Federal Home Loan Bank (FHLB) Confirming Letters of Credit

(This post relates to FHLB Confirming Letters of Credit and the prohibition of federal guaranties under the Code.)

General Information:

The Housing and Economic Recovery Act of 2008 (the “Act”), signed into law by President Bush on July 30, 2008, permits a regional Federal Home Loan Bank (“FHLB”) to extend its existing guarantee programs (each, a “Program”) to a wide array of tax-exempt bonds.   The ability to “wrap” bond transactions improves credit ratings and reduces interest costs to borrowers.

Statutory Authority:

Pursuant to Section 3023 of the Act, bonds issued after the date of enactment of the Act, and before January 1, 2011 (the “Issuance Period”) by states and local governments and guaranteed by a regional FLHB are eligible for treatment as tax-exempt bonds.  Prior to the enactment of the Act, the tax-exempt status of interest on bonds (other than bonds issued to finance housing programs) that were guaranteed by a regional FHLB was questioned by the Internal Revenue Service in various audits and generally prohibited under the Internal Revenue Code of 1986, as amended.

In accordance with the Act, the FHLB guarantee must be made in connection with the original issuance of bonds and includes a renewal or extension of the original guarantee.  Consequently, the protection of the Act does not apply to a FHLB guarantee that is added after the original issuance of tax-exempt bonds even if those bonds were issued during the Issuance Period.  The Act also requires that any guarantee by a FHLB must meet safety and soundness requirements similar to those in effect under regulations applicable to FHLBs as of April 9, 2008.  Eligible issuances could include new money and refunding issues that are issued during the Issuance Period.  (See Notice 2008-79 for the refunding discussion.)  A recent example of a refunding issue utilizing an FHLB Boston confirming letter of credit is the $5,800,000 Massachusetts Development Finance Agency Variable Rate Demand Revenue Bonds Family Service Association of Greater Boston Issue, Series 2009 (available via EMMA).

The typical guarantee extended by a FHLB is either in the form of a LOC (direct-pay or standby) or in the form of a confirmation of a LOC issued by a Member Bank.  The need for the FHLB LOC or confirmation of a LOC issued by a Member Bank arises in the case of either a low credit rating or the lack of a credit rating altogether of a Member Bank.  A LOC extended by a Member Bank with a low or nonexistent credit rating will result in unfavorable rates for the bonds guaranteed by the LOC, whereas a LOC issued or confirmed by a FHLB, which boasts a “AAA” rating, will result in favorable rates on bonds and lead to interest savings for borrowers.

An issuance or confirmation of a LOC by a FHLB can be obtained via request of a Member Bank to the FLHB of which it is a member.  A FHLB will not deal directly with the issuer of bonds.  In a representative transaction, if a FHLB issues a direct-pay LOC to a bond trustee on behalf of a Member Bank, the related reimbursement agreement is executed between such FHLB and the Member Banks, and not between such FHLB and the issuer of bonds.  In turn, the issuer of bonds is responsible for providing the funds required by the Member Bank to reimburse the FHLB.

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