FROM THE OFFICE OF PUBLIC AFFAIRS

Summary

Last year, the Federal Home Loan Bank (FHLBank) System -- i.e., the 12 FHLBanks -- issued over $2 trillion of debt securities. During the first half of this year, the FHLBank System issued $1.2 trillion in debt securities and replaced the Treasury as the world's largest issuer of debt.

Most of this debt is short-term, and thus poses less risk than the numbers might suggest. Yet we must ask why the System issues so much debt -- debt that receives favorable treatment in the marketplace because of the System's government sponsorship. Moreover, why is the Federal Home Loan Bank System issuing billions of dollars in debt securities only to reinvest the proceeds in other short-term capital market instruments?

The answer is that the FHLBanks are using their government sponsorship to benefit their shareholders even if doing so may not necessarily serve the Bank System's public purpose. Since government sponsorship permits the FHLBanks to borrow at subsidized rates, most of their investments constitute an arbitrage of credit flows in the capital markets -- borrowing funds in the capital markets at below-market rates and investing them in securities at market rates.

We do not believe that the System's public purpose -- promoting housing finance by providing access to capital for home lenders, particularly community banks and thrifts -- can justify the System's current debt issuance and investment activity.

Since the early 1990s, the System has increasingly been borrowing funds in the capital markets and investing them in other marketable securities. As of June 30, 1998, the FHLBanks' investment portfolio stood at $143 billion, or 43 percent of the System's outstanding debt. The FHLBanks argue that their investments are necessary to: (1) ensure that the FHLBanks have adequate liquidity; (2) produce income to pay certain System obligations; and (3) generate dividends sufficient to keep the System's members from leaving the System. We find these arguments unpersuasive.

The FHLBanks often argue that they need their large investment portfolios to maintain adequate liquidity -- i.e., to hold assets sufficiently marketable that they can easily be sold to meet unexpected demand for advances from member institutions. Yet the System's government sponsorship gives the FHLBanks preferential access to the capital markets, permitting them to borrow on better terms than fully private firms. And the sheer size of the System's debt issuance demonstrates that the FHLBanks have no difficulty raising funds whenever they want, in almost any amount they need. Thus they need not hold a large volume of short-term liquid investments to secure liquidity for future advance demand.

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) imposed on the System: (1) an obligation to make $300 million in annual interest payments on Resolution Funding Corporation (REFCorp) bonds, which were issued to help resolve the savings and loan debacle; and (2) the Affordable Housing Program, to which the System must contribute the greater of 10 percent of its net income or $100 million.

In the early 1990s, thrift institutions' demand for FHLBank advances fell dramatically as the government closed troubled thrifts and as a national recession led other thrifts to decrease their borrowing. To meet the System's FIRREA obligations in the face of declining demand for advances, the FHLBanks sharply increased their investment portfolios.

Whatever the logic of temporarily increasing the FHLBanks' investments during the early 1990s, those circumstances are long past. And the System's steady rebound in membership and advance volume -- and the accompanying increase in earnings -- mean that the REFCorp and AHP obligations do not justify maintaining such a large investment portfolio. By the end of 1997, outstanding advances reached an all time high of $202 billion, representing a 153 percent increase since 1992. Yet the System's investment portfolio also increased 77 percent since 1992.

The FHLBanks have argued that maintaining a dividend adequate to retain voluntary members is necessary for ensuring stability within the System. The general argument underlying this statement runs as follows. Since most FHLBank members are voluntary members, they may redeem their capital stock and leave their FHLBank upon six months notice. As profit-maximizing firms, members are said to be ready to leave if the return on their FHLBank stock falls below some market rate of return. Thus, the reasoning goes, since demand for advances falls short of a FHLBank's ability to earn the desired rate of return, the FHLBank should hold investments in order to maximize returns to members. Besides helping to retain existing members, paying attractive dividends also helps the FHLBank attract new members.

This argument fails to reflect the true economics of System membership, and ignores the overall benefits of the System's government sponsorship, including its public mission. Banks and thrifts have powerful incentives to become FHLBank members, regardless of dividend rates. The bottom line is that the overall economic returns to System membership -- of which dividends are only one facet -- are very attractive.

Indeed, any argument that the FHLBanks' current volume of investments is necessary to make the benefits of System membership outweigh its cost seems dubious. Between January 1, 1993, and December 31, 1997, only 25 FHLBank members withdrew from the System, while more than 3,000 commercial banks became System members. And System members hold some $2.3 billion in FHLBank stock beyond the minimum required by law. This fact suggests that System members find the current return on FHLBank stock attractive enough to hold extra amounts of it -- that is, as an investment its return exceeds its opportunity cost.

We believe that the FHLBanks' large investment portfolios violate the spirit and arguably the letter of the FHLBank Act. In our view, the only effective way to limit FHLBank investments is through objective limits on the amount of those investments. Thus we would propose that, as a general principle, the FHLBanks' consolidated obligations should not exceed their advances. This would limit a FHLBank's investments to its capital plus its member deposits.

Such a limit would still permit the FHLBanks to hold a considerable investment portfolio. As of June 30, 1998, it would have allowed an investment portfolio of $42 billion, representing over 10 percent of the System's $379 billion in total assets (which now includes $143 billion in investments). If this proposal were fully implemented and the System reduced its investments from $143 billion to $42 billion, based on the System's $227 billion in outstanding advances as of June 30, 1998, the System would still have over 15 percent of its total assets in investments.  TABLE OF CONTENTS I. Introduction . . . . . . . . . . . . . . . . . . . . .1 II. FHLBank Investments Are Not Necessary to Advance the System's Public Purpose . . . . . . . . . . . . . . . . . . . .4 A. The System's Government Sponsorship Gives the FHLBanks Immediate Access to Market Liquidity. . . . . . .5 B. The FHLBank System's FIRREA Obligations Do Not Justify Maintaining a Large Investment Portfolio. . . . .7 C. Maintaining Dividend Rates Does Not Justify the FHLBanks' Investment Portfolio. . . . . . . . . . . . . . .9 1. Banks and thrifts have powerful incentives to become and remain members of the System -- if those institutions are doing the kind of activities the System is designed to encourage. . . . . . . . . . . . . . . . . 11 2. System practices indicate that System membership provides very attractive economic returns 13 III. FHLBank Powers, the FHLBank Act, and the Finance Board14 IV. FHLBank Investments Should Be Limited by Legislation and Regulation 15 V. Conclusion . . . . . . . . . . . . . . . . . . . . . 17  I. Introduction

Mr. Chairman, Mr. Kanjorski, Members of the Subcommittee. I appreciate this opportunity to present the Treasury's views on the investment practices of the twelve Federal Home Loan Banks, which I will refer to collectively in my statement as the System or the Bank System.

Today's hearing is one of a series of hearings and bills that you, Mr. Chairman, have initiated in this difficult area. While FHLBank issues may attract little notice from the general public, the issues are of great importance and the financial stakes are high. We at the Treasury commend the leadership that you, Mr. Kanjorski and others on this Committee have demonstrated in pursuing FHLBank reform legislation.

As I believe our testimony and the General Accounting Office's testimony will show, there is much about the Federal Home Loan Bank System that warrants scrutiny. At the same time, the Bank System does some good, and there is more that it could do.

As you have requested, Mr. Chairman, today I will describe the Treasury's view of FHLBank investments.

Last year the FHLBank System issued over $2 trillion of debt securities. During the first half of this year, the System issued $1.2 trillion in debt securities and replaced the Treasury as the world's largest issuer of debt. As of June, 1998, the System had $329 billion in debt outstanding.

Most of this debt is short-term, and thus poses less risk than the numbers might suggest. Yet we must ask why the System issues so much short-term debt -- debt that receives favorable treatment in the marketplace because of the System's government sponsorship. Almost all of the short-term debt issued is used to either make short-term advances (i.e., loans to members) or to make short-term investments. The issue I want to focus your attention on today is the System's investments. Why is the Federal Home Loan Bank System issuing billions of dollars in debt securities only to reinvest the proceeds in other short-term capital market instruments?

The answer is that the FHLBanks are using their government sponsorship to benefit their shareholders even if doing so may not necessarily serve the Bank System's public purpose. Since government sponsorship permits the FHLBanks to borrow at subsidized rates, most of their investments constitute an arbitrage of credit flows in the capital markets -- borrowing funds in the capital markets at below-market interest rates and investing them in securities at market interest rates. In short, the FHLBanks are doing what any rational capitalist would do: using every available advantage to maximize net income.

We do not believe that the System's public purpose -- promoting housing finance by providing access to capital for home lenders, particularly community banks and thrifts -- can justify the System's current debt issuance and investment activity.

To fully appreciate how these activities fail to serve the FHLBank System's public purpose, one must take a moment to understand why the System was created and endures. Congress created the System during the Great Depression because thrifts lacked access to capital markets and therefore could not make long-term mortgage loans even to creditworthy borrowers. Anyone who has read or seen The Grapes of Wrath remembers the tragedy of Dust Bowl residents unable to refinance when their five-year mortgages came due. The System rested on the following logic: by providing long-term funding to thrifts -- which were then exclusively engaged in mortgage lending -- it would encourage those thrifts to make more 30-year, fixed-rate mortgages to creditworthy borrowers.

But much has changed since 1932. The Great Depression is long past. Capital markets have become far better developed. An enormous secondary market for mortgages, which was non-existent in the 1930s, now readily enables banks and thrifts to sell mortgages and use the proceeds to make new loans. Meanwhile, thrifts have become full-service retail financial institutions, with activities that go well beyond home mortgage lending, and banks have gained access to the System. Thus there is much less assurance today that FHLBank funding will actually result in greater mortgage lending -- as opposed, for example, to more commercial lending or derivatives trading.

We view the lack of assurance that FHLBank advances will be used to fund mortgage lending as a fundamental problem with the System. But a key fact I wish to emphasize today is that currently 38 cents of every dollar raised by the System is never even lent to banks and thrifts, where it could be used for residential mortgage lending. Instead, the FHLBanks simply reinvest those funds in higher yielding securities in order to earn an arbitrage profit.

As I will explain, no valid public purpose, including the need for the System to pay obligations associated with the savings and loan debacle, can justify the System's current level of arbitrage profits. A look at the System's balance sheet makes clear that it is using these profits to attract and retain as System members those larger depository institutions that have no need for government-subsidized liquidity. In other words, the System is conducting government-subsidized arbitrage to attract -- through high dividends or low-cost overnight funding -- depository institutions that have ample access to other funding sources.

In sum, we believe that by limiting the System's debt issuance and through other reforms, Congress ought to focus the System on its public purpose. FHLBank advances have remained an important source of funds for residential housing finance, particularly for community banks and thrifts that hold mortgage loans in portfolio. The FHLBanks have also provided member institutions with a reliable source of funds, the ability to better manage interest rate risk, and the tools to stay competitive in the residential housing finance market.

In the 1990s, the System's Affordable Housing Program and Community Investment Program have expanded credit opportunities for lower-income communities. Moreover, at a time when FHLBank members, including small community banks, have ready access to the capital markets to fund standardized (or "cookie cutter") home mortgage loans, the System should increasingly focus its use of government subsidized advances on meeting more difficult affordable housing and targeted community development needs that are not being effectively met by other market participants. To that end, we support expansion of the AHP, easing membership rules for small institutions, and allowing advances to be used for targeted community development lending. We also support giving community development financial institutions that are ineligible for System membership access to advances as nonmember mortgagees on the same basis as state housing agencies. But for these ends to be served, the System needs to be reformed, and its arbitrage practices ended.

I would now like to describe (1) the extent of the System's investment arbitrage; (2) the reasons the System has offered for its arbitrage activity, and why those reasons are a departure from the System's public purpose; (3) the questionable statutory authority for these investments; and (4) what we believe should be done to stop this abuse of the System's government sponsorship. II. FHLBank Investments Are Not Necessary to Advance the System's Public Purpose

Since the early 1990s, the System has been increasingly borrowing funds in the capital markets and investing them in other marketable securities. As of June 30, 1998, the FHLBanks' investment portfolio stood at $143 billion, or 43 percent of the System's outstanding debt and 38 percent of the System's total assets. Two of the 12 FHLBanks had over 50 percent of their assets in investments, and 9 out of 12 had ratios of investments to total assets that exceeded the System's 38 percent average. Note what this means in practice: at some FHLBanks, fully half of the money raised at government-subsidized rates is never advanced to the System's member banks and thrifts. Note what else this means: other FHLBanks can attract and retain members by sticking primarily to advances, not arbitrage investments.

Mortgage-backed securities account for 35 percent and Federal funds (short-term loans between financial institutions) account for another 36 percent of total System investments. The FHLBanks' other investments include commercial paper, U.S. government and agency securities, and reverse repurchase agreements. These securities and marketable financial instruments trade in deep and liquid markets. In short, the System does not advance its public purpose by purchasing such securities.

In reviewing FHLBank investments, we have examined the arguments commonly presented to justify those investments, and find them unpersuasive. The three primary arguments are as follows: First, that investments are necessary to ensure that the FHLBanks have adequate liquidity. Second, that investments are necessary to produce income to pay System obligations associated with the savings and loan debacle. Third, that investments are necessary to generate dividends sufficient to keep members from leaving the System. A. The System's Government Sponsorship Gives the FHLBanks Immediate Access to Market Liquidity

The FHLBanks often argue that they need their large investment portfolios to maintain adequate liquidity -- i.e., to hold assets sufficiently marketable that they can easily be sold to meet unexpected demand for advances from members. The inherent characteristics of the System's government sponsorship and the sheer size of the System's debt issuance renders an argument based on liquidity difficult to understand.

Government sponsored enterprises (GSEs) by definition have ready access -- indeed, preferential access -- to capital markets and therefore do not need to hold liquid funds. In view of the System's government sponsorship, investors give preferential treatment to the FHLBank System's debt obligations. These obligations -- known as consolidated obligations because each FHLBank is jointly and severally liable for them -- carry a disclaimer stating that they are not guaranteed by, or otherwise an obligation of, the federal government. Yet the market prices for these securities, and the fact that the market does not require them to be rated by a national rating agency, suggest that investors believe the government implicitly guarantees these securities. This perception of an implicit guarantee -- growing out of the numerous ties between the FHLBank System and the federal government -- enables the System to borrow at near-Treasury rates, rates cheaper than those paid by even by AAA-rated private firms.

Another conceivable argument for the FHLBanks' investment portfolio is that the FHLBanks should be able to issue consolidated obligations to lock in favorable long-term interest rates, and then temporarily invest the proceeds until members borrow the money. Such a strategy, of course, may entail significant interest rate risk. However, such an approach does not appear to explain the System's investment activity. The System's issuance of consolidated obligations overwhelmingly consists of short-term discount notes, many with overnight maturities. In 1997, of the System's $2.1 trillion in debt issuance, over $1.5 trillion, or 73 percent, were overnight issues. This debt issuance pattern hardly seems consistent with locking in favorable long-term funding for members, and it further illustrates the System's ample access to market liquidity. And the pattern of daily borrowing underscores that the FHLBanks can remain liquid without such large investment portfolios. B. The FHLBank System's FIRREA Obligations Do Not Justify Maintaining a Large Investment Portfolio

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) brought about fundamental changes in the FHLBank System. In particular, FIRREA imposed two financial obligations on the System: (1) an obligation to make $300 million in annual interest payments on Resolution Funding Corporation (REFCorp) bonds, which were issued to help resolve the savings and loan debacle; and (2) the Affordable Housing Program, under which the System must contribute to affordable housing efforts the greater of 10 percent of its net income or $100 million.

The FHLBanks have used these financial obligations to justify building and maintaining large investment portfolios. Some FHLBanks have even referred to these financial obligations as the "System's financial mission." Although such an argument may have had some justification in the early 1990s -- shortly after Congress imposed these obligations -- no such justification exists today.

In the early 1990s, thrift institutions' demand for FHLBank advances fell dramatically as the government closed troubled thrifts and as a national recession led other thrifts to decrease their borrowing. Although many commercial banks joined the System after FIRREA, they had only limited demand for advances.

To meet the System's FIRREA obligations in the face of declining demand for advances -- the System's core product -- the FHLBanks sharply increased their investment portfolios. Changes made in the early 1990s to the FHLBanks' regulatory investment limits permitted this increase in investments. Previously, the FHLBanks could not issue more than $12 in consolidated obligations for each $1 of capital, and the FHLBanks' share of mortgage-backed securities could not exceed 50 percent of capital. The Federal Housing Finance Board (Finance Board) expanded the FHLBanks' investment authority by permitting the FHLBanks to have $20 in consolidated obligations for each $1 of capital, and increasing the FHLBanks' allowable share of mortgage-backed securities to 300 percent of capital.

The General Accounting Office (GAO) foresaw the risks of increasing investments to relieve the earnings pressure of the early 1990s. In 1993, the GAO warned that the FHLBanks would likely maintain their investment portfolios even after advance demand returned: At the present time, facing a fixed payment of $350 million (REFCorp and AHP) while experiencing a downward turn in advance demand and having lost most of their retained earnings to capitalize REFCorp, the FHLBanks have increased their investment portfolios to generate the needed income.... Still, allowing FHLBanks to increase their investment portfolios raises two concerns. First, running a large securities portfolio may conflict with the System's objective of providing liquidity to mortgage lenders if it distracts the System and [the Finance Board] from focusing on that objective. For example, FHLBanks may be reluctant to reduce their investment portfolios -- thereby forgoing the added income generated by having a large securities portfolio -- and return to their traditional mission when advance demand returns. Second, large investment portfolios may conflict with safety and soundness by adding interest rate and management and operations risk to a System that traditionally has operated relatively risk-free. By the mid-1990s, the turmoil faced by the FHLBank System had subsided, and the System's basic advance business rebounded. By the end of 1997, outstanding advances reached an all time high of $202 billion, representing a 153 percent increase since 1992. Yet the System's investment portfolio also increased 77 percent since 1992. This trend continued in 1997 as outstanding advances grew 25 percent and investments grew 12 percent.

Whatever the logic of temporarily increasing the FHLBanks' investments during the early 1990s, those circumstances are long past. And the System's steady rebound in membership and advance volume -- and the accompanying increase in earnings -- mean that the REFCorp and AHP obligations do not justify maintaining such a large investment portfolio.

We should also bear in mind that the Bush Administration proposed, and Congress enacted, the REFCorp obligation for a reason: to spread the cost of resolving the savings and loan debacle. Treasury Secretary Nicholas Brady made the point as follows: "The S&L industry will be a major beneficiary of restoring its own financial health. From the outset, the administration has stated that the S&L industry must, therefore, contribute its fair share before the Federal Government makes good on its pledge to protect insured depositors." The FIRREA obligations represent a Congressional decision to raise the rent charged in return for the System's government sponsorship. Congress presumably did not intend for the System to recoup the rent increase through government sponsored arbitrage. Note that Congress could, over time, have raised a similar amount of money by trimming other benefits of the System's government sponsorship, such as exemption from federal income taxes or securities registration.

I would note that we have consistently supported changing the REFCorp allocation formula to a percentage of income payment in the context of comprehensive FHLBank reform. Changing the REFCorp allocation formula should remove some of the perverse incentives to increase investments that have existed in the past.

The REFCorp obligation, even if restated as a percentage of income, does not justify the FHLBanks' investment arbitrage portfolio -- any more than a federal department or agency would be justified in sponsoring a mutual fund and using the income to replace money that Congress had chosen not to appropriate. C. Maintaining Dividend Rates Does Not Justify the FHLBanks' Investment Portfolio

The FHLBanks have argued that maintaining a dividend rate adequate to retain voluntary members is necessary for ensuring stability within the System. The general logic underlying this statement runs as follows. Since most System members are voluntary members, they may redeem their capital stock and leave the System upon six months notice. As profit-maximizing firms, they are said to be ready to leave the System if the return on their FHLBank stock falls below some market rate of return. Thus, the reasoning goes, since demand for advances falls short of a FHLBank's ability to earn the desired rate of return, the FHLBank should hold investments to fully leverage its capital and maximize returns to members. Besides helping to retain existing members, paying attractive dividends also helps the FHLBank attract new members.

This argument fails to reflect the true economics of System membership, and ignores the overall benefits of the System's government sponsorship, including its public mission. Consider how a private individual would evaluate a similar financing arrangement, if it were available. By making a small redeemable investment in an AAA-rated firm, the individual would receive: (1) above market returns on that investment; (2) access to a line of credit -- at almost any maturity -- at the lowest rate available; and (3) other services at no cost or discounted cost. This would be a substantial package of benefits. So in deciding whether or not to undertake the financing arrangement, the individual would evaluate all elements of the package, and not just the investment return.

If it is true that the FHLBanks' investments are needed to attract and retain members, then the System is operating just at the point where the benefits of membership equal the costs of membership -- so that members are likely to leave at any time. However, recent changes in System membership severely undermine this view. Between January 1, 1993, and December 31, 1997, only 25 FHLBank members withdrew from the System, while more than 3,000 commercial banks became System members.

In fact, System members hold some $2.3 billion in FHLBank stock beyond the minimum required by law. This fact suggests that System members find the current return on FHLBank stock attractive enough to hold extra amounts of it -- that is, as an investment, its return exceeds its opportunity cost. It also suggests that reducing excess capital would permit a significant reduction in money market investments without any reduction in dividend rates.

To illustrate this latter point, assume that the $2.3 billion in excess stock is fully leveraged into investments -- that is, that the FHLBanks borrow 20 times $2.3 billion, or $46 billion, and invest the proceeds. If the FHLBanks retired this excess stock and eliminated $46 billion in investments, they could keep their dividend rates unchanged. In fact, to the extent that the liquidated investments carry lower yields than advances, the dividend rate would actually increase despite the substantial reduction in total investments.

Most FHLBanks' stock pays dividends at rates exceeding the risk-adjusted return on member institutions' other assets. This is so even before accounting for the non-pecuniary value of System membership -- access to credit across the maturity spectrum and other non-dividend benefits of System membership that I will describe shortly. According to the Finance Board, between 1992 and 1997, members received dividends on their capital stock that averaged 157 basis points above the rate on a six-month consolidated obligation, with a range from 27 to 409 basis points. While members (as equity investors) take on greater risk than System debt holders, they also receive numerous additional benefits. In sum, earning dividend rates substantially above market rates for comparable investments while enjoying the benefits of System membership seems to be a very good deal for members -- and not one they would be eager to forego.

But most importantly, the dividend-maintenance argument rests on an erroneous premise: that maintaining or increasing the size of the System is, in itself, a worthy goal. On the contrary, we believe that the public interest lies in a smaller FHLBank System -- one focused on community banks and thrifts and residential (and potentially community development) lending. 1. Banks and thrifts have powerful incentives to become and remain members of the System -- if those institutions are doing the kind of activities the System is designed to encourage

First, the FHLBanks' public purpose is to extend credit to eligible members in order to finance housing. The essential benefit of System membership is access to credit: short-, intermediate-, and long-term. The System makes such credit readily available and instantly accessible, and generally charges lower interest rates than other available sources. The private sector offers no perfect substitute for a FHLBank line of credit, particularly at longer maturities.

Second, FHLBank System membership carries -- quite apart from access to credit across the maturity spectrum -- many non-dividend benefits. These benefits include: Credit features that aid in asset-liability management. Advances may have a variety of amortization and prepayment features designed to match the repayment of borrowing institutions' underlying mortgages. Advantages over deposit funding. Advances involve no reserve requirements, no deposit insurance premiums, and no withdrawal risk. And a member institution can take out more advances without increasing its other funding costs. System membership permits members to operate with fewer liquid assets. Because System members have ready access to liquidity from their FHLBank, they can hold fewer low-yielding liquid assets than they otherwise would -- and place more of their funds in higher-yielding loans and securities. Availability of other financial management products. The FHLBanks offer interest rate swaps, either directly or as an intermediary, and provide letters of credit to members. Ability to provide subsidized funding to borrowers through the Affordable Housing Program and Community Investment Program. Both programs help member institutions serve low- and moderate-income communities and increase returns on community development lending. Other FHLBank services useful to member institutions. The FHLBanks offer deposit programs (overnight and longer-term), securities safekeeping, cash management and settlement (i.e. wire transfer and lockbox processing), and various advisory services. 2. System practices indicate that System membership provides very attractive economic returns

As noted above, the FHLBanks pay high and varying dividend rates to their members. The differences in dividend rates across the FHLBanks largely reflect different choices about how to allocate the benefits of membership, and suggest that dividends are not determinative in whether the FHLBanks retain members. As the Finance Board's staff paper on investments pointed out, "One of the Banks that has paid one of the lowest dividends in the System has been very successful at attracting new members."

Each FHLBank is cooperatively owned by its members. Thus its has two ways to pass along to its members the federal subsidies inherent in the System's government sponsorship: first, in the pricing of the products it offers; and second, through the dividends it pays from its net earnings. The principal benefit of the System's government sponsorship is ready access to capital market funding at rates lower than those paid by even the most creditworthy private borrowers. When a FHLBank advances those funds to a member, it may pass through this benefit by charging a low rate on advances. Alternatively, it may charge a market rate for advances and then distribute the excess spread earned to all its members through the dividend paid on its stock.

Of course, there are countless intermediate points along the continuum between conveying benefits purely through low prices and conveying benefits purely through dividends. The variability in FHLBank dividend rates -- from 27 to 409 basis points above the rate on a six-month consolidated obligation -- partly reflects different FHLBanks' decisions along this continuum. The wide variance in FHLBank dividend rates across the FHLBanks -- even though all 12 FHLBanks have the same cost of funds, the same capital structure, and the same basic business -- also suggests that System members' decision to remain members is driven by more than dividends.

Thus, although the FHLBanks emphasize the need to have investments that generate earnings from which they can pay high dividends in order to maintain a stable membership base, the economics of System membership suggest otherwise: the total returns on System membership far exceed the dividends paid on FHLBank stock. And that all-inclusive return -- dividends plus the other benefits of System membership -- must be compared to the cost of obtaining comparable credit lines and other services from fully private institutions. III. FHLBank Powers, the FHLBank Act, and the Finance Board

We believe that the FHLBanks' large investment portfolios violates the spirit and arguably the letter of the FHLBank Act.

In exchange for the benefits of government sponsorship, the FHLBank Act limits the FHLBanks to making advances, operating targeted lending programs, and such other activities as are incidental to making advances -- such as accepting deposits and processing payments. The FHLBank Act explicitly prohibits the FHLBanks from engaging in general banking activities. The FHLBank Act also strictly limits both the scope and amount of the FHLBanks' investments.

Three provisions in the FHLBank Act deal directly with investments. Section 11(g) requires the FHLBanks to invest members' deposits in certain advances with maturities not exceeding five years or in a limited set of securities. Section 16(a) requires the FHLBanks to invest their reserves -- that is, their retained earnings -- in a slightly broader class of acceptable securities. Section 11(h) provides the general statutory basis for all other investments: Such part of the assets of each Federal Home Loan Bank (except reserves and amounts provided for in subsection (g) of this section) as are not required for advances to members, may be invested, to such extent as the bank may deem desirable and subject to such regulations, restrictions, and limitations as may be prescribed by the Board . . . . The statute thus permits the FHLBanks to hold investments for such purposes as meeting their cash management needs and managing changes in members' demand for advances. As wholesale banks, the FHLBanks need to hold such investments. For example, prepaid advances may create "assets . . . not required for advances." Likewise, a FHLBank cannot perfectly match the amount raised from consolidated obligations with the amount requested by members seeking advances. Thus the statute rightly permits the FHLBanks to invest money not currently needed for advances.

The statutory language makes clear, however, that Congress contemplated that any such investment activity would be incidental to making advances -- used only when funds are not needed to make advances. Specifically, the statute does not support the FHLBanks' current practice of artificially creating "assets . . . not required for advances." By directing their Office of Finance to raise funds that they never intend to advance to members, the FHLBanks violate at least the spirit of section 11(h). The Finance Board has facilitated this practice by giving the Office of Finance virtually unlimited debt issuance authority.

The FHLBanks' current investment levels go far beyond the incidental investment authority granted in section 11(h). As of June 1998, the FHLBanks had $329 billion in consolidated obligations outstanding, which financed $227 billion in advance demand. No fair reading of section 11(h) could conclude that the remaining $102 billion of investments is the incidental difference between FHLBanks' funding sources on the one hand, and their members' borrowing requests on the other.

Furthermore, since section 11(e)(1) prohibits activities not incidental to the FHLBanks' enumerated powers, such investments are prohibited even if they arguably further the purpose of the FHLBank Act. Congress has not authorized the FHLBanks or the Finance Board to expand System investments for any purpose beyond the three powers specified in the Act: deposit liquidity, reserves, and surplus assets. IV. FHLBank Investments Should Be Limited by Legislation and Regulation

In our view, the only effective way to limit FHLBank investments is through objective limits on the amount of those investments. Subjective limits -- that is, allowing any investment that serves certain enumerated purposes, with monitoring by the Finance Board -- are in our opinion doomed to failure. The System currently operates under a subjective standard that is quite narrow -- allowing investment only of such funds "as are not required for advances to members" -- yet that standard yields over $140 billion in investments. If Congress were to require, for example, that such investments had to be for housing purposes, then the System would simply contend that they were. Nothing would change.

Thus we would propose that, as a general principle, the FHLBanks' consolidated obligations should not exceed their advances. This would limit a FHLBank's investments to its capital plus its member deposits. Such a limit would still permit the FHLBanks to hold a considerable investment portfolio. As of June 30, 1998, it would have allowed an investment portfolio of $42 billion, representing over 10 percent of the System's $379 billion in total assets (which now includes $143 billion in investments). If this proposal were fully implemented and the System reduced its investments from $143 billion to $42 billion, based on the System's $227 billion in outstanding advances as of June 30, 1998, the System would still have over 15 percent of its total assets in investments.

The overall investment limitation described here should include investments in mortgage-backed securities. The FHLBanks' holdings of mortgage-backed securities averaged $47 billion in 1997. While these securities make up a significant portion of the System's balance sheet, they are a small portion of the over $1.7 trillion in outstanding government-related mortgage-backed securities. Gradually removing the FHLBanks from this large, liquid, highly efficient market should have no effect on the pricing and availability of housing credit. The System adds no value to the operation of the mortgage-backed securities market and was not intended to do so.

Limiting consolidated obligations to advances outstanding would effectively limit System investments to an appropriate level. Such an investment restriction would have the added benefit of focusing the FHLBanks on their primary mission of making advances, which should benefit small banks and communities. We recognize that a specific set of rules implementing this principle would need sufficient flexibility to account for two factors.

First, there may be slight differences in timing and dollar amounts between the issuance of consolidated obligations and the making of advances. To a large extent, the investment authority implicit in the rule we are suggesting -- that investments could equal FHLBanks' capital plus member deposits -- should be sufficient to deal with these differences. More importantly, perhaps, members may prepay their advances, albeit with prepayment penalties for almost all but the shortest-term advances. The FHLBanks should have authority to invest prepaid advances. However, care should be taken so that prepaying advances does not become a loophole for expanding a FHLBank's investment authority.

Second, there may be rare occasions when added investments may be needed for safety and soundness or other business reasons. For these occasions, the Finance Board has, and should exercise, its authority to permit temporary and limited increases in a FHLBank's investments. V. Conclusion

Mr. Chairman, I look forward to continuing to work on these issues with you and other members of the Subcommittee.

I would be pleased to answer any questions.