Banks flooded the Federal Home Loan Bank System with requests for up to $90 billion in billions in low-cost funding to shore up liquidity and avert a crisis due to a runoff of deposits.
Demand for liquidity from the Federal Home Loan Bank System skyrocketed on Monday, prompting the system’s Office of Finance to raise a record $88.7 billion through the sale of short-term, floating rate notes — the system’s largest debt issuance in a single day, reflecting the need for liquidity by community and regional bank members.
The largest banks were not tapping the Home Loan banks, experts said, largely because they have been the beneficiaries of depositors that have moved their money to large banks after being spooked by bank failures.
The two banks that failed in the past week — Silicon Valley Bank and Signature Bank — both borrowed heavily from the Home Loan banks in the third and fourth quarter. Both banks were particularly vulnerable due to a concentration of deposits, massive uninsured deposits and failures by top management to address interest rate risk in their securities portfolios.
Higher interest rates have forced banks of all sizes to make mark-to-market adjustments on their investment portfolios resulting in unrealized losses. Fears that other regional banks are facing similar challenges, and a potential run on deposits have persisted despite efforts by federal regulators and President Biden to quell the panic.
Banks with unrealized losses in their securities portfolios are tapping the Home Loan banks in the hopes of eventually recovering deposits as they increase deposit pricing. The banking industry as a whole is sitting on some $620 billion in unrealized losses on its securities portfolios as of the end of 2022, according to the Federal Deposit Insurance Corp.
“Banks are just hoping they can ride out the liquidity and pay back the FHLB and not have to recognize the loss on the securities in their loan portfolio,” said Peter Freilinger, founding partner at Paladin Advisors Group, a wealth management and financial advisory firm in Elkridge, Md.
Regulators invoked a systemic risk exception to bail out depositors of Signature Bank, the $110.4 billion-aset bank in New York, and Silicon Valley Bank, the $202 billion-asset bank in Santa Clara, Calif. Both banks were insolvent because the market value of their assets was less than their deposits.
“There are no individual banks that have the same mix of massive uninsured concentration as Silicon Valley and Signature, also with the same insolvency position of mark-to-market of their securities book,” Freilinger said. “But there are a lot of banks that are effectively insolvent if they were to mark-to-market their securities book.”
The crisis was brought on by the massive monetary and fiscal stimulus by the Federal Reserve during the pandemic that caused deposits at most banks to skyrocket. Rather than make loans to consumers and businesses, many banks instead bought highly-liquid, mortgage-backed securities and available-for-sale securities. When short-term rates started rising last year, banks sought to avoid paying higher rates for CDs and other deposit products — which normally bring in “sticky” deposits. Many bank customers fled for higher rates elsewhere — notably in money market funds, which have had consistently high inflows since early 2022, Freilinger said.
The lifeblood of the 11 regional Home Loan Bank System, which mirrors the Federal Reserve bank system, is liquidity that comes in the form of so-called advances or short-term secured loans. The system is often referred to as a “lender of next-to-last resort,” largely because banks are more likely to tap the Home Loan banks than the Fed’s discount window, which has a stigma associated with it among financial institutions and the public.
“Today, as members seek a stable source of funding in an unsettled market, the purpose of the FHLBanks has been on full display,” said Ryan Donovan, president and CEO of the Council of Federal Home Loan Banks, a trade group for the system. “We have continued to meet members’ heightened needs for liquidity, supported by a record day of debt issuance. The Federal Home Loan Bank System stands ready to continue to serve our members.”
Some experts are searching the filings of the Home Loan Bank System to detect warning signs of liquidity risk at other banks. Bank historians have noted that Washington Mutual, Countrywide Financial, Merrill Lynch and Wachovia Corp. were among the system’s top borrowers before the 2008 financial crisis.
“If a bank starts facing liquidity constraints, they have to go to the one and only lender of last resort, which really should be the Fed,” said Kate Judge, a law professor and vice dean at Columbia Law School. “We effectively have two different backup sources of liquidity for most banking organizations.”
The Home Loan Bank System was designed to be tapped during times of stress. The banking cooperative issues debt with an implied government guarantee that is directly correlated to members’ demands for liquidity. Banks buy membership in the cooperative, and purchase additional stock with each borrowing.
“There is no moral hazard related to the FHLBs because we, the bank members that seek liquidity from the FHLBs, have to pledge our assets as collateral,” said Steven M. Gonzalo, president and CEO of $1.2 billion-asset American Commercial Bank & Trust, a 10-branch bank near Chicago.
Others said it was necessary that the Federal Reserve created a new facility, also announced Sunday, that will provide “an additional source of liquidity against high-quality securities,” to eliminate the need for banks to sell securities during times of stress. The Bank Term Funding Program will offer loans of up to one-year terms to banks, credit unions and others that pledge Treasuries, agency debt and mortgage-backed securities as collateral, which will be valued at par. The facility may lessen pressure on the Home Loan banks, some experts said.
The Home Loan banks’ regulator, the Federal Housing Finance Agency, is conducting the first full review of the system in 90 years. Part of that review is addressing the Home Loan Bank System’s “super lien” priority ahead of other creditors — including the Federal Deposit Insurance Corp.’s deposit insurance fund — in the event of a bank failure. Policymakers also are concerned that when institutions borrow from the Home Loan banks, they pledge their best collateral, increasing the severity of failures because the highest-quality assets have already been used.
“I don’t think the FHLBs are necessarily thinking of the interests of the Fed and the FDIC and the financial system writ large when they are making these advances,” said Arthur Wilmarth, professor emeritus at George Washington University Law School. “If banks are going to the FHLBs for large amounts of money, doesn’t that indicate a real red flag and a likely failure? There should be a review process and reporting and accountability to Congress.”