With credit tightening in 2007, the Federal Home Loan Banks played a crucial role in the economy, helping Countywide Financial Corp. and failed subprime lenders IndyMac Bancorp. and Washington Mutual stay alive longer by lending them money when no one else would. The sharp expansion lending, which went mostly unnoticed at the time, was one of many emergency measures used by the government and the private sector to keep the financial system from collapsing.
But the banks also heavily marketed and sold risky mortgages called Option ARMs that let borrowers choose the amount of their monthly payments — loans that now are facing rising defaults and are expected to cause more losses for lenders and investors, even well into 2011, as the loans reset to much higher payments.
The sinking Option ARMs market shows how actions taken during the height of the credit crunch by lesser-known institutions like the Federal Home Loan Banks still have troubling consequences. A banking system that can borrow money cheaply because of its implicit government backing put failing lenders that sold high-risk mortgages on artificial life support, lending out billions of dollars in a short period of time. The huge loans even drew the ire of Sheila Bair, chairman of the Federal Deposit Insurance Corp. Yet the banks’ actions mostly flew under the radar.
The hard lesson of taxpayer money spent under the Troubled Assets Relief Program has been the need for accountability and openness. Looming foreclosures and defaults for Option ARMs show that other kinds of lending that went on in the thick of the credit crisis also needs to be reviewed — especially as the government moves forward with yet another financial rescue plan.
“People should be looking at this, including Congress,” said Peter Wallison, an American Enterprise Institute fellow who studies financial deregulation and a former general counsel for the Treasury Department. “It’s a very serious problem. The home loan banks kept the Countrywides and the IndyMacs in business. And they were the lenders who were the source of some of the problems we’re having now. Of course taxpayer dollars are at risk.”
In Countrywide’s case, the lender turned to the Atlanta Federal Home Loan Bank for a total $51.5 billion in loans to keep itself afloat as credit dried up elsewhere. Countrywide put up $62.4 billion worth of mortgages as collateral — or nearly 80 percent of the company’s total mortgage holdings — just as the once high-flying lender was in a downward spiral. Borrowers were defaulting in droves. Lending practices came under fire as predatory and reckless. A worsening credit crisis cut off the company’s ability to borrow money.
Some 81 percent of those pay-option mortgages — although listed as “prime” loans — required little or no documentation of the borrower’s income or assets. And 81 percent of borrowers chose to make less than the full payment on their loans. Countrywide noted that “our borrowers’ ability to defer payment…may expose us to increased credit risk.” And it did; the percentage of loans 90 days or late increased from 5.3 percent in 2007 to 12.4 percent by June 2008, the lender reported.
Sen. Charles Schumer, D-N.Y., complained in November 2007 that Countrywide had been pledging a significant chunk of Option Arms as collateral for its home loan bank advances, and denounced the practice as risky. Countrywide teetered on collapse and eventually was bought by Bank of America in January of last year. Bank of America has already received $45 billion in taxpayer help, dragged down by Countrywide’s losses on its Option ARMs and other loans. And the bulk of Countrywide’s Option ARMs won’t even reset until 2011, guaranteeing more pain to come.
Countrywide wasn’t alone in getting assistance from a Federal Home Loan Bank.
IndyMac bank used more than $10 billion in advances from the San Francisco bank, specifically to continue making Option Arms, even as investors stopped buying those kinds of mortgages, said banking analyst Bert Ely, who has studied the IndyMac situation. The bank failed in July, costing the federal insurance fund some $9 billion. And fully one-third of its liabilities were the advances from the San Francisco FHLB. Washington Mutual, which was seized by the government in September, in the largest bank failure in American history, borrowed $31 billion from the San Francisco home loan bank in mid 2007.
In hindsight, Ely said it’s clear the lending only helped IndyMac continue to make more bad loans that made its failure even more costly. None of the banks had any business keeping afloat lenders that generated the kind of mortgages that led to the housing crisis, he said. The banks, he noted, should have asked themselves at some point why they were the only institutions willing to lend to firms like Countywide.
But regulators actually shoulder most of the blame, Ely said.
“Where were the regulators? Where was the Office of Thrift Supervision and the Federal Deposit Insurance Corp.?” Ely asked. “Why did regulators let IndyMac keep making those kind of loans?”
The popular financial newsletter The Institutional Risk Analyst summed it up this way last month, in calling for Congress to look into the federal home loan banks:
“Most of the failed banks resolved by the FDIC during 2008 have been excessive users of FHLB advances…Remember, it was the availability of the FHLB advances as funding source which allowed the management of IndyMac to grow the bank’s size beyond that supported by its natural deposit base… Like WaMu and Countrywide, but even to a larger degree, IndyMac leveraged government funding via the FHLBs with unsafe and unsound lending practices — and all with the full approval of federal regulators!
Controversy is something new for the 12 once-obscure regional banks, which serve as an important source of low-cost mortgage money to 8,000 members, including banks, thrifts and credit unions. In January, a Moody’s Investor’s Services report concluded that in a worst-case scenario, eight of the banks could run low on cash due to potential losses on investments in toxic mortgage backed securities. The government could be required to put some of the banks in conservatorship or to provide financial help, Moody’s said.
The banks blame accounting rules for their troubles and maintain their system is safe. They say don’t put taxpayer money at risk — the banks never have experienced a credit loss on an advance, and they are first in line to be repaid if a member fails. In extending a lifeline to Countrywide, IndyMac, and others, the banks were fulfilling the mission the government created them for in the 1932, which is to provide liquidity to their members.
“In the most difficult of financial circumstances in any of our lifetimes, we did exactly what we were supposed to do and what we were created to do,” said Atlanta Federal Home Loan Bank spokesman Chris McEntee.
Josh Rosner, an analyst at the Graham Fisher investment research firm in New York, agreed. “They were just doing their job,” he said.
The banks’ financial problems have been overblown, and they don’t pose any imminent risk to the financial system, Rosner added. But, he said, that doesn’t mean Congress shouldn’t be asking larger questions, such as defining the purposes of the banks and questioning whether there are too many of them.
John von Seggern, president of the Federal Home Loan Bank Council, which represents the banks, described the federal home loan bank system as “very safe and sound,” and said much of the controversy over the banks stems from misunderstandings about how the banks operate. All the banks require significant amounts of top quality collateral for advances, he said. But the banks, in doing the job they were created to do, can’t simply pick and choose arbitrarily which members to lend to, and they have no say in how members use their advances.
“We don’t control the money once they get it,” he said.
McEntee, the Atlanta bank spokesman, said he couldn’t comment on advances made to individual members, or on the type of collateral used for them. But, he said, the Atlanta bank has a longstanding policy of accepting only prime mortgages, with high credit scores, to back loans. In addition, mortgages used as collateral that become delinquent have to be swapped out for performing loans, or the member has to pay back some of its advances. “We have very high standards,” he said.
Until recently, the banks’ regulator was the Federal Housing Finance Board, created in the wake of the savings and loan crisis of the late 1980s — and staffed with some previous regulators of the failed S&Ls. In July, the home loan banks and mortgage giants Fannie and Freddie were put under a new regulator, the Federal Housing Finance Agency. A representative of the agency did not respond to a request for comment.
Both Wallison and Ely say that that even with a new regulator, the federal home loan banks need to be examined. But they’re not counting on it. Lawmakers would have to take some responsibility for what the banks did, because of their government charter. It’s much more convenient for Congress to take fire at abuses by private banks that misspent TARP money.
“Congress doesn’t like to look in the mirror,” Ely said.
The controversy over the collateral stems in part from the changing nature of Option ARMs, said Guy Cecala, publisher of Inside Mortgage Finance, which covers the subprime industry. Option ARMs once had been considered prime mortgages, a niche product for borrowers with fluctuating incomes, such as physicians with student loan debt but high earning potential. The loans allowed a borrower the flexibility to make a partial payment occasionally.
Option ARMs were sold for years by the former World Savings bank, which regularly used them for collateral for San Francisco home loan bank advances, with no problems and no questions raised about the practice, Cecala said.
But during the subprime boom, Countrywide led the industry in “cannibalizing” the loans, marketing them en masse and selling them with the idea that borrowers could consistently pay any amount they chose. The loans wouldn’t reset to higher payments until their third year or so. But during that time, the loan balance still grew, meaning borrowers would face monthly payments as much as $1,000 higher when the loans reset. With house prices falling, they can’t refinance out of them. Countrywide also required little or no documentation, making the loans much easier to get than in the past.
Richard Baker, a former Republican congressman from Louisiana who has long been concerned about government-sponsored entities such as the home loan banks, said the Atlanta bank’s advances continue to bother him. The Atlanta bank can’t justify having made such a huge advance to one member. And, “no one can say with a straight face” that no-documentation mortgages should be considered prime loans or safe collateral, regardless of high credit scores, he added.
Baker said he particularly was concerned that Countrywide loans from the Atlanta bank constituted 37 percent of bank’s outstanding advances at the time. The accepted standard is that no more than 20 percent of advances should go to one member, he said.
“Those kinds of numbers don’t add up,” he said.
But Countrywide was a successful subprime lender, the nation’s largest, and making a lot of money. The situation was similar to that of Bernie Madoff and his investment schemes, Baker said. No one wanted to ask questions, with the profits rolling in.
During the mortgage lending boom, the banks’ conservative lending standards left them competing for members, in the same way regulators like the Office of Thrift Supervision sought out banks to regulate, Cecala said. The only controversies over the banks during the boom was whether they were necessary.
While some critics, like Rosner, think there are too many of the banks, Cecala noted the banks’ membership of mostly mom and pop community banks, with strong political connections, protects them. No one’s predicting they’ll be the major focus of any financial regulatory overhaul — despite their major role in the credit crisis. But as a new administration moves ahead with a new rescue plan, and as Option ARM defaults mount, the Federal Home Loan Banks remain a cautionary tale, a warning about emergency measures taken with little oversight that have lasting consequences.