WASHINGTON — As the Federal Home Loan banks continue to struggle with charges on their mortgage holdings, the Federal Housing Finance Agency is considering the creation of an insurance fund that could absorb losses at a troubled Home Loan bank.

The 12 Home Loan banks are already jointly and severally liable for one another's debt, but such a fund would drive the system's members, which have historically prided themselves on their independence, closer together.

"The FHLBank System's joint and several liability for consolidated obligations is a great source of strength for the FHLBanks and to investors in the FHLBanks' debt," Finance Agency Director James Lockhart told American Banker in a response to inquiries about the discussions already under way with the Home Loan banks.

"Although very preliminary, the FHFA has begun to assess whether there are ways for the FHLBanks to provide comparable support for one another with respect to other obligations and capital — such as through a form of insurance fund," Lockhart said.

The effort "is not focused on any particular FHLBank," he said. "Rather, it grows out of the FHFA's duty to ensure the FHLBanks operate in a financially safe and sound manner, so they can serve as a reliable source of liquidity to member institutions to support housing finance in this country."

The issue could surface today, when Lockhart is scheduled to testify before a House subcommittee on the future of Fannie Mae and Freddie Mac.

The FHFA could also adopt an alternative strategy, such as requiring strong Home Loan banks to assist weak ones directly.

Though either approach would be controversial, both could benefit the Home Loan Bank System. For one thing, they may help instill confidence that the system has safety nets in place that would prevent the ad hoc rescue policies that have become a staple of the financial crisis.

An insurance fund would also spread the costs across the system, instead of calling on just one or a few Home Loan banks to help out a troubled one.

"It strikes me as a responsible, appropriate thing the regulator should be doing," said Dick Swanson, the president and chief executive officer of the Home Loan Bank of Des Moines. "It's not so much focused on strong banks helping weak banks. It's more developing ideas for how the bank system might put in place mechanisms that would provide support along the lines of some sort of insurance fund."

Others said the FHFA's efforts would simply codify an existing assumption that Home Loan banks would help one another before turning to the government for funding.

"We think there's a high degree of cooperative support, and what we mean by that is, should an individual Home Loan bank have difficulty, it's highly likely that the other banks would provide support," said Brian Harris, an analyst at Moody's Investors Service Inc. "And that would happen before any type of government support."

But there are many open questions about how the assistance would work in practice.
For instance, it is unclear whether a strong Home Loan bank would help a troubled one by purchasing assets or by making capital injections. Healthy Home Loan banks are unlikely to favor the injection approach in an environment where capital is critical for all financial institutions.
"If one bank has to subsidize another bank, it means the members of that bank are taking a hit to help the members of another bank," said a source close to the Home Loan banks, underscoring a sentiment among many CEOs in the system that their primary job is to maximize the value of membership for their shareholders.

There are also concerns about the creation of an insurance fund, including how much money each Home Loan bank would need to contribute and how long it would take for the fund to become operational.

Swanson said such questions are premature, since the FHFA and the Home Loan banks are still deciding what kind of insurance fund would be most appropriate.

He cited the Federal Deposit Insurance Corp. and Farm Credit System as two possible examples of templates.

"People are thinking about models," Swanson said. "It's nowhere near 'How much is this going to cost me?' It's not at that level."

Several sources also privately expressed hesitation about paying for an insurance fund while making payments to the Resolution Funding Corp., which helped finance the savings and loan bailout in the 1980s. The Home Loan banks are supposed to pay off that agency by 2030 but are on track to do so earlier than that. Once those payments are completed, some worry that Congress would require the Home Loan banks to fund new projects in addition to an insurance fund.

As the FHFA has considered its options, it has been careful not to specifically name any Home Loan bank that might be deemed weak.

Even though it seems that none of the Home Loan banks need immediate assistance, the Federal Home Loan Bank of Chicago tops the list of candidates that could need help if financial markets deteriorate further.

Problems with the Chicago bank's mortgage holdings were evident well before the housing market crumbled, and it is far from clear that its woes would subside once the market turmoil eases. The bank spent much of 2007 and 2008 considering a merger with the Home Loan Bank of Dallas.

The Chicago bank lost $119 million last year and another $39 million in the first quarter — the second largest loss among the 10 banks that have reported results for the quarter.

(The Home Loan banks of Pittsburgh and Topeka told the Securities and Exchange Commission last month that they would file first-quarter results late, since they were still studying the impact of other-than-temporary impairment charges.)

Last month Moody's downgraded the Chicago Home Loan bank's debt rating to A2, from Aa2.
The bank is "likely to be unprofitable for several quarters," Moody's said. "These losses increase the risk that FHLBank of Chicago's capital base could erode to the point that it violates its minimum total capital requirement."

Moody's also said a solution to the Chicago bank's financial trouble could include selling assets to another Home Loan bank, though it is unclear whether there are interested buyers at the moment.

Despite the severity of the Chicago bank's problems, there is reason to believe it could right itself in the months ahead. "None of those things speak to me of a business model that doesn't work," Harris said.

Its first-quarter loss dropped by half from a year earlier, and net interest income more than quadrupled, to $141 million, as a result of accelerated repayments of loans held in the mortgage partnership finance portfolio. Still, that was not enough to blunt the impact of $86 million of credit-related other-than-temporary impairment charges and a $72 million loss on derivatives.

Other Home Loan banks with persistent weaknesses include those in Seattle and Boston. Dragged down by a $126.9 million other-than-temporary impairment charge, the Boston bank reported a $83 million first-quarter loss, the largest of the 10 banks that have filed results, on top of a $116 million loss last year.

Total capital for the Boston bank slid more than 24% in the first quarter, to $2.6 billion. The Seattle bank, meanwhile, recorded a $71.7 million other-than-temporary impairment charge for the first quarter, sending it $16 million into the red. Its $199 million loss last year was the largest in the system and helped exhaust its retained earnings, making it the first Home Loan bank in the system's history to "break the buck."

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