Seattle's Federal Home Loan Bank in big money trouble again

Don't look now, but another big Seattle-based bank is struggling under the weight of distressed mortgage-backed securities, declining loan business and the deflated housing market.

This time it's not a consumer-oriented bank such as Washington Mutual, which collapsed last year, but the Federal Home Loan Bank of Seattle, a behind-the scenes funder of mortgage loans that faces its second major financial crisis in five years.

The Seattle FHLB, a cooperative that lends money to its member banks at below-market rates, has accumulated $247 million in net losses over the past four quarters, mainly because of losses in its pile of mortgage-backed securities.

The bank's $16.2 million first-quarter loss would have been even deeper if not for a timely change in accounting rules.

So far, the bank's troubles haven't affected its ability to make loans to its members. That's especially important to smaller, more rural banks, which generally rely on the nationwide FHLB system more than larger institutions do.

But affordable-housing groups, who've looked to the Seattle FHLB as a key funding source for years, have seen the bank cut its grants nearly in half, to an estimated $2.6 million this year from nearly $4.4 million in 2008.

That will make finding money to build new low-cost housing "very difficult" especially with other sources also cutting back, said Sharon Lee, executive director of the Low Income Housing Institute in Seattle.

The Seattle FHLB's Home$tart program, which helps first-time buyers put together their down payments and meet closing costs, also has been cut this year, to $1.8 million from $3.6 million last year.

And member banks may find the FHLB is a less appealing funding source than it used to be. That could hinder any recovery in local housing markets.

"They have historically been important financial partners but they are not indispensable to us," said Roy Whitehead, CEO of Seattle-based Washington Federal, the Seattle FHLB's third-biggest shareholder.

"Their current problems probably make them less competitive than they've been in the past."

Through a spokeswoman, Seattle FHLB's chief executive, Richard Riccobono, declined to be interviewed for this article.

Though the Seattle FHLB is among the most troubled of the 12 Home Loan Banks, it's hardly the only one facing difficulties. Five others also have suspended cash dividends; five others also posted first-quarter losses.

In a report issued last month, the Federal Housing Finance Agency, which regulates the Home Loan Bank System, called the overall condition of the Seattle FHLB and three other banks in the system "less than satisfactory."

The report said the Seattle FHLB's financial condition was "weakening" and called its governance "unsatisfactory," its operational risk management "weak" and its credit risk "high and increasing."

The upheaval in the banking world is cutting into the Seattle FHLB's lending business:

• WaMu, which accounted for more than a third of the Seattle FHLB's lending business, now is owned by JPMorgan Chase of New York. Chase isn't a member of the regional bank and can't become one, meaning it can't take out any new loans.

• Bank of America, the Seattle bank's second-biggest customer, bought Merrill Lynch, the third-biggest. In March, Merrill Lynch repaid its $2.9 billion in outstanding Seattle FHLB loans and hasn't taken out new ones, suggesting it may withdraw its membership.

• Federal recovery efforts, such as the Temporary Liquidity Guarantee Program, may cut into demand for FHLB loans.

All of which raises the question of whether the Seattle bank — already the second-smallest of the 12 Federal Home Loan Banks — will have the scale it needs to remain healthy going forward.

"You lose a very big customer, and you lose the capital base they have pledged to support their borrowings," said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a Washington, D.C.-based research firm.

Creation of Congress

Since Congress established the Home Loan Banks in 1932, their main business hasn't changed much.

They raise money by selling bonds to investors and advance the proceeds to their member banks, which use it to make home loans.

Because the FHLBs don't pay income taxes and have the implicit backing of the federal government, they can offer funds to their members at relatively low rates.

As of March 31, the Seattle FHLB had $31.8 billion in outstanding loans — or "advances" in FHLB terminology — down from $46.3 billion as recently as Oct. 31, before the housing market went into deep-freeze and several members failed or were merged out of existence.

"The advance business is a safe business, but the problem is it's a very low-return one," Petrou said.

That prompted all the FHLBs, in varying degrees, to look for other ways to boost returns.

One such effort earlier this decade landed the Seattle FHLB in its first round of financial trouble.

Under Norm Rice, who became the bank's president in 1999 after two terms as Seattle's mayor, the bank began buying mortgages directly from member banks, setting itself up as a junior competitor to Fannie Mae and Freddie Mac.

WaMu, by far the Seattle FHLB's largest member, supplied 87 percent of those home loans.

Rush to refinance

But when mortgage rates plunged and borrowers rushed to refinance, the Seattle FHLB was left holding billions of dollars it couldn't profitably reinvest in mortgages.

The bank compounded its problems by buying $8 billion in debt from the Home Loan Bank System itself.

That move eventually led to several quarterly losses and in early 2005 the Federal Housing Finance Agency tightened its regulatory scrutiny of the bank's business practices. Rice stepped down a couple of months later.

By 2007, though, the Seattle FHLB seemed back on top of its game.

Advances were at record levels, as other funding sources began to flee the deteriorating housing market, and the bank posted a $70.7 million profit on the year.

Most of the problems haven't been in the core advance business, but in the Seattle FHLB's investment portfolio — specifically so-called "private label" mortgage-backed securities, issued by private mortgage lenders such as WaMu or Bank of America rather than by Fannie or Freddie.

At the time, private-label mortgage securities seemed to be a reasonably safe way for the Seattle FHLB to earn higher returns than it could get from Fannie or Freddie, said Whitehead, a former director.

Rug pulled out

But last fall, as more and more borrowers defaulted on their mortgages, investors began shunning the securities built on top of them.

That meant the institutions holding those securities could neither sell them nor, because of their brain-busting complexity, accurately value them.

That was a big problem for the Seattle FHLB, which had piled up $5.6 billion in private-label mortgage securities — nearly 10 percent of its assets, the highest concentration of any Home Loan Bank.

As of March 31, the Seattle FHLB estimated that the fair value of that investment was just $3.1 billion.

It recognized some of that decline at the end of 2008, resulting in a $241.2 million quarterly loss and causing the bank to fail a key regulatory capital test. An additional $71.7 million in losses on those securities came in the first quarter.

The bank would have had to book an additional $823.5 million in first-quarter losses if not for a change in accounting rules earlier this year.

Dividends stopped

As a result, the Seattle FHLB has stopped paying its members cash dividends on their shares and suspended buybacks of excess stock.

In public statements, bank management has insisted that most of those private-label mortgage securities won't go sour, but accounting rules are forcing it to overstate its losses on them.

"These appear to be 'money-good' assets over time, but there's no buyer for them right now," Whitehead said. "Their view is that the economic value of the assets is not reflected by the accounting treatment, and at this point, we have no reason to believe differently."

Even if the bank's losses are due mainly to arcane accounting rules, they'll have a real-world impact on local affordable-housing efforts.

The Seattle FHLB has been both the "first funder" on projects — allowing the developer to start predevelopment work while it lines up other funding — and "last funder," filling holes when projects went over budget, said the Low Income Housing Institute's Lee.

The bank helped fund two of the institute's current affordable-ownership projects, the 33-unit Copper Lantern Homes in Kenmore and 15 units in the Dearborn Commons development along Rainier Avenue South.

Beyond its direct aid, the bank also helps groups like Lee's build positive relationships with lenders, she said, since the FHLB channels its help through member banks that team up with developers to apply for grants.

Brian Harris, a senior analyst for Moody's, said that as long as the bank's private-label investments perform more or less as expected — that is, as long as too many of the underlying borrowers don't default on their mortgages — it should be able to get through its current troubles.

"We believe the core business of the Home Loan Bank of Seattle is healthy, and the losses embedded in the private-label portfolio are manageable," he said. "The real question is, how big are the credit losses?"

The 12 Home Loan Banks together hold more than $50 billion in private-label mortgage securities, Harris said. Moody's estimates that when all is said and done, $2.8 billion of those notes will go bad — up from its previous $1 billion estimate, but still manageable.

But Petrou, of Federal Financial Analytics, isn't convinced the bank has fully come to grips with its various issues.

"I think, from a regulatory perspective, you have to take a very conservative view, especially with these private-label MBS," she said, referring to the mortgage securities.

"It's kind of like a 12-step program: First you have to admit you have a problem."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com