Editor's Pick: The Effective Nationalization of the U.S. Mortgage Market in Q3 07

What is really going on here? Where does FHLB get its funds? Would the editors please comment on these charts with lines exploding through the top or falling through the bottom?

The BNP Paribas piece by Richard Iley provides in fact all the background information (p4): "So what explains the mysterious ‘other loans and advances’ category that sky-rocketed to USD 746.2bn or 5.3% of GDP? This is how the Flow of Funds classifies advances a.k.a. loans made by the Federal Home Loan Bank (FHLB); the so-called third GSE. Typically neglected, this ‘other’ GSE has understandably shot to prominence given the unprecedented explosion in its activities during the credit crunch. The FHLB is actually a system of twelve regional, government-chartered but cooperative, i.e. member-owned, enterprises that work to increase liquidity in the mortgage market. The FHLB system was created by Herbert Hoover in 1932 in the teeth of the Great Depression to stimulate mortgage lending by thrift institutions. Membership of the FHLB system was broadened in 1989 to include other players in the mortgage origination business i.e. commercial banks. The FHLB system now has over 8000 members, ranging from the economy’s biggest commercial banks to the smallest thrift. How the FHLB works is very simple. It simply borrows in the bond market (both long – bond issuance – and short term – so-called discount notes) at below-market rates thanks to its government charter (although, like Fannie and Freddie, the FHLB is not de jure government guaranteed, markets assume that the GSEs de facto are) and then lends (‘advances’) these funds to mortgage originators. In turn, the mortgage loans the FHLB finances are used to collateralise its advances. Importantly, FHLB advances are typically heavily collateralised – the market value of mortgage collateral often covers 125-150% of the advance. Moreover, the FHLB also has priority claim to other assets of the borrowing institution in the event of failure and were the pledged mortgage collateral to prove insufficient. This is both a strength and weakness of the FHLB system. On the plus side, over-collateralisation and its senior claim status mean that the FHLB has an unblemished record in terms of recovering advances. On the negative side, the FHLB can reasonably be regarded as a key source of moral hazard in the mortgage finance system. As its advances are essentially free of credit risk, it has little or no vested interest in withdrawing funding or imposing more punitive loan conditions when the credit or default risk of borrowing institutions rises. In turn, the knowledge that there is a forgiving guardian angel hovering over the mortgage market may have increased lenders’ willingness to take excessive risk. Did somebody say ‘subprime’? In short, the FHLB would seem to violate Bagehot’s maxim that the lender of last resort should not always be taken for granted and should always lend at a penalty rate. However, it is clear that the FHLB performed its role as lender of last resort to mortgage lenders as the credit crunch intensified. The FHLB acted as a forgiving lender of last resort providing the liquidity to sustain mortgage production while Fannie and Freddie acted as risk intermediators of the last resort with record purchases of mortgages. By definition, however, the entire mortgage pipeline from origination to securitisation was skewed much more heavily towards conforming loans. continued borrowings by the GSEs on the totally unprecedented scale of around 15% of GDP seen in Q3 is wholly unsustainable for a number of reasons. First, while there is, of course, no explicit government guarantee of these agencies, in reality there probably is one. The FHLB system cannot continue to grow its assets at a 25% annualised or 5% of GDP pace without the risk of a sudden loss of confidence in one or several of its banks rising sharply and so leaving the taxpayer unacceptably exposed. The increasing concentration of the FHLB’s assets only adds to these risks. Furthermore, a long-established concern given its relative intolerance to credit risk and its seniority in bankruptcy claims, is that a too rapid expansion of the FHLB’s assets risks undermining the deposit insurance system. As discussed above, when a FHLB member bank fails, the FHLB is first in line for repayment before even the FDIC. As a result, the less the FHLB loses, the more FDIC does. When the FHLB’s exposure to one or two institutions rises very rapidly as it has done since the summer, this is a real concern. The Federal Reserve’s continued expansion of the discount window via the Term Auction Facility (TAF) will have reduced the pressure on FHLB finance. Indeed, the introduction of the TAF may, to some extent, have reflected tacit recognition that the FHLB’s ability to act as lender of last resort for the mortgage market has reached its natural limits."

here's the link again: http://www.rgemonitor.com/redir.php?clid=8328&sid=1&tgid=10000&cid=237219

Thank you for that quote from the BNP Paribas piece. The link doesn't work for me -- something about being already logged in on a different computer! I'm not, actually, as far as I know, but it's not important.

While I am definitely less knowledgeable in economics than all of the people posting here, I cannot help from asking myself - out loudly - two things: - Why nationalization? Both FHLB, and the other GSEs are - and by that count, the FED as well - privately owned albeit federally chartered... - Isn't that an attempt to sweep it all under the rug, with the rug being the US Govt name lending? And by that I mean, aren't the private shareholders of the GSEs using the federal charter as a trump to borrow cheaply (and tap sources otherwise out of their reach) to get themselves out of trouble? Otherwise said, yes the GSE's are a LOLR, but is it normal that there would be at least a circuit breaker between the ones causing the troubles and the ones bailing them out? Maybe I'm missing something... I wonder how big that rug must be and what could happen to it if it's overstretched.