advances portfolio. In addition, attracting new members required an adequate dividend to service the new stock, long before increased lending could be cultivated.

For these reasons, the historical disapproval of the level of investment activities may have been unfair. It was once necessary. But for the future, there is a need to transform the balance sheets of the Banks to concentrate on assets which create community credit availability through members and generate adequate profit to support the members' stock holdings in the System.

The balance sheet transformation will take place incrementally, because the FHLBanks are very large financial institutions whose risks have to be managed prudently. And, as I will discuss later, it can be moved along by the legislative changes under consideration. But change has already begun to take place. Moreover the Finance Board strategy is to encourage development of additional mission-related assets that are profitable to both the members and the Banks.

Development of the new assets to which I am referring is occurring primarily through pilot projects that create new ways of providing housing and community development capital to local communities. These pilots test new ways for the FHLBank System to serve its fundamental mission of increasing the credit that goes to creditworthy people to purchase homes and to creditworthy projects that revitalize communities. There is no mission creep here. Rather, there is innovation in the ways that the FHLBanks and their members are partnering -- using the unique cooperative structure of the System -- to meet housing finance needs.

These pilots came up through member institutions and FHLBanks to the Finance Board. They were not mandated by the regulator in Washington. Rather, the Finance Board encouraged members and Banks to "knock on the door" with creative programs to meet the System's mission, and they have done so.

To date, three pilot programs have been approved. I want to thank the many members of Congress who have come forward with their support of these projects. And, although the projects have not been without controversy, I think most members of Congress and other observers are taking a "wait and see" attitude -- as is appropriate with experiments entailing modest risk but potentially large payoff.

One of these pilots is in North Carolina and has just recently been approved for actual implementation. I commend you, Senator Faircloth, for having been a strong supporter of that project from the outset, for having recognized it as a way to re-cycle scarce funds into affordable housing. Under this pilot, the FHLBank of Atlanta is purchasing participation interests in affordable multi-family housing loans originated by the Community Investment Corporation of North Carolina (or CICNC). CICNC is an affordable housing consortium of small banks -- most of which are FHLBank members -- whose sole purpose is to facilitate the availability of long-term permanent financing for the development of low- and moderate-income multifamily housing throughout the state.

This pilot has two appealing aspects: first, it facilitates multifamily housing, where the secondary markets are underdeveloped; and second, it offers a model for increasing the lending capacity of "loaned up" affordable housing consortia that can be replicated nationwide. It demonstrates a method to help members better manage their asset risks by improving the liquidity of multifamily housing loans.

A second pilot permits the FHLBank of New York to purchase participation interests from members and eligible non-member mortgagees in mortgage assets to meet financing needs of underserved communities. This project reduces the member's loans-to-one-borrower levels by the amount of the FHLBank's participation, thereby permitting a member to originate housing and community development projects it otherwise might be unable to fund, due to the member's size in relation to the size of the project. This pilot, too, has just reached its implementation phase with a commitment to the "take-out" of a $15 million construction loan to finance a major new shopping facility in Harlem.

The third pilot -- the one which has attracted the most controversy -- offers a potential new alternative to holding loans in portfolio or selling them in the secondary market -- something smaller members have asked for so that they might profitably re-enter the mortgage lending business beyond the mortgage banker role. Under this Mortgage Partnership Finance Program (or MPF), FHLBank of Chicago members will market and originate one-to-four family home mortgage loans and be responsible for all functions involving the customer relationship. The FHLBank of Chicago will fund and retain in portfolio the home mortgage loans originated, serviced and credit-enhanced by members.

This project seeks to create an optimum allocation of risk between the FHLBank and its members and provides a more competitive capital arrangement than currently available to portfolio lenders. It should allow members to realize more profit in home mortgage finance, thereby expanding mortgage availability. It introduces competition into the market which may lower costs to homebuyers. And because credit risk remains primarily with the local member, no credit-worthy borrower should be locked out because of a "non-conforming" property or condition.

Since announcement of this program in January, five additional FHLBanks have signed on to invest in the Chicago pilot, whose limit remains at $750 million. Some Banks are considering whether to pursue MPFs for their own members. This support is enormously gratifying as a measure of confidence in the pilot's potential. The Chicago pilot introduces competition between FHLBank members and Freddie Mac and Fannie Mae that can only be healthy for the homebuyer over the long run. And being able to operate the pilot on a regional basis means that, unlike Fannie and Freddie, neither the FHLBank of Chicago nor its members have to subsidize higher default rates in other parts of the country.

A fourth pilot, submitted by the FHLBank of Seattle, will shortly be coming to the Finance Board for consideration. In brief, the Seattle FHLBank would purchase from member institutions FHA-insured loans that benefit low and moderate-income families and foster homeownership through "rent-to-own" programs, which generally are difficult to fund from other sources.

Through encouragement of these pilots and others we expect to see flowing through the pipeline for approval, the Finance Board is committed to increasing the percent of assets devoted to mission-related activities.

In addition to the pilots, the Finance Board has undertaken some regulatory initiatives aimed at clarifying mission, at measuring mission, and at devolving governance to the FHLBanks as the statute permits. I will describe these initiatives in more detail later in my testimony. Now, however, I would like to comment briefly on one regulatory matter that has apparently caused some misunderstanding in this Subcommittee.

At the beginning of April, the Finance Board issued an advanced notice of proposed rulemaking requesting public comment on how best to discharge our statutory responsibility to ensure that the FHLBanks carry out their housing and targeted community investment finance mission. We asked a series of questions, all directed to help determine the best approach for the Finance Board to do this job which Congress has defined. Based on the 70 comments we received, we are evaluating how to proceed. But one thing should be clear: the issue is not changing the mission, but rather assessing the System's accomplishment of the mission Congress has already established.

In pursuit of this objective, the Finance Board has contracted with a highly respected financial services consulting firm for a comprehensive study of the FHLBank System. The study is designed to provide a systematic and objective analysis of the value created by the System for its members and, through them, for communities all across the country. The study will examine the ways in which the System is changing and needs to change to meet changes in market conditions. Most significantly, the study will provide us with the analytical tools to measure the Banks' mission performance -- that is, to understand the unique nature of the business the FHLBanks do and should develop. This is vastly more precise than measuring mission performance by how much funding the System generates. We are looking for reliable data on what the System contributes in terms of the mortgage finance marketplace generally and in terms of the impact of individual district Banks at the community level, as well as data on what public costs and risks are created by the System.

LEGISLATIVE PROPOSALS

There is no question that today the FHLBank System is a healthy, stable cooperative with much to be proud of in its past and much to accomplish in the future. Nonetheless, the System exists within a statutory framework that retains a number of anachronistic provisions dating from the inception of the FHLBank System in 1932, layered with constraints imposed by FIRREA in 1989 that no longer serve any compelling public purpose. If the FHLBanks are to continue to fulfill their mission of housing and targeted community investment finance in an efficient and effective manner, there is a need for modest legislative reform that would remove the existing structural impediments. It is gratifying that both the House and the Senate have undertaken the task of developing precisely that type of legislation.

As you know, on June 19, the House Committee on Banking and Financial Services approved an amendment to H.R. 10 that would remove the structural impediments in current law and would better enable the FHLBank System to address the needs of its members. Congressman Richard Baker, the architect, with Congressman Paul Kanjorski, of prior FHLBank System reform bills, has stated that the FHLBank System amendments in H.R. 10 "contain all the elements of essential reform. They will put the System in proper order to sustain itself for the foreseeable future." I agree wholeheartedly with that characterization and believe that the amendments would address all of the technical and structural anomalies that need to be corrected so that the FHLBank System can enter the 21st century able to operate at peak efficiency and effectiveness. Certainly there are provisions within H.R. 10 on which some parties may disagree, and which should be modified, but the H.R. 10 amendments address the right topics in largely the right way.

I also applaud Senator Hagel's initiative with Senator Bennett in developing the recently circulated discussion draft which builds on H.R. 10 in a very constructive fashion. As the discussion of FHLBank System reform moves forward, I would like to offer to the Subcommittee any assistance that I or my staff can provide in fashioning the details of the bill.

The following review of the pending legislative provisions has not been adopted by the board of directors of the Finance Board, but represents my own analysis. Among the structural provisions most in need of reform are those relating to the System's obligation to help finance the REFCorp bonds. The fixed $300 million obligation, which does not rise or fall with earnings, is a tax on the System that has driven the Banks to increase their levels of non-mission-related investments. Both H.R. 10 and the discussion draft circulated by Senator Hagel would change the REFCorp formula from an annual fixed dollar amount to one based on a percentage of the FHLBank's annual earnings. Each FHLBank would be required to pay 20.75 percent of its earnings each year (after deductions for the Affordable Housing Program obligations and operating expenses) towards servicing the REFCorp debt. Although the dollar amount contributed each year by the Banks may vary, the 20.75 percent figure was scored by the Congressional Budget Office as increasing federal revenues by $44 million over the next 5 years. Freeing the Banks of the obligation to generate sufficient earnings to pay $300 million annually regardless of business levels with their members should allow them to reduce investments not related to mission, concentrating a larger portion of their assets in mission-related investments.

Another important provision of H.R. 10 and Senator Hagel's discussion draft relates to equalizing the terms on which institutions may become members of the System. Historically, FHLBank System membership was limited to savings institutions. Federally chartered savings associations were, and still are, required to become members of the System by statute; state chartered savings associations also were required to become members of the System as a condition to obtaining deposit insurance from the Federal Savings and Loan Insurance Corporation. Although state chartered savings associations no longer are required to be members, all federal savings associations and savings banks are mandatory members of the FHLBank System.

With FIRREA in 1989, the Congress opened the FHLBank System to commercial banks and credit unions, but did so on a voluntary basis. Those institutions are free to join the System and, subject to some restrictions, can leave the System whenever they choose. As a result, what we have today is a System in which federal law mandates that a significant number of institutions must become and remain members of the FHLBank System, but in which a substantially greater number of institutions currently are voluntary members.

Again, both H.R. 10 and the discussion draft of Senator Hagel would abolish the mandatory membership requirement, making membership entirely voluntary effective January 1999. This provision makes eminent sense and I endorse it. Moreover, I have no reason to believe that we will see significant numbers of federal savings associations withdrawing from the System. On the contrary, the large number of commercial banks that have joined the System as voluntary members confirms that the System offers very real benefits, which I believe that those who are now mandatory members will want to retain.

H.R. 10 and the discussion draft also would equalize the treatment of members, removing provisions that have imposed added requirements on commercial bank members. Under current law commercial banks that do not meet the "Qualified Thrift Lender" (QTL) test applicable to savings associations are subject to a series of restrictions not applicable to QTL members. Thus, a "non-QTL" member must purchase more stock in its FHLBank than is required of a QTL member in order to obtain the same dollar amount of advances. Moreover, non-QTL members are subordinated to QTL members with respect to access to advances, may use their advances only for housing finance, and may obtain no more than 30 percent of the advances from the Banks, on a System-wide basis. Like the mandatory membership provisions, the QTL provisions result in two classes of members, one of which receives preferential treatment. There is no compelling public policy reason for this distinction. Especially with the changes to the QTL test adopted by Congress in 1996, which allow the inclusion of commercial loans to small businesses, credit card loans, and education loans in the QTL test, the differential treatment among types of members seems ever more arbitrary.

In sum, under H.R. 10 and the discussion draft, all depository institutions would be entitled to determine for themselves whether membership in the FHLBank System benefits their businesses and all members will receive equal benefits. As a consequence of addressing the issue of voluntary membership, however, there is a need to address the issue of the capital structure of the Banks and the appropriate level of capital required of them. Eliminating mandatory membership requires the introduction of another type of permanent capital into the System. In addition, the current structure of primarily "subscription capital" (i.e., membership purchase requirements based on the assets of members) guarantees that the System will always have more capital then it can adequately leverage in advance business with members. As a result, the "excess" capital must be leveraged with other assets in order to earn enough to service it through dividends. The new flexibility and added permanence provided in both H.R. 10 and Senator Hagel's discussion draft have made substantial headway in addressing those difficult issues. Although I believe that most people would agree that the proposed capital provisions could be improved, they are workable in their present form and allow enough flexibility so that problems that might arise during implementation could be solved through the regulatory process.

Under both H.R. 10 and Senator Hagel's discussion draft, the Banks would be authorized to issue two types of capital stock: Class A stock, which would be redeemable with one year's notice, and Class B stock, which would be redeemable with five years' notice. The inclusion of five-year redeemable stock introduces a greater degree of capital permanence than is presently the case with respect to stock owned by voluntary members, which now may redeem their stock on six months' notice. The Class B stock falls somewhat short of true permanence, but nonetheless is a good step toward a permanent capital structure. I believe that the legislation will induce members to purchase Class B stock by allowing the Banks to pay a higher dividend on that stock and by conferring greater voting rights in the election of directors. The legislation also will induce the Banks to encourage the purchase of Class B stock by giving Class B stock a 50 percent greater weighting than the Class A stock in satisfying the leverage capital requirement applicable to the Banks. Finally, because the legislation would allow retained earnings to have the same weighting as the Class B stock, I would hope that it would induce the Banks to retain a greater portion of their earnings than presently is the case, which should incorporate an even greater amount of "permanent" equity in the System. At the same time, the stock purchase requirements are made more flexible, presenting the opportunity to avoid unneeded capital contributions.

The last key issue that I believe any legislation must address concerns the devolution of management functions from the Finance Board to the Banks. One of the anachronisms from the days of the Federal Home Loan Bank Board is the degree to which the Finance Board, the regulator of the Banks, is required to approve day-to-day operational decisions of the Banks. Unfortunately, the Finance Board cannot extract itself from many of these matters, which are committed to Finance Board approval by current law. The most appropriate approach to these issues is to return all of the managerial responsibilities to the individual Banks, which can be accomplished only through legislation. These items are not controversial and I am not aware that anyone opposes these provisions.

Taken item by item, H.R. 10 and the discussion draft both would allow the Banks to set the compensation of their officers and employees and to determine the amount to pay to their directors, without first obtaining Finance Board approval. The Finance Board would have the authority to prohibit any compensation that is not reasonable and comparable to that paid to persons with similar responsibilities at comparably sized institutions. On this matter I believe that provisions in Senator Hagel's discussion draft are preferable, principally because they track much more closely the authority conferred on the Office of Federal Housing Enterprise Oversight (OFHEO) with respect to the compensation of senior officers of Fannie Mae and Freddie Mac.

Each bill also would remove the requirement that the Finance Board approve the dividends paid by each FHLBank to its members. As the safety and soundness regulator of the Banks, the Finance Board has ample authority to prevent excessive dividends, or any other unsound business practices. Indeed, each bill enhances the enforcement authority of the Finance Board by giving it administrative enforcement powers comparable to those OFHEO has over Fannie Mae and Freddie Mac.

Apart from the fundamental structural issues that H.R. 10 and the discussion draft address, there are a number of other provisions that are of substantial importance to the FHLBank System, especially to the community bank members. Recognizing the difficulty that smaller institutions have experienced in recent years in funding their assets with local deposits, as well as the inability of smaller institutions to obtain direct access to the capital markets, the legislation would ease membership requirements for such smaller institutions and would allow them a wider use of FHLBank System advances. Thus, for any FDIC-insured institution with less than $500 million in total assets the amendments would eliminate the membership requirement that at least 10 percent of their assets be in residential mortgage loans, would allow long-term advances for funding small business, agriculture, rural development, and low-income community development, and would allow those categories of loans to be used as collateral for advances.

The Senate discussion draft does not include several provisions from H.R. 10, and I would like to touch on that briefly, preferring the discussion draft in these areas. First, H.R. 10 would direct the Banks to reduce their investments to those necessary for liquidity, safe and sound operation, and for housing finance. Changes to the REFCorp formula and Finance Board guidance will, as I have pointed out, make "exchange of assets" easier, although the Banks will need some time within which to restructure their balance sheets. Given the general regulatory authority of the Finance Board, I believe that this provision of H.R. 10 is unnecessary.

H.R. 10 also includes a provision that restates current law on the incidental powers of the FHLBanks. Its presence can only cause confusion and it seems to add nothing of substance to current law.

Since its approval by the House Banking Committee, H.R. 10 has been referred to the House Commerce Committee. One amendment before the Commerce Committee would subject securities issued by the Finance Board or the FHLBanks to the registration and reporting requirements of the federal securities laws and oversight by the Securities and Exchange Commission. Although this has not yet been reported out of the full committee, I feel compelled to address what I believe is a troublesome issue.

The securities of the FHLBank System have been exempt from the requirements of the federal securities laws since the System's creation over 60 years ago. Moreover, the other housing government sponsored enterprises (GSE's) that issue debt obligations, Fannie Mae and Freddie Mac, are exempt from such registration and reporting requirements under current law.

Whether the securities of any of the housing GSE's should be subject to the requirements of the federal securities laws is an important issue of policy that properly is within the purview of the Congress to decide. But to impose these requirements on the housing GSE's would make it more expensive to make and hold mortgages financed by the GSEs. Inevitably, these costs would be passed on to the American homebuyer. Nothing in the legislative record indicates a need for this change and these new costs for homebuyers. And, to the extent such a change is made only for the FHLBanks, and not Fannie Mae and Freddie Mac, as the House Commerce Committee apparently contemplates, the members of the Banks would be placed at an unfair disadvantage in competing for mortgage business.

I would like to thank the Subcommittee for taking up the issue of FHLBank reform. I am heartened by the similarities between H.R. 10 and the provisions of the discussion draft. I hope this reflects a growing Congressional consensus not only that the time has come to address FHLBank System reform, but about how best to accomplish that reform. I think that we all can agree on the need to perfect the legislation, but we should not hold up reform in the name of perfection.

REGULATORY INITIATIVES

Regardless of what happens in the legislative arena, the Finance Board intends to pursue the regulatory initiatives that advance the System's ability to serve its mission. First, as I have already discussed, I have been urging the FHLBanks to increase the proportion of assets on their balance sheets that support the System's Congressionally-defined mission of increasing the availability of housing and community investment financing. One of the primary vehicles to address these efforts is the Financial Management Policy. We are working now on comprehensive revisions that will transform the FMP into a document that establishes clear standards while allowing the FHLBanks to have adequate control over and flexibility in their financial activities. The standards for investments will involve both safety and soundness considerations and proper guidelines and incentives to increase the proportion of assets which are mission-related.

Second, I think there is general agreement that the Finance Board should be an arms-length regulator and not a manager. As I've said, in some areas this requires legislation because of the statutory requirements for Finance Board approval. However, since 1993, the Finance Board has sought to devolve as many purely management responsibilities as it could.

Since June 1995, when I became Chairman, a number of regulatory initiatives to achieve devolution of corporate governance responsibilities have been achieved. They are as follows:

In October 1995, the Finance Board amended its policy on Director Fees and Allowances to delete a requirement that the Finance Board approve all out-of-district meetings of FHLBank boards of directors and committees thereof.

In December 1995, the Finance Board adopted a final rule repealing a regulation that restricted FHLBank charitable contributions to specific dollar amounts.

In July 1996, the Finance Board adopted a final rule granting each FHLBank authority to approve applications for FHLBank membership, subject to guidelines set forth in the rule.

In July 1996, the Finance Board adopted a final rule transferring to the FHLBanks authority to determine the appropriate level and structure of compensation for FHLBank directors, within guidelines established in the regulation.

In October 1996, the Finance Board adopted a final rule granting the board of directors of each FHLBank final authority to approve its own business plan and operating/capital budget.

In December 1996, the Finance Board adopted a final rule authorizing each Bank's board of directors to establish, within certain guidelines, FHLBank performance targets upon which to base incentive payments to its president and other employees.

In February 1997, the Finance Board adopted a final rule that vested authority to approve applications for nonmember mortgagee status in the FHLBanks and that established uniform eligibility requirements and review criteria.

In February 1997, the Finance Board ceased its practice of making annual appointments of the FHLBank presidents.

In August 1997, the Finance Board adopted a final rule granting the board of directors of each FHLBank authority to approve AHP applications.

A number of other administrative governance matters will be proposed for devolution in the fourth quarter of 1997. Several additional regulatory initiatives are worth noting:

Amendments made to our Affordable Housing Program (AHP) regulation were a significant undertaking and involved much more than the mere devolution of application approvals to the FHLBanks. The final rule also made significant changes to the AHP by clarifying operational standards, streamlining and decentralizing the competitive scoring process, reducing the overall monitoring burden for projects, establishing thresholds for the long-term retention of projects, and clarifying and expanding the remedies available for noncompliance with the regulation.

In May 1997, the Finance Board approved amendments to its Community Support regulation instituting uniform performance standards to be met by all FHLBank System members -- including, for the first time, credit unions and insurance companies. The rule also streamlines and expedites the review process, simplifies the reporting process, reduces the regulatory burden on System members, and enables the Finance Board to determine how all System members are complying with the statutory requirement to reach out to first-time homebuyers.

Finally, at our most recent meeting, the Finance Board approved for publication for notice and comment rule changes designed to make the FHLBank System more accessible, and thereby more useful, to current and potential members. One proposed rule would allow combination farm or business properties on which there is a residence to count toward the asset requirements for membership eligibility and as collateral eligible as security for advances. Another rule implements certain statutory and other changes to the definition of "qualified thrift lender" (QTL). This rule will help many member institutions, and particularly smaller, community based institutions, to qualify as QTL lenders and thereby lessen the disparity between QTL and non-QTL members.

THE CONDITION OF FEDERAL HOME LOAN BANK SYSTEM

You asked also that I report on the condition of the FHLBank System and the structure of the Finance Board. I am pleased to report that the FHLBank System is in excellent financial condition and extremely well capitalized. The FHLBanks are a triple-A rated system with a flawless credit record.

At June 30, 1997, the FHLBanks had assets of $315 billion. This represents an increase of 15 percent from one year earlier. More important than the growth rate of assets is the growth rate of advances. At the end of June, the FHLBanks had advances outstanding of $172 billion, which was an increase of 19 percent from one year earlier. Advances as a percent of assets have increased to 55 percent of assets, up from 53 percent as of 12 months earlier.

The System's total capital at June 30, 1997 was $18.0 billion, up $1.8 billion from June 30, 1996. Because assets grew somewhat faster than capital, the System's capital-to-assets ratio fell to 5.7 percent from 5.9 percent one year earlier. System net income for the first half of 1997 was $723 million, which is an increase of $97 million from the first half of 1996. The FHLBanks operate on extremely narrow interest-rate spreads. The annualized return on average total assets was only 0.50 percent, which was up only slightly from the first half of 1996. The return on equity was 8.32 percent before the required transfer of $150 million to pay part of the interest on the REFCorp bonds. The average annualized dividend rate for the first half of 1997 was 6.69 percent. The System remains extraordinarily well capitalized because of the very low credit risk the System faces. All advances are collateralized.

The types of investments that the FHLBanks can purchase are limited by the Finance Board's Financial Management Policy (FMP). That policy sets limits on the issuer, credit quality, and maturity of the obligations that the FHLBanks can purchase. The FMP also sets limits on the interest-rate risk exposure of the FHLBanks. The Finance Board monitors the interest-rate risk position of the each FHLBank every month to ensure compliance with the policy. The Finance Board conducts an annual on-site safety-and-soundness examination of each FHLBank.

As to the Finance Board, we are an independent agency in the executive branch of the Government established by the Financial Institutions Reform, Recovery and Enforcement Act of 1989, with Congressionally mandated duties of ensuring that the FHLBanks operate in a financially safe and sound matter; supervising the FHLBanks; ensuring that the FHLBanks carry out their housing finance and community investment mission; and ensuring that the FHLBanks remain adequately capitalized and able to raise funds in the capital markets.

Management of the Finance Board is vested in a board of five directors consisting of the Secretary of HUD and four individuals appointed by the President by and with the advice and consent of the Senate. At the present time, one of these seats is vacant. The Chairman has authority to act as the administrative head of the agency, delegated by Board resolution, and the Managing Director manages the day-to-day operations of the agency.

The other core components of the agency are: the Managing Director's Office, which includes the Executive Secretariat; the Office of Inspector General; the Office of Supervision; the Office of Policy; the Office of Public Affairs; the Congressional Relations Office; the Office of General Counsel; the Office of Strategic Planning; and the Office of Resource Management.

The Finance Board currently has 119 employees (including members of the board of directors), of which 15 are other than full time (i.e., temporary and term employees). Of these 119 employees, 91 are competitive service; the remaining 28 are in the excepted service. The rate of staff turnover has stabilized since the inception of the agency, and currently averages approximately 12 to 14 percent of the agency's regular work force.

Almost three-quarters of the agency's budget is expended on employee-related costs, including salaries and benefits. Hence, employee staffing levels and turnover are the primary determinants of the agency's budget.

For the first three years of its existence, the Finance Board's budget experienced steady growth as the agency sought to reach operating staffing levels, promulgate regulations and adopt procedures, and acquire the capability to carry out its statutory responsibilities. Between 1993 and 1996, the agency experienced virtually no growth, and its budget stabilized with staffing levels of between 100 and 110 employees, with actual expenditures averaging between $13.5 and $14 million. In 1997, the agency's budget grew to $17.8 million to meet new staffing needs and increased turnover; to undertake a major study of the FHLBank System referred to earlier in this testimony; and to undertake several major systems and technology improvement initiatives.

APPOINTMENT OF PUBLIC INTEREST DIRECTORS FOR THE FHLBANKS

Finally, you have asked that I describe the process by which public interest directors for the boards of directors of the FHLBanks are selected and appointed by the Finance Board. Before addressing the details of that process, I would like to emphasize the importance of the role the public interest directors play on the FHLBanks' boards of directors. They provide a necessary balance in the composition of the boards, countering the pressures of and on the industry directors and providing a powerful internal incentive for ensuring that the public purpose and mission of the FHLBanks are considered and addressed at the highest levels of the FHLBanks.

The Federal Home Loan Bank Act prescribes generally that the boards of directors of the FHLBanks shall be composed of fourteen directors, eight of whom are elected by the FHLBanks' members, and six of whom must be appointed by the Finance Board. At least two of these appointed directors must be "community interest" representatives, i.e., persons chosen from organizations with more than a two-year history of representing consumer or community interests on banking services, credit needs, housing or financial consumer protections. The Finance Board's regulations provide further that the community interest directors also must have more than two years of recent experience representing one of the four designated consumer or community interests.

The majority of the FHLBanks have six appointed directors, who serve staggered four-year terms. Beginning in 1998, the FHLBanks of Boston, Des Moines and Seattle will each have seven appointed directors.

The Federal Home Loan Bank Act requires that, to be considered for an appointed director position, a candidate must be a United States citizen and a bona fide resident of the FHLBank's district. In addition, the candidate may not be an officer, director, employee or stockholder of any member or of any non-diversified holding company, subsidiary or affiliate of any member.

A large part of the Finance Board's process involves soliciting a diversity of candidates from a broad range of sources. Candidate recommendations are received from the Congress, the administration, the financial institutions industry, national housing groups and trade associations, non-profit organizations, the FHLBanks, the members, and from the candidates themselves. In considering candidates for appointment, the Finance Board takes into account the professional experience of the candidate and their qualifications for the position, and their familiarity with issues in the industry, and particularly in the areas of housing, community and economic development, banking and consumer protection. Candidates also must have a proven record and reputation for honesty and integrity. Appointments since I became Chairman have always been by vote of the Finance Board, Board of Directors, although in the past, some such appointments were made by the prior Chairman under the management delegation from the Board of Directors.

Thank you again for this opportunity to testify. I look forward to answering any questions you may have.

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