Viewpoint: Liquidity Aid Via the Home Loan Banks

Article excerpt

The debt markets are in turmoil. Mortgage availability, especially for large loans, is tight. This has become a significant factor in the dramatic slowdown in home sales and the nationwide decline in home values.

Some fear that the entire economy will suffer as orders for furniture, appliances, and other household goods diminish and consumers become more reluctant to make discretionary purchases.

These problems were triggered by concerns about the credit quality of subprime mortgages. The credit markets became reluctant to purchase mortgage-backed securities and, eventually, other debt issued by companies that could have subprime exposure. The market's reaction transformed a subprime mortgage problem into a liquidity crisis affecting a wide range of assets, including higher-quality mortgages.

Through my experience as counsel to the Council of Federal Home Loan Banks, I came to understand that liquidity is crucial for mortgage finance.

Most home loans are for 15 or 30 years, sometimes longer. Lenders must provide the entire amount of the loan at the time of closing but are repaid only a bit at a time over the course of the loan. Obviously, the ability to make loans will diminish quickly if there is no way to replenish the coffers sooner. Mortgage lenders needs to raise additional funds quickly, and at a low cost, to continue making home loans and earn a profit.

There are several ways to accomplish this goal. One method is securitization. The lender sells the mortgage to a third party, who creates a trust to hold that mortgage and thousands of others in a pool that supports bonds or other debt, the so-called mortgage-backed securities. The monthly mortgage payments are received by the trust, which pays the bondholders according to the terms of their notes.

The bondholders thus provide funds to the lender, allowing it to make additional mortgages to consumers.

The main reason for the current liquidity crunch is that investors have become reluctant to purchase mortgage-backed securities.

However, there is another source of liquidity that can play a critical role in restoring the smooth functioning of our mortgage markets without exposing the government to additional risk. That source is the Federal Home Loan Bank System.

The system was created in 1932 as a response to the crisis in mortgage finance during the Great Depression. Over 1,700 thrifts had failed, and the need for liquidity in the mortgage market was acute. The legislation established 12 Federal Home Loan banks in districts throughout the United States for the purpose of providing funds primarily to savings and loan associations. The funds were provided to lenders through loans, or "advances," secured by mortgages.

In 1989 commercial banks and credit unions that engage in a significant mortgage lending became eligible for membership in the Home Loan banks. More recently, in 1999 the banks were authorized to make advances to "community lenders" collateralized by small-business and agricultural loans. All members of the Home Loan banks are highly regulated financial institutions.

Each Home Loan bank is a privately owned cooperative responsible for system debt. The stock of each bank is not publicly traded, but instead is held exclusively by member institutions. Members elect a majority of each bank's directors, and its regulator, the Federal Housing Finance Board, appoints a minority.

A portion of the profits earned from a Home Loan bank's activities is returned to members in the form of dividends. …