THE FEDERAL HOME LOAN BANKS AND RISK DISTRIBUTION IN U.S. HOUSING FINANCE ALEX J. POLLOCK March 11,

2 OUTLINE I. Overview of the Federal Home Loan Banks I. Risk Distribution Perspective I. Historical Development of the FHLBs I. Postulates of Housing Finance

3 ESSENCE OF FHLBs FHLBs efficiently link long-term residential mortgages with the bond markets.

4 FEDERAL HOME LOAN BANKS Overview AAA/Aaa rated government-sponsored enterprise (GSE) created by Congress to provide economical housing finance. FHLB debt raised in the global capital markets provides financing for 7,900 member financial institutions. Over 75% of U.S. banks and thrifts are members. Each FHLB has own board and management. 70 years of profitability. No losses on advances to members.

5 FHLBs HAVE SIGNIFICANT SIZE U.S. Banking Companies & Housing GSEs As of 12/31/02, in Billions Rank OrganizationAssets 1 Citigroup$1,097 2 Fannie Mae $887 Federal Home Loan Banks $766 3 Federal Home Loan Banks $ J.P Morgan Chase $759 5Freddie Mac $722 5 Freddie Mac $722 6 Bank of America $660 7 Wells Fargo $349 8 Wachovia $342 9 Bank One $ Washington Mutual $ MetLife $268* 12 Taunus $254* Source: Bloomberg Professional, National Information Center (Federal Reserve System), FHLB 2nd Quarter 2002 Financial report ; *3Q 2002 Financial Information

6 Advances $489,598 Mortgage loans 60,553 Investments 215,723 TOTAL ASSETS $765,874 Bonds and discount notes 674,841 Deposits 27,679 TOTAL LIABILITIES $729,570 Capital stock 35,188 Retained earnings 1,191 TOTAL CAPITAL $36,304 FHLBs COMBINED BALANCE SHEET As of 12/31/02, in millions

7 FHLB MEMBERSHIP As of Sept. 30, 2002 % of Industry Banks 5,873 74% Thrifts1,408 95% Ins. Cos. / CUs 711 TOTAL7,992

8 THE FUNDAMENTAL RISK DISTRIBUTION PERSPECTIVE Who has which risk? Who should have which risk? Mortgage Finance Systems = Different patterns of risk distribution

9 CREDIT RISK

10 CREDIT QUALITY AND GEOGRAPHIC CONCENTRATION Distribution of One-Year Net Charge-Off Ratios FHLB Chicago Thrift Members by Institution Mean + 3SD: 39.9 bp (98.2% of Distr) Mean: 2.8 bp (81.3% of Distr)

11 INTEREST RATE RISK AND PREPAYMENT RISK

12 WHO HAS THE INTEREST RATE / PREPAYMENT RISK? Variable Rate Mortgages Mark-to-Market Prepayment Fees Bond-Based Systems Pass-Through MBS GSE Balance Sheets Deposit Insurance Borrower Capital Market Participants Government Support } } }

13 STRUCTURAL MODELS FOR PROVISION OF HOUSING FINANCE Banking Model –Deposit financed, portfolio lenders European Mortgage Model –Bond financed, specialized portfolio lenders Contract Savings Model –Deposit financed, specialized institutions offering loan-linked savings contracts Secondary Market Model –Bond financed, securitizing loans from primary lenders

14 STRENGTHS OF EUROPEAN MORTGAGE BANK SYSTEM Specialized Institutions Viewed as Lower Risk –More transparent –Separate and specialized regulatory focus Focus on Pure Mortgage Finance Ability to tap Capital Market Funding –Source for longer term fixed rate funds Tested Model –200 years in Denmark, 100 years in Germany, 70 years in the U.S.

15 FHLBs LINK MEMBER LENDERS TO THE GLOBAL BOND MARKETS The U.S. mortgage finance system must distribute the risks inherent in long-term, fixed-rate mortgages. Private credit institutions require an efficient link to the bond markets in order to prudently make long-term fixed-rate mortgages. The Federal Home Loan Banks are such an effective link for member lenders.

16 AMERICAN HOMEOWNERSHIP RATES % % % % %

17 HOMEOWNERSHIP RATES INTERNATIONAL PERSPECTIVE Ireland80% Spain78% Italy78% Norway76% Luxembourg72% New Zealand71% Australia70% U.S. 67.7% U.K.67% Finland67% Belgium65% Canada64% Source: International Housing Finance Sourcebook (International Union for Housing Finance, 2001)

18 FEDERAL HOME LOAN BANKS 1932  2002

19 FHLB OWNERSHIP 1932: U.S. Treasury purchases initial capital 1933 – 1951:Transition to private ownership 1951 – Present: 100% private ownership by member institutions

20 FHLB MEMBERSHIP 1932 – 1933:Voluntary 1933 – 1989:Primarily Mandatory 1989 – 1999: Federal Thrifts – Mandatory All Others – Voluntary 1999 – Present:Entirely Voluntary

21 FHLB GOVERNANCE Mixed Boards of Directors 1932 Present Stockholder majority 9 10 Gov’t appointed minority Chairmen of FHLB Boards : Appointed by government 2000-Present: Elected by Board of Directors

22 FHLB GOVERNANCE Government oversight of the FHLBs has changed : Federal Home Loan Bank Board Manager / Regulator / Cheerleader of FHLBs and thrift industry : Federal Housing Finance Board Manager / Regulator / Cheerleader of only FHLBs 1999-Present: Federal Housing Finance Board Regulator of FHLBs

23 TRADITIONAL FHLB PRODUCTS Loans (advances) -- fully collateralized, low-cost, short and long-term, fixed and floating-rate Affordable housing and community development funding (AHP and CIP) Deposits Off balance sheet / risk management products (Letters of credit, interest rate swaps, caps, floors) Operating services

24 MORTGAGE PARTNERSHIP FINANCE ® A new line of business for the FHLBs An alternative for financial institutions to fund fixed-rate, conventional mortgages. Creates a partnership between the FHLB and its members to manage the risks of mortgages –Each handles what it does best Adds needed competition to secondary market –FHLB members and their customers benefit –Credit risk is dispersed, not concentrated in GSEs

25 MPF ® : A BETTER METHOD OF FUNDING HOME MORTGAGE LOANS Management of credit risk is not the problem. Financial institutions should be rewarded for creating high-quality loans. Financial institutions should receive fees for managing the credit risks of the loans they originate, rather than paying GSEs to manage those risks.

26 MPF ® KEY CONCEPT: MORTGAGES ARE BUNDLES OF RISKS Marketing Risk Credit Risk Servicing/Operations Risk Funding Risk Interest Rate Risk Options/Prepayment Risk } Natural Competitive Advantage Financial Institution } GSE

27 EVOLUTION OF RISK DISTRIBUTION Traditional Lending Lender Allocation by Mortgage Program Interest Rate and Options Risk Credit Risk Secondary Market GSE MPF Program FHLB Lender

28 BASIC POSTULATES OF HOUSING FINANCE Homeownership is important for every society, as it promotes individual progress and social stability. A robust mortgage financing system is needed to achieve widespread homeownership. Robust mortgage finance requires private credit institutions, with market incentives to balance risk and return, innovate, allocate resources and increase productivity. For lenders to offer long-term fixed-rate mortgages, an effective link to the bond markets is required.

29 “As a people we need at all times the encouragement of home ownership.” -- President Herbert Hoover, proposing the Federal Home Loan Bank Act in 1932

30 THE FEDERAL HOME LOAN BANKS AND RISK DISTRIBUTION IN U.S. HOUSING FINANCE ALEX J. POLLOCK March 11,