The Federal Home Loan Bank of Seattle has become the first bank in the 76-year history of the system to run out of retained earnings, triggering what once was an unthinkable scenario by "breaking the buck."
The depletion of the retained earnings fund, which totaled $162.3 million on Sept. 30, puts the value of member capital at the Seattle Home Loan bank at risk. It also forces its 380 members in eight states to make a tough decision: write down the value of their stock investment or ride out the troubles at the Seattle Home Loan bank and hope shares regain their $100 par value.
Financial institutions do not appear to have a road map on how to proceed.
"There is not a tremendous amount of guidance out there," said Brian Harris, an analyst at Moody's Investors Service. "It may be a challenge for smaller member banks to perform their evaluations."
The problems in Seattle and at the 11 other Home Loan banks may only intensify in the months ahead. Continued deterioration in the housing market could lead to bigger other-than-temporary impairment charges and erase retained earnings at other Home Loan banks by the end of the first quarter.
"We simply have, over time, lurched from one crisis to another with things getting ever worse," said a source close to the Home Loan banks. "We're heading toward a crisis of some sort with the Federal Home Loan Bank System that will most likely come to fruition in the May time frame when you have first-quarter reports."
The immediate impact on members remains unclear. There is little dispute that, with retained earnings gone, member stock is worth less than par value at the moment. "If the Federal Home Loan Bank of Seattle got liquidated today then the member banks would not get back 100 cents on the dollar for their investment," said Bert Ely, an independent consultant in Alexandria, Va.
But things get murky very quickly. If a member were to turn to the Seattle Home Loan bank today to request a return of its stock, rules state that the member would have to wait five years to receive their money. During that time, the stock could and quite likely will regain its value.
That leaves banks and their accountants in a conundrum where a prediction must be made about whether the stock's value will return to par. If so, then they do not have to account for any change on their balance sheet. But if a bank's accountant is less sure, writedowns could be in order.
The Seattle Home Loan bank remains mum on how its members should record their exposures, though it said in a press release on Monday that actual losses in its portfolio of private-label mortgage-backed securities would ultimately total $12 million, well below the $304.2 million charge it was forced to take.
If accountants believe that estimate, Harris said a writeoff would likely be unnecessary.
"I would expect that what the regulator and the individual banks and their members would look at would be the economic losses that the Home Loan banks are estimating for their securities portfolio," he said. "That $12 million may or may not be realized. Ultimately, they could realize more or less. But as of a point in time, that's their best estimate of the economic loss, and if that's true, it's highly unlikely that you could come to a conclusion that the stock is impaired."
The Federal Housing Finance Agency appears to support this view. The agency, which also regulates Fannie Mae and Freddie Mac, confirmed Tuesday that the Seattle bank is the first Home Loan bank with negative retained earnings, which it said "breaks the buck."
"However, breaking the buck does not have to equate to impairment of FHLBank of Seattle capital stock, which is based principally on the 'ultimate recoverability of par,' " the agency said.
Additionally, a memo from the American Bankers Association last month said accounting rules dictate that auditors take a long-term view when judging Home Loan bank stock.
"When evaluating FHLB stock for impairment, its value should be determined based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value," the memo said.
But concern is growing that the Seattle bank could soon have company as other Home Loan banks run out of retained earnings.
"A couple of banks are pretty close," Harris said, noting that the Federal Home Loan Bank of Boston had only $22.9 million of retained earnings left on Dec. 31, which could be consumed by an OTTI charge.
"All but one or two of the Home Loan banks are showing significant signs of stress because they hold such significant positions in private-label mortgage-backed securities," said Karen Shaw Petrou, the managing director of Federal Financial Analytics.
Those holdings are at the center of the storm battering many Home Loan banks. Though they are generally highly rated, the market for all mortgages has soured in recent months and mark-to-market accounting rules can prompt significant OTTI charges.
The rules require writeoffs in the event that securities have been downgraded, the market price has fallen to less than 60% of the purchase price or the asset has significant credit enhancements. But the Home Loan banks and their members charge that the rules drastically overstate the actual losses embedded in their books.
"Just because somebody is only willing to pay them 40 cents on the dollar, does that mean that's what the bonds are really worth?" asked Steve Bumann, the chief financial officer of BankWest in Pierre, S.D., a member of the Federal Home Loan Bank of Des Moines.
Federal Reserve Board Chairman Ben Bernanke acknowledged the issue in a speech Tuesday to the Council on Foreign Relations.
"Determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly," he said. "Further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their pro-cyclical effects without compromising the goals of disclosure and transparency."
Still, the Fed chief rejected calls for an outright suspension of mark to market rules. Petrou said the Home Loan banks were right to point out problems with accounting rules, but she said it would be wrong to suggest there aren't deeper problems, such as the loss of Washington Mutual Inc. and other major members in Seattle.
"The Seattle and Home Loan bank approach is to simply avert their gaze and say, 'I'm fine,' " she said. "That's the problem I have with this approach, to say that it's all mark to market and all artificial and 'I'm fine. Don't worry about that cough.' "