Concern is mounting that losses on private-label MBScould exhaust the capital of several Federal Home Loan banks, sources inside and close to the system said this week.

In a worst-case scenario, eight of the banks would be undercapitalized if they were forced to recognize these losses, according to a report issued Thursday by Moody's Investors Service What would happen next is the source of debate, with options ranging from regulators putting one or more of the 12 banks into conservatorship to forcing healthy ones to support struggling ones.

"One of the open questions on our mind is 'What will the Federal Housing Finance Agency do?' " Brian Harris, the Moody's analyst who authored the report, said in an interview. "There are a lot of paths they could take. One would be, yes, you have to go into conservatorship."
A spokeswoman for the Federal Housing Finance Agency, which regulates the Home Loan banks and put Fannie Mae and Freddie Mac into conservatorship in September, said the agency has options beyond seizing control of a Home Loan bank.

"If an FHLBank falls below its regulatory capital, it will not be permitted to pay dividends to shareholders; it will not be permitted to repurchase member stock; and it will be required to file with the agency a capital restoration plan," the spokeswoman said in an e-mailed response to questions.

At issue is the accounting treatment of private-label securities held to maturity by the banks. Fair-value accounting rules dictate that the holdings be written down to their current market value. Since the market for mortgage-related securities has tanked in recent months, the banks must value these assets at much less than the original cost.

Moody's said the Federal Home Loan Bank System's $76.2 billion private-label MBS portfolio was actually worth $62.7 billion at the end of the third quarter, resulting in $13.5 billion of unrealized losses. Values likely fell further last quarter.

The loss in value forces the Home Loan banks to take other-than-temporary impairment charges. The Atlanta, Chicago, and Seattle banks reported $209 million of such charges for the third quarter.

Observers are running through a host of scenarios in the event that a Home Loan bank becomes undercapitalized. At the extreme end of the spectrum, the Finance Agency could put the bank into conservatorship. But that tactic would raise concerns. For one thing, some observers questioned whether the other 11 Home Loan banks could still function independently. Also, the impact of a conservatorship on the system's ability to sell debt is unclear.

"That is an important issue," Harris said. "Absolutely, one of the consequences is that funding costs for Home Loan banks could go up."

Moreover, the case of Fannie Mae and Freddie Mac shows that once a company is seized by the government, the next step is often murky. Treasury Secretary Henry Paulson acknowledged as much Wednesday when he urged those government-sponsored enterprises to be replaced by private entities governed by the type of commissions that oversee public utilities.

Another concept being discussed would call on healthy Home Loan banks to divert some of their capital to weaker ones, but Harris said that could also create problems.

"The regulation is clear that the owners of Home Loan bank retained earnings are its members," he said. "There are a number of challenges the banks would have to resolve before they could take that action."

A far less attractive alternative would be to require Home Loan bank members to raise more capital. But Karen Shaw Petrou, managing director of Federal Financial Analytics, said that with capital already thin at many financial institutions, such a move could spark a clash with banking regulators.

"Calling capital from members in the current situation would certainly be something the FHFA could seek to have the banks do," she said, "but I would think the bank regulators, most especially" the Federal Deposit Insurance Corp., "would object to that and would create a profound confrontation in the regulatory arena."

The Home Loan banks are continuing to cry foul over the accounting issue.

"This issue does not reflect the true economics," said John von Seggern, the president of the Council of Federal Home Loan Banks. "We would hope" the Financial Accounting Standards Board, the Securities and Exchange Commission, "and everyone involved in this issue would look very closely at this."

But Petrou said that "unless you like to believe that accounting has no basis in reality," the accounting should not be so readily dismissed.

"These are not the most robust assets," she said. "The ratings have dropped, though obviously they were fictitious ratings in the first place."

Finance Agency Director James Lockhart said last month in an interview with American Banker that he supported writing assets down to market value.

"My view on fair value is I think it provides useful information and is important to have," he said. "If an asset is impaired, it should be written down."

But Harris said the agency should do more to clarify its position on whether the losses are purely related to accounting or actually reflect losses embedded on the Home Loan banks' books, which would require more serious action.

"That would certainly provide a lot of benefits to the market," he said.The Finance Agency spokeswoman seemed to indicate that the charges are viewed as actual losses.

"The actual amount of realized loss, over time, will be determined when the security is actually sold or by the extent that credit problems result in the investor receiving less than the contractual cash flows," she said. "Those will be real economic losses, but they are unlikely to be as great as the current depreciation in market price, because today's market prices of private-label MBS are impaired, because of both credit and liquidity concerns."

Sources said the situation could become quite severe for some Home Loan banks in the coming months. The picture will be clearer when fourth-quarter reports are filed in March.

The Home Loan Bank of San Francisco warned its members last month that weaknesses in the mortgage market are "increasing the risk that some of these securities will require an impairment charge."

Under the Moody's analysis, the Home Loan Bank of Seattle's regulatory capital would fall to 2.31%, well below the 4% minimum.

"Seattle has the thinnest retained earnings base," Mr. Harris said. "That's why you see that impact on Seattle."

The San Francisco, Atlanta, and Boston banks would also find their capital levels straddling the 3% mark, according to Moody's. Only the Cincinnati, Dallas, Des Moines, and New York banks would have enough capital to meet regulatory requirements.

It is noteworthy, however, that even in the worst-case scenario, none of the Home Loan banks run out of capital. And the banks are taking steps to conserve their capital. Last month the Boston and Des Moines banks announced plans to stop redeeming excess stock.

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