Los Angeles - On August 16, Dawn Kopecki of Dow Jones News Service filed a story, "Atlanta Fed Paper Says GSE's Fuel US Housing Market," which seemingly began a cascade of requests for the favorite page on the IRA web site. That page shows the percentage of obligations issued by government sponsored enterprises held as assets on the balance sheets of American commercial banks.

Released on August 5, 2005 by Federal Reserve Bank of Atlanta staff economist Karsten Jeske and German economist Dirk Krueger, the Working Paper "says the nation's three housing government-sponsored enterprises have helped fuel the red hot housing sector with policies that primarily benefit wealthier consumers, drive up U.S. housing stock, increase rental prices and lead to higher default rates," reports Kopecki.

So offensive was the paper to the mortgage lobby that economists at Freddie Mac (NYSE:FRE) and the Mortgage Bankers Association went on record refuting the paper as soon as it was released. Jay Brinkman, VP of Research and Economics at the MBA, was quoted saying the "results are hard to believe." Ms. Kopecki recorded Freddie Mac Senior Economist Frank Nothaft asserting that "With each assumption, it takes away from the reality of how the market works."

What was the Atlanta Fed paper saying that warranted that kind of public rebuke by the mortgage industry? Economists are notorious for slinging hash at each other's equations, but this initial clash suggests something more serious. For background, look at a the working paper by Jeske and Krueger and earlier papers published in May 2005 by Rosalind Bennett (FDIC), Mark Vaughn (FRB-Richmond) and Timothy Yeager (FRB-St. Louis) and in 2002 by Scott Frame and Larry Wall both from the Atlanta Fed.

Readers of Washington & Wall Street will recall that Fed Chairman Alan Greenspan, in his testimony last month before the Senate Banking Committee, explained that prudential concepts such as safety and soundness cannot be applied to the swelling balance sheets of the GSEs because they do not have sufficient capital to "self insure" like commercial banks. Click here to see the top 100 bank units over $1B in total assets that invest heavily in GSE debt. Note that the $30 billion asset, UT-based thrift subsidiary of Washington Mutual (NYSE:WM) has over 65% of its tangible assets in GSE debt -- and this is not the most extreme example.

The core thrust of Jeske and Krueger has to do with measuring the interaction of safety and soundness concerns between the worlds of the GSEs and the banks that use FHLB Advances to fund their operations. Of note, most of the FHLBs have been forced to delay their filings with the SEC because of problems with internal controls and accounting issues.

The Atlanta Working Paper is ground breaking because it asks whether or not the "perverse consequences" discussed in research papers written one business cycle ago by Frame and Wall have in fact manifested, an issue which Chairman Greenspan and Treasury Secretary John Snow publicly raised in congressional appearances with respect to the GSEs.

Do banks utilize FHLB Advances to drive earnings and asset growth in a potentially unsafe and unsound fashion? The latest data from the FDIC suggests that the answer is yes. Click here to see the top 100 bank units with total assets over $1B that rely heavily on FHLB Advances for funding. We think that FHLB Advances may become the new favorite "red flag" page on the IRA web site.

The Richmond working paper by Bennett, Vaughn and Yeager sets up a computation structure that attempts to measure the net magnitude of the problem using a bottoms up approach. Working paper models normally ooze with evidence that the many coefficients are only beginning to be calibrated. One would think that other economists would take an academic interest in helping to calibrate the "swags," but given that these works asks a rather uncomfortable question we can see some people would rather not.

If cheap money FHLB Advances are used irresponsibly to superheat bank profitability, for example by creating a subsidized class of sub-prime loan product, does this generate a downside "moral hazard" risk that the FDIC may have to make good on the FHLB Advances? That question certainly does seem worthy of a "safety and soundness" analysis by both OFHEO on the GSE side and the bank regulators at the Fed, OCC, OTS, FFIEC and FDIC.

Ironically, the statute empowering OFHEO refers to "safety and soundness" as one of the criteria for measuring the financial state of GSEs such as the FHLBs, FRE and Fannie Mae (NYSE:FNM), ridiculous as that may be in purely financial terms. As Chairman Greenspan explained in his exchange with Senate Banking Committee Chairman Richard Shelby (R-AL) on July 21, 2005, prudential tests such as safety and soundness cannot be applied to the GSEs -- whether the housing statute says so or not -- because they simply have too little capital to withstand losses on their greatly expanded mortgage portfolios.

The whopper assumption in the Richmond exercise is that a bank relying upon FHLB Advances excess of 15% of total assets is cause for concern. Indeed, they suggest that such a business posture could activate a CAMELS rating downgrade which places the subject institution into a category disqualifying it from accessing any FHLB Advances. Bank regulators, after all, are not interested in maximizing housing originations; their job is to make sure nobody bites a chunk out of the Bank Insurance Fund (BIF).

Jeske and Krueger attempt to examine the consequence of the so-called "implicit guarantee" and quantify the effects that may have resulted. The combined body of research posits an intriguing shock where bank regulators take out the Prompt Corrective Action (PCA) chain saw and direct that all banks liquidate FHLB Advances back down below the 15% safe and sound mark. Reducing FHLB Advances by all US banks below 15% of assets would force the market to absorb tens of billions of dollars worth of GSE paper -- paper that the Sell Side dealer community could not easily place elsewhere.

Economists at the GSEs and MBA are of course correct in observing that a draconian reduction in FHLB Advances is unlikely barring an "extraordinary event" -- like large blocks of sub-prime mortgages going into non-accrual and new originations going flat as a pancake because $3.00 a gallon gasoline has broken the back of consumer disposable income. No, that would never happen.

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