The Federal Home Loan Banks are part of a system created by the federal government to promote home ownership. This Commentary looks at new initiatives undertaken by these government-sponsored enterprises to expand their role in financial markets-and the attendant implications for their balance sheets.Federal home loan banks ; Mortgages ; Housing - Finance

Daniel K. Maloney

James B. Thomson

English

Research Papers in Economics

perceived implicit government backing of
their liabilities. Therefore, the continuing
evolution of FHLB activities merits peri-
odic review. 
n  Providing Liquidity to
Mortgage Lenders
The FHLBs were established as a liquid-
ity facility for the housing finance indus-
try. Initially, they operated as deposit-
replacement facilities, making advances
to thrifts and other FHLB member insti-
tutions. Thrifts would use FHLB
advances to insulate their mortgage lend-
ing activities from shifts in loan demand
and deposit flows. Through time, these
housing lenders began to use FHLB
advances as a routine source of funding
for their mortgage assets. 
For the better part of six decades, mem-
bership in the FHLBs was limited to
institutions specializing in housing
finance—largely savings associations.
The Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
opened up membership in the FHLBs to
commercial banks. Starting from zero at
the beginning of 1990, commercial bank
membership has grown to 5,886 institu-
tions (73 percent of all FHLB members)
as of December 31, 2002.
June 2003
Federal Reserve Bank of Cleveland
The Evolving Role of the Federal Home Loan
Banks in Mortgage Markets
by Daniel K. Maloney and James B. Thomson
ISSN 0428-1276
The Federal Home Loan Banks are
part of a system created by the fed-
eral government to promote home
ownership. This Commentary looks at
new initiatives undertaken by these
government-sponsored enterprises to
expand their role in financial markets
and the attendant implications for
their balance sheets.
The 1929–33 contraction had far reach-
ing effects in many directions, no least
on monetary institutions and academic
and popular thinking about the role of
monetary factors in the economy. A
number of special monetary institutions
were established in the course of the
contraction, notably the Reconstruction
Finance Corporation and the Federal
Home Loan Banks, …
—Friedman and Schwartz (1963)
Created by 1932 legislation, the Fed-
eral Home Loan Bank System is part of
the federal infrastructure for promoting
home ownership in the United States.
For much of its history, the System’s 12
Federal Home Loan Banks (FHLBs)
have fulfilled their mission by providing
liquidity to the housing finance industry,
primarily the nation’s savings and loans
and savings banks. More recently, they
have assisted commercial banks as well.
The FHLBs increase the liquidity of
mortgage markets by making advances
(loans) to member institutions, which
use the advances to make new mortgage
loans. Advances are secured against the
members’mortgage-related assets. 
The 1980s thrift debacle resulted in 
legislation that completely overhauled the
federal regulatory system for savings and
loans and the Federal Home Loan Bank
System. The System underwent major
restructuring, but the fundamental mission
of the FHLBs remained housing finance.
While the mission of the FHLBs has not
changed, their activities have expanded
in a number of important ways. Over the
past decade, the FHLBs substantially
increased the size of their investment
portfolios, including their holdings of
mortgage-backed securities. In 1999, the
FHLBs’lending authority was extended
by the Gramm-Leach-Bliley Act to
include the loans secured by small 
business and agricultural credits of com-
munity depository institutions (currently
defined as depository institutions with
$538 million or less in total assets). 
To date, lending activity under this 
new authority has been trivial—only
$8.4 billion of advances (1.72 percent of
total advances) secured by small busi-
ness and agricultural loans were out-
standing on December 31, 2002. 
From the perspective of its traditional
housing finance mandate, the FHLB
System undertook a major new initiative
in 1997: the direct holding of mortgage
loans. Through purchases of mortgage
loans from FHLB System member insti-
tutions, the FHLBs join the ranks of the
two other government-sponsored enter-
prises that have a mission to promote
home ownership—the Federal National
Mortgage Association and the Federal
Home Loan Mortgage Corporation—
in promoting the secondary market for
mortgages. The evolution of FHLB
mortgage activities took another impor-
tant turn recently as the FHLB of
Chicago recently received permission 
to operate a new program in which 
mortgage assets purchased from FHLB 
members are securitized.
The public commitment to support home
ownership remains strong, and expanding
the FHLBs’housing-related asset powers
is consistent with that objective. But as
with other government-sponsored enter-
prises, the FHLBs’public charters convey
upon them special treatment not afforded
privately chartered firms, providing them
with competitive advantages in the 
marketplace—not the least of which is theProviding liquidity through secured
lending remains the FHLBs’most
important activity. More than 64 percent
of the FHLBs’total assets ($764 billion)
consisted of outstanding advances 
($490 billion) as of December 31, 2002.
While the current ratio of advances to
assets is substantially below the high
mark set in 1980 (90 percent), it is 
considerably above the historical low of
less than 49 percent recorded in 1995.
Moreover, on average, advances
accounted for nearly two-thirds of
FHLB assets over the past five years.
And despite the widening of the pool of
eligible collateral for community finan-
cial institutions under the 1999 Gramm-
Leach-Bliley Act, over 98 percent of
advances are still secured by housing-
related assets.
The shift away from advances is
reflected largely in the FHLBs’invest-
ment portfolio. From 1990 through 
the end of of 2002, FHLB investments
increased from $72 billion to 
$206 billion (over 27 percent of total
assets). These investments—which 
consist largely of holdings of mortgage-
backed securities, securities of the U.S.
Treasury and official agencies, federal
funds sold, and interest-bearing deposits
in banks—increase the flexibility with
which the FHLBs can manage their 
balance sheets. For instance, the FHLBs
can use their investment accounts to
accommodate unforeseen changes in
demand for advances by making offset-
ting changes in their investments—
increasing investments when demand
for advances is falling and decreasing
investments when demand for advances
is rising. Investments appear to be
attractive assets to hold in portfolio for
their own sake as well, for their magni-
tude has grown enormously since 1990.
Certainly, the $96 billion of mortgage-
backed securities (nearly 47 percent of
total investments) held by the FHLBs on
December 31, 2002, provide a means of
supplying credit to the housing industry
other than the more traditional
advances. 
n  Direct Holdings of
Mortgages
On January 9, 1997, the FHLB of
Chicago received approval from the 
Federal Housing Finance Board to oper-
ate a pilot program for a new initiative,
the Mortgage Partnership Finance Pro-
gram, which allowed the Chicago bank
to engage in a new activity, directly 
purchasing mortgages from FHLB 
members. Two years later, all 12 FHLBs
were granted the right to establish 
mortgage-asset programs similar to
Chicago’s. In June 2000, the Finance
Board removed a $9 billion cap on the
Chicago pilot and made mortgage-asset
programs permanent for those FHLBs
that decided to offer them. By the end of
2000, 11 of the 12 FHLBs held mort-
gages purchased under one of two such
programs: the program pioneered by the
FHLB of Chicago or a program estab-
lished in 2000 by the FHLBs of Seattle,
Indianapolis, and Cincinnati called the
Mortgage Purchase Program. Seattle,
Indianapolis, and Cincinnati offer their
program to their members, and all other
FHLBs offer Chicago’s program to
theirs. The FHLB of Atlanta plans to
offer the Mortgage Purchase Program 
to its members in 2003. Currently, all 
12 FHLBs are holding mortgage assets
on their balance sheets.
Both mortgage-asset programs offer
FHLB System member institutions a
new method for funding fixed-rate con-
ventional, FHA, and VA mortgages.
Under the programs, member institutions
may sell mortgage loans to an FHLB as
an alternative to retaining these assets on
the balance sheet or selling the loans in
the secondary market to Fannie Mae or
Freddie Mac. By selling mortgages to an
FHLB, the member institution avoids
paying guarantee fees to Fannie or Fred-
die. Under Chicago’s Mortgage Partner-
ship Finance Program, members receive
credit enhancement fees from the FHLB.
This fee compensates the member insti-
tution for sharing some of the credit risk
after the loan is purchased by the FHLB.
Under the Mortgage Purchase Program,
the equivalent of the Fannie or Freddie
guarantee fee is deducted from the 
purchase amount and deposited into a
lender’s reserve account. A separate
account is established for each pool of
loans bought from a member. Members
receive payments from the FHLB out 
of their reserve account based on the 
performance of the underlying loans.
While the structure of the loss-sharing
arrangement under each of the two 
mortgage-asset programs is somewhat
different, both programs offer members 
a higher return on sales of mortgage
loans in exchange for retaining some of
the credit risk. In addition to a portion of
the credit risk, the FHLBs fully assume
the interest-rate risk and prepayment risk
of the mortgages they purchase. 
FHLB mortgage assets have grown con-
siderably since the two mortgage-asset
programs received final approval in
2000. Over the past 12 months, total
mortgage assets have more than 
doubled, rising from $27.6 billion on
December 30, 2001, to $60.1 billion at
the end of 2002. Mortgage assets increased
from 3.62 percent to 7.93 percent of
total assets, accounting for 49 percent 
of total FHLB asset growth over the
same period. Mortgage loans held under
the Mortgage Partnership Finance 
Program were $42.3 billion as of
December 31, 2002, and $18.3 billion
under the Mortgage Purchase Program.
Continued strong mortgage growth has
implications for the capital adequacy of
the FHLBs. Asset growth exceeded
FHLB capital growth in eight of the last
10 years, including 2002, and as a conse-
quence, the FHLBs’capital-to-asset ratio
declined from 6.92 percent in 1991 to
4.76 percent as of December 31, 2002.
Moreover, the shift in asset composition
from low-risk advances to mortgages and
mortgage-backed securities has implica-
tions for capital adequacy because the
FHLBs are subject to risk-based capital
requirements. Even with the loss-sharing
agreements in place, FHLB mortgage
holdings are riskier than advances and
hence, under risk-based capital require-
ments, incur a higher capital charge
(require more capital to be held against
them) than advances. In other words,
asset growth driven by the mortgage-
asset programs requires higher growth in
FHLB capital than balance-sheet growth
driven by advances.
Due primarily to differences in the num-
ber of member institutions participating
in FHLB mortgage-asset programs, the
growth in FHLB mortgage assets has
been uneven across the 12 FHLBs. The
FHLB of Chicago alone holds just under
$26.2 billion in mortgages, which
accounts for 43 percent of the FHLB
System’s mortgage assets (and it repre-
sents over 40 percent of the Chicago
bank’s assets). The top five FHLB mort-
gage holders, accounting for 32 percent
of FHLB System assets, collectively own
85 percent of System mortgage holdings.
For some of these FHLBs, continued
growth in their mortgage-asset programs
may be constrained by capital require-
ments, resulting in the need to raise 
capital from members or to find alterna-
tives to funding additional mortgages
purchased on their balance sheets.1One such alternative to funding mort-
gage purchases on the balance sheet is
the FHLB of Chicago’s recently
approved Shared Funding Program,
which allows Mortgage Partnership
Finance Program loans to be securi-
tized.2 The Shared Funding Program
will increase the flexibility the FHLB
of Chicago has in funding new Mort-
gage Partnership Finance Program
loans by turning relatively illiquid
mortgage loans into more highly liquid
instruments (mortgage-backed securi-
ties) that can then be booked to the
FHLB of Chicago’s balance sheet or
sold. While the specifics of the new
program are still being worked out, ini-
tial reports indicate that the sales of the
program’s mortgage-backed securities
will be limited to FHLBs and to FHLB
System member institutions. This does
not, however, appear to be an overly
binding constraint given that 5,886
banks, 1,390 savings associations, 660
credit unions, and 75 insurance compa-
nies are members of the FHLB System.
Overall, the commercial bank and sav-
ings association members of the FHLB
System hold a total of $4.8 trillion of
assets, which is close to 50 percent of
total bank and thrift industry assets.3
n  Conclusion
There is no question that the FHLBs are
undergoing change. Such evolution is
natural and necessary given the contin-
ued and often dramatic changes in 
financial markets—and particularly in
the housing finance markets the FHLBs
were created to support. Increased hold-
ings of mortgage-backed securities and
direct holdings of mortgages through 
the two new FHLBs mortgage-asset 
programs represent new methods for 
fulfilling the FHLBs’original housing-
related mission. These mortgage-asset
programs also appear to be important
drivers of FHLB asset growth. In addi-
tion, part of the FHLB System’s mission
is to promote access to housing for all
Americans. The FHLB mortgage-asset
programs indirectly support this goal by
providing member financial institutions
liquidity to accommodate further resi-
dential mortgage loan originations.
Finally, to the extent that the FHLB
mortgage-asset programs displace or
reallocate loan sales that would have
normally been purchased by Fannie Mae
or Freddie Mac, the Mortgage Partner-
ship Finance Program, Mortgage Pur-
chase Program, and the Shared Funding
Program increase the competitiveness of
the secondary mortgage market—further
lowering the cost of housing finance to
homeowners.
n  Footnotes
1. Interestingly, the most aggressive
purchaser of mortgages, the FHLB of
Chicago, has bucked the declining capi-
tal trend for the FHLBs as a group. The
FHLB of Chicago’s 97 percent capital
growth has exceeded its 83 percent
asset growth since the end of 2000—its
capital-to-asset ratio has risen from
4.81 percent to 5.16 percent over the
same period.
2. Information on the Shared Funding
Program can be found at
<http://www.fhfb.gov/Hal2000/docs/
Approvals/2002_pdfs/2002-APP-
07.pdf>.
3. Commercial bank members of the
FHLB System hold around $3.8 trillion
in assets or 43 percent of total U.S.
banking assets. Close to 100 percent of
savings associations, both in terms of
number of institutions and share of
industry assets (over $1.0 trillion)
belong to the FHLB System. 
n  Recommended Readings
Congressional Budget Office, 2001,
“Federal Subsidies and the Housing
GSEs,” Washington, D.C.: Government
Printing Office, May.
Ronald J. Feldman, 2002, “Mortgage
Rates, Home-ownership Rates, and
Government Sponsored Enterprises,”
Federal Reserve Bank of Minneapolis,
The Region vol. 14 (no. 1), p. 4–23. 
Milton Friedman and Anna J. Schwartz,
1963, A Monetary History of the United
States: 1867–1960, Princeton, N.J.,
Princeton University Press.
Edward J. Kane, 1989, “The S&L Insur-
ance Mess: How Did It Happen?” 
Washington, D.C.: The Urban Institute.
James B. Thomson, 1993, “The Cost of
Buying Time: Lessons from the Thrift
Debacle,” Federal Reserve Bank of
Cleveland, Economic Commentary,
January 1.
James B. Thomson, 2002, “Commer-
cial Bank Borrowing from the Federal
Home Loan Banks,” Federal Reserve
Bank of Cleveland, Economic 
Commentary, July 2002.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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the above address.
Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
Daniel K. Maloney is an examiner specialist
in the Supervision and Regulation 
Department and James B. Thomson is a vice
president and economist in the Research
Department of the Federal Reserve Bank of
Cleveland. The authors thank Ron Feldman,
Scott Frame, Alex Pollock, and Mark Vaughn
for helpful comments and suggestions on 
previous drafts.
The views expressed here are those of the
authors and not necessarily those of the Fed-
eral Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
Research Department of the Federal Reserve
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The evolving role of the Federal Home Loan Banks in mortgage markets

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The evolving role of the Federal Home Loan Banks in mortgage markets

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