A streak of bad news has left many observers wondering just how many hits the Federal Home Loan Bank of Seattle can take and whether its business can recover.
The Federal Housing Finance Agency has said the bank may be undercapitalized while it has also lost its biggest customer, wiped out its retained earnings and continues to have problems with its mortgage investments.
"The real question is, where do they get new business?" asked Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc. "If they can't do a viable advance business, which I think is an open question, then they're comatose neither living nor dying as an undercapitalized institution waiting for things to get better."
The Seattle Home Loan bank has 30 days to appeal last week's agency notification of potential undercapitalization. It has already voluntarily suspended dividend payments and excess stock repurchases moves the Finance Agency would require if it decides Seattle is undercapitalized.
The bank argues that, in the current market the capital rules overstate its problems. The risk-based capital rule that each bank must comply with consists of credit, market and operational risk. The Seattle Home Loan bank has failed only the market risk component, since the declining value of its private-label mortgage-backed securities has triggered higher capital mandates.
In an interview this week, Richard Riccobono, the bank's chief executive, continued to blame a familiar culprit accounting rules.
"We have not lost a nickel on our private-label MBS," Riccobono said. "To date, these are accounting losses and not economic losses."
Problems with managing market risk sent the Seattle Home Loan bank below its risk-based capital requirement in December, though it regained compliance in January. Under new capital rules, the Finance Agency could agree with the Seattle bank and not consider it undercapitalized, or overrule them.
In some respects, the problems in Seattle mirror those faced by the other 11 Home Loan banks.
Mark-to-market accounting rules have led to losses that continue to dent capital levels. In December the Seattle Home Loan bank became the first in the system to exhaust its retained earnings, which technically called into question the value of members' capital stock. By March 31, the bank built up its base of retained earnings, but total capital was still down 45.6% from yearend, to $960.6 million.
All the Home Loan banks have also found they are competing with the government to provide liquidity to the industry. Combined advances were off 11.4% from yearend on March 31 at the 10 Home Loan banks that filed reports, with the Seattle bank's advances off by 13.8%.
But observers said Seattle faces more pressure than its peers as it deals with the loss of Washington Mutual Inc., whose banking operation was acquired by JPMorgan Chase & Co., and Merrill Lynch & Co. Inc., which was acquired by Bank of America Corp.
"At some point, one really has to wonder how they go forward," said Frederick Cannon, the chief equity strategist at KBW Inc.'s Keefe, Bruyette & Woods Inc.
Wamu was the Seattle bank's biggest customer during the first quarter, accounting for 34.2% of the advance business on March 31. In its quarterly report, the Seattle Home Loan bank said most of those advances will mature this year. JPMorgan Chase is not yet a member of the Seattle Home Loan bank, so it cannot continue borrowing.
"It is unknown whether we will be able to replace these advances or reinvest the proceeds of the maturing advances into similarly yielding investments," the Home Loan bank said in its quarterly report.
In the interview, Riccobono appeared to brush off the impact and held out hope that JPMorgan Chase could use a charter in Utah to become a member of the Seattle Home Loan bank. "We still have the opportunity to have JPMorgan come back," he said.
Questions about the credit risk on its books are complicating the Seattle Home Loan bank's efforts to regain its footing. Though it only purchased loans that were rated triple-A, it has been dogged by downgrades. The value of triple-C alternative-A mortgages in its portfolio ballooned from $49.2 million in 2005 to $308.9 million in 2007 and presumably grew further as the market declined.
More recently, three triple-A private-label MBS worth $283.8 million were downgraded between March 31 and May 8. Another $191.3 million were placed on watch for potential downgrade.
Steve Horton, the Seattle Home Loan bank's chief operating officer, said that the mortgage holdings have been hurt by the declining financial market and that actual credit risk is much less.
"What we want people to understand is the price of the security does not reflect the true credit risk of what we could potentially lose," Horton said. "There is credit risk there, but it's not an unmanageable number."
Others are less convinced.
"You can talk about OTTI" other-than-temporary impairment "or the value, but ultimately it's going to be the realized value or loss that determines the capital position of these companies," Cannon said. "And some of these bonds are not worth a lot of money. It's not just because of liquidity issues. It's because underlying some of these bonds are some bad loans, and that's going to be ultimately what determines the capital position, and I think it's why rating agencies continue to view these bonds skeptically."
As Seattle struggles to turn things around, questions grow about whether it should merge with another Home Loan bank.
"The Home Loan bank system was designed to serve regional members, and as the nation underwent massive consolidation, the system didn't keep up... The entire system needs to move to something that realizes that a regional member model against national consolidation creates these sorts of conflicts," said Jim Vogel, the head of fixed-income research at First Horizon National Corp.'s First Financial Capital Markets Corp.
The most obvious potential merger partner for the Seattle bank would be the Federal Home Loan Bank of San Francisco. But consolidation is tricky, as the fruitless merger talks last year between the Chicago and Dallas banks proved.
"The problem you have in terms of a merger is, does one of the stronger banks want to accept the stock of a weaker bank?" Cannon said.
Moreover, the San Francisco bank has problems of its own, including losses related to its mortgage holdings. "I would hope that FHFA has learned from all the mistakes the bank regulators made merging two weak institutions does not create a big, strong one," Petrou said. "It creates a big, really weak one. B of A is case No. 1."
If it wanted to avoid a merger, the Seattle Home Loan bank could consider shrinking its business by perhaps selling off some investments or reducing the level of advances it makes. But Horton said such tightening would not help regain compliance with the interest rate risk model, which is at the heart of the problem.
"The assets we could shrink in a relatively short period of time have such a small impact on the risk-based capital requirement that the difference it would make would be minimal," he said.