Government-sponsored enterprises (GSEs) represent an unusual intervention by the federal government into private capital markets. GSEs are financial institutions that are individually chartered by Congress, but owned by private shareholders (cooperative members or outside investors depending on the ownership arrangement).

The Congressional charters, extraordinary ongoing interactions between these institutions and government officials, and past government actions have created a perception in financial markets that GSE debt obligations are implicitly guaranteed by the federal government. This perception allows each institution to borrow at favorable interest rates and then pass some of these savings on to consumers. Hence, by chartering a specific GSE, the federal government can target benefits toward a specific sector of the economy without recognizing the attendant costs in the federal budget. The three most prominent GSEs are those serving housing: the Federal Home Loan Bank (FHLB) System, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Measuring the extent to which a GSE’s primary business activities provide gross social benefits -- as defined by its statutory mission -- is a critical first step in understanding whether such interventions are desirable. (Of course, even then, one has not accounted for costs, including general equilibrium distortions.) With respect to Fannie Mae and Freddie Mac, a large literature has emerged that attempts to estimate the effect of their activities on mortgage interest rates. Remarkably, as noted by McCool (2005), there has been little attempt to examine similar questions for the FHLB System. This is the aim of our paper.

The FHLB System is a collection of 12 cooperatively owned wholesale banks. The statutory mission of this GSE is to provide their members financial products and services, including collateralized loans (advances), to assist and enhance such members’ financing of (1) housing and (2) community lending. Membership is open to all depository institutions with more than 10 percent mortgage assets and also to community financial institutions (i.e., those with less than $587 million in total assets as of December 2005). Over 8,000 financial institutions are currently members of the FHLB System.

In this paper, we focus on the role of FHLB advances in stabilizing commercial bank members’ financing of housing. We specifically consider three questions. First, are unexpected changes in advances correlated with changes in residential mortgage lending and other forms of bank lending? Second, are unexpected changes in bank loan portfolios, including residential mortgages, accommodated using FHLB advances? Third, do FHLB advances help to insulate bank portfolios from macroeconomic shocks (e.g., unexpected changes in the federal funds rate, the yield curve, or GDP) and do these shocks have less of an effect on residential mortgage lending than on other forms of bank lending?

Toward answering these questions, we first develop a loan pricing model that provides the conditions for relatively cheap, or more steadily priced, FHLB advances to influence loan rates and thereby affect bank credit and, in particular, mortgage credit. As we demonstrate later, if mortgage markets are heavily influenced by securitization or other forms of market-based financing, then a bank might hold a mortgage portfolio (because it “cherry picks” from the flow of mortgage originations) but still have no influence on mortgage pricing or mortgage credit availability.

As suggested by our theory, a better measure of a bank’s influence on mortgage markets, relative to other forms of lending, is to compare changes in mortgage supply after either a change in the bank’s cost of funds or a change in an exogenous factor that could be offset by a change in a bank’s cost of funds. If FHLBs are providing funds that ultimately create more mortgage credit or if they stabilize members’ financing of housing --- rather than simply funding all bank assets --- then it is through innovations in supply or demand across loan types that this relationship might be observed.

We use the predictions of the theoretical model to interpret recent dynamic responses of U.S. commercial bank portfolios to FHLB advance shocks, to unexpected loan demand shocks, and to macroeconomic shocks using a panel-VAR. We present the following results. First, bank portfolio responses to FHLB advance shocks are of similar magnitude for mortgages, for commercial and industrial loans, and for other real estate loans. Hence, advances are just as likely to fund other types of bank credit as to fund single-family mortgages. Second, unexpected changes in lending, due to changes in loan demand for example, are accommodated using advances by active FHLB members. Mortgage lending is not unique in this respect. Third, FHLB advances do not appear to have reduced the variability in residential mortgage lending by banks that resulted from either federal funds rate shocks or GDP shocks. However, some banks appear to have used FHLB advances to smooth commercial and industrial lending in response to such macroeconomic shocks. Therefore, FHLB advances do not appear to be stabilizing commercial bank members’ financing of housing. Overall, we find that commercial banks are increasingly relying on FHLB advances as a wholesale funding source and -- because money is fungible -- advances are being used to fund all types of commercial bank assets, not just residential mortgages.

The rest of the paper is organized as follows: Section 2 provides some background information on the FHLB System to lay the foundation for understanding our theoretical and empirical modeling strategies. Section 3 provides a theory for considering the effects of FHLB advances on bank portfolio lending in the context of modern capital markets. Section 4 describes our empirical approach, while Section 5 discusses our findings. The last section provides a summary.

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