November 07, 2008

Fannie Mae (FNM) and Freddie Mac (FRE) were controversial for years before they fell into government conservator ship this year. But few people have considered the risks posed by the Federal Home Loan Bank System (FHLB), even though it occupies the same gray area between the public and private sectors.
Created by Congress in 1932 to bolster mortgage finance, the system, with its 12 member banks, lends to financial institutions of all sizes, with more than $900 billion in outstanding loans as of midyear, up 43% since 2006. Like Fannie and Freddie, the system can borrow cheaply because of the assumption that the federal government won't let it fail. As private cooperatives, the 12 banks make profits and pay dividends to their owners—more than 8,000 financial institutions.
Here's the problem: The system has weak restraints against overlending. Its stated mission is to make loans, and by law it's not responsible for monitoring or controlling what those loans are used for. That's the job of the borrowers' primary regulators. In addition, if a bank with an FHLB advance goes under, the FHLB is at the head of the line to get repaid, so it has little reason to lend cautiously. And in a potential conflict of interest, the FHLBs are lending to their owners—the member banks. The result: Bountiful funding from the FHLBs could allow some banks to "gamble for salvation," getting into even deeper trouble.