It's a real pleasure to have a chance to try to set the context for this conference and the direction of the FHLBank System. I hope to give you my perspective on what it is the System is facing, where we are, and where we might go. I would put this discussion under three headings: the first I would call, "The Good News;" second, "The Not So Good News;" and third, "The Best News."

The good news is about the substantial history of accomplishment of this System. The not so good news is that some things that have been necessary to get us to this point have caused the System, in a few basic areas, to be structured in a less than desirable way. But the best news is that there are real opportunities in a changing environment to move beyond the things that some of us here in Washington find disturbing - to move on to a second generation of the kind of achievements that have been reflected in the last 65 years.

Let me try to put a little meat on those bones and tell you specifically what I am talking about. A story that I like to tell is that when I was five years old, my father put me in the car and drove me downtown in Northport, NY, where I grew up, to pay the mortgage interest on our home. On the way he said, "Well, the mortgage isn't all that big and we could now afford to pay it off, but we don't because it's good to have a mortgage." Now at five years old I didn't understand that, and at fifteen I didn't understand that, and at 45 I still didn't understand what my father was talking about.

But in my early 50’s, I became Chairman of the Finance Board and I learned the history of mortgage finance in the United States, and I finally understood what my father was telling me. When he was young, trying to buy a house, the world of mortgage finance was such that you couldn't go to a range of mortgage originators and look for the best price on a 30-year amortizing mortgage knowing that, if you've got a reasonable job and a reasonable income and a good credit background, there would be no problem.

When my father was looking to buy his first house, when the terms were 50% down with a 3-5 year interest only balloon mortgage, you had to hope that your investor wanted to roll it over after that time period or you were in deep trouble.

And when somebody came along to buy your house, if you had already paid your entire mortgage off, that poor person had to go running around to find that kind of mortgage. So it was better to have a mortgage that could be assumed by the buyer so he wouldn't have to come up with 100%, but only 50% to purchase.

That's a whole world that most of us either never knew or have long since forgotten. But the Federal Housing Finance Board has not forgotten that the Federal Home Loan Bank System brought one of the key innovations that changed the basic structure of how people buy homes – a way to base your mortgage on your wages and to pay on a month-to-month basis over a long period of time. Houses became much easier for average people to acquire.

Now that's all history and that's part of the good news. There's another part to that I want to emphasize. When people talked about those folks in the 1930’s who couldn't come up with 50% or couldn't manage the risk of short-term mortgage finance, they said, "Well, those people just aren't creditworthy to buy homes; they don't have the financial capacity to buy a home. There's nothing wrong with the system, it's just that some people have and some people don't."

But we demonstrated in the 1930’s that it wasn't true at all - those people had the capacity to manage mortgages - if the obligation could have been re-engineered so that they could pay it on the right terms. It wasn't that the people changed, it was that the system was modified to be accessible to them, and the whole country was the winner. So when I hear people talk today about various kinds of projects that can't pay their way, I'm always reminded of that history and ask people to think about whether that's true. Certainly so

me people don't pay their way whether they can or not, and everybody understands that you don't loan money to people who don't have the intention or the fundamental ability to pay back.

But there are many projects that can pay their way with one structure of financing and can't pay their way with another. So I hope that, as we think of the future of this System and the difficult challenges of credit availability in our communities today, we don't make the mistake that people made back when my father was young, saying that, if you couldn't come up with 50% down, you couldn't buy a house because you didn't have the wherewithal. The wherewithal was there if only a reliable way to tap it could be found. We found a way, and we changed America much for the better by doing that. So the good news is that this System is based on a belief that thoughtful, effective re-engineering of financial projects can make credit more available to people who are ready, willing and able to pay what it takes, but need a structure that fits their circumstances.

Number two on the good news list is that, while the 1980s were a nightmare for the thrift industry around which the Home Loan Bank System was built, with some of us wondering aloud whether the Federal Home Loan Bank System was on its last legs, the Bank System responded in the 1990s with renewed energy and creativity.

Under the circumstances, the performance of the System was extraordinary in that the industry was essentially cut in half in terms of the number of member institutions going out of business. And the core business of advances was cut in half. On top of that, the Congress put some new obligations on the System, which we know affectionately as the REFCORP payment - a tax to help pay for the bonds involved in resolving the thrift crisis - and the creation of the Affordable Housing Program.

I was in Congress in 1988 and 1989, and I didn't get many visits from Federal Home Loan Banks or member institutions asking for the Affordable Housing Program. In fact, it was a program that was opposed in many quarters. Even those of us on the Banking Committee who were famous for programs wondered aloud to Congressman Gonzales whether or not this was the right vehicle for this kind of a program. But the Affordable Housing Program grew from something people wished they never had to a marquee item for the System to talk about - not only how it contributes to the construction of affordable housing but also about the relationships it builds between members of the System and those who produce affordable housing.

The creation of business relationships is as important as any of the dollars that have been expended because the silver lining of CRA is that, even though such requirements can be burdensome, they have created new understanding of business opportunities. At the end of the day, "doing good by doing well and doing well by doing good" is really a thing we would all like to see to the greatest extent possible. So the Affordable Housing Program is something that the System took on and really made something of, and everybody who's ever had anything to do with it is proud of it.

And the System found a way to pay the bills for the Affordable Housing Program and REFCORP and at the same time pay sufficient dividends to attract new commercial bank members into the System. It found a way to rebuild the membership base and the core business of advances, which now is higher in dollar terms than it has ever been in the System’s history. Those are all real achievements that the System doesn't always get credit for in Washington. Again, that's the good news: a System that has a basic cooperative structure, that is supportive of and supported by stockholder members has demonstrated, in times of stress, a flexibility and an ability to change that is appropriate to an institution that is looking to the future, not to the past.

What's the not so good news? The not so good news was what it took to do this and where it leaves the System’s financial structure. I'll try to explain to you why this is a matter of concern on two levels: how other people think about it and how I think about it, which are not necessarily the same.

How did the System pay its way? At various times - and in fact up to now - the core business of the System has not earned enough money to pay all of its obligations. If the System had only had advances to pay its way from 1991 to now, it would not have been viable. It would not have been able to pay a reasonable dividend to service the stock. That's a fact. The System had to do something about it, and it was authorized to make a fairly narrow set of investments, such as mortgage backed securities, agency issues, and short-term money market investments in highly rated financial

institutions. That was all, even though the universe in the statute is broader. But the Finance Board, building on things that had been long standing under the Home Loan Bank Board before 1989, laid out those options and the System has gone down that road.

What that has done is create a System with a balance sheet that raises the question: is it appropriate for the System to borrow money in the capital markets with a government-assisted advantage - using its agency status to borrow money cheaper, longer term, in a variety of structures and a volume of borrowing not necessarily available to a similarly capitalized private institution - to make investments that have little or nothing to do with the basic mission of the System?

Anybody who would say it wasn't appropriate historically is spitting in the wind. Something had to be done. The real question is whether going forward, the System should be trying to maximize what it returns for that borrowing advantage, maximizing the benefit to the public. That's the public policy issue involved in discussions about the balance sheet of the system. I don't think it should be a contentious debate, but it sometimes gets to be. Maybe it's a lack of agreement on timeframes, and maybe it's a lack of agreement on ultimate goals, but from where I sit one of the greatest liabilities of the System is the belief by a variety of decision-makers in Washington that this System isn't important. They say it isn't important today, and it will be less important in the future.

There are plenty of people around this town who will say that to you. And they don't sit in some low-level office; they sit at the top of institutions on Capitol Hill, in the Treasury, at the Fed, and OMB and elsewhere. I don't want to overstate the risk by saying that somebody's going to shut the System tomorrow, because we all know that it pays $300 million a year to the U.S. Treasury to service REFCORP, which has a present value of over $4 billion.

Under the budget act, if you wanted to close down the Federal Home Loan Bank System somebody would have to come up with the $4 billion. Nobody's going to do that. But what they can do is to tie you hand and foot or at least to render you a weak institution unable to help its members compete in the housing finance market or be innovators in the less well-served parts of our economy. That would be a great tragedy and that is really what I think this challenge is about.

What are we talking about here? We are talking about a model of the System in which its assets reflect why it exists, which is the way it was before 1989. Now almost half of the System’s assets are in investments that don't directly serve the members. Although they serve purposes that are perfectly legitimate from an economic standpoint, they don't maximize in any way what the government assistance represents. And they create a high level of skepticism about whether the System is truly focused on its mission. That's not to say that the evidence is being correctly used or that the analysis is correct, but it is a fact that this is the biggest stick that I've been beat over the head with since I began interviews for this job in 1994.

So, that's the not so good news; that the System is in a changing environment where its history is a good one, but its doesn't answer all the questions about its future. Its present circumstances show many good things, but also things that people find disturbing.

Now what's the best news? In my opinion, the best news is that there are reasonable answers that reasonable people can agree upon to solve these problems and to reinvigorate the System in a dynamic way. And that is "the change agenda" that I think we all need to work on together. There are those in the System who say, "it ain't broke and it doesn't need to be fixed." Well, it certainly "ain’t broke" in the sense that it's hobbled and not doing a job for people. But if "broke" has anything to do with the distance between capacity and performance, there are many things that this System can do more of and do better than it's doing now.

Let me tell you what I think the three things are that this System can accomplish in the 21st century. First, it should become the central bank for community banks. The history of this System is that it was the central bank for the thrifts, which were the community banks of an earlier era. Community banking is broader now; it includes institutions with the thrift and housing background as well as institutions with a commercial background. Community banks are extremely important to the continued democratization of credit availability in this country.

Some smart people think that other countries like Germany or Canada or Britain are better places for the efficiencies that come from only a few largely consolidated financial institutions. I'm on the other side of that debate, with the belief that we may not have needed the large number of institutions that we had, but that locally-based community institutions have been very important to the entrepreneurial character of American economic history. One should not turn to large consolidated institutions as the only answer. There are great efficiencies in the largest institutions; they do many things well that smaller institutions can't do. But they leave an awful lot undone and that's why community banking is so important.

I've read that it's likely that 15% or 20% of banking assets will be left for community banks in the brave new world that we seem to be building. That sounds like a small percentage, but when you multiply it by a seven trillion-dollar economy you realize that is a huge amount of money, and it's very important to economic health. Those kinds of institutions will not prosper in a world where their access to capital markets is only through large competitors, as opposed to having a cooperative relationship with non-competitors as shareholders of the Federal Home Loan Bank System.

Second, the System should continue to be the vehicle that allows depository institutions to be effective competitors in the mortgage market. This System is the only way that the agency cost of funds, which drives housing finance in America, can be available to depositories so they can manage risks related to mortgages. In the absence of this System, Fannie and Freddie are the only game in town. Now Fannie and Freddie are a very big game in town, and they have accomplished many things that have been beneficial for Americans, for the financial system and financial institutions, including members of the Federal Home Loan Bank System. It's not an either/or.

But one way is never the right way; in a competitive economy, choices are what make things work fairly, decently, and efficiently, and this is a System that has the capacity to allow that competition to occur. Whether it be traditional advances, or innovations like the various pilot programs that look at new ways to split the risks attendant in the mortgage business, that is how depository institutions remain as real competitors in housing finance. I think that is a key role for the future, whether they are large, medium or small institutions.

Third, this System is uniquely positioned to help its members serve hard-to-serve communities and borrowers. When I talked about change in the mortgage market, I pointed out that what used to be hard-to-serve became routine-to-serve, because people engineered a difference. This System can provide liquidity when illiquidity is the reason loans don't get made. All kinds of projects don't get done, not because the basic loan isn't any good, but because the banking institution says it can't have that large an illiquid asset on its books.

If it's a shopping center in suburbia, I know I can sell it to ten other banks, but if it's a shopping center in the middle of D.C., I know nobody will want to buy it and I'm in for the fifteen or twenty years needed to make it work. Bringing liquidity to those kinds of situations can make the difference between things happening or not. That's a third way in which the System can help realize its goal of credit availability for housing finance and for targeted economic development. There is an enormous potential for the System to operate in these areas.

Why don't we just do it? I think a lot is going on in that direction, but there are inhibitions. One of the inhibitions is that it's easier to simply arbitrage funds in the capital markets. These projects take more work, and in the initial stages they are more expensive. Secondly, the System has a lot of antiquated structural features that need to be changed, such as mandatory members and voluntary members, an artifact of the time when this System was just a thrift industry. That should be ended; all members should be voluntary.

Then there's differential leverage for the stock purchases of members depending on whether they are QTL or non-QTL members, which makes the ability to assist members depend simply on their assets and has nothing to do with the particular loans they are trying to make. Then there's a highly inefficient capital structure that is not driven by the risks on the balance sheet of the Bank but by members joining. It's subscription capital structure. What's wrong with that? By definition, it will always overcapitalize the Bank by giving it capital over and above any risk-adjusted capital requirement.

When institutions join, they join in part to borrow, but also to have the capacity to borrow, to have a liquidity backup. By definition, that means that the Banks are never going to be loaned up. They'll always have something like twice as much capital as they need, based on the balance sheet. That means that the leverage is low and the efficiency of the Bank as an institution is low. Also, there is stock to be serviced on which there aren't member-driven, earning assets to earn the money, so you have to go somewhere else to earn the return. That's what drives a lot policy makers in Washington mad about the arbitrage activities.

So we can solve that problem if we fix the capital structure. We can do that by having the capital requirement be flexible, based on the balance sheet of the Bank, which is the way all other financial institutions operate. We can improve the capital to make it stronger, more like equity and less like subordinated debt and therefore be better able to police the risks in the System than under the current structure. We can do those things if people want to.

What do we have to do to make the best news the real news? I think there is a lot of work to be done in a lot of places, and there is a certain amount of pulling and shoving that's going to occur and you as directors are going to feel it.

The Bank level view is going to be, "We have more time," and the Finance Board view is going to be, "Get on with it." There is going to be a tension; we have different roles and we are at different places, and we have different priorities. That's natural; if we didn't have somewhat different perspectives one of us would be redundant.

The fact is that the market doesn't accomplish all of the needs of the GSE and that's why there is a GSE regulator—to prod the System toward public objectives. There's nothing wrong with that; there's nothing wrong with healthy disagreement and the tension that comes with that. It's a very creative tension and one we should work to keep creative by keeping the disagreements on a professional level and not a personal one.

I think there is one critical thing that you as directors can do to contribute to how this moves forward and that is, ask yourselves and your management: " To what extent does the current business and current balance sheet of your Bank reflect the ideal of where you would like to see this GSE go? To what extent is it maximizing and to what extent is it under the ideal?"

And to the extent it is not where we would like to see it -- and most people who honestly assess this would say we would like to accomplish more, to really set a course of change – we need to make a commitment to change, to get to a different place in the next five years or so. I think that decision is critical to the progress we need to make, and I think it is within the hands of the management and the boards of all the Banks to make such a decision.

And if you make such a decision, one thing I can guarantee you will conclude, is that the sooner structural reform legislation is passed to free the System of the historical artifacts that make it less efficient than it should be, the better. While there are details about legislation that we can argue about forever, there are fundamentals about capital, membership, governance, and REFCORP that, if fixed - even if not fixed perfectly - will brighten the future of this System in terms of its goals.

So I'd ask those of you who are new and those of you who are not so new to this System to put that test to your boards and to your management. Have that conversation. I think the best news is that there are answers to the transitional problems, there are answers to the structural inefficiencies, but there is no answer if people don't want to take the leap required to go in a new direction. That, to me, is our challenge and my hope is people will take on that challenge and we will work together to get there. Thank you very much.

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