Q&A with Richard Dorman

Mortgage Banking

March 2009



The Federal Home Loan Bank of Atlanta, along with the 11 other regional home loan banks, has been providing needed liquidity to the market during the credit crisis. But even these conservative institutions are facing large potential writedowns on privatelabel MBS.



By Robert Stowe England


Since June 2007, Richard Dorfman has served as president and chief executive officer (CEO) of the Federal Home Loan Bank of Atlanta, whose members are commercial banks, credit unions, thrifts and insurance companies headquartered in Alabama, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia and the District of Columbia. The Atlanta bank is one of 12 regional banks in the Federal Home Loan Bank System. The others are located in Boston; New York; Pittsburgh; Cincinnati; Indianapolis; Chicago; Des Moines, Iowa; Dallas; Topeka, Kansas; San Francisco; and Seattle.


Each of the home loan banks is a government-sponsored enterprise (GSE) that provides member institutions in its region with advances that are used by the banks to fund mostly residential mortgages. The advances are backed by pledged collateral from the member institutions - typically residential mortgages.


The 12 regional home loan banks in the system earned $506 billion in the third quarter of 2008, the most recent reported quarter - down from $732 billion for the same quarter in 2007. Earnings for the first nine months of 2008 were $1.921 trillion - only slightly less than the $1.981 trillion in the first nine months of 2007.


Dorfman brings to his challenging job at the Atlanta bank decades of experience in mortgage banking and investment banking. Prior to his taking the reins of the Atlanta bank, he was operational and advisory consultant to several home loan banks, as well as to the Federal Home Loan Bank's Office of Finance in Reston, Virginia.


From 1997 to 2005, Dorfman was managing director and head of U.S. agencies and mortgage business at ABN AMRO Inc., Ann Arbor, Michigan. From 1983 to 1996, he held a number of senior executive positions with Lehman Brothers, New York. He was Lehman's manager of global securities of- ferings and advised clients that included Fannie MaeFreddie Mac, the Federal Home Loan Banks, and the Canada Mortgage and Housing Corporation (CMHC), Ottawa.


Before becoming an investment banker, Dorman was an attorney with the Federal Deposit Insurance Corporation (FDIC), as well as regulatory counsel for the New York Bank for Savings. He obtained his juris doctorate from Syracuse University, Syracuse, New York, and his bachelor of arts degree from Hofstra University, Hempstead, New York.


Mortgage Banking caught up with Dorfman at his office in Atlanta in December, where he was more than happy to talk about the expanding role of the Federal Home Loan Banking System in the mortgage markets.


Q: Recent news about impaired mortgage-backed securities at the home loan banks might suggest that you will at some point need government funding or face problems similar to those at Fannie Mae and Freddie Mac. Is that the case?


A: While we share similarities such as the government-sponsored designation, the home loan banks have significantly different business models and are performing very differently in the current market. The banks are self-capitalizing in the sense that borrowers also purchase stock when they come in for funding. So, we have been able to build and grow our capital base even as we expanded liquidity to our members. Risks remain, but overall, our operating model and the cooperative structure have been rather effective in helping us weather the storm. With respect to the mortgage-backed securities, they are considered impaired because of market values and accounting standards, but they continue to perform and we intend to hold them until maturity.


Q: Let's get to some of the basics, since some people are unfamiliar with how the system works. For example, what is the Federal Home Loan Banking System and how does it differ from Fannie Mae and Freddie Mac in terms of its role in the mortgage market?


A: I'd like to look at the form-and-f unction question first. What do we do? And what do they do? Fannie and Freddie Mac . . . buy mortgages from originators and ultimately - either to invest in them by holding them or to fund them in the short-term - securitize them and sell them. Fundamentally, [the Federal Home Loan Banks] interface with the mortgage origination world overwhelmingly through depository institutions. [While] Fannie and Freddie interface with depository institutions, they also interface with non-depositories and intermediaries, among them mortgage bankers. And we do not have mortgage bankers in membership because it is not permitted by statute.


Q: How specifically is your relationship with mortgage originators different from Fannie's and Freddie's relationship with originators?


A: Our relationship with the mortgage origination world ... is not to be a buyer of mortgages, but to lend them money on the collateral of mortgages to allow them to fund these mortgages either in the very short term, essentially to keep them liquid, or in the longer term, [to allow member institutions] to buy and hold these mortgages.


Q: So, how is your balance sheet different from Fannie's and ' Freddie's?


A: Our balance sheet is overwhelmingly characterized by an asset called "advances," meaning loans to members. And, remember, we are a cooperative - as opposed to a stock-exchange-listed corporation - so only our shareholders can be members. It's like the college [cooperative] book store. You buy a membership card and you can buy your books there. And at the end of the year they send you a dividend, presumably. And we're not really different from that. You buy shares, and we have two classes of shares. We have membership shares and usage shares.


To be a member, you invest a relatively small amount in shares. And to be a user, you borrow your funds [and you invest a proportional amount in shares]. We have about 60 funding products, ranging from the [simplest, which is] overnight funding, out to intermediate, out to longer-term advances, which provides various kinds of options that are extremely useful in controlling interestrate risk. We sell products that are not only for funding, but for risk-management purposes as well.


Q: How do you determine what should be accepted as collateral?


A: We have rules as to what kind of collateral is acceptable and how much collateral an institution needs, which is a function of their credit rating, and what the collateral is worth, which helps us come down to an over all figure. If you are posting ? face value of acceptable collateral with y market value, we will lend you ? against that collateral. We call that lendable collateral value. Just to give you some sense of dimensions, the business I described, the business of advancing funds, loans on collateral, has a present activity level across the 12 banks of approximately $ 1 trillion. So to say the least, this is nontrivial.


Q: It's hard to ignore the significance of $1 trillion in lending activity on both the mortgage market and the overall economy.


A: The aggregate of balance sheets is about between $1.3 trillion and $1.4 trillion, the balance of those assets being, to a large degree, mortgage-backed securities [MBS]. So, like Fannie and Freddie, we are holders of portfolios of mortgage-backed securities, but those are strictly limited by a small multiple of capital: three times capital and in some cases up to six times capital, with the permission of the regulator [the Federal Housing Finance Agency].


Overwhelmingly, our job - our mission by law - is to keep the banking system of the United States healthy by making it liquid. That's the value of the Federal Home Loan Bank System. The mortgage connection is that overwhelmingly the collateral we accept for [making those funds available] are mortgages that must have a lendable value of not less than 100 percent of the money advanced. So, that's the mortgage connection. We help banks, thrifts and credits unions to own mortgages either briefly or permanently, and advance them funds to enable them to do so.


Q: Where do Federal Home Loan Banks get their funds?


A: The answer is exactly the same as [for] Fannie Mae and Freddie Mac. We are huge participants in the global and domestic debt capital markets. We are entirely funded in what's known as the public market, which means private money. We are not funded by the U.S. government. We are not owned by the U.S. government. We operate under the rubric of a GSE, and we have the same kind of access to Federal Reserve clearance facilities and government oversight that Fannie Mae and Freddie Mac have. And you may be aware that [since September] we are all - Fannie, Freddie and the home loan banks - regulated by the same regulator, which is the Federal Housing Finance Agency. 


Q: Between July 2007 and the fall of 2008, the total amount of advances made by Federal Home Loan Banks went from about $600 billion to $1 trillion. Could you explain what drove this expansion?


A: Actually, that's a wonderful story. Sometimes you can see very great good in the midst of very trying times. . . . [T]he current financial crisis can be traced back initially to a progressive lockdown of credit markets, running from subprime to mortgages to corporate |bonds] and so forth until it became almost impossible to borrow money for any purpose and any reason, regardless of who you are. The credit freeze, going back [to the summer of 2007], had a severely negative impact on depositories, banks and such, across the country, in terms of their liquidity. Their overwhelming inability to borrow through private facilities, directly accessing the market, required that the Federal Home Loan Banks step up and use our highly developed global access, and that means 80 countries around the world whose central banks invest heavily in our paper.


Q: How big a role do foreign central banks play?


A: If you look at funding patterns for Fannie, Freddie and the home loan banks, about 60 percent of that money comes from outside the United States. Through this mechanism, the home loan banks were able to fill the gap and lend hundreds of billions of dollars in the space of a few months. The Atlanta bank had a disproportionally high share of that in our own market.


We are very well-known, for example, among our 1,200 banks [members of the Atlanta Federal Home Loan BankJ and the 8,000 member banks nationwide. We're very, very well-known as the guys who came to the rescue. It's amazing that this story - the ability to step up and do that amount of business almost seamlessly attracted so little attention. We operate very quietly. And I strongly feel that now is the time, if there ever was a time, to tell our story better than we have. So, it's the credit freeze and our ability to fill the space with lots of liquidity and keep banks healthy [that is the reason] our balance sheets grew so sharply.


Q: As I understand it, you have not taken subprime loans as collateral. How were you able to avoid that?


A: Because we do not own mortgages we take as collateral, we are in a position to impose some very demanding rules that protect [us] around that collateral. We do not accept any mortgages - and we return mortgages - that miss even one payment. Generally speaking, we do not accept nonperforming collateral.


That has a lot to do with the fact that, unlike Fannie and Freddie, we have no worldwide group of third-party private-market shareholders to whom we have to show ROE [return on equity] and ROA [return on assets], and ultimately a market capitalization that is the end-all and be-all for them. Our members and our customers are the same institutions.


Q: What governs how much capital member institutions invest in each home loan bank?


A: Their investment in us is variable, according to the amount of money they borrow. First, to become a member you have a stock investment. When you borrow from us, you invest further [with usage capital]. And when you repay that advance, your stock is redeemed [and you get your investment capital back]. And so we do not have a fixed pool of highly expectant investors. And we are not constrained to take risk to satisfy that kind of earnings level. We're all about service. We're all about lending money in volume at times and in structures that are very, very advantageous to the mortgage-creation world. As we see more and more institutions avail themselves of the benefits of being a bank, we arguably become ever more relevant.


Q: How does share ownership affect the relationship of the home loan bank to its members? 


A: I like to talk to constituents about what I like to call the duality of membership. You buy shares and what do you get? What you get is proportional interest in a balance sheet that is capable of producing dividends and capable of absorbing theoretical risk shocks by being well-capitalized. So, obligation No. 1 is to maintain a very safe and highly sound bank that members can have confidence in. Now, confidence for what purpose? Confidence for the purpose of benefit No. 2 - to be able to fund in ways and in structures, at prices, in volumes and timing [to] provide members what they need.


We are member-need-driven. We cannot tell them what they need. We can't follow 1,200 banks and know what they need. They tell us what they need. We are able, in most cases, to provide exactly what they want exactly when they want it.


Q: Getting back to the increase in advances, this took place at a time when everyone else cut back - which points to the countercyclical impact of what the Federal Home Loan banks can do. Can you explain how they operate countercyclically? Why are funds available from Federal Home Loan Banks when everyone else is pulling back?


A: Let's begin with the availability of funds in the market. Until very recently, the global debt capital markets have had no problem in funding what we need when we need it, and at attractive levels. Only in the [worst] days of the crisis we are in !currently] has the funding tightened up for everybody, include Fannie, Freddie and the home loan banks. Having postulated availability of funds, how was it we were able to advance funds to members while investors in mortgages were pulling back? And the answer to that is that we feel that we are a very prudent, very safely managed, indirect investor in mortgages. That is to say, the mortgages we hold are not our assets, but the assets of our members.


Q: So, holding mortgages as collateral rather than owning them makes a big difference?


A: We hold them as collateral against the possibility of default, understanding, please, that no home loan bank has ever lost even one dollar on an advance. The reason for that is that when you do have the occasional inability to pay - bank failures, defaults short of failure - the collateral we hold is carefully evaluated for its quality. In a sense, [the question is] how prime is it? Or how prime is it not? What is the credit level of the member? What is the value of that collateral, given its nature in the market? And, ultimately, combining those factors, how much collateral would we require, understanding that the law tells us not less than 100 percent? But it can be more than 100 percent.


Q: What leads you to require more than ioo percent collateral?


A: When we feel there is some unusual degree of credit jeopardy.


Q: What does the excess collateral provide in terms of security?


A: We are able to very carefully place a buffer between ourselves and credit risk of a borrower by inserting enough collateral at the right quality and at the right price, so we have a ratio that tells us we should feel confident that we are properly covered on a member-to-member basis, given the nature of the credits, the kind of business they do, and the nature of the collateral and what that collateral is worth. And when you model all that together, you come out with our collateral position.


When you look at the Atlanta bank, our balance sheet is about $2 io [billion] to $215 billion. It varies from day to day and it is growing. But the mortgage collateral we hold in terms of market value is something just below $300 billion. So, you clearly have a ratio there that tells you we have adjusted collateral we hold to reflect the risk we take. That's our trademark for being able to serve our market when others who are investing directly in mortgages feel uncomfortable about taking that risk in mortgages.


Q: So, all in all, the Federal Home Loan Banks are doing a lot of things that are really needed?


A: Really needed and really supportive of the whole mortgage industry.


Q: You were talking about the financial strength of the Federal Home Loan Banks. What is their average leverage ratio?


A: On average, you run into [a ratio of] 1 to 22 or 1 to 23 [in leverage], somewhere in that category - not in the 1 to 35 and 1 to 40 [ratios] that you saw in some financial institutions. From an absolute percentage level, we're at 4 percent minimum capital, as opposed to 2.5 percent capital [as was the case with Fannie and Freddie].


Q: Until recently, you had another regulator with a different name - the Federal Home Loan Bank Board.


A: Yes, but it was the same deal. And essentially the new regulator - FHFA [the Federal Housing Finance Agency] - has absorbed the old regulator. So, those [personnel] at the regulator who look after the home loan banks are the same people.


Q: How have things played out in the geographical area covered by the Federal Home Loan Bank of Atlanta, which has its own set of issues - particularly, I guess, the problems in Florida?


A: Across our region, as in all regions, unfortunately, you have some degree ... of weakness within the banking system that implies a level of concern for bank regulators, and therefore implies a level of concern for [us], because these owners are our members and also our customers. And yes, Florida is a distressed area; [however,] North Carolina is not. . . . We respond to these issues very much by market, very much on a bank-by-bank-bybank basis. We run credit tightly on every single one of roughly 1,200 banks [that] are members. We understand their condition.


We correspond frequently with the bank regulators to understand where they are and what their needs are. Now, they do not disclose information on individual banks, but give us regional views. We are very much in the swim, so to speak, in terms of understanding the balance sheet and the greater credit quality of our members. . . . Yes, we understand what the CAMEL rating is. [The CAMEL rating system is a method of evaluating the health of credit unions by the National Credit Union Administration. The rating is based upon five critical elements of a credit union's operations: Capital adequacy, Asset quality, Management, Earnings and asset/Liability management.]


We understand [the credit condition of] those members who are publicly rated by Moody's [Investors Service, New York], S&P [Standard & Poor's, New York] and Fitch [Ratings, New York], what the credit rating is. But most importantly, we have our own internal rating system, which is a 10-grade system. And a member's internal credit rating derives in part from the arrangement we require as collateral.


Q: So your internal credit rating determines the collateral level for a given financial institution?


A: In part, that is one of the factors that determine the level of collateral.


Q: No doubt there is a range of ratings for financial health among the 1,200 banks that are members of your home loan bank, so you would have to vary the collateral accordingly. At this point, you have quite a lot of collateral there.


A: Just for the sake of this conversation, of our $200 billion to $220 billion balance sheet, if advances constitute $175 billion, we would compare that to approximately $280 billion in collateral.


Q: That would appear to be a significant buffer.


A: It's like $100 billion in excess of what is lent out. In rough terms, that's very accurate as a working ratio. As I said before, the minimum relationship by law is 1 to 1. You can see that it's more like 1.7 to 1. So, the implication there is that we have some number of members of whom we require greater than 1 to 1.


Q: You probably can't comment on a single member, but Countrywide [Home Loans, Calabasas, California] was relying on you at one point. You saved the day for Countrywide in 2007 before it was acquired by Bank of America [Charlotte, North Carolina].


A: Inasmuch as our members must be depository institutions, in the case of Countrywide our member was Countrywide Bank.


Q: Which is based in Alexandria, Virginia?


A: Yes, that's right. And that's how they arrive in Atlanta, through Virginia. Our [Atlanta] bank's increase of advances was mostly due to Countrywide. They basically came in for about $30 billion of the $42 billion increase we experienced since mid-2007.


Q: In terms of the institution, has there been any change since mid-2007 in terms of which size institutions are coming to you and representing a bigger share of your business?


A: That's a very good, important and interesting question. I'll give you the Atlanta philosophy of that. You will see in our membership banks of [the] smallest size, truly community banks. Overwhelmingly, of the 1,200 members, almost every one of them is a community bank. And then you have a few banks that are simply the largest banks in the world [based] in our district. They all constitute our 1,200 members. We take a very strongly argued view that our diversified integrated membership is [a way of] internally leveraging. They advantage each other.


Q: Why is the combination of big and small banks so valuable to the Federal Home Loan Bank System?


A: Essentially, [it's because] the market loves big deals. Foreign governments like to buy huge deals that are very liquid and, of course, very high in quality. And those huge deals are propelled by our largest members, in most cases. And we are then able to enlarge those deals to create very attractively priced availability [of funds for advances] for our community bank members. . . . So, if you think of us, I like to use the metaphor of a bridge, going from Hometown USA going to the global markets in China and Japan and Europe and so forth - that would be a very accurate visual image of what we do.


Q: As you know, Fannie and Freddie were rescued by FHFA and the Treasury Department in September, and mortgage rates initially fell. However, within a week, when a panic ensured from the failure of Lehman Brothers, mortgage rates went back up. And the spreads widened against Treasuries. Once the Fed announced it was buying up the mortgages in November, the rates started back down. Have activities by the Fed affected rates from financial institutions that are members of the Federal Home Loan Bank System?


A: The Fed announced, too, it was going to participate in new [debt] issues [of Federal Home Loan Banks; that is, they intend to] buy our consolidated obligations. In theory what that would mean (and in practice there is apparently some of this occurring), their demand for our debt obligations lowers our cost of funds, which, in turn, means lower borrowing cost to our members. And [this] kind of flows through the system.


Q: The Fed has actually begun doing this?


A: Yes, they have. But, again, this should be seen as more of a stimulus than as a full-coverage program. Our funding needs are so vast, and their capabilities are significant but only a relatively small fraction [of our needs]. So, we are hardly dependent on them, but their presence in the market is a stimulus that we hope will be just that - a stimulating event to broader global markets for others to get involved.


Q: I notice the earnings of the Federal Home Loan Bank System in the latest quarterly report were affected by the collapse of Lehman Brothers. Did that affect your bank?


A: Certainly - it is publicly known that we were exposed to Lehman Brothers special funding, and that has caused us to take a sizable reserve pending the recovery of that collateral from Lehman Brothers.


Q: That collateral is mortgages?


A: It's MBS and agency debt. It's very common liquid collateral.


Q: So, theoretically, there should be hope for a reasonable recovery?


A: Especially if you're religious.


Q: Yes, and pray daily. . . . How does the future look for the Atlanta bank and the Federal Home Loan Banks in general?


A: That obviously depends on the shape of the banking system going forward - [which, in turn, depends on] whether we're going to be in a consolidating banking environment, and what support we get from Congress and the new administration. Will they expand our mission and so forth? We are focused on doing the singular job we do well, which is to keep banks highly liquid.


Q: Will a consolidation among community banks affect their overall role in the Federal Home Loan Bank system?


A: [The 8,000 members of the Federal Home Loan Bank system] are overwhelmingly community banks that need access to capital markets that they could not otherwise have. A relatively small number are huge banks who are perfectly capable of financing in their own name, but who find that using us as a material funding alternative from time to time is very useful for them. No matter how big they are, we are yet bigger. We are in the market all the time. And they can take advantage of that by including themselves our financing activities.


My point is that our country is overwhelming a country of community banks. Whether [the total number of] those banks will be 8,000, 6,000 or 5,000, this will still be a country dominated by community banks. And our business model has served those banks for 77 years [with] astonishing efficiency and effectiveness.


Q: Will changes in the banking industry affect the role of the Federal Home Loan Bank System?


A: Whatever the ultimate configuration or composition of the banking industry is going to be, I think anyone would be well-supported by reason to say that home loan banks will continue to do our job in pretty much the same way going forward. There may be some adjustments, but I think the job we have done, the job we will do, is filling this critical need - providing the most effective and available funding to the world of community banks and very important alternative funding to super-regional, national and global banks. So, I think we have a very bullish organization and bank system, and we intend to do everything we can to keep it that way.




 Copyright © 2009 Mortgage Bankers Association of America. Reprinted with Permission.



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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