The Federal Housing Finance Board - which regulates the Federal Home Loan Bank system - last week signed an agreement with FHLB Chicago's board to implement changes to FHLB Chicago's risk and capital management, governance and internal audit control practices and procedures.

In response to this move, Standard & Poor's lowered its long-term counterparty credit rating on FHLB Chicago to AA+' from AAA.' S&P also affirmed the A-1+' short-term counterparty credit rating on the bank. The outlook is negative.

"The agreement confirms many of the concerns Standard & Poor's has had with the rapid growth in the bank's on-balance-sheet, longer-dated, fixed-rate mortgage assets, which had led to the negative outlook revision in November 2003," said the rating agency. However, S&P clarified that the AAA' rating on the senior debt of the FHLB system's consolidated obligations is not impacted by this action.

In a report, Merrill Lynch said that the agreement seems to show that both FHLB Chicago and its regulator recognize that the bank's risk-management systems have not kept up with the rapid growth in the bank's MBS exposure. In the long run, the actions taken by the Housing Finance Board "seem proactive and are debt holder-positive," wrote analysts. However, in the short term, analysts are worried that rising rates in the second quarter of this year have caught the FHLBs by surprise in terms of risk management. Merrill also noted that debt spreads remained unchanged or only moved one basis point on the news.

Representatives from FHLB Chicago said that the provision included in the agreement - which is to limit the growth of the on-balance-sheet Mortgage Partnership Finance (MPF) loans that the bank will purchase going forward - would probably have a minimal short-term effect on its ability to serve its members by purchasing mortgages from them. This is due to the significant slowdown the mortgage market has experienced since the beginning of the year.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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