March 12, 1998

Mr. Chairman, Members of the Committee, I appreciate this opportunity to provide a statement for the record of this hearing on the issue of rural credit and on S. 1423, the Federal Home Loan Bank System Modernization Act of 1997, introduced by Senator Hagel. Please note that these comments are made in my capacity as Chairman of the Federal Housing Finance Board and do not necessarily represent the views of the Administration or of the other Directors of the Finance Board.

At the outset, Mr. Chairman, let me express my appreciation to you for holding these hearings, which are an excellent follow-up to the oversight hearings held by Senator Faircloth in the Subcommittee on Financial Institutions and Regulatory Relief last September. And, of course, I remain deeply indebted to Senator Hagel for the time and skill he has devoted to Federal Home Loan Bank System issues in the process of developing his Federal Home Loan Bank modernization proposal.

I strongly support S. 1423. It is a proposal very much in the best interests of the Bank System and the institutions and people it serves. It is a proposal that contains all the essential ingredients for a viable, active, and essential FHLBank System in the next century.

I want to begin with a central and timely focus of this hearing – community bank and rural credit needs. Community banks from rural markets are a very significant component of the System’s membership at present, and a consistent theme for community bankers, rural and otherwise, has been the funding difficulties they are confronting as a result of "deposit drought."

Because of new technology and changes in the legal structures governing the provision of financial services, consumers today have a broader choice of, and easier access to, investment options than at any other time in history. Savers may live on Main Street, but they can invest effortlessly on Wall Street. Demographic pressures and a buoyant stock market have attracted many individuals into the equities market and out of bank accounts as investment vehicles. Even FDIC insurance is no longer the money magnet it once was. This has created the environment in which smaller depository institutions that lack easy, reliable access to the wholesale capital markets, saddled by the inability to attract adequate levels of retail deposits at economic rates, are forced to turn away borrowers they otherwise would be able to help. The problem is particularly acute in rural communities, which not only experience deposit drought, but a dearth of lenders as well. But many urban community banks also face the same trends.

Thrift institutions have long used the Bank System as a way of marshalling funds from the capital markets for their home mortgage loan funding needs, and now community bankers from the commercial banking sector -- who have been permitted to join the FHLBank System since l989 -- rightly see the System as a prudent and reliable mechanism for meeting their funding needs in order to serve the needs of their borrowers. S. 1423, as part of its overall modernization of the System, would address this issue head-on. Banks and thrifts with total assets of less than $500 million could obtain long-term advances from their FHLBank for funding small business, agriculture, rural development and low-income community development, and those categories of loans could also be used as collateral for advances. In addition, institutions within that asset range no longer would be subject to the membership requirement that at least 10 percent of their assets be in residential mortgage loans. Further, all differential requirements relating to qualified thrift lender status would be eliminated, thus reducing the stock purchase requirements applicable to non-QTL banks in obtaining advances.

Indeed, last year the Finance Board published a proposed rule for notice and comment designed to make the FHLBank System more accessible to current and potential rural members. This rule would qualify a residence on combination farm or business properties to count toward the asset requirements for membership eligibility and as collateral eligible as security for advances. I can report that the many positive responses to this measure were truly "heartfelt from the heartland," so urgent is the need for access to the liquidity the FHLBank System provides.

I would also like to comment, more generally, that serving as a central bank for community bankers is one of three key directions I envision for the FHLBank System in the 21st century. The history of the System is that it was the central bank for thrifts. As I’ve said, community banking is broader now; it includes institutions with the thrift and housing background as well as institutions with a commercial bank history.

Many commentators extol the efficiencies that come from a largely consolidated financial services industry. There is no doubt of some of the benefits of these changes. But there is another side, as well. Community banks are extremely important to the continued democratization of credit availability in this country; they are key to the entrepreneurial character of American economic history. Forecasters predict that perhaps 15 percent or 20 percent of banking assets will be left for community banks in the brave new world following industry consolidation. While that sounds like a small percentage, when you consider the huge size of the banking system you realize that we are talking about a vast amount of money that will have a key impact on this country’s economic health. More importantly, this money is key to the economic health of smaller communities that are out of the economic mainstream and often suffer even during prosperous times.

Community bankers cannot prosper in a world where their access to capital markets is only through large competitors;. They need the assistance of the access through the Federal Home Loan Bank cooperative that does not compete with them. The rural credit provisions of S. 1423 recognize that the System may be the best hope for maintaining the viability of smaller financial institutions and enhance the move in this critical direction of central banking service to smaller institutions.

While the specific provision on membership and collateral for community banks in S. 1423 is crucial, the change will be of little benefit if not accompanied by other parts of the bill. In particular, the changes in other membership and borrowing rules to create voluntary, equal rights for QTL and non-QTL members alike, and the changes in capital are essential to economized borrowing access for community commercial banks. And these and other changes will also enhance the System’s ability to serve community credit needs though all members in the future.

Serving as the central bank for community bankers is one way the System will do so. Second, the System should also continue to be a vehicle that allows depository institutions to be effective competitors in the mortgage market by funding mortgages through member institutions. This is good for members, and it is good for the dispersal of credit risk. In the absence of the FHLBank System, Fannie Mae and Freddie Mac are the only game in town. These secondary market agencies have developed and altered mortgage finance in irreversible, efficient ways. But they also carry an enormous concentration of credit risk -- some $1.4 trillion in residential mortgages held or guaranteed. The FHLBanks comprise a triple-A-rated System that empowers the retail institutions to offer healthy competition to the secondary market giants. Competition – choice – is what can lead to lower costs for homebuyers. The System has the capacity to allow that competition to occur. Whether it be through traditional advances, or through innovations such as the various pilot programs that provide new ways to allocate the risks attendant to the mortgage business -- the Mortgage Partnership Finance pilot at the Federal Home Loan Bank of Chicago being most on point -- the System makes it possible for depository institutions to remain real competitors in housing finance.

The third role the Federal Home Loan Banks are uniquely equipped to perform is to target underserved markets. The System can offer both smaller and larger institutions a way to funnel housing and community investment dollars to populations and projects that might otherwise go unfunded. About one-third of our nation’s households still do not own their own homes; changing demographics demand product innovation to make homeownership possible for new groups. The same challenges confront community development. The System can provide liquidity when illiquidity – rather than lack of creditworthiness – may be the only reason a loan cannot be made. The cost of funds advantage can be used to fund nonconforming home mortgage loans, loans for multifamily dwellings that cannot be sold into the secondary market, and to put together the difficult-to-do-economic development deals that might otherwise not be do-able at all. Remember that this System was created to bring homeownership within reach of millions of hardworking average Americans of whom it was said, "But they cannot pay." They could pay, but what they needed was the FHLBanks’ support for the creation of long-term, fixed-rate, amortizing mortgages. Today it is small businesses, rural and urban, and small multifamily projects and local economic development initiatives that are said to be unable to pay their way. Surely that is true of some, but many just need the financial structure reengineering magic that the System brought to homeownership and can now bring to other credit availability needs.

Why don’t we just go in these directions? As the System’s regulator, I will use all the authority Congress has given the Finance Board to promote such reform and modernization and to achieve a more mission-related System that can fulfill the roles I have outlined. But there are statutory inhibitions, and I will now turn my attention to those. There are four structural reforms that are most important to address, and S. 1423 hits all the right bases in acceptable ways.

S. 1423, in addition to the collateral-related changes, provides universal voluntary membership, a more appropriate and workable capital system, rationalization of REFCorp payments and removal of inappropriate management responsibilities from the Federal Housing Finance Board. These are all the elements of essential reform. They will put the System in proper order not merely to sustain itself but to move in the directions I have outlined for the 21^st century at peak efficiency and effectiveness.

One of the most important provisions of S. 1423 relates to equalizing the terms on which institutions may become members of the System. When the Congress opened the FHLBank System to commercial banks with passage of FIRREA in 1989, it 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. But all federally-chartered thrifts are mandatory members of the System. S. 1423 abolishes the mandatory membership requirement, making membership entirely voluntary. I have no reason to believe that we will see significant numbers of federal thrifts withdrawing from the System. On the contrary, as I’ve said, given today’s needs and the System’s very real benefits, I believe today’s mandatory members will remain members, but there will be parity among all members in their ability to belong to the System and use it.

As a consequence of addressing the issue of voluntary membership – and in order to wind down arbritraged investments, a topic which I will return to again in the context of REFCorp -- 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" (that is, membership purchase requirements based on the assets of members) guarantees that the System will always have more capital than it can adequately leverage in advances 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 S. 1423 address these difficult issues; while there may be some disagreement on precise provisions, they are workable and provide an appropriate framework such that problems that might arise during implementation could be solved through the regulatory process. An option of true "permanent capital" to be held only by System members, if added to S. 1423, would complete the transition to a modern, risk-based capital system.

With respect to REFCorp, the structural inhibition perhaps most in need of reform, there is no question that this legislation does the right thing. It converts the fixed $300 million annual obligation that currently exists to an annual payment equal to 20.75% of net income. This would reduce the potential negative effects on the System of any income fluctuation, while opening the real possibility of reducing, through continued revenue growth, the share of the overall REFCorp funding burden borne by the Treasury. The Congressional Budget Office has estimated that the change would be a net gain for the taxpayer. With a small technical revision, the provision can assure that the Treasury will ultimately receive the same overall contribution to servicing the bonds, while the annual payment may vary.

Let me also say that freeing the Banks of the obligation to generate sufficient earnings to pay $300 million annually regardless of business levels with their members will help them to reduce investments not related to mission and to concentrate a larger portion of their assets in mission-related investments. I am committed to reducing the level of arbitrage activities and increasing the Banks’ focus on advances and other mission-promoting assets. We recognize that this process is one that must be done gradually, with the utmost care, and with the maintenance of a dividend that is sufficiently attractive to retain voluntary members as a central safety and soundness obligation of the regulator. But the recovery of the System from the effects of the thrift industry’s severe problems in the late eighties and early nineties allows the Finance Board prudently and appropriately to begin the process and the changing of the REFCorp formula and capital structure would will help to speed that process forward.

The fourth and final area of reform that the legislation addresses 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 is required to approve day-to-day operational decisions of the Banks. Unfortunately, the Finance Board cannot extract itself from some of these matters under current law. These items are not controversial and, indeed, allow us to return appropriate managerial responsibilities to the individual Banks while retaining necessary oversight and enforcement authority for the Finance Board.

These provisions in S. 1423 reflect years of study, discussion, hearings and debate. They constructively address the deficiencies in the Federal Home Loan Bank Act and expand the ability of community banks to serve the credit needs of the homebuyers and small businesses they serve. They are supported by the Council of Federal Home Loan Banks, representing ten FHLBanks. They contain neither more nor less than is necessary to construct a rational Federal Home Loan Bank System for the next century – a System that can meet the needs of its members and their communities, that can focus more on mission, and that can help advance the frontiers of credit availability.

I commend you for holding these hearings, thank you for the chance to express my views on rural credit issues and S. 1423, and I look forward to working with you to make this legislation a reality.

Return to Press Releases...

Return to the Federal Housing Finance Board's Home Page.