Monday, January 26, 2009

Fannie, Freddie, FHLB About To Remind World Of Their Pathetic Existence

As Bloomberg reported last week, Tuesday, January 27, may be much more than consumer confidence / Case-(C)hiller day. On Tuesday the Federal Housing Finance Agency, the government oversight agency run by Jim Lockheart, will announce a new set of parameters for capital requirements and investment restrictions for Freddie, Fannie, and the Federal Home Loan Banks. Freddie and Fannie, which were nationalized in September, hold a combined $1.7 trillion in mortgages between them. Lately they have been somewhat behind the scenes, absent the occasional cry for extra capital. What should be much more concerning is the status of the FHLB system, which is the single largest U.S. borrower after the government itself, with $1.25 trillion in debt. The member banks provide low-cost loans to more than 8,000 member banks and finance companies, including banking behemoths Bank of America, Citigroup and JP Morgan. What is worrying is that according to Moody's stringent standards for capital sufficiency, as many as 8 of the 12 banks may fall short of minimum capital requirements as auditors require writedowns from their $76 billion of private mortgage bond holdings to market.

The big unknown is whether tomorrow Lockhart will tighten or loosen the banks' capital requirements, aka reserves against losses. According to Bert Ely, a banking consultant, “[the FHFA] will bend over backward to not cripple the Federal Home Loan Banks or the member institutions. They are a major source of funding for the banks and thrifts" that are making home loans.

On the other hand, Rajiv Setia, a Barclays analyst said he wouldn't be surprised if FHFA increased the capital requirement, "From a regulator’s perspective, what’s my upside in lowering the requirement and then, say you’re wrong. If I’m a regulator, I want to be more punitive because I’m protecting my domain."

The banks are required to hold a minimum capital cushion equal to 4% of assets to reserve against losses, and according to Lockhart the proposed change to the rules will lay out when a bank can be classified as "adequately capitalized, significantly undercapitalized or critically undercapitalized." As the FHLB is lobbying the FHFA and SEC hard to be allowed to stop margin mortages to market, one can assume what the proper classification should be.

In the past two weeks, the Seattle and Pittsburgh FLHBanks said they are either likely to fall shortly of capital requirements for Q4, or to be narrowly in compliance. Both banks, plus the San Francisco FHLB, have suspended dividend payments to protect reserves.

Could the market be ahead of the government in this one? FT Alpha points out the aggressive rise in 3 month LIBOR over the past week, which has gone from 1.12% to 1.18% in 5 days, is indicative of the potential risk from a change in the regulatory framework. As we have pointed out previously, 3 of the 16 banks that make up the BBA committee that sets the LIBOR rate, Citi, JPM and BofA, are not only direct beneficiaries of the FHLB's generosity (and continued existence), but are also the BBA members that recently have posted some of the lowest LIBOR rates! The following blurb from Bank of America analyst Michael Cloherty describes the incestuous relationship between capital preservation tactics at the FHLB and the ultimate impact on LIBOR:

"In order to borrow from the Home Loan system, banks must buy FHLB capital notes which pay a dividend. The FHLB system then levers up this capital roughly 20 to 1 by issuing debt, and lends the proceeds back to the borrowing bank. So the all-in cost to the borrowing bank is the rate on the loan minus the dividend income received on the capital note.

Historically, in order to preserve capital the regional Home Loan Banks first stop paying dividends on their capital notes (other options include not allowing banks to redeem capital notes that are not being fully borrowed against, calling in more capital from member banks, or receiving a capital injection from the Treasury). This dividend reduction is already underway- in Q3 2007, the average dividend was 5.16%, while in Q3 2008 it was 3.50%.

But if we assume one of the FHL Banks pushed its dividend to 0% to preserve capital (a 350bp reduction), that would raise the cost of funds for a bank borrowing to full capacity (assume 20 to 1) by roughly 15bps. This would likely cause banks to be more aggressive in financing themselves through wholesale deposits, which would impact the LIBOR setting."

Is the LIBOR trend indicating an expectation that the FHLB may soon be in deep trouble and/or follow the fate of its Freddie and Fannie zombie cousins? If the 3 major depositor banks, which previously could rely on the FHLB for cheap financing, are forced to rely exclusively on pricier depositor assets, this could be yet another fat tail that whacks the house of cards known as the U.S./global financial system. Sphere: Related Content
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