OIG Finds FHLBanks Corrected Foreign Credit Exposure, more Supervision Needed

The Office of the Inspector General
(OIG) of the Federal Housing Finance Agency (FHFA) issued a report this morning
that was mildly critical of the FHFA’s oversight of Federal Home Loan Banks (FHLBanks)
granting of unsecured credit to European banks.   OIG said that extensions of unsecured credit
in general increased by the FHLBanks during the 2010-2011 period, even as the
risks for doing so were intensifying.

FHFA regulates the FHLBanks and has
critical responsibilities to ensure that they operate in a safe and sound
manner.  FHFA’s OIG initiated an
evaluation to assess the regulator’s oversight of the Banks unsecured credit
risk management practices.

Unsecured credit extensions to European
institutions
and others grew from $66 billion at the end of 2008 to more than
$120 billion by early 2011 before declining to $57 billion by the end of that
year as the European sovereign debt crisis intensified.  During this period extensions of unsecured
credit to domestic borrowers remained relatively static but extensions to
foreign financial institutions fluctuated in a pattern that mirrored the
FHLBanks’ total unsecured lending.  That
is, it more than doubled from about $48 billion at the end of 2008 to $101
billion as of April 2011 before falling by 59 percent to slightly more than $41
billion by the end of 2011.

FHFA OIG also found that certain
FHLBanks had large exposures to particular financial institutions and the
increasing credit and other risks associated with such lending.   For example, one FHLBank extended more than
$1 billion to a European bank despite the fact that the bank’s credit rating
was downgraded and it later suffered a multibillion dollar loss.

During the time period in question OIG
found there was an inverse relationship between the trends in lending to
foreign financial institutions and the Banks advances to their own members.  Since mid-2011 the extensions to foreign
institutions have declined sharply but the advances have continued their
longstanding decline.  OIG said it
appears that some FHLBanks extended the unsecured credit to foreign
institutions to offset the decline in advance demand and that they curtailed
those unsecured extensions as they began to fully appreciate the associated
risks.

At the peak of the unsecured lending,
about 70 percent of the FHLBank System’s $101 billion in unsecured credit to
foreign borrowers was made to European financial institutions and 44 percent
were to institutions within the Eurozone. 
About 8 percent of unsecured debt ($6 billion) was to institutions in
Spain, considered by S&P to be even riskier than the Eurozone as a whole.

Some banks within the FHL System had
extremely high levels of unsecured credit extended to foreign borrowers.  The Seattle Bank’s exposure to foreign
borrowers as a percentage of its regulatory capital was more than 340 percent
in March 2011; Boston was at 300 percent, and Topeka 360 percent.  All three had declined substantially by the
end of 2011 but Seattle and Topeka remained above 100 percent.

OIG said that the vast majority of the
Banks’ extensions of unsecured credit appeared to be within current regulatory
limits (although OIG said these limits may be outdated and overly permissive),
some banks did exceed the limits and OIG found the three banks (which for some
reason it treated anonymously) definitely did so and blamed that on a lack of
adequate controls of systems to ensure compliance.

OIG reviewed a variety of FHFA internal
documents during the 2010-2011 period during which it found the Agency had
expressed growing concern about the Banks’ unsecured exposures to foreign
financial institutions.  But, even though
FHFA identified the unsecured credit extensions as an increasing risk in early
2010, it did not prioritize it in its examination process due to its focus on
greater financial risks then facing the FHLBank system especially their private
label mortgage-backed securities portfolios. 
In 2011, however, FHFA initiated a range of oversight measures focusing
on and prioritizing the credit extensions in the supervisory process and
increasing the frequency with which the Banks had to report on that part of
their portfolios.

OIG believes that FHFA’s recent initiatives
contributed to the significant decline in the amount of unsecured credit being
extended by the end of 2011.

The final findings issued by OIG in its
report are:

  1. Although
    FHFA did not initially prioritize FHLBank unsecured credit risks, it has
    recently developed an increasingly proactive approach to oversight in this
    area.
  2. FHFA
    did not actively pursue evidence of potential FHLBank violations of the limits
    on unsecured exposures contained in its regulations.
  3. FHFA’s
    current regulations governing unsecured lending may be outdated and overly
    permissive.

To correct
these deficiencies, OIG recommends that the Agency:

  • Follow up on any potential evidence of violations of
    the existing regulatory limits and take action as warranted;
  • Determine the extent to which inadequate systems and
    controls may compromise the Banks’ capacity to comply with regulatory limits;
  • Strengthen the regulatory framework by establishing
    maximum exposure limits; lowering existing individual counterparty limits; and
    ensuring that the unsecured exposure limits are consistent with the System’s
    housing mission.

…(read more)

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