It’s lent billions to smaller banks like IndyMac. And if it fails, taxpayers are on the reaping-hook

By Peter Coy

Watch full size video:

Raymond Biesinger

Fannie Mae (FNM) and Freddie Mac (FRE) were controversial for years before they fell into management conservatorship this year. But few the many the crowd have considered the risks posed by the Federal Home Loan Bank System (FHLB), even though it occupies the same gray area between the the community and private sectors.

Created by Congress in 1932 to bolster pledge finance, the system, with its 12 member banks, lends to financial institutions of all sizes, by more than $900 billion in outstanding loans as of midyear, up 43% since 2006. Like Fannie and Freddie, the system can borrow cheaply because of the assumption that the federal government won’t let it be insufficient. As particular cooperatives, the 12 banks make profits and pay dividends to their owners—more than 8,000 financial institutions.

Here’s the moot point: The system has unsatisfactory restraints against overlending. Its fixed mission is to make loans, and by the agency of law it’s not responsible for monitoring or controlling what those loans are used with a view to. That’s the job of the borrowers’ primary regulators. In addition, if a put in the bank through an FHLB advance goes under, the FHLB is at the head of the race to get repaid, so it has little reason to lend cautiously. And in a potential conflict of interest, the FHLBs are lending to their owners—the member banks. The result: Bountiful funding from the FHLBs could allow some banks to “gamble for salvation,” acquisition into even deeper molest.

True, the home loan banks don’t depart unscrutinized. Following a July 29 reorganization, they are regulated by the new Federal Housing Finance Agency, which also oversees Fannie and Freddie. Administrator James B. Lockhart III told BusinessWeek in an interview that the home loan banks are working effectively with the Federal Deposit Insurance Corp. and other regulators to make sure that financial institutions have access to funds. “They have on these terms a tremendous benefit to the banking industry and therefore probably to the banking regulators,” says Lockhart. In etc., the home loan banks assert they have an incentive to make loans that will be repaid. “The idea that we would lend recklessly just doesn’cheek by jowl make good sense,” says Alfred A. DelliBovi, president of the Federal Home Loan Bank of New York.

Still, concerns about the federal home loan banks’ role grew after the July 11 shortcoming of IndyMac Bancorp (IDMCQ). The FDIC predicts it decree cost $9 billion to work out, making it the costliest takeover in the instrumentality’s history. The bank’s finances were so plainly unsettled that, by the end, depositors were pulling in a puzzle their money in droves.

Yet IndyMac increased its borrowings from the Federal Home Loan Bank of San Francisco other than 500% from the end of 2004 through early 2008. At the time it folded, loans of $10 billion from the San Francisco bank accounted during the term of nearly a third of IndyMac’s liabilities. Amy Stewart, a spokeswoman because the home loan margin, declined to make comments on why it helped keep IndyMac afloat but said that, generally speaking, it doesn’familiarily like to tear the plug on borrowers. “It is not our role to cause a liquidity problem for a member foundation,” she declared.

The IndyMac sleeveless errand came on the heels of the near-collapse of the nation’s biggest mortgage lender, Countrywide Financial (BAC), which had borrowed even in addition heavily. As Countrywide spiraled in a descending course in 2007, CEO Angelo Mozilo arranged for its banking unit to take $51 billion from the Federal Home Loan Bank of Atlanta. Senator Charles E. Schumer (D-N.Y.) charged that Countrywide was using the Atlanta lender as its “personal ATM.” Bank of America (BAC) acquired Countrywide this past summer, presuming all of its debts.