The Federal Home Loan Bank System funds mortgages and affordable housing using a smart and sophisticated derivatives strategy.

By Jim Cataldo

A few years ago the Federal Home Loan Bank System (FHLB System) was one of the last places one might look for sophisticated derivative activities. Not any longer. Today it demonstrates shrewd skills in hedging risk and locking in returns, despite lagging behind its Wall Street counterparties in terms of trading information and broad and deep expertise.

This large but somewhat obscure federally sponsored system is in the bread-and-butter business of providing wholesale funds to home mortgage lenders. It became a significant derivatives player with a bang in the early 1990s, when the boom in structured note issuance plunged it into the most sophisticated and dynamic derivative markets. Today the FHLB System's $194 billion position in swaps, options, caps and related products rivals the size of its $267 billion on-balance-sheet asset base. The story that follows strikingly illustrates the integral role that derivatives products have come to play at an institution that just a few years ago was in the backwaters of financial management.

Track record

The Federal Home Loan Bank System was originally established as a government-sponsored enterprise in the 1930s. At the time mortgage lenders (mostly thrift institutions and savings and loans) often were unable to meet demands for home mortgage funds due to limits on their local retail deposit sources. The FHLB System was set up to provide a low-cost source of wholesale funding to mortgage lenders-helping alleviate bottlenecks in the flow of funds to housing finance. Operating through its 12 affiliated regional banks, the FHLB System went about its business quietly and effectively, with few significant changes until the interest rate cycles of the late 1970s and early 1980s.

The dramatic interest rate increases occurring at the time caused some financial pain for the FHLB System-but unlike parts of the retail mortgage industry, the Home Loan Banks seemed to learn the lessons of rate risk management well. During the 1980s the Home Loan Banks gradually began to increase their use of hedge instruments such as swaps and futures to manage their rate risk. Also, Home Loan Bank products (primarily long-term fixed rate credit and "vanilla" interest rate swaps) were increasingly used by its borrowers to help manage rate risk on their own balance sheets.

The 12 district Home Loan Banks are independently managed, but operate in accordance with common guidelines set by the Federal Housing Finance Board in Washington. The Home Loan Banks issue debt securities as joint and several obligations, which are arranged through the System's central fiscal agent (the Office of Finance) in Virginia. The FHLB System rightly prides itself on its conservative financial management. Perhaps the most dramatic demonstration of the FHLB System's tradition of tight risk management occurred during the late 1980s and early 1990s, when the FHLB System suffered not a single dollar of credit losses despite the decimation of much of its thrift industry borrower base.

While the Home Loan Banks have gone through their share of internal hand-wringing over recent upheavals in the mortgage lending industry, their financial performance would be the envy of most financial corporations. The FHLB System has recorded steady increases in assets and earnings each year since 1992, all while contributing $300 million annually to finance the thrift bailout, and dedicating a substantial share-now 10 percent-of its net income to subsidize its affordable housing programs.

After the gold rush

After the tumult of the 1980s, the early 1990s saw the greatest change in the day-to-day financial management of the Home Loan Banks as the structured note market arrived, courtesy of Wall Street's derivatives demons. The Home Loan Banks, along with other agency issuers such as Fannie Mae, Sallie Mae, and Freddie Mac, were major beneficiaries of the boom in these complex instruments. Although the agencies nominally issued the notes, they acted more as high-tech "coupon clippers" than as structuring participants in the market.

Underwriting dealers proposed the issues to the agencies as fully hedged packages, with the note coupons converted to simple fixed or sub-LIBOR floating liabilities by means of matched interest rate swaps. The Home Loan Banks would not have been able to participate the market otherwise as they simply lacked the tools to evaluate many of these structures in trading situations. Because the Home Loan Banks swapped away the risks, the valuation of the notes was for practical purposes irrelevant to the their bottom lines. In general, the agencies accepted or rejected structured note issues on the basis of the swapped funding cost they offered. In the heyday of the market, agencies would commonly attain funding spreads of LIBOR less 35 basis points or wider.

The Home Loan Banks and other agencies were also largely in the dark about the buyers of structured notes and how they were being used. This state of ignorance has served both the underwriters of the notes and the agencies themselves. "We have no direct knowledge of investors," says one senior FHLB System manager. Although the Home Loan Banks' insulation from the buyers of its paper limits their ability to negotiate with underwriters, it also keeps them arm's length from issues of investor suitability. In the early days of the market, structured notes were often used inappropriately in short-duration bond portfolios, causing celebrated losses. Many notes that were nominally floaters held significant market risk because of embedded options, or exposure to changes in yield curve slope or basis relationships.

For the Home Loan Banks, suffering the aftereffects of the thrift boom/bust cycle, the advent of structured notes was like manna from heaven. "The reason the System got involved in this market was the low cost of funds we could pass on to our shareholders," says Frank Nitkiewicz, treasurer at the Federal Home Loan Bank of Boston. "Our ability to fund with structured notes definitely played a role in the resurgence in advances since 1992. ("Advances" is the FHLB System's term for wholesale loans made to its institutional customers.) To its credit, the Home Loan Banks have developed and enforced some of the strictest underwriting guidelines in the business, which include strict minimum-size requirements (effectively excluding individual investors), assurances on investor suitability and (alone among the agencies) restrictions on distribution by downstream brokers. While none would claim that these restrictions were entirely effective, the reason lies largely with the Home Loan Banks' limited role as issuer, rather than any failing of diligence on their part. The biggest misapplication was sale to portfolios that should have stuck to shorter-duration instruments-this was beyond the scope of the issuers' responsibility and ability to monitor.

Windfall ended

But the structured note boom was a once-in-a-lifetime experience for the FHLB System. The core idea of the structured note-a customized investment or hedge vehicle which relieves much of the management overhead of off-balance-sheet positions-still retains some appeal. However, absent the gold rush mentality of the early market, investors are much more likely to scrutinize the cost-effectiveness of structured notes versus their off-balance-sheet equivalents, limiting agency funding spreads-and dealer profits-to more modest levels.

The unexpected plunge into derivatives issues proved so successful that the FHLB System has expanded its activity in other areas. Following increases in their investment authority, the Home Loan Banks underwent a significant expansion to their mortgage-backed securities (MBS) holdings in the period 1991­1993. The Home Loan Banks now hold about $41 billion in MBS, and are essentially fully invested to their permitted limit of 300 percent of capital. The Home Loan Banks' acquisition activity generated a strong demand for mortgage-related hedge products. This demand continues, but at a relatively low level now that the System is fully invested.

The Home Loan Banks participated in a second wave of asset swap activity during the widespread sell-off of structured notes in 1994 and 1995. The Home Loan Banks currently own about $16 billion in agency notes, much of it asset-swapped structured paper. However, the secondary market in structured paper now seems headed the way of the nearly extinct primary market. Once bought into an asset-swapped portfolio, structured notes rarely trade out again.

Durable legacy

Callable debt arbitrage is the most durable legacy of the Home Loan Bank's innovations in the debt markets. The system's recent derivatives activity is dominated by creating synthetic sub-LIBOR floating rate debt from callable bonds. Callables accounted for almost half of the $164 billion in bonds outstanding at year-end 1995. Most of the Home Loan Banks' callable debt issues are matched against swaps (see box). In effect, the FHLB System issuer buys a call option embedded in the note, and sells a mirror image call option in the form of a callable note. The savings (over and above a fixed rate non-callable issue swapped to floating) represents an arbitrage between the price of the note call and the price of the swap call. While this arbitrage has persisted over time, funding spreads have narrowed from two or three years ago, and seem to have stabilized around the LIBOR-less-25-basis-point level.

The happy relationship?

The innate conservatism of the Home Loan Banks mean their traders operate with a somewhat unusual mix of caution and flexibility. Although the FHLB System is huge in the aggregate, each of the 12 Home Loan Banks are independently run, with diverse requirements. Trade objectives are typically very clear: if a transaction clears a Home Loans spread hurdle, the response is swift. Since the Home Loan Banks deal only in very liquid markets-such as swaps, CP, Fed funds and repo-they can generate hedged spreads only by flogging dealer coverage for best execution. While price competition can be withering, the Home Loan Banks' responsiveness can be invaluable to dealers that need a quick turnaround to complete a trade. The competition can cut two ways, though, as the availability of 12 potential district bank counterparties tends to expedite the response of any individual Home Loan trader.

Unlike most large investment managers, market direction (or expectations) have little if any impact on Home Loan trading activity. The Home Loan Banks' insistence on hedged returns tends to inoculate them against most trade ideas peddled elsewhere by the Street.

In the recent past the Home Loan Banks have become acutely aware of their disadvantages in information and analytics relative to the Street. But the Home Loan Banks seem to have successfully compensated for these disadvantages by effective use of competition and their insistence that all arbitrage transactions are fully hedged. Even with recent improvements in derivatives technology, some Home Loan Banks place little emphasis on analytics in trading situations. "We don't try to do valuations to verify dealer pricing," says one senior FHLB System source. "We have models to value derivatives pricing, but we don't use them in a trading environment. We put people into competition instead."

Improved analytics have helped alleviate the nagging concern that dealers were getting too large a share of the benefits from structured funding. "[Better analytics] make the Home Loan Banks more responsive and alleviates a lot of mistrust," says one dealer source. "The Home Loan Banks operate in a competitive market with other agencies and corporate issuers. Dealers have other outlets if they can't agree with the Home Loan Banks on price."

But the market's shift to relatively generic (and highly competitive) callable notes and a concentration in vanilla swap products mean that dealers have been feeling the pinch. And the Home Loan Banks' better view of dealer pricing sometimes leads only to frustration. Home Loan Banks are still essentially price takers in most structured funding transactions and their huge appetite for callable note hedges has led to a distinct one-way flow.

It is a recipe for skinflint profit margins. "We think that a lot of trades we see are losing money on an offset basis," says one dealer source. "A lot of dealers seem to be doing these just to take positions in volatility." Adds another dealer: "Callable swaps used to be 15­20 percent of our business with the Home Loan Banks; now it's maybe 1 percent."

Simply by virtue of their size, the Home Loan Banks remain a valued counterparty, even in product areas which currently offer little profit. As the dealer above notes, the Home Loan Banks' unimpeachable credit ratings and their consistent presence in the market continue to make them "a good place to lay off risk."

Macro bank, micro hedge

The key to the FHLB System's conservative risk stance is the design of its hedges. A large proportion are individually designed as exact pair-offs-an approach that might seem unusual for such a large and sophisticated user. One important consideration in choosing a method, says Nitkiewicz at the FHLB System in Boston, is the expense of monitoring positions and periodically verifying the validity of hedges. This task is made much easier by adopting perfectly matched transactions.

Another motive is the desire to maintain a steady net income profile. Unlike their retail brethren, the Home Loan Banks operate on very narrow margins-spread on interest bearing liabilities averaged 20 basis points in 1995. "As wholesale lenders," says Nitkiewicz, "we've seen spreads narrow quite a bit over the past five years. In this operating environment our shareholders like to see a stable interest spread and steady dividends." The FHLB System's almost obsessive conservatism is accentuated by the fact that some of their shareholders are "involuntary"-that is, their federal banking charters require them to own shares in the system.

The Home Loan Banks depart from a strict pair-off strategy when it comes to hedging their MBS holdings. The Home Loan Banks' holdings are managed to meet strict duration and stress test guidelines. Hedge strategies vary from bank to bank, but Boston's approach is probably fairly typical. Boston tends to use generic, liquid instruments-such as LIBOR caps-to hedge embedded caps in floaters. Floors indexed to CMT or LIBOR, as well as callable notes, are used to hedge prepayment risk. Nitkiewicz finds that MBS are one asset class where some basis risk is unavoidable. "We've stayed away from customized hedge transactions because of the large premiums charged by the Street. MBS are one of the few profit centers in the bank where controlled basis risks are permitted," he says.

When Nitkiewicz first proposed a hedge strategy for the portfolio, he engaged in an extensive dialogue with the internal accounting and audit areas of the bank. As Nitkiewicz notes, the learning process was two-way. Many hedge transactions that seemed straightforward from a financial standpoint entailed complex accounting issues. "All parties had to go through a process of familiarizing each other with their expectations and objectives," says Nitkiewicz. His internal efforts paid off when it came time for regulatory exams. "We had extensive discussions with examiners about purpose and expectations of our hedges"-not a simple matter when strategy departs from exact pair-off-"but time has proven them effective."

Futures in the past

The Home Loan Banks' hedging activities are dominated by OTC interest rate swaps. Futures trades are rare by comparison. The ability to specifically tailor OTC contracts is an important consideration. "If we're hedging, say, a three-year transaction with a futures strip, our cost of funds is the forward rate curve," says Nitkiewicz. "With a level yielding asset, we could wind up booking a negative spread in future periods."

In cases like these, level coupon OTC contracts that specifically match floating rate resets are much more convenient. Given the competitive coverage from Wall Street, customized contracts do not seem to differ appreciably in cost compared their futures equivalents. "We'll occasionally use futures on short-dated hedges," says Nitkiewicz. "Futures are sometimes more efficient for short transactions, and the accounting is cleaner."

Customer and conduit

The FHLB System's extensive customer franchise puts it in a unique position to offer hedge products to the relatively underserved sector of small- to medium-sized banks. FHLB System's historic role as "partner" with its borrowers-all customers are shareholders-has fostered a degree of trust seldom accorded to Wall Street firms. The FHLB System's triple-A rating and government-sponsored status disposes of any credit concerns that might stand in the way of a first-time participant in the marketplace. The FHLB System's role as an intermediary is also bolstered by the virtually bulletproof credit facilities it has pre-established with all its borrowers. This eliminates the need for most of the FHLB System's member counterparties to deliver collateral or purchase letters of credit.

Interest rate swaps have been a steady business for some Home Loan Banks. The Home Loan Banks' swaps with its customers are typically lined up back-to-back with offsetting dealer trades. While the FHLB System may occasionally compete with individual dealer firms on specific transactions on a global basis, the FHLB System's customer trades always represent new business for someone on the Street. Since the Home Loan Banks explicitly offsets all their swaps, their pricing necessarily involves a mark-up to dealer pricing. "Many of our borrowers can do swaps with the Street, but like our triple-A credit," says one FHLB System source. This same source finds that the Bank's markup is often offset-and sometimes more than offset-by the FHLB System's ability to source the best dealer offerings.

The Home Loan Banks also offer a variety of customized loan products, typically targeted to fit the asset/liability management requirements of mortgage lenders. Structured loan products are an acknowledged area of opportunity for the Home Loan Banks, but one which they approach cautiously. Structured loans offered by the Home Loan Banks are typically engineered as simple offsets with dealer trades. "We look for derivatives market opportunities that we can layer onto advances products," says Marshal Auron, risk manager at the Federal Home Loan Bank of Pittsburgh.

Home Loan Bank product offerings vary according to the needs of borrowers in their different districts. Pittsburgh has gotten good response to its offerings of capped floating rate advances from holders of adjustable rate mortgages. San Francisco, along with some other Home Loan Banks, offer loans with amortization and payment features that help borrowers manage prepayment risks in their mortgage portfolios.

The FHLB System's public charter is a constant consideration in developing new products. "We don't take a shotgun approach on financial products," says Nitkiewicz. "We avoid hard sells and pushing products our members don't need." For Wall Street firms, structured products offered by the FHLB System represent a business opportunity for their own derivatives desks. Financial product ideas sometimes originate with Wall Street firms, but not all these ideas past muster with the Home Loan Banks. "We look for products that facilitate housing finance for portfolio lenders," says Nitkiewicz. "The Street isn't always as focused on this market."

Some products that show promise as revenue generators don't make the cut because of concerns about use and suitability. This approach might seem paternalistic by Wall Street standards, but here, the endemically cautious FHLB System might be in a vanguard of sorts. As the recent settlement between Bankers Trust and Procter & Gamble suggests, caveat emptor may hold legally, but not economically with complex financial products. The FHLB System's perspicacity extends to the pricing of their more structured loan products to members. Complexity is not sought as a means of profit. "Markups are comparable to our other [generic] advances products," says one senior FHLB System manager.

Not fanning regulatory flames

The Home Loan Banks are subject to strict regulation by the Federal Housing Finance Board in Washington. However, the Banks' use of derivatives, in itself, appears to be a non-issue as far as the Housing Board is concerned. "The FHLB System's use of derivatives is strictly to reduce or manage risk. If it were otherwise the examiners would be all over them," says Tom Sheehan, acting director of the Board's Office of Policy. Following a reorganization of the System in 1989, the Banks were subjected to intense regulatory scrutiny by the newly restructured Housing Finance Board. While nearly everyone claims that they use derivatives only to "manage" risk, all indications are that appearance has matched reality in the case of the Home Loan Banks.

Investments-not derivatives-are perhaps the most controversial aspect of the FHLB System's operations from a regulatory standpoint. In addition to their importance as a liquidity reserve, the FHLB System's use of short-term investments is key to their effective participation in the funding markets. The ability to "warehouse" note proceeds in short-term investments allows the FHLB System's quick response to funding opportunities, some of which may hinge on momentary swings in the marketplace.

However, the FHLB System's oversight body is not entirely pleased with the current size of the system's money market investment portfolio. "The Finance Board believes that the System's balance sheet profile is not quite what a government-sponsored enterprise should look like," says Sheehan. "Assets should be more related to the FHLB System's housing mission. We've been trying to move the Home Loan Banks away from money market investments in particular."

For the moment, however, there seems to be no alternative to meeting the system's financial obligations, which includes providing a return on its large capital base. The FHLB System's 5.6 percent capital ratio, almost twice that of Freddie Mac and Fannie Mae, is extremely high for an institution with its low risk profile. "The System's capital levels are driven by statute, not risk," says Sheehan. "We've estimated our risk-based capital along the Basle Accord guidelines and come out with a FHLB System average of about 22 percent." Regulatory reform now under discussion in Congress would ease the FHLB System's capital requirements-and some of the earnings and leverage pressures which go along with them. If this comes to pass, Home Loan balance sheets could shrink and along with them their participation in the debt and swap markets.

The future

Callable note issuance-a linchpin of the Home Loan Banks' recent capital market participation-is perhaps the most important sector to watch. Prospects here depend on the persistence of the swap call arbitrage, and, of course, continuing investor appetite for callable paper. "There has been a durable discrepancy between the cost of options in the debt and swap market, but you've got to sell the paper to get the arbitrage," says one dealer. "The FHLB System has already seen a lot of change in demand for their notes. It's mostly interest rate environment driven. Changes like an inverted yield curve could alter demand."

On the product front the FHLB System continues to look for new ways to meet the risk management needs of its borrowers. A major challenge for the Home Loan Banks is finding ways to serve borrowers with loan requirements too small to hedge with individual dealer transactions. The FHLB System's growing analytics resources should be helpful in this regard. Auron expects more application of hedge products for overall balance sheet management-departing somewhat from individual transaction pair-offs-as the FHLB System becomes more sophisticated. This is an area where Auron sees value added by dealers. "Wall Street has been a tremendous resource in developing our understanding of the markets. If I ask a good shop for input on risk management issues, they are usually very helpful," he says.

While Wall Street remains a valuable technical resource, it's the Home Loan Banks that are in the best position to generate product ideas. "The Home Loan Banks are going to have to drive the dialogue with their borrowers," says one dealer. "Good [structured] product opportunities are going to arise from a detailed understanding of the asset/liability needs of their members. Since the Home Loan Banks can transact efficiently with the Street and secure the credit of their members, they're in a good position to serve as a pass-through. I think it can be a win-win-win situation."

The tools and opportunities of the derivatives market have played a significant-perhaps even crucial-role in the FHLB System's prosperity in the 1990s. However, the nature of their relationship to the market has changed radically in the course of these few years. No longer just passive beneficiaries of the market, the Home Loan Banks find the future is in their hands.

Developing an Analytics Base

The Home Loan Banks quickly realized a need to upgrade their analytics when their derivatives activities began to rapidly expand in the early 1990s. However, the road to a solution was a long one. Developing a system to meet the needs of the Banks was a tall order. The structured note market gave rise to an incredible variety of financial gadgets: notes linked to various rate, currency and equity indexes; notes with all sorts of embedded options; mortgage-linked principal paydowns; and other variations too numerous to mention. The very difficulty of valuing these structures played a significant role in the profitability of the market for dealer firms. In this respect, the more opaque the structure, the better. While the Home Loan Banks issued all their structured notes on a perfectly hedged basis, they recognized the need to better monitor the credit risk of a growing book of exotic hedges and were anxious to better understand what was a growing part of their business.

The basic philosophy of a good valuation system, according to Trevor Colvin of Pinehurst Analytics, involves "taking the known value of liquid instruments and using them to calculate the value of illiquid ones." With complicated structures, this is easier said than done. Even swaptions-usually the most liquid instrument available to specify term structure volatility-can show wide variations in quoted prices. Colvin emphasizes complete transparency of methods in his system. "It's not a black box," he says. Although this kind of sophistication would seem to play to a limited audience, Colvin observed a keen interest by the Home Loan Banks in understanding the fundamentals.

The 12 banks, true to their separate business identities, took different paths to boosting their analytics capabilities. The Federal Home Loan Bank of Chicago was one of the first to commit to a major trading quality system, commissioned Colvin's firm to develop a system around their needs. Pinehurst Analytics's system went online in late 1994, and since then has been adopted by two additional regional Home Loan Banks.

Another group of banks took a collective approach, joining together with the Office of Finance in Virginia to look for a common solution. The search for the best provider took about 18 months from start to the signing of an agreement. It was an excruciating process, but according to Marshal Auron at the Home Loan Bank of Pittsburgh, one that was worth the effort. The group, which now includes seven district banks, selected Principia Partners to deliver a dealer-developed system based on one that they had originally built for Republic National Bank of New York. Auron says that, despite the formidable complexity of the system, the software implementation was the smoothest he's ever seen. Auron attributes this to the group's insistence on carefully defining its requirements and seeing the system in operation before committing.

The results of the Bank's effort and expense has been gratifying. Says Auron: "The system has made us a lot smarter in entering into transactions-both with pricing and modeling behavior. It's also made a difference in product development and delivery-rather than pester dealers we can model things ourselves." A dealer concurs: "I think they're going about [the application of derivatives technology] in an intelligent way. They're measuring their exposures more objectively, and can price deals themselves."

Colvin is particularly gratified by the use of his system by FHLB System traders to negotiate better deals. Both Principia and Colvin's system can be used to readily evaluate most structured transactions. Although being able to calculate a value does not necessarily strengthen the Home Loan's bargaining position, it sometimes can serve as a basis for negotiating-or simply refusing-a mispriced deal.

The regional Home Loan Banks have differed in the way they use their systems-though an important aspect for all is keeping close track of counterparty credit exposures. Theresa Adams, director of sales and marketing at Principia Systems, says: "Our system provides integrated front, middle and back office functions, but each bank has a different emphasis, such as credit risk, accounting or transactions."

Successful application of valuation systems depend on a lot more than good software code. Both Pinehurst Analytics and Principia emphasize ongoing user training and ongoing development. The systems also rely on daily data inputs from a wide range of markets, a feature that is typically packaged into the service contract. "Our product's scope is constantly broadening, as clients use the systems for more than trading," notes Adams. "In the future, I see more emphasis on the portfolio management capabilities of systems such as ours."

After years of playing catch-up, the Home Loan Banks now seem satisfied with the results of their efforts. The costs in time, money, and effort have been daunting, but unavoidable given the depth of the System's involvement in the markets. Each organization's challenges are different, and the Home Loan Banks' experience seems to offer no clear road map. Asked what else he's learned from the process, Auron says simply, "a lot of patience."