a higher cost of funds for the FHLBanks, which would adice of advances and other FHLBank services.

is building for the creation of a credible, high quality regulator Department to replace OFHEO. Now would be a propitious ss to consider whether oversight of the FHLB System should this new regulator. To be sure there are important policy deterress needs to make regarding the FHLB System's mission and portant not to impede the momentum behind the transfer of soundness functions. However, concurrent action could assure f all three major housing GSE's, and prevent a widening of further weaken the System.

airman. I will now be happy to answer any questions you may

EPARED STATEMENT OF TERRY SMITH

NT AND CEO, FEDERAL HOME LOAN BANK OF DALLAS

SEPTEMBER 9, 2003

anking Member Johnson, and Members of the Subcommittee, I rtunity to speak to you today about the Federal Home Loan Terry Smith, and I am President and CEO of the Federal Home s. I am also the current Chairman of the Bank Presidents Conral Home Loan Banks (FHLBanks). Along with my colleagues, ovide an update on the FHLBanks' activities and our progress HLBank provisions of the Gramm-Leach-Bliley Act (GLB Act). HLBanks

were created in 1932 to support America's housing finance systhe FHLBanks' ability to raise long-term debt in the capital hat funding along to their member financial institutions that enopment of the 30-year fixed-rate mortgage that is the predomiin the U.S. mortgage finance system today.

ontinue to play a vital role in the Nation's housing finance and system. Our member institutions, primarily community banks FHLBanks' advances program to meet the mortgage and com-ds of their local markets, and use our Affordable Housing Prousing more affordable for thousands of low-income families in These are our primary purposes, and we are proud of our accoming them out.

ystem, as it is sometimes called, is comprised of 12 individual
080 member institutions, and the Office of Finance which issues
the FHLBanks. Each FHLBank is a separate and distinct cor-
its own stockholder/member institutions and its own board of di-
FHLBanks issue debt collectively and are jointly and severally
ment of those debt obligations, there is no single controlling cor-
responsibility for or authority over the FHLBanks. The 12
independently under the authority granted by Congress through
Loan Bank Act (Bank Act), as amended, and in accordance with
cablished by and under the regulatory oversight of the Federal
oard (Finance Board).

are cooperative institutions that operate within districts originally
Federal Home Loan Bank Board, the predecessor to the Finance
Bank's capital stock is owned only by its member institutions, and
members (plus certain nonmember housing associates such as
orities) may conduct business with an individual FHLBank.
ers must meet certain statutory eligibility criteria. Each member
FHLBank's capital stock in order to become a member, and must
tock holdings sufficient to support its business activity with the
in accordance with the statutory formula or, for FHLBanks that
emented the capital plans required by the GLB Act, in accordance
1 FHLBank's capital plan.

apital stock cannot be issued to or held individually by members
pard of directors, its management, its employees or the public, and
aded. There is no market for FHLBank capital stock other than

among FHLBank members. The price of a FHLBank's capital stock cannot fluctuate, and all FHLBank capital stock must be purchased, repurchased, or transferred only at its par value. There are no stock options or other forms of stock-based compensation for FHLBank management, directors, or employees.

Prior to the passage of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989, the FHLBanks' membership was generally limited to thrift institutions (building and loan associations, savings and loan associations, savings banks, homestead associations, etc.) and a handful of insurance companies. FIRREA expanded eligibility for membership to include commercial banks and credit unions with a demonstrated commitment to housing finance. The GLB Act further refined FHLBank membership rules by making federally chartered thrifts voluntary members for the first time and eliminating the remaining statutory differences in the terms of access between thrift institutions and commercial banks and credit unions.

The combination of the FIRREA and GLB Act statutory changes, along with changes in the mortgage lending market, have caused FHLBank membership to expand exponentially in the last decade. As of June 30, 2003, the 12 FHLBanks had a total of 8,080 member institutions, which included 6,037 commercial banks, 1,273 thrift institutions, 693 credit unions, and 77 insurance companies.

As an indication of the role the FHLBanks play in today's financial system, the FHLBanks' 7,310 commercial bank and thrift institution members represent approximately 79 percent of all FDIC-insured institutions in the country. Reflecting the structure of the depository institutions industry, approximately 6,519 (or 89 percent) of those FDIC-insured members are Community Financial Institutions (CFT's), as defined by the GLB Act. (CFI's are FDIC-insured institutions with average total assets for the 3 years ended December 31, 2002 of $538 million or less.) Altogether, approximately 7,493 member institutions (93 percent of all members) as of June 30, 2003 were community lenders with total assets less than $1.0 billion.

As noted previously, every member institution has made a voluntary decision to belong to a FHLBank. Among other things, that means that the FHLBanks must offer, and continue to provide, a membership value proposition that members perceive as adding value to their institutions. The value the FHLBanks provide our members is a blend of the modest dividends we pay on members' capital stock investment, the value of access to stand-by liquidity from the FHLBanks, availability of short- and long-term funds at attractive rates, and access to other products that make a community lending institution better able to profitably serve the credit needs of its community.

The FHLBanks' primary product offerings include traditional advances (fully secured loans to member institutions) and the more recently introduced Acquired Member Asset (AMA) programs. Advances represent the core of the FHLBanks' business, providing a source of funds members can use to support mortgage lending and, for CFI's, other community banking assets. The AMA programs, through which the FHLBanks acquire mortgage loans originated by member institutions under risk-sharing rules and other parameters established by Finance Board regulations, provide a secondary market alternative for those loans. In addition, the FHLBanks offer favorably priced advances for members' special community lending activities under their Community Investment Cash Advances (CICA) programs, and competitive grant programs that provide funds for housing for low-income families under Affordable Housing Programs (AHP) established following FIRREA.

Implementation of Gramm-Leach-Bliley Legislative Changes

Since the enactment of the GLB Act in November 1999, a principal focus of the FHLBanks has been the implementation of the FHLBank provisions contained in Title VI of that Act. The modifications to the Bank Act made by the GLB Act represented the culmination of many years of effort to reform the FHLBanks, particularly the membership rules and capital structure. The main purposes of the FHLBank provisions were to establish a system of universal voluntary membership, provide for a more permanent capital structure to accommodate voluntary membership, equalize the terms of access to the FHLBanks for all types of institutions eligible for membership, and to expand the types of collateral that community banks can pledge to secure advances. I am pleased to report that the FHLBanks are in the last stages of implementing those changes and fulfilling that purpose.

Before FIRREA, the membership of the FHLBanks was comprised almost entirely of thrifts that were required to be members by terms of their charter or deposit insurance. FIRREA authorized commercial banks to become voluntary members, but most thrifts continued as mandatory members. In addition, the terms of access to the FHLBanks for newly eligible institutions, including capital stock purchase requirements, differed from the requirements for thrift institutions. It quickly became

arate treatment was inconsistent with the cooperative strucand was not needed to ensure that thrift institution members o the FHLBanks. As a result, the FHLBanks and their memto amend the Bank Act to provide for universal voluntary terms of access.

voluntary membership has been successfully implemented. All
he same rights to access FHLBank products and services. In
capital stock purchase requirements for advances to commer-
unions based on their different asset mix have been elimi-
oled community bank members better access to advances and,
e the credit needs of their customers. And, although FHLBank
oluntary for all, only a handful of institutions whose business
from FHLBank membership have taken the opportunity to
ership.

historically have had a somewhat different customer base than
en spreading their lending activity among the various types of
ommunity, such as mortgage, small business, and small farm
of this fact and in order to allow the FHLBanks to better serve
, the GLB Act authorized the FHLBanks to make advances to
1 business and small farm loan collateral. The FHLBanks have
onsibly implemented this new authority, acting prudently as
sign appropriate lending values to the new collateral and main-
ever having suffered a credit loss on an advance to a member.
collateral authority has enabled community bank members to
munities.

ent universal voluntary membership, while at the same time
with more permanence, the GLB Act outlined a new capital
LBanks. The major differences include authorization to issue
1 stock-Class A stock redeemable with 6 months notice and
able with 5 years notice and implementation of new leverage,
capital requirements. This new framework adds permanence to
al structure by requiring them to maintain sufficient Class B
arnings to meet the new risk-based capital requirements.
ted a series of statutory deadlines for adoption of new capital
inance Board and adoption and implementation of new capital
al FHLBanks. All of the relevant deadlines have been met and
well on their way to implementing their new capital plans. In
have already implemented their new capital plans, I believe an-
implement its plan later this year, and the remaining five
ement their plans by mid-2005. Each FHLBank has developed
onsultation with its members and in accordance with the Fi-
ations. The plans have been well received thus far, with only
exercising their right to withdraw from membership before im-

provisions of the GLB Act have been very positive for the members. These changes have had, and will continue to have, the Banks' ongoing ability to fulfill their statutory role, and Oundly.

n Banks Financial Profile

pansion of their membership base, the overall growth in the nd increased usage of FHLBank advances and AMA programs, ave grown considerably in the last decade. As of June 30, 2003, combined total assets of $809 billion. The FHLBanks' balance ed by nearly $38 billion of capital, of which more than $36 bilital stock contributed by member institutions. The FHLBanks' assets ratio was 4.7 percent at June 30, with capital ratios for is ranging from 4.2 to 5.6 percent.

total assets, $596 billion (74 percent) represented direct fundsets through advances and AMA. The FHLBanks' aggregate 5 billion at June 30, representing 63 percent of their combined AMA were $90 billion, accounting for about 11 percent of the ate assets. The remaining $209 billion (26 percent) of the sheets were comprised primarily of various highly rated investLBanks hold to maintain a ready supply of liquidity to satisfy advances and AMA, and to supplement earnings to keep adad maintain adequate returns on members' capital stock investy $78 billion of the FHLBanks' investments were in short-term

instruments such as Federal funds sold or commercial paper used by the FHLBanks to warehouse liquidity to meet members' credit needs and the FHLBanks' other dayto-day obligations.

The FHLBanks also maintain longer-term investment portfolios that provide a source of standby liquidity and supplement earnings so the FHLBanks can provide advances and other credit products at attractive rates. At June 30, 2003, the FHLBanks' longer-term investment portfolio represented about 16 percent of their total assets and included $23 billion in securities issued by the U.S. Government or U.S. agencies, approximately $6 billion of securities issued by state or local housing agencies to support their housing finance activities, and approximately $98 billion of mortgage-backed securities. The FHLBanks' mortgage-backed securities have been purchased in accordance with Finance Board guidelines not to exceed three times an individual FHLBank's total capital. These securities are all issued by the U.S. Government or U.S. agencies, or rated triple-A when they are purchased by the FHLBanks.

After weathering the storm of the thrift crisis of the late 1980's and its aftermath, the FHLBanks have been consistently profitable throughout the past decade. Although actual earnings and rates of return have fallen with the decline in interest rates over the last 3 years, this reduction in earnings is a natural and expected result of the way the FHLBanks are structured and how they operate. Because the FHLBanks are wholesale institutions investing primarily in fully secured advances, high credit quality mortgage loans or highly rated investment securities, they operate on very narrow interest spreads between their cost of funds and the yields on their assets. It is typical for a FHLBank to have a net interest spread (the difference between the cost of its liabilities and the yield on its assets) of about 20 basis points (0.20 percent). By way of comparison, a commercial bank might have an interest spread closer to 400 basis points (4.0 percent). Given the FHLBanks' small interest spreads, a much greater proportion of the FHLBanks' earnings are derived from the investment of capital than is the case for commercial banks.

Before paying dividends to members, the FHLBanks' earnings from these and other sources must cover the FHLBanks' operating expenses and assessments. These assessments include the expenses of the Finance Board and the FHLBanks' obligations to contribute 20 percent of their earnings toward the payment of interest on REFCORP bonds issued in the early 1990's to help finance the cost of resolving the thrift institution crisis, and an additional 10 percent to fund their own regional AHP.

As interest rates have fallen (particularly short-term interest rates such as the Federal funds rate which is now at 1.0 percent), the return on a FHLBank's investment of its capital has necessarily fallen as well. If a FHLBank could completely insulate itself from interest rate risk by perfectly match funding all of its assets and maintaining a constant interest spread as interest rates fall, it would expect its rate of return on invested capital to fall about 75 basis points (0.75 percent) for every 100 basis point (1.0 percent) reduction in interest rates.

Because of this dynamic, the FHLBanks' earnings and rates of return generally rise and fall with the level of interest rates, and our dividend rates follow suit. In the case of the Dallas Bank, we paid dividends at an average rate of 6.36 percent in 2000 when the average Federal funds rate was about 6.25 percent, while we expect to pay dividends at an annual rate of 2.0 percent in the third quarter of this year, with the Federal funds rate at 1.0 percent.

Our experience indicates that this result fits very well with our members' investment expectations. Members do not invest in FHLBank capital stock with the expectation of earning equity investment returns. Rather, members' investment in FHLBank capital stock represents a very low-risk asset with explicit returns in the form of dividend payments that fluctuate with market interest rates, and overall benefits that include the value of access to FHLBank funding. The FHLBanks do not attempt and are not expected to produce rates of return comparable to other equity investments.

Corporate Governance of the FHLBanks: The Role of the Board of Directors

Congress established a unique ownership and governance structure for the FHLBanks, which has served the FHLBanks well in the past and continues to do so. The most critical feature of this structure is that the FHLBanks are wholly owned by their members/customers. In addition, the boards of directors of the FHLBanks are truly independent of management. No member of management may serve as a director of a FHLBank, and management is precluded by regulation from recruiting directors or participating in the election of directors.

ovides that a majority of each FHLBank's directors be elected by
tions from among officers and directors of those institutions.
irectors representing member institutions from their States. The
rs currently elect approximately 57 percent of the FHLBanks' di-
, with the remaining directors being appointed by the Finance
embers assured of the ability to elect the majority of their
rs, but the Bank Act also provides that no member may cast a
eater than the average number of shares all the members in its
equired to hold. This prevents large members holding relatively
FHLBank's capital stock from dominating director elections and,
that the majority of each FHLBank's elected directors generally
Il institutions that make up the great majority of all members.
amework that controls the composition of the FHLBanks' boards
s that each FHLBank's board of directors will have a balance of
ed. With no members of management on the board of directors,
position to independently oversee management actions. The mem-
e capital and benefit from the FHLBank's products and services
ority of the directors. The director election voting preferences for
sure that larger members cannot dominate the board of directors
ank's policies will not be detrimental to small members. Finally,
nt of appointed directors ensures that the FHLBanks will appro-
heir public policy obligations.

regulations require that the FHLBanks' boards of directors not
pical corporate director duties of care and loyalty, but that they
cific responsibilities. These duties include, but are not limited to,
to select and oversee management, the responsibility to ensure the
maintenance of an adequate internal control system, the respon-
risk management policy, a strategic business plan, and a member
at details the Bank's credit and pricing policies, and the responsi-
he FHLBank's annual operating budget and quarterly dividends.
their responsibilities, the boards of directors typically establish
committees. Finance Board regulations require each FHLBank's
to have an audit committee with very specific regulatory respon-
g direct oversight of the FHLBank's internal and external audit
ards of directors also typically establish other committees to facili-
nt of management. Committees vary from FHLBank to FHLBank,
ude risk management, human resources, and housing oversight
rious elements of the FHLBanks' corporate governance structure
e boards of directors that are active, knowledgeable, and engaged,
aware of their responsibilities and take them seriously.
rsight of the FHLBanks

n of this governance structure and the regulatory oversight pro-
ance Board make the FHLBanks among the most intensively
n the country. As noted above, each FHLBank has its own inde-
auditor, who actively and regularly audits all FHLBank operations
ly to the board of directors. In addition, each FHLBank's financial
reviewed by an outside accounting firm (currently
Coopers). Finally, the Finance Board's "primary duty" under the
nsure that the Federal Home Loan Banks operate in a financially
anner."

oard is not limited by funding constraints in carrying out its densuring the FHLBanks' safety and soundness because its funding sessments on the FHLBanks that are not subject to review or chalBanks. The Finance Board not only has regulatory authority over hat extends beyond that which is typically afforded a safety and tor-the GLB Act extended to the Finance Board the regulatory ers of both the Federal banking regulatory agencies and the Office ng Enterprise Oversight (OFHEO) and—but also has wide-ranging any aspects of FHLBanks' operations.

regulations govern every facet of the FHLBanks' operations, from to eligible collateral to risk management to capital plans to direccies to new business activities. The Finance Board also collects and al and risk management data from the FHLBanks each month, perviews of all aspects of the FHLBanks' operations and conducts anninations of all 12 FHLBanks. While the FHLBanks do not always ected to regulatory scrutiny, all believe that it is essential that the