Market Reacts to FHLB Ruling Restricting MBS

The Federal Housing Finance Board's approval of a proposal last week to phase out the arbitrage investments of the Federal Home Loan Bank (FHLB) system and divest the banks of their mortgage-backed securities assets over a five-year period turned many heads in the MBS community.

Though the decision, which will have a 90-day public comment period, was not completely unexpected, market players generally viewed it as a significant event, possibly impacting both spread product and buyside activity down the road due to the FHLB's status as one of the largest buyers of MBS, sources say.

"This has already had an impact," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "This type of liquidation is definitely a concern. The FHLB is one of the major forces in pushing spreads tighter, and now, one of the largest buyers will no longer be a buyer at all.

"[This decision] hurts spread product, making it more difficult, at these levels, to recover. This definitely puts a little bit of a wet blanket on the market."

"This will cut off buying right away," added Art Frank, director of mortgage research at Nomura Securities. "Though I wouldn't jump to conclusions that there will be a wholesale liquidation, the Federal Home Loan Banks were significant short-term CMO buyers."

The FHLB system, which held $59.7 billion in MBS as of March 31 - a rather large chunk of the approximately $2 trillion MBS market - had come under fire in the past several years for its investment tactics.

The banks used the proceeds of their security sales - and their special status as government-sponsored enterprises - to arbitrage investments in MBS and other high-yielding instruments that were completely unrelated and inconsistent with its core mission of promoting housing and community development.

According to the proposal from the Finance Board, which regulates the FHLB, the five-year phase-out of MBS purchases will begin on Jan. 1, 2000, when 80% of the money the banks raise will have to go to mission-related activities only; the year after that, 85% must be mission-consistent, increasing by 5% each year until Jan. 1, 2005, when 100% of what the system borrows must be compliant with mission-related guidelines.

The gradual, incremental transition will also require the banks to "roll off" their current MBS holdings, but the drawn-out nature of the change will not shock the market right away, sources say.

"The banks still could invest in MBS, but the money couldn't come from capital that they raised on Wall Street," said Bill Glavin, spokesman for the Finance Board. "They will only be able to invest in mortgages of their member institutions, or even pools of mortgages of their member institutions, so that is an alternative.

"But effectively, the banks won't have much incentive to invest in MBS anymore, since MBS will not be considered a permissible investment," he said.

Additionally, Glavin said that there will even be a "safe harbor" for the banks in 2005 if they still have MBS on their balance sheets.

"If they have a very good reason at that time for having MBS, we will make an exception," Glavin said.

New Territory for the FHLBs?

According to sources in the banking community, the new proposal was a culmination of many years on the part of the Finance Board of trying to point the FHLBs in a different direction in terms of the types of assets they purchased.

It was also an attempt to change the capital structure of the FHLB system from an asset-based structure to a risk-based one.

"Right now, the FHLBs are way overcapitalized," Glavin said. "If this new capital structure is in place, they won't be overcapitalized and they won't need to engage in arbitrage anymore."

The proposed regulation would create a risk-based capital requirement for the banks, based on credit risk, market risk and operations risk, similar to the structure of Fannie Mae and Freddie Mac.

According to Glavin, another piece of legislation currently going through Congress is also seeking to switch the FHLBs to a risk-based structure.

"The FHLBs are being asked to go into a new territory, and along with that, their boards and senior management are given more leeway to control what types of investments they make," Glavin added. "In fact, they will have more of an array of investments than they've had in the past in the past, if they choose to deal with their member institutions."

It is the Finance Board's view that the competitive spreads which the FHLBs garnered from MBS transactions and the loss of income suffered because of the new proposal can be made up by making other types of asset and loan purchases from individual FHLB members.

However, many market sources believe that the proposal will actually cut back, not increase, the banks' broad spectrum of investment opportunity.