August 10, 2006


The Honorable Michael G. Oxley
Chairman

The Honorable Barney Frank
Ranking Member

Committee on Financial Services
2129 Rayburn House Office Building
United States House of Representatives
Washington, DC 20515

Dear Chairman Oxley and Mr. Frank:

We want to thank you for your leadership in raising questions about the Federal Housing Finance Board’s proposed regulation on excess stock and retained earnings in your letter to the Finance Board of June 30, 2006. We too have concerns about the Finance Board’s proposal and believe that it could have a significant negative impact on the Federal Home Loan Banks, their member institutions and their communities. We would like to provide our perspective on the Finance Board’s response to your letter.

While we appreciate the declaration that the Finance Board is taking an open-minded, cautious approach, we remain concerned that the Finance Board has not adequately considered the capital regime established by Congress in the Gramm-Leach-Bliley Act (GLBA), the Board’s own precedents, and the impact of the proposal on the FHLBank System and the System’s member institutions, particularly smaller institutions. While there are indications that the Finance Board may be willing to stretch out the period for FHLBanks to come into compliance with the proposed restrictions, we respectfully submit that time cannot cure the problems with the current proposal. We continue to believe that the best approach is for the Finance Board to withdraw the current proposal and begin anew with an advance notice of proposed rulemaking process that would foster a better dialogue among the various stakeholders in the FHLBank System.

Our key concerns are discussed in more detail below.

The Proposed Rule is Inconsistent with Capital Standards Mandated by Congress

We must respectfully disagree with the assertion that the proposed rule conforms to the requirements of GLBA.

Under GLBA, Congress gave each FHLBank discretion to determine, subject to Finance Board approval of the capital plan required under GLBA, the precise combination of Class B stock and retained earnings that it would utilize to satisfy its capital requirement. Moreover, GLBA gives
the boards of the individual FHLBanks the authority to determine the amount of excess stock that an FHLBank can have at one time. These determinations by the individual boards are necessarily based on the individual circumstances, balance sheets and activities of each of the FHLBanks. The one-size-fits-all policy proposed by the Finance Board does not comport with GLBA’s capital scheme.

Moreover, while GLBA provides that member Class B stock, which is redeemable within five years from a request to redeem, is permanent capital, the proposed rule suggests that retained earnings are the only real buffer against economic loss in the FHLBank System. The Finance Board’s treatment of Class B stock has resulted in an excessive focus on retained earnings as the sole means of absorbing certain potential losses, and a proposed regulation that requires an unnecessarily high proportion of retained earnings in total capital. Congress did not mandate a set proportion of retained earnings to Class B stock; rather, it left this determination to the individual FHLBanks.

Much of the Finance Board’s rationale for the proposed rule is based on the assertion that FHLBank member stock is a volatile source of capital redeemable at a member’s will. Member stock is not redeemable at the will of a member. Rather, it is a stable source of permanent capital. The vast majority of the member stock in the FHLBank system is Class B stock with a five-year redemption period, subject to controls that prevent redemption beyond the five-year redemption period in times of financial stress.

Moreover, having just approved the individual FHLBank capital plans required by GLBA in 2002, the Finance Board necessarily approved the FHLBanks’ determination of the appropriate mix of retained earnings and Class B stock and use of excess stock. We believe that the Finance Board’s letter fails to provide an adequate explanation for its fundamental departure from the approvals it so recently granted the FHLBanks in connection with their capital plans.

The Proposed Rule Will Have a Serious, Negative Impact on Operations of FHLBanks

The Finance Board fails to recognize the proposal’s potential for altering the long-term operation of the FHLBanks. The response does not adequately acknowledge the likely impact of the proposed regulation on the cost of FHLBank advances. In fact, the retained earnings requirement (REM) and the resulting restriction on dividends will have a significant adverse impact on member institutions and will have great potential to create instability within the FHLBank System. The FHLBanks will have to increase retained earnings by over $3 billion over the next 18 to 36 months. Also, the FHLBanks will have to target an amount of retained earnings above the actual REM requirement because the consequences of falling out of compliance once the target is obtained are significant. These dividend restrictions will reduce the member institutions’ income and increase the all-in cost of advances. Large member institutions with access to other wholesale funding sources will seek those alternatives and reduce their use of FHLBank advances. Reduced use by the larger members will deprive the FHLBanks of a valuable source of earnings and limit their scale of operations, increasing costs and reducing services to smaller member institutions. The net result is that the proposal likely will reduce mortgage finance services to member institutions and simultaneously frustrate the Finance Board’s overall goal of increasing retained earnings.

The burden of these restrictions will fall the heaviest on smaller institutions that rely on the dividend income that comes from FHLBank stock ownership and that are unable to access the capital markets directly for funding. In an evaluation of the impact of the proposal on publicly traded financial institutions, one analyst estimated that smaller institutions could suffer a five percent reduction of net income until full dividends are restored.

The REM is based on a flawed formula that does not justify the proposed large increase in retained earnings, and results in a level of retained earnings beyond what is needed for FHLBank System safety and soundness. As a result, the REM may needlessly depress dividends and increase the cost of advances on an on-going basis.

The formula for the retained earnings requirement also is constructed to disfavor investments in securities needed to provide liquidity. As a result, the FHLBanks will have less flexibility in managing their balance sheets and providing services to their members. This point was emphasized in a recent ratings agency report from Standard and Poor’s.

The Finance Board suggests that the FHLBank of New York will have no problem in complying with the REM requirement. This is not the case for the other FHLBanks, and it may be uneconomic for the FHLBank of New York to remain in compliance if the rule is adopted. In fact, the proposed rule’s impact will have a disparate impact on the FHLBanks for reasons unrelated to financial performance. For example, the FHLBank of San Francisco has never had an earnings problem and has capital well in excess of the minimum. Yet, the FHLBank of San Francisco will have one of the largest retained earnings deficits. We question the rationale of a regulatory proposal that attains such results.

Impact on AHP

The proposed rule will result in a decrease in funds available for the FHLBanks’ affordable housing programs (AHP). As noted above, the proposed rule will likely lead to reduced use of the System by larger member institutions with access to alternative sources of wholesale funding. As a result, the earnings of many of the FHLBanks will be reduced, which will reduce the funds available for AHP.

While acknowledging that lower earnings will reduce AHP payments, the Finance Board argues an FHLBank’s earnings might increase as a result of the excess stock restriction if member banks take out new advances, triggering new activity-based stock requirements, rather than accept stock redemption. This assertion is based on the illogical premise that a member institution will take on advance obligations that it did not need.

Additionally, the Finance Board argues that higher retained earnings will give the FHLBanks a larger base of capital that should increase earnings over the long-term. However, the increase in retained earnings will not be available to support additional earning assets, but instead will be required under the proposal to support the existing asset structure. In any event, this argument represents an unexplained change in position by the Finance Board. In the preamble to the proposed rule, the Finance Board said its “purpose proposing the rule change is not necessarily to require the Banks to increase their overall levels of capital.” 71 Fed. Reg. 13311. If the Finance Board’s true intent is reflected in the preamble, then the letter’s assertion that FHLBank earnings will increase has no foundation.

The Proposed Rule is Based on Flawed Analyses and Assumptions

The Finance Board’s letter implies that it does not favor FHLBank investments in highly liquid assets and acquired member assets (AMA). It argues that these investments are not essential to the mission of FHLBanks. ACB disagrees. The acquisition of money-market securities and similar highly liquid assets is fundamental to the mission of the FHLBanks. Additionally, the AMA programs are considered core mission activities for FHLBanks under Finance Board regulations.

Finally, it is important to keep in mind that the Finance Board has based its legal authority for the proposed rule on its general safety and soundness powers, not on the explicit capital provisions of GBLA. But, the Board has failed to make a case that there are system-wide safety and soundness concerns that justify the current proposal. In fact, the Finance Board has admitted in its regulatory proposal that “[the Board’s] capital rules and the FHLBanks’ overall capital levels remain adequate and the risk of capital insolvency at any FHLBank in the foreseeable future is de minimis.” 71 Fed. Reg. at 13311.

To address these and other concerns, we believe that the interests of the public would best be served by a congressional oversight hearing on the proposed rule before the Finance Board issues a final rule. We are confident that the Finance Board, Congress, member institutions and community development organizations share a common interest that the FHLBank System’s mission is fulfilled in an efficient and a safe and sound manner. We promise our full and vigorous support of your efforts to ensure this result. Thank you for this opportunity to present our views.

Sincerely

Robert R. Davis
Executive Vice President and
Managing Director, Government Relations

Cc: Chairman Ronald A. Rosenfeld