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updated 11/7/2008 5:59:47 PM ET 2008-11-07T22:59:47

Fannie Mae and Freddie Mac were controversial for years before they fell into government conservatorship this year. But few people have considered the risks posed by the Federal Home Loan Bank system, even though it occupies the same gray area between the public and private sectors.

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Created by Congress in 1932 to bolster mortgage finance, the system, with its 12 member banks, lends to financial institutions of all sizes, with more than $900 billion in outstanding loans as of midyear, up 43 percent since 2006. Like Fannie and Freddie, the system can borrow cheaply because of the assumption that the federal government won't let it fail. As private cooperatives, the 12 banks make profits and pay dividends to their owners — more than 8,000 financial institutions.

Here's the problem: The system has weak restraints against overlending. Its stated mission is to make loans, and by law it's not responsible for monitoring or controlling what those loans are used for. That's the job of the borrowers' primary regulators. In addition, if a bank with an FHLB advance goes under, the FHLB is at the head of the line to get repaid, so it has little reason to lend cautiously. And in a potential conflict of interest, the FHLBs are lending to their owners — the member banks. The result: Bountiful funding from the FHLBs could allow some banks to "gamble for salvation," getting into even deeper trouble.

True, the home loan banks don't go unscrutinized. Following a July 29 reorganization, they are regulated by the new Federal Housing Finance Agency, which also oversees Fannie and Freddie. Administrator James B. Lockhart III told BusinessWeek in an interview that the home loan banks are working effectively with the Federal Deposit Insurance Corp. and other regulators to make sure that financial institutions have access to funds.

"They have provided a tremendous service to the banking industry and therefore probably to the banking regulators," says Lockhart. In addition, the home loan banks say they have an incentive to make loans that will be repaid. "The idea that we would lend recklessly just doesn't make good sense," says Alfred A. DelliBovi, president of the Federal Home Loan Bank of New York.

Still, concerns about the federal home loan banks' role grew after the July 11 failure of IndyMac Bancorp. The FDIC predicts it will cost $9 billion to work out, making it the costliest takeover in the agency's history. The bank's finances were so plainly precarious that, by the end, depositors were pulling out their money in droves.

Yet IndyMac increased its borrowings from the Federal Home Loan Bank of San Francisco more than 500 percent from the end of 2004 through early 2008. At the time it folded, loans of $10 billion from the San Francisco bank accounted for nearly a third of IndyMac's liabilities. Amy Stewart, a spokeswoman for the home loan bank, declined to comment on why it helped keep IndyMac afloat but said that, generally speaking, it doesn't like to pull the plug on borrowers. "It is not our role to cause a liquidity problem for a member institution," she said.

The IndyMac failure came on the heels of the near-collapse of the nation's biggest mortgage lender, Countrywide Financial, which had borrowed even more heavily. As Countrywide spiraled downward in 2007, CEO Angelo Mozilo arranged for its banking unit to borrow $51 billion from the Federal Home Loan Bank of Atlanta. Sen. Charles E. Schumer, D-N.Y., charged that Countrywide was using the Atlanta lender as its "personal ATM." Bank of America acquired Countrywide this past summer, assuming all of its liabilities.

Why taxpayers are on the hook
The problem for taxpayers is that if a bank that has borrowed from an FHLB fails, the home loan bank gets fully repaid, even if the collateral it holds proves insufficient. That raises the cost for the FDIC, which has to protect depositors by reaching deeper into its insurance fund — and, if necessary, tapping the Treasury.

Concerned that her agency is getting squeezed, FDIC Chairman Sheila C. Bair has taken shots at the home loan bank system recently. In an interview for an in-depth analysis in the November issue of Bloomberg Markets magazine, she said: "We really get a double whammy," adding that the agency has "a beef with excessive reliance on Federal Home Loan Bank advances."

The FDIC is proposing to increase its premiums for deposit insurance on banks that rely more than average on home loan bank advances and on brokered deposits — another big source of concern. (Brokered deposits come from wealthier customers who parcel out their money among many banks so they can qualify for FDIC insurance on the entire amount.)

Several economists share Bair's worries. "My concern is that there is not enough oversight by the [FHLBs] of the risk that the commercial banks take when they use advances," says Timothy J. Yeager, a former economist at the Federal Reserve Bank of St. Louis who is now a finance professor at the University of Arkansas Sam M. Walton College of Business.

In theory, home loan bank advances needn't be destabilizing. Home loan banks should open and close their funding spigots in consultation with the borrowing banks' primary regulators, such as the FDIC or the Office of Thrift Supervision. Some of that may be happening: Advances that appear unwise could have been made at the request of a regulator that wants to tide a bank over a rough spot or ease it gently into receivership.

Still, the credit bubble was all about bad loans overlooked by bankers and regulators. In the rush to revive the U.S. economy, it's important to watch out for the FHLBs funding banks that really shouldn't get the money.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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