By Bud Conrad in Casey's Daily Dispatch:

Who is the FHLB? Even if you heard their name, you probably haven't been worrying about what they do. They were created in 1932 as a government-sponsored entity (GSE) made up of 12 regional Federal Home Loan Banks, each of which is an individual corporation. Founded in the depression, they have carried on, providing money for mortgages.

Even though there is no explicit government guarantee, the FHLB has been able to borrow at attractively low rates, because the public assumes such a guarantee. (Sound familiar? Fannie and Freddie pop to mind?) As such, the debt issued by FHLB is considered AAA by Standard & Poor's - so it's used regularly as a substitute for cash. Municipalities often invest here.

The real question is whether they are playing the same game that all the other big financial institutions have been playing; namely, keeping toxic waste on their books that isn't worth as much as its face value. Given their leverage, if as little as 5% of their loans were ultimately written off, the capital base of FHLB would be wiped out.

It's no easy task ascertaining what is actually on the balance sheet of these complex institutions, but I saw a lot of references to Alt A mortgages and more than $281 billion of interest rate swap derivatives with counterparties of Deutsche Bank, JPMorgan, and Barclays - and this in just the San Francisco branch operation alone.

If, in total, the FHLB ultimately suffers defaults equal to just 10% of the face value of their assets, a reasonable expectation, they'll be forced to write down more than $110 billion - which is better than twice the capital on their dwindling books. That sets the stage for another federal government takeover or receivership like Fannie and Freddie. That means even more bailouts, and eventual Fed monetization to fund it. Credit collapse is destructive for housing, but it is dollar-destructive to bail out everybody.

My bet is some of both will happen, with the easy path toward bailouts and dollar destruction being the more likely.

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