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:
- Although FHFA did not initially prioritize FHLBank unsecured credit risks, it has recently developed an increasingly proactive approach to oversight in this area.
- FHFA did not actively pursue evidence of potential FHLBank violations of the limits on unsecured exposures contained in its regulations.
- 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.
