On February 24, 2020, the Federal Housing Finance Agency (“FHFA”) issued a Request for Input (“RFI”) on the eligibility requirements for membership in a Federal Home Loan Bank (“FHLB” or “FHLBank”).1 Significantly, the RFI does not provide for the restoration of FHLB membership for captive insurers or foreclose restoration at a later date. Rather, the RFI contains an even-handed summary of the recent controversy involving the eligibility requirements and poses open-ended questions that do not indicate what changes, if any, may be made to the eligibility requirements. Comments on the RFI must be submitted by June 23, 2020.
The FHLB Act restricts membership in the FHLB System to US-based insured depository institutions, community development financial institutions (“CDFIs”) and insurance companies that make home mortgage loans.2 For many years, the FHFA and its predecessors interpreted this restriction as effectively authorizing membership to any regulated insurance company domiciled in the United States, including captive insurance companies owned by real estate investment trusts and other entities that would not qualify for FHLB membership on their own.3
Beginning in 2010, however, the FHFA began to reassess participation in the FHLB System by captive insurance companies that are controlled by ineligible parent companies.4 Underlying the agency’s concern was the fear that ineligible companies were forming captive insurers solely to acquire FHLB System membership in order to access below-market funding through advances from FHLBs.5 This reassessment culminated in a 2016 rulemaking in which the FHFA defined “insurance company” to exclude licensed insurance companies whose primary business is underwriting insurance for affiliates.6 As a result of this regulatory change, a number of captive insurance companies lost their FHLB System membership in 2017 or will lose it by February 2021.7
Many in the housing finance industry, including the regional FHLBs, expressed concerns with and opposition to the FHFA’s restriction on insurance company participation in the FHLB System.8 By excluding captive insurers, the FHFA reduced both the number of members sharing in the FHLBs’ obligations and the financial resources available to the FHLBs’ housing mission. Until the RFI, however, FHFA had been unwilling to reconsider its action against the captive insurers.9
Request for Input
The RFI covers three primary topics. The first topic is a restatement of the FHLB eligibility requirements that summarizes in one place the relevant legal authority, prudential concerns and application process. While this may be of interest to those looking for trends in interpretation or emphasis, almost all of the content is existing blackletter law.
The second topic is background and commentary by the FHFA on the issue of who should have access to FHLB advances. The background discussion discloses that the FHLBs have had difficulty implementing the eligibility requirements. It states that “on several recent occasions FHLBanks have improperly applied regulatory provisions on membership eligibility when assessing applications, resulting in a number of erroneous membership approvals.” Additionally, the RFI states that some nonbanks have tried to use for-profit and other non-depository CDFIs and special purpose insured banks as “conduits” for obtaining FHLB advances. While these attempts apparently were unsuccessful because the applicants failed other eligibility requirements, their disclosure indicates that FHFA is uncomfortable with the literal language of the eligibility requirements. This discomfort, and the potential for such a nonbank applicant to structure its conduit to satisfy the other eligibility requirements, may be the genesis of the RFI.
Further, the commentary in the RFI emphasizes the residential housing focus of FHLB membership, which it implies may be at odds with the business plans of some nonbanks that have tried to create conduits to FHLB advances. However, FHFA also recognizes in the RFI that the administration’s 2019 Housing Reform Plan encouraged the expansion of access to FHLB advances.
Based on this balanced treatment, it is not surprising that the third topic of the RFI is a series of open-ended questions asking what FHFA should do about the FHLB eligibility requirements. We have attached the questions at the end of this Legal Update as Appendix A. The questions emphasize the need for a solution to be consistent with the FHLB Act’s focus on housing finance and principles of safety and soundness but do not otherwise reveal FHFA’s intended direction. For example, there are questions premised on the FHFA banning arrangements through which a nonbank uses a conduit to access FHLB advances, and there are other questions that ask for suggestions regarding prudential measures that FHFA or FHLBs could take to manage the risks associated with nonbank access to FHLB advances. More broadly, the questions seem torn between adopting a uniform, easily administered approach and a nuanced approach that effectively distinguishes among different categories of applicants.
It remains to be seen if the RFI is a prelude to a loosening or tightening of the FHLB eligibility requirements. For example, one trade group already is on the record as recommending that independent mortgage banks be given access to FHLB advances, but others see potential resistance to that idea within FHFA.10
We expect there will be many industry comments that point out the harm caused by the FHFA’s tightening of the insurance company membership requirements and emphasize the housing policy goals that would be served by a more liberal and literal interpretation of the eligibility requirements in the underlying statute. This could lead to the FHFA issuing a formal notice of proposed rulemaking that would be subject to a further public comment period. However, it is an election year, and the combination of lengthy comment periods, the ongoing judicial challenge to the constitutionality of FHFA’s structure11 and the risk of a permanent roadblock through the Congressional Review Act12 may delay any meaningful changes until after least the second half of 2021.
Appendix A: RFI Questions
- General. FHFA seeks to develop requirements to address questions regarding membership eligibility on a consistent basis, guided by the twin objectives of ensuring that the FHLB System remains safe and sound and able to provide liquidity for housing finance through the housing and business cycle and ensuring that all members have an appropriate nexus to the housing finance and community development mission of the FHLBanks.
- In addition to the statutory requirements of the FHLBank Act, what are the most important general principles and factors FHFA should consider in achieving those objectives?
- Are there classes or types of institution not currently eligible for FHLBank membership under FHFA’s current regulation whose eligibility would simultaneously further both of those objectives and, if so, how? In particular:
- What would be the safety and soundness risks, if any, to the FHLBanks or the FHLB System of making such institutions eligible for membership? What impacts, if any, would allowing such institutions to be members have on the FHLB System’s cost of funds and ability to provide low-cost liquidity to current members?
- How, specifically, would membership of such institutions further the housing finance and community development mission of the FHLBanks?
- Would allowing such institutions to be members further FHFA’s duty to ensure that the operations and activities of the FHLBanks foster liquid, efficient, competitive and resilient national housing finance markets? How would doing so affect competition among existing participants in housing finance markets? How would doing so improve the FHLB System’s resiliency through the cycle? Please be specific.
- Financial condition requirement. As described above, the provisions of the current regulation implementing the “financial condition” eligibility requirement establish different standards of review for different types of eligible entities.
- In general, what financial factors should FHFA consider for the types of entities eligible for membership, and how many years of financial statements and other data is sufficient for a FHLBank to make a sound assessment of an applicant’s financial condition?
- Would there be benefits to establishing financial condition review requirements that are substantially similar for all applicants, regardless of whether they are organized as an insured depository institution, insurance company or CDFI? What would such requirements comprise, and would such changes entail risks to the FHLB System’s safety and soundness and the FHLBanks’ ability to provide liquidity to members through the cycle?
- Use of conduit arrangements by ineligible entities.
- Should FHFA amend its regulations to bar from FHLBank membership particular types of otherwise-eligible entities that are most susceptible to being used as conduit vehicles by institutions that are not themselves eligible for membership? Which types of currently eligible entities are most susceptible to such use?
- How should FHFA balance the legitimate housing finance activities of those types of entities against the risks that they could be misused as funding conduits by ineligible entities to create another form of de facto membership?
- Should FHFA amend its regulations to impose conditions on membership approvals pertaining to those entities that are susceptible to being used as conduits that do not apply to other types of members?
- Irrespective of membership requirements, should FHFA limit conduit activity by FHLBank members through other means, such as by restricting the amount of advances a FHLBank may have outstanding to a single member (for example, to a percentage of the member’s total assets) or limiting the extent to which affiliates may pledge collateral to secure a member’s advances? If so, what should those limitations be? Should FHFA impose any such limitations on all FHLBank members as a prudential measure, irrespective of any concerns about conduit activity?
- Unsupervised members and affiliates.
- What are the principal risks to the FHLBanks from doing business with members that are not subject to supervision by a prudential safety and soundness regulator, and are those risks materially greater than those associated with doing business with members subject to such oversight?
- If FHFA were to allow conduit arrangements, what would be the principal risks to the FHLBanks in cases where the affiliate to which the FHLBank funding is being passed by the conduit member is not subject to supervision by a prudential safety and soundness regulator?
- To the extent there are added risks arising from either scenario, what measures could FHFA or the FHLBanks take (for example, enhanced collateral discounts, capital requirements or other counterparty risk management practices) that would best mitigate those risks? Would such measures be sufficient? Please be as specific as possible.
- What would be the added risks and costs, if any, to the FHLBanks and the FHLB System, including with respect to the cost of funds, in the event of a default or failure of a member and/or parent institution for which a bankruptcy or similar proceeding would be the resolution regime (as opposed, for example, to an FDIC resolution for an insured depository institution)?
- Nexus to FHLBanks’ public policy mission.
- Is the current membership regulation sufficient to ensure that the activities of FHLBank members have a sufficient nexus to the public policy mission of the FHLBanks? If not, what changes should be made?
- Should FHFA require FHLBank members to demonstrate an ongoing commitment to housing finance in order to remain eligible for membership? If so, how should that commitment be measured and monitored?
- If FHFA were to permit conduit arrangements, should it limit such arrangements to members whose parent company is actively and substantially engaged in activities that are consistent with the housing finance and community development mission of the FHLBanks? If so, what criteria should be employed, and how could compliance with such criteria be monitored and enforced?
- Would the use of FHLBank advances to finance the purchase of mortgage-backed securities by the conduit entity or its parent, as was the case with mortgage REITs that created captive insurance companies, be consistent with the mission of the FHLBanks, particularly if the mortgage-backed securities have been issued or guaranteed by Fannie Mae or Freddie Mac?
- Rebuttable presumption approach of regulation. As discussed above, an applicant’s failure to meet the specific standards by which compliance with a membership eligibility requirement is determined may, in some cases (specifically, with respect to the “subject to inspection and regulation,” “financial condition,” “character of management” and “home financing policy” requirements), raise a mere presumption of non-compliance that the applicant may rebut by meeting additional criteria. The intent behind this approach is to facilitate the processing of membership applications by the FHLBanks by allowing them to exercise a degree of judgment in assessing the unique facts that may be presented by some applicants. Because those additional criteria allow the FHLBanks considerably more discretion than do the primary standards, however, they also are more subject to misinterpretation and misapplication, particularly when the FHLBanks are considering cases of first impression.
Would the safety and soundness of the FHLBanks be enhanced if FHFA were to establish new standards that provided less discretion to the FHLBanks and all of which must be met for an applicant to be admitted to membership? If so, what should those standards be? Please explain in detail.
- Other issues and concerns. Are there any issues not explicitly discussed above that relate to FHLBank membership and need clarification?
1 FHFA, Federal Home Loan Bank Membership: Request for Input (Feb. 24, 2020), https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Issues-RFI-on-FHLBank-Membership.aspx.
5 81 Fed. Reg. at 3254-58. FHLB advances are a low-cost wholesale source of funding for FHLB members because FHLBs fund their operations through the issuance of consolidated obligations that are exempted government securities that benefit from an implicit federal government guarantee. Additionally, FHLBs and their consolidated obligations are not subject to state or federal income taxes.
9 See our earlier Legal Update on a 2018 bill that would have partially reversed the FHFA’s action. That bill stalled in committee and was not enacted.
11 Laurence Platt, “High Court CFPB Review May Determine Fate Of FHFA Too,” Law360 (Oct. 28, 2019) https://www.mayerbrown.com/en/perspectives-events/publications/2019/10/high-court-cfpb-review-may-determine-fate-of-fhfa-too.