Understanding the Federal Home Loan Bank System

Amongst the alphabet soup that we have been treated to these past few days – SI, SVB, SB, FRB, CS, UBS – there is one set of letters that we all need to pay attention to. It is the FHLB .aka The Federal Home Loan Bank System.

The FHLB raised a monumental $300bn last week. Why?

Here is an as-concise-as-it-gets primer on the FHLB and what you need to watch for.

  • The FHLB is a depression era creation. It was created in 1932 as a govt sponsored enterprise to support mortgage lending and community investment. Eventually the FHLB gained the role of a lender of next-to-last resort. Even during the financial crisis, before the meltdown, it played a key role in maintaining market stability by providing funding to Banks collateralized by mortgages and mortgage related instruments. (See red oval in chart below).
  • However, over the past 6-7 years, the FHLB became one of the primary sources of short term liquidity to the entire banking system – including the largest banks in the US. (see red arrow below).
  • All FHLB advances to banks have “super priority in lien” – even in the event of an insolvency. i.e. FHLB loans are prioritized even over depositors money. As of Sep 2022, the total loans made to the banks, thrifts, insurance companies, etc amounted to approx. $660bn. Investment securities form the other major asset of the FHLB amounting to $195bn as of Sep 2022.
  • FHLB, since it is a quasi-government entity, is rather thinly capitalized, with a capital level of about 5-6% of total assets. As of Sep 2022, the total capital of FHLB was $60bn and total assets were $1.09 trillion.
  • The FHLB primarily raises funds by issuing discount notes and bonds – termed as Consolidated Obligations. Total FHLB borrowing as of Sep 2022 was $1.01 trillion. Post the 2008 financial crisis, the proportion of short term funding (maturity less than 1 year) on the FHLB books vis-à-vis its total obligations was down from peak GFC levels to ~50%. Over the years this number has steadily increased and as of Sep 2022 approximately 90%of the total $1.02 trillion of FHLB obligations mature within 1 year. In simple words, this means the extent of maturity transformation that FHLB takes on its books has progressively grown larger over the years.
  • Given the thin capitalization and short term funding nature of the FHLB system, it cannot support large losses in the financial system, Of course, given its super lien characteristics, it will not face immediate losses even in the event of bank insolvency. i.e. even in an FDIC takeover scenario.
  • The summary takeaways are dual. First – irrespective of the structural seniority of FHLB claims, keeping a close eye on the FHLB bond issuances and advances will provide a clearer picture of the liquidity requirements of and strains in the US banking system. Second – Should the FHLB system start experiencing some stress, the effects would likely be sudden, severe and contagious.  
  • The dichotomy between the original purpose of creating the FHLB and the eventual key money market and banking system giant that it has morphed into is stark. Prior to money market fund reform and certain Basel regulatory requirements, prime funds fulfilled a key purpose of providing wholesale funding to Banks. With the growth of the FHLB, it is now effectively the key source of wholesale liquidity – with a major difference – the FHLB is quasi US government risk. In simple words, Banks still depend on wholesale funding as they did prior to 2008. Now that wholesale funding has a government backstop!   
  • Which gets us to the final point of the thought process. Ultimately if the FHLB ranks super senior in an insolvency scenario, the buck stops with the FDIC. Now with the SVB and SB events, the US government has set a precedent for full coverage of unlimited deposits. Total deposits of all Commercial Banks in the US amounts to approximately $17.5 trillion. The FDIC insurance fund is approx. $130bn. You do the math. Is the US Government Debt to GDP really 120% or higher?

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