WASHINGTON — Have the Federal Home Loan banks drifted too far from their original purpose?
That's the fear among top officials at the Federal Housing Finance Agency, who have watched with alarm as the level of the banks' investments has surged, sometimes surpassing the level of their advances.
Four of the 12 Federal Home Loan banks — Chicago, Seattle, Cincinnati and Indianapolis — now hold more in investments than advances, and two others — Boston and Topeka — are close to joining them.
In a speech to Home Loan bank officials last week, FHFA Acting Director Edward DeMarco warned the banks this cannot be allowed to continue, emphasizing that their role is to promote liquidity through advances, not grow an investment portfolio.
"Making advances is central to an FHLBank's business, but investments intended to arbitrage the FHLBanks' funding advantages are not," DeMarco said in a speech to the Federal Home Loan Banks Directors Conference. "A large investment portfolio intended to generate added earnings is inconsistent with the purposes of the FHLBank System and is a misuse of the system's preferential access to capital markets."
DeMarco delivered much the same message last year, but the situation has only worsened as the Home Loan banks continue to struggle to build their advance business.
A decade ago, banks' assets were predominantly made up of advances, which totaled roughly 80% to 90% of their assets.
But by March 31 of this year, advances exceeded barely more than half the system's combined assets, reaching just 52.4%. Investments, meanwhile, have steadily grown, equaling a combined 38.7% of total assets by the end of the first quarter.
That's a sign to DeMarco that some of the banks, at least, are moving too far afield from their original purpose, which was to promote liquidity at financial institutions in order to spur more mortgage lending.
"This is not a sustainable operating condition for an FHLBank," DeMarco warned.
Industry observers agreed.
"It just points to the strategic challenge for the system, which is that their mission is to provide advances, but their business increasingly isn't," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. "The banks are moving into investments because they cannot make ends meet with advances."
Regulators are also worried about the risk that may be inherent in the banks' portfolios. While advances produce virtually no losses for the Home Loan banks, that is not the case with their investments.
"The FHLBanks' various financial problems of the past 20 years have not come from the traditional advances business," DeMarco said. "Instead, investments and mortgage purchase programs have been the source of deterioration in the financial condition of some FHLBanks."
Some industry observers said such fears are overblown.
"For the most part, the rest of the investment securities are plain vanilla, short-term corporate AA, or AAA securities," said William Longbrake, an executive-in-residence at the University of Maryland and former board of director at the Federal Home Loan Bank of Seattle. "They are highly liquid and trade close to par, so there isn't really any valuation risk."
But despite efforts behind the scenes to force the banks to concentrate on their advance business, the situation is not improving. Last year, only two of the banks — Chicago and Seattle — had investments top their advances.
Like many other banks, however, Cincinnati and Indianapolis saw their advance business drop while investments continued to grow.
In Cincinnati, advances fell 14%, to $28.3 billion, while investments grew 34%, to $32 billion by March 31. In Indianapolis, advances fell 18% from the same point last year, to $17.9 billion, while investments grew 14%, to $19.2 billion.
Boston and Topeka appear likely to hit the threshold soon.
In Boston, investments and advances are roughly even, at $25.9 billion, after advances fell 26% from the first quarter of last year. In Topeka, advances fell nearly 20%, to $17.8 billion, but still top investments by a little more than $2 billion.
Despite the likelihood that soon half the banks will hold more in investments than advances, the FHFA appears unlikely to be able to turn the situation around anytime soon.
The agency has yet to issue any proposals to limit the size and nature of the banks' existing portfolios, which are allowed to grow to three times the size of the capital they hold.
That may reflect a reluctance to tamper with an area that has been profitable for the banks.
"The conundrum from FHFA's perspective is they need the banks to be profitable first, to retain and build their capital levels to a sufficient level, and then they can go about limiting the investment portfolio," said Brian Harris, an analyst at Moody's Investors Service.
It may also reflect political worries about a significant change in policy when DeMarco is only an acting director, and not nominated by the president or confirmed by the Senate.
"Without a confirmed director there's always a hesitancy to set policy in a strongly new direction over vigorous opposition — and redefining the Home Loan banks is definitely that," Petrou said.
She said acting directors tend to "avoid more difficult decisions versus [take] controversial actions."
Regulators also recognize the difficulties the banks are facing after they ramped up advances during the financial crisis only to see them start dropping dramatically once cheaper funding sources — including the Federal Reserve Board's multiple liquidity programs — dried up demand.
The total level of advances fell once again in the first quarter, by 7%, to $445.1 billion, due in part to low demand for loans and alternative funding sources.
With demand so low, most observers said the banks have little choice but to focus on their investment portfolios.
"If there's not demand for advances, if there's not demand for mortgages, what they're left with is, do they have the capacity to increase their investment portfolio," Harris said.
John von Seggern, the president of the Council of Federal Home Loan Banks, said the banks are doing their best to deal with a difficult situation.
"The Federal Home Loan banks are prudently managing their portfolios in a way to assure sufficient liquidity for members and navigate a cyclical decrease in advances," he said. "They're simply going through an adjustment period."
Still, the issue may fuel more questions about whether the system really needs 12 Home Loan banks. As advance demand continues to weaken, lawmakers may find themselves considering merging some of the banks, observers said.
"Consolidation is driven by the need for additional income," Petrou said.
"The investments are not the leading indicator of that — it is the significant strain on profitability."
But Longbrake said it was easier said than done, noting the political and operational problems of merging the banks.
"Considering consolidation is somewhat diminished, but it is certainly not off the table," he said.