This report was researched and written at the behest of the Farm Credit System Insurance Corporation (FCSIC) in order to evaluate the liquidity of the Farm Credit System (FCS), analyze the FCS’s vulnerability in the event of a broad financial market shutdown, and look at the policy aspects of a lender of last resort in such a circumstance. In the following sections the authors detail the structure of the FCS, provide background on how the FCS, other Government Sponsored Enterprises (GSE) and Federal insurance agencies weathered the 2008 crisis, compare these entities’ access to a lender of last resort, and finally provide analysis and recommendations on the state of FCS’s liquidity and options for securing a backstop in the event of a market shutdown.
The FCS is a GSE designed to expand the availability of credit for agriculture and rural America. There are four FCS Banks (Banks)—AgFirst, AgriBank, Farm Credit Bank of Texas (FCB), and CoBank. The Banks are owned by the member associations, which in turn are owned by their agricultural borrowers. CoBank is also owned by eligible retail cooperative borrowers. At yearend 2011, the FCS had combined assets of $230 billion on a capital base of $35.9 billion. The Banks own the Federal Farm Credit Banks Funding Corporation (Funding Corporation), which raises cash in the wholesale markets to fund the lending of the Banks and their affiliated associations. That is, the borrowers obtain credit from their associations (and CoBank in the case of eligible borrowers) and the associations obtain wholesale funding from their affiliated Banks through the Funding Corporation. The Farm Credit Administration (FCA) oversees the FCS and is responsible for supervising and for setting and enforcing rules that safeguard the safety and soundness of the Banks. FCSIC is a government controlled independent entity that insures the timely payment of interest and principal on bonds and notes issued by the Banks through the Funding Corporation. FCSIC is funded by premiums on the Banks, and at the end of 2011 it had an insurance fund of $3.4 billion against guarantees of $184.2 billion in notes and bonds. 
The FCS is the only GSE without explicit legislated access to emergency liquidity from the Treasury Department. For example, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBanks) have long had legislation granting them a small line of credit at the Treasury, which added to the perception that the taxpayers of the U.S. stood behind them. And, for those three GSEs that backup was greatly expanded during the financial crisis, making more explicit the government guarantee. Those facilities weren’t utilized by the FHLBanks, but they were by Fannie and Freddie, whose solvency was restored with U.S. Government capital injections. About the same time, the supervision of these three GSEs was transferred to a new agency, the Federal Housing Finance Agency (FHFA), which was given much more explicit authority to oversee the activities of the three housing GSEs and to protect their safety and soundness.
The two other Federal Insurance programs also have access to government funds in an extreme situation and that access was expanded during the crisis. The Federal Deposit Insurance Corporation’s (FDIC) $30 billion permanent line of credit to the Treasury was expanded to $100 billion; while the FDIC’s total borrowing authority was temporarily increased to $500 billion. In order to avoid using these extra funds the FDIC’s Deposit Insurance Fund (DIF) used its premium authority to impose a special assessment on insured institutions in which they prepaid their estimated risk-based assessments. During the crisis, the National Credit Union Share Insurance Fund’s (NCUSIF) permanent line of credit with the Treasury was increased from $100 million to $6.0 billion. In addition, the NCUSIF was granted temporary authority to borrow up to $24 billion through the temporary Corporate Stabilization Fund, which expired in December 2010.
Access to back up sources of liquidity was critical in stabilizing the financial system during the financial crisis of 2007-2009 and restoring confidence and more normal flows of credit. In addition to the extraordinary actions just outlined, depository institutions insured by the FDIC and NCUSIF borrowed heavily at the Federal Reserve’s discount window and, in the case of retail credit unions, from the NCUA’s Central Liquidity Fund (CLF). The authority of the CLF to borrow from the Treasury was increased during the crisis. The Federal Reserve also extended its discount window facilities to nonbank borrowers through a variety of facilities designed to get liquidity to money market mutual funds, issuers of commercial paper, and to purchasers of securitized debt.
The FCS does not have explicit access to a federal government source of back up liquidity. After reporting losses in the wake of the collapse of agricultural land values and commodity prices in the early 1980s, Congress passed a series of amendments to the Farm Credit Act of 1971. The Act reorganized the Banks, made FCA an “arm’s-length” regulator with increased supervisory and regulatory powers, including new enforcement authorities, and authorized up to $4.0 billion in federal assistance to the FCS. In total, the FCS received $1.3 billion in federal assistance through government guaranteed Financial Assistance Corporation bonds, which were fully repaid in 2005. As with the housing GSEs in 2008, taxpayer funds were put behind obligations of the Banks and, to forestall a repetition of the problems, more disciplined and tighter supervision was imposed under FCA’s new authorities.
However, in the Agricultural Credit Act of 1987, Congress, rather than giving the Banks explicit access to the Treasury, chose to reinforce the creditworthiness of the obligations of the Banks by creating a Federal insurance corporation to stand behind them and giving the FCSIC the ability to raise funds through collecting an insurance premium from the Banks. In contrast to the FDIC and the NCUSIF as Federal insurance funds, however, the FCSIC itself was not given the explicit authority to turn to the Treasury for funds in an emergency. And, unlike the banks, thrifts, and credit unions whose deposits the FDIC and NCUSIF insure, the entities whose obligations FCSIC insures do not themselves have explicit access to the Federal Reserve or any other lender of last resort.
This lack of access to a lender of last resort was not a problem for the FCS for many years. But it became a potential issue in the freeze up of financial markets after FHFA placed Fannie Mae and Freddie Mac into conservatorship and Lehman Brothers filed for bankruptcy. As reported in its third quarter 2008 report, the unprecedented instability in the global financial markets reduced FCS’ ability to issue debt with preferred maturities and structures. More specifically, FCS operations were funded primarily through short-term discount notes as issuance of longer-term debt had become more restrictive. To provide additional flexibility, the FCA authorized an increase in the ceiling of the Discount Note program from $40 billion outstanding to $60 billion at the Funding Corporation. The shortening of the liability structure of the Banks’ funding in turn implied that the existing holdings of liquid assets might not cover the required 90 days of maturing obligations. The FCA adopted the Market Emergency Standby Resolution, which provided for a waiver if the resolution ever went into effect. In early 2009 it also initiated the monthly collection of regular detailed information about the days of liquidity at each Bank in a specified format.
The disruption of the long-term funding market for FCS obligations was temporary and the consequences were not serious. But, in the view of FCSIC management, that relatively benign outcome was partly due to several favorable circumstances that might not be repeated in a similar future event. First, during the most severe period of the market disruption, the FCS did not have a large amount or very concentrated maturities of notes and bonds coming due. Second, over the several years preceding the crisis the farm economy had been quite prosperous; consequently the performance of the loans made by the FCS had been good. FCA, the System’s regulator had imposed stronger capital regulations in the early 90s requiring that System institutions build and maintain enough surplus to weather stressed environments. Thus, even the slump of commodity prices and freezing up of trade credit that followed the Lehman-related market disruption did not call into question the capital adequacy of the Banks. The consequences for the FCS might have been more serious in the volatile and risk averse environment that naturally follows a financial crisis if FCS maturities had been larger or more “lumpy,” if the farm economy had been more vulnerable to a global slowdown, or if the market had been disrupted for longer. If any of these possibilities had occurred at the same time as the crisis or had other adverse shocks, such as trade restrictions affecting agricultural exports, been experienced, the spill over concerns could have negatively affected the viability of the Banks and caused more lasting constrictions on the funding capacity of the Funding Corporation and the availability of loans to agricultural borrowers.
At the onset of the crisis, the Banks held minimal amounts of U.S. Treasuries that were so much in demand during the height of the crisis. A high proportion of the supposedly liquid assets were in housing GSE obligations and in non-agency MBS and ABS. The latter categories to be sure had been rated AA or AAA, but the prices of these assets fell sharply as the market deteriorated and they did not form an effective liquidity backstop for the Banks.
The FCA and FCS took a number of steps in response to the newly perceived vulnerability. For example, the FCA and FCS explored whether and under what circumstances the Federal Reserve Banks could lend to the Banks under section 13(13) of the Federal Reserve Act during a liquidity crisis in the market. One of the authors of this paper, Kohn, was a party to those discussions when he was at the Federal Reserve. Section 13(13) of the Federal Reserve Act authorizes Federal Reserve lending to individuals, partnerships and corporations collateralized by U.S. Treasury securities or the obligations of U.S. government agencies held by the Banks. The Board’s regulation A limits such lending to “unusual and exigent circumstances” and only in cases when the borrower is not able to obtain credit from other sources and when the failure to obtain credit would adversely affect the economy. Based on such considerations, the Federal Reserve Board judged that lending was not warranted at the time, and the Board has followed its longstanding policy of refraining from any commitments about providing such emergency credit in the future.
Somewhat later, FCSIC also approached the Federal Financing Bank (FFB) at the Treasury department about possible borrowing in a future liquidity emergency triggered by a market shutdown. As envisioned by FCSIC, it might issue notes to the FFB or the borrowing might take the form of obligations issued by the Funding Corporation, purchased by the FCSIC and in turn bought by the FFB, with the funds passed back to the holders of maturing FCS obligations. The FFB seemed open to exploring whether and how it may be a potential source of funding for an organization—FCSIC—that was a federal agency and at least implicitly already had full faith and credit backing of the U.S. government. With the guarantee already in place, the FFB would be providing liquidity, not capital, to the FCSIC to make good on guarantees; funding would not increase the exposure of the Federal Government. But the FFB pointed out several ambiguities and uncertainties about the authority of the FCSIC to borrow from the FFB and the modalities of how any such funding would work. And, critically, Office of Management and Budget (OMB) may need to score any agreement between the FFB and FCSIC for budget purposes.
Importantly, the Banks, their regulator the FCA, and the FCSIC as insurer recognized that the Banks themselves needed to hold more high quality liquidity. In late 2008, the FCS formed a liquidity committee to conduct a strategic review of FCS liquidity and to make recommendations to meet future liquidity challenges. Also, earlier in 2008, Congress amended the Farm Credit Act to allow 90% of Federal government guaranteed investments to be deducted from total insured debt on which FCSIC premiums are assessed. In response to these initiatives, the Banks greatly increased their holdings of U.S. Treasury securities and securities with explicit government guarantees. In 2010, the Banks entered into a voluntary agreement in which they agreed to hold the very highest quality and most liquid assets (cash, cash equivalents, or Treasuries maturing in less than three years) to cover the first 15 days of maturing obligations; very high quality securities for the next 30 days and somewhat lesser quality instruments for days 46 through 90. In December 2011, the FCA published a proposed rule closely resembling the 2010 agreement. In general, the FCA proposal would improve the Banks’ liquidity reserve requirement, promote liquidity risk management best practices, and better prepare the Banks to withstand a liquidity crisis. The proposed rule would continue to require the Banks to maintain a liquidity reserve sufficient to fund a minimum of 90 days of maturing obligations but with higher quality instruments that closely mirrors the 2010 voluntary agreement. The proposed rule also requested comment on a new concept that would require all Banks to establish and maintain a supplemental liquidity buffer that would provide a longer-term stable source of funding beyond 90 days. A key aspect of the proposed regulations is the requirement for Banks to have contingency funding plans to ensure they have sufficient liquidity to fund operations under a variety of stress scenarios, including market disruptions and loss of market access, as well as rapid increases in loan demand or drawdowns of unfunded commitments. As of this writing (early November) the final regulation had not been published.
Finally, in response to the concerns raised by the interruption of market access, the FCSIC engaged the authors to examine various liquidity issues around the FCS—access to lender of last resort as compared to other GSEs and Federal insurance corporations, and the liquidity of the Banks. To these ends, in the process of preparing this report, we have had discussions with individuals at FCSIC, the Funding Corporation, the FFB/Treasury, the Federal Reserve, and some other GSEs and government insurance corporations with access to the Treasury as a lender of last resort—the FHLBanks, and the NCUSIF.
Analysis and Recommendations
It is important to emphasize the limited nature of the examination we were asked to undertake and the reach of our recommendations. They are focused solely on liquidity, not solvency or capital, and a liquidity need occasioned by a shock to markets external to the agricultural sector or the FCS. In our conversations, we encountered some concerns about the potential impact of a decline in land prices should agricultural commodity prices fall considerably. Commodity prices have been elevated on balance over recent years by growing demands from emerging market economies, by unusual weather patterns and drought in some regions of the world, and by environmental regulations mandating the use of ethanol in gasoline. Any of these factors could be reversed or market participants could come to the view that prices had overreacted to them. Extended declines in agricultural commodity prices and in the prices of the land used to produce agricultural commodities could cause loan problems at the Banks and their affiliated associations and call into question the adequacy of their capital, which would then have an effect on their access to markets. We did not evaluate the risk of this particular cause of a loss of access to market funding or of the desirability of providing a backup source of funding under these particular circumstances.
Lender of last resort. As outlined above and shown in more detail in the appendix, the FCS and FCSIC stand out from other GSEs and Federal insurance corporations in their lack of explicit access to a governmental source of back up liquidity. Legislation explicitly gives Fannie, Freddie, the FHLBanks, the FDIC, and the NCUSIF some access to Treasury liquidity in an emergency. Moreover, the institutions insured by the FDIC and NCUSIF can borrow from the Federal Reserve, which so far has not granted similar access to the Banks.
However, there are reasons to question whether such access for the FCSIC on behalf of the FCS would be in the public interest. For one, to date this lack of formal legislated access to government liquidity has not seemed to have adversely affected the ability of the FCS to fulfill its public policy role of providing competitive financing for the agricultural economy. The spreads of Bank obligations over Treasury securities closely mirror the spreads of the obligations of other GSEs. FCSIC as a federal insurance corporation is probably already backed by the full faith and credit of the U.S. government, at least implicitly, providing some assurance of repayment of the market notes and bonds of the Banks. Moreover, when FCS’ solvency was threatened in the mid-1980s, the Congress structured a work out that involved taxpayer backing and no losses for private investors. More recently in 2008 during an event widely characterized as the “worst financial crisis since the 1930s”, the Funding Corporation was able to raise funds in the open market, albeit only with maturities of a year or less, which allowed the FCS to avoid any liquidity issues and meet all its obligations.
Second, there may be incentive and moral hazard costs to firming up the implicit government backing. The lack of explicit access to a governmental lender of last resort has probably contributed to the willingness of the Banks and their regulator to raise liquidity standards in the wake of the financial crisis. Higher standards have costs in terms of interest forgone and capital held against non-loan assets, and naturally, borrower-owners may not be entirely receptive to making the Banks safer and more liquid—that is, reducing the value of the implicit support of the taxpayers. From the broader public policy perspective that takes account of taxpayer as well as agricultural interests, however, any formal access to government liquidity should not be allowed to reduce the momentum toward making the Banks themselves safer.
If access to government liquidity is granted to the FCSIC on behalf of the FCS, in order to limit moral hazard it should be tailored narrowly to deal with a liquidity event external to the agricultural sector and the Banks. In the event that market access is at risk because of concerns about solvency or lax management of liquidity by the Banks, the FCS should be required to approach the Congress and the administration for legislative help. In these circumstances, Congress should evaluate the causes of the difficulties, the conditions for any assistance, and any flaws revealed in the structure or oversight of the FCS before putting additional taxpayer resources behind agricultural credits. And it should require that investors should look first to the resources of the FCS— the FCSIC fund and its ability to collect fees in the future—before public money is put at risk. In the end, it would be important for a federal insurance program to make good on its commitments–failure to do so might call into question other insurance programs, like the FDIC and the NCUSIF—but under conditions arrived at through the legislative process.
But under a very narrow set of circumstances–when the problem is purely a liquidity issue that cannot be handled by FCSIC and the Banks alone, and it originates external to the agricultural sector and the FCS in a prolonged market shutdown situation–we can see some net benefit to giving the Banks, through FCSIC, a process for applying to the Treasury for back up liquidity. The FCS plays an important role in agricultural finance. Self-insuring against any possible liquidity event could be very expensive and constrain credit availability. Depository institutions have been given access to the Federal Reserve as a liquidity backstop, but in restrictive circumstances and with considerable regulatory and supervisory oversight to limit moral hazard. And other GSEs and Federal deposit insurance corporations can tap the Treasury as a lender of last resort, suggesting that Congress saw the cost of complete self-insurance or the risk of failure as being too high to be in the public interest for these types of institutions. 
The potential access would be tail insurance for highly unusual situations that could not be reasonably foreseen. It would not be a substitute for strong liquidity management by the Banks, including holding liquidity against a variety of potential stress situations, as is being required of commercial banks. Access would not act as a substitute for the Funding Corporation utilizing term borrowing as much as is consistent with good risk management and business practices to reduce the FCS vulnerability to market events. And it would be a last resort—to be utilized only after other means of obtaining funding for on- and off-balance sheet obligations had been exhausted. Such means would include utilizing the liquidity reserves of the Banks and temporarily increasing the short-term borrowing of the Funding Corporation, as occurred in the fall of 2008. The utilization of this facility would be reserved for a situation in which there was an extended market shutdown that impaired the ability of the Funding Corporation to raise sufficient funds even in short-term or floating rate markets.
We believe the most direct and logical way to structure any such access is through the FFB, building on the preliminary discussions already held. Any lending by the FFB would be at the discretion of the Secretary of the Treasury, with a clear written understanding that: it would be reserved for a general market closure unrelated to the solvency of the Banks; that it would be a last resort after other sources had been utilized; and that its availability would depend on the Banks following sound liquidity risk management practices.
Within that broad framework, several key issues need to be addressed.
- Are FCSIC guarantees already full faith and credit (FFC) obligations of the U.S. government so that FFB access would not increase the credit exposure of the government? If they are, is this explicit or implicit and how is it perceived by the public? If it is implicit and the public is uncertain, an agreement would strengthen the implied guarantee, loosening market discipline, and this could be an important policy issue.
- How should any loan from the FFB be structured? There are alternative mechanisms for the FFB to provide liquidity, from lending to the FCSIC to pass on to the Funding Corporation to lending to the Funding Corporation with FCSIC guarantees. The choice could depend in part on what the FCSIC is empowered to do—specifically whether it can borrow from the FFB, which should be clarified. The need for and composition of any collateral backing a loan also should be determined. For example, collateral may not be needed if FCSIC can repay its borrowings with its premium collections. If collateral is appropriate, FCSIC or the Funding Corporation could back a loan with the assets of the Banks, the assets of the FCSIC fund, and a pledge of future insurance premiums from the Banks.
- Would there be implications for the budget of the United States? FFB and FCSIC would need to determine, in consultation with OMB, if an agreement would need to be scored by OMB under the Federal Credit Reform Act. Based on the similarity of FCSIC legislative language with that of the FDIC and precedent with the Resolution Trust Corporation, it is possible that an agreement to lend wouldn’t require scoring. If, however, an agreement does need to be evaluated by OMB, the score would depend on estimates of any subsidy, which in turn would be judged by comparing the loan amount to the present value of expected future repayments of any loan. Collateralizing the loans would increase the likelihood of repayment and therefore reduce or eliminate any subsidy. If scoring is required, a Congressional appropriation apparently also would be required, even if the potential lending was found not to entail a subsidy. The FFB does not have signed lending agreements with other GSEs and federal insurance corporations. But these agencies have the explicit authorization of Congress to borrow from the FFB.
We recommend that an agreement between FCSIC and the FFB be established well before any precipitating event–as soon as possible after the preceding issues have been dealt with, rather than waiting for a crisis situation to arise. Under the circumstances in which the FCA and FCSIC determine it needs to be activated, the Secretary of the Treasury could then make a judgment based on the already established agreement.
We recommend that the effort to craft such an agreement be discussed with the appropriate Congressional committees. Because the Congress did not explicitly authorize the FCS to borrow from the Treasury, it appears Congress believed that the insurance fund it authorized would be sufficient to deal with any problem. Due to the 2007-2009 financial crisis, the FCSIC and Treasury are considering circumstances when that backstop might not be sufficient. Without Congressional consultation, an adverse reaction by Congress to a surprise activation of the facility in the middle of a market crisis could well be destabilizing for markets generally as well as for the FCS.
Bank Liquidity. Because the facility we envision could only be used in the event of an extreme generalized market shut down, it is imperative that the Banks continue to hold ample liquidity against various contingencies. As noted, considerable progress had been made in this regard since the fall of 2008. The exact requirements of the final FCA regulation on liquidity are not available as of this writing in early November. Assuming it closely mirrors the proposed regulations of December 2011, we would emphasize several issues. First is the critical role of stress tests in assessing liquidity and liquidity management. The Banks need to be prepared to handle combinations of stresses that, while falling short of complete market shutdown over a prolonged period, would be very serious and challenging. For example, in a market panic the prices of all but the highest quality and most liquid assets, such as Treasury securities, could fall eroding the value of assets available for short-term sale to meet obligations.
Second, it is important that those stress tests include the contingent need for funding and liquidity that a take down of off-balance sheet obligations could pose. In particular, the FCS has some commitments to extend credit to borrowers on their demand. In periods of high commodity price volatility the draws on those commitments tend to increase (especially in response to spikes in commodity prices that cause grain elevators to need more credit to maintain hedges). Usually, these draw downs have been funded by increases in the issuance of discount notes, but if those notes are already on the rise because of a partial market shutdown, further sharp increases could be problematic. At a minimum the Banks under the direction of the FCA need to engage in a thorough analysis of how large any such draws might be under various circumstances, how those circumstances might coincide with other market disruptions, and the potential liquidity implications of draws on unfunded commitments in the midst of other adverse market events. The results will vary among individual Banks and each should be able to cope with a liquidity stress arising from its particular circumstances—the stress tests should be individually tailored under the direction of the FCA.
Finally, the FCA is considering whether the largest Banks should be held to higher standards for liquidity (and capital) under stress scenarios. The resources of the System–the capital and liquidity of other institutions plus the insurance fund– would be quite stretched if either one of the two larger institutions had problems meeting its obligations and the other banks or FCSIC were required to step in. From the perspective of the FCS, the two largest Banks are systemically important in that problems at one of those institutions could cause market participants to have legitimate questions about the viability of the whole FCS. Market participants view the FCS as a single entity. A clear lesson of the recent financial crisis is that trouble in very large components of a financial system can threaten the whole system, in part by raising questions about the implications for other components of the system through interconnections, such as the joint and several liability of the Banks. As a consequence, the Dodd-Frank Act and the new banking regulations growing out of the Basel process incorporate higher requirements for systemically important financial institutions (SIFIs). Although CoBank and AgriBank have over $50 billion in assets, they are not subject to the SIFI rules of the Dodd-Frank Act. Nonetheless, we believe stress tests and the resulting liquidity requirement should incorporate interconnections and make allowance for the systemic importance of institutions—the macro-prudential overlay—as well as the particular risk profile of each individual institution.
The liquidity standards for banks coming from the Basel Committee on Bank Supervision are being discussed and modified this year and, consequently, the resulting liquidity regulations for U.S. banks have not yet been proposed. What is appropriate for commercial banks may not be exactly applicable to FCBs, but the general principles are the same and FCA should monitor this progress of the Basel and U.S. processes for ideas about best-practice liquidity regulation that should be applied within the FCS.
Resolution. As the number of Banks shrinks, the opportunities to handle a troubled institution unable to meet its obligations by merging it into a stronger institution also diminish. In particular, if one of the two larger Banks were to be in trouble, the orderly wind down of the institution’s book of business and repayment of insured obligations would be handled by FCSIC. This could be challenging in a number of dimensions, even if the resources of the FCSIC fund were ultimately adequate to meet the Banks’ obligations. Among those challenges could be accessing the liquidity to fund an orderly wind down as obligations came due. FCSIC has options