On December 27, 2010, the Federal Housing Finance Agency (the “FHFA”) issued an advance notice of proposed rulemaking (“ANPR”) which poses substantial issues regarding certain types of existing members (“Members”) of the Federal Home Loan Bank System (“Bank”) and certain types of applicants that previously would have qualified for membership. The stated intention of the proposed rules is to strengthen the relationship between the Members and the FHFA’s primary housing finance mission. However, the potential impact of the ANPR, depending upon the final version, may have broad implications regarding continued access to this historic source of funding for housing finance.
In particular, the FHFA identified three regulatory amendments intended to strengthen the connection of Members or applicants with their commitment to housing finance and asks for various types of public comments on them.
The 10 Percent Requirement
The first FHFA proposal would require that an insured depository institution that was not a Member as of January 1, 1989, may become a member only if it has at least 10 percent of its total assets in residential mortgage loans. The proposal would require that Members consistently maintain this 10 percent of assets as an ongoing obligation. By way of background, the current regulations employ an approach that deems an applicant to be in compliance with the 10 percent of assets requirement if, based on the applicant’s most recent regulatory report, the applicant has at least 10 percent of its total assets in residential mortgage loans. The impact of this requirement is that applicants need to demonstrate compliance with the 10 percent requirement only at the time the application is filed. Even though the FHFA states in the ANPR that it has no evidence that significant numbers of Members have subsequently reduced their residential lending, the changes are intended to ensure institutions are not encouraged to reduce their commitment to housing finance. The FHFA therefore seeks to amend its regulations to make the 10 percent requirement an ongoing obligation.
The ANPR makes clear that there is nothing in the Federal Home Loan Bank Act (the “Bank Act”) that would prohibit an ongoing 10 percent obligation. In addition, the FHFA requests comments for suggestions regarding the methodology it should use to properly measure compliance. Finally, comments are solicited regarding how to enforce compliance with the 10 percent requirement and how that should be tested.
A related issue in the ANPR is whether to apply this same on going 10 percent requirement to community development financial institutions and to insurance companies. Currently, these institutions are only required to have assets that demonstrate a commitment to housing finance and applicants must state such a commitment with a plan in their application.
Implementation of a regulation mandating continued compliance with the 10 percent requirement could chill applications from insurance companies and have far reaching implications for other non-traditional financial institutions. A continuing 10 percent requirement likely is not being met at this time by these institutions and could cause institutions to consider leaving the Bank system rather than having to substantially change the business mix of their organization. In addition, insurance company applicants likely would not consider membership with this requirement in place. This fact would effectively prohibit such institutions from becoming or staying Members should this rule be implemented.
The “Makes Long-Term Home Mortgage Loans” Requirement
The Bank Act currently requires that, in order to become a Member, all applicants must make long-term home mortgage loans. This provision is implemented through a “presumptive compliance” approach, by which an applicant is deemed to have satisfied the long-term home mortgage loan requirement if its most recent regulatory financial report demonstrates that it originates or purchases long-term home mortgage loans. Like the 10 percent requirement, compliance with this requirement is not assessed at any subsequent date. Also like the 10 percent requirement, the FHFA seeks to amend its regulations to make the long-term home mortgage loan requirement an ongoing obligation.
As the requirement now exists, an applicant could satisfy this requirement by a purely minimal effort to build a mortgage loan portfolio in the reporting period immediately preceding its application for Bank membership. The ANPR seeks comment regarding how much of applicant and member assets should be required to be invested in long-term home mortgage loans and whether any asset requirement should take into account the different kinds of institutions eligible for Membership.
The Home Financing Policy Requirements
The FHFA requires that, in order to become a Member, any applicant that was not a Member as of January 1, 1989, must demonstrate that the character of its management and its home financing policy are consistent with sound and economical home financing. This assessment is done in various ways, including by looking at the applicant’s Community Reinvestment Act rating. If the rating is “satisfactory” or better, the applicant is deemed to be in compliance with the home financing policy requirements. An applicant not subject to the Community Reinvestment Act is required to file a written justification of how and why its home financing policy is consistent with the FHFA’s housing finance mission. Like the two previous provisions discussed, compliance with the home financing policy requirements are determined at the time the Bank membership applicant is evaluated.
The FHFA is considering whether, like the two previous provisions, the policy requirements should be made ongoing requirements. In addition, the FHFA is considering making the policy requirements more specific. One proposal the FHFA presents is to create a presumption of compliance with the home financing policy requirements if the institution is in compliance with the 10 percent and long-term mortgage loan requirements.
Other Provisions: Captive Insurance Companies and Shell Insurance Companies
The FHFA also asks for comments on issues related to captive or shell insurance companies. For these purposes, a captive insurance company does not underwrite insurance for third parties and a shell insurance company is inactive. The FHFA expresses concerns that these entities are not subject to the proper degree of supervision and examination and questions whether they have a bona fide involvement in supporting housing finance. The FHFA seeks comment regarding amending the regulations to require that insurance company applicants and Members actively underwrite third party insurance and be actively examined and supervised by state insurance regulators.
In the past, structuring an affiliate as a captive or shell insurance company allowed various benefits, including Bank membership. Depending upon how the final rule may be drafted, such captive and shell entities may be in danger of being booted out of the Bank system, requiring such institutions to find a FHFA substitute.
FHFA also seeks comments on how it should enforce these regulations. It is considering two possible courses of action for Members that have fallen out of compliance. The FHFA proposes that it could either terminate the violating institutions membership or something less drastic, like prohibiting further access to Bank services during a specified period. Adopting regulations that prohibit access to Bank services for even a short period of time could have far reaching consequences. As a practical matter, banks that depend in part on Bank services could see their liquidity discounted both by regulators and the market based on the reduced availability of funding/advances. Historically Members that pledged assets to Banks to secure Bank advances were assured these advances were always available as a ready and continuing source of funds for housing finance. The distinct possibility of alternatives posed by the ANPR is to inject uncertainty into the funding/advance system in the future. Finally, the ANPR addresses two issues related to its regulatory structure.
The FHFA seeks comment addressing whether the regulatory standards currently in place, which presume compliance in certain situations, are the most effective. It also asks how it should interact with the Banks and Members on membership issues. This suggests that the FHFA is looking to expand their role into the area of enforcement at a time when so many other agencies are also expanding their mandate, the consequences of which may take some time to be fully understood.
The ANPR presents several issues that could fundamentally change the way financial institutions do business. At a minimum it is clear that a stable source of funding for housing finance may be dramatically changed in the future.