How a Bet on Rates Went Wrong for FHLB of Seattle

For all the talk of the inherent risks of fixed-rate mortgages, the final blunder that put the Federal Home Loan Bank of Seattle in its current pickle involved a different sort of investment.

Last summer it bet on interest rates by buying gobs of callable debt of other Home Loan banks and financing the investment with borrowings that were partly short-term and mostly noncallable.

What led the Home Loan bank to take that gamble, especially after it had acknowledged that problems with its mortgage program showed shortcomings in its interest rate risk management?

According to officials at the bank, a report it issued this month, and outsiders, the bad call stemmed in large part from a reluctance to make changes that would have been unpopular with members because they would have raised their taxes and lowered their profits from investing in the Seattle bank.

The lesson for other Home Loan banks is that having too much capital can be just as problematic as having too little.

The bet on the system's debt quickly soured, contributing to a 42% plunge in earnings last year and a further asset-liability mismatch. The bet also led to the early retirement of the Seattle bank's chief executive (and former Seattle Mayor) Norman B. Rice and a supervisory agreement with its regulator.

The bank expects to earn minimal profits, if any, in the next three years, but its executives say the risk-taking is over. It plans to cut staff by 25%, shut down its mortgage purchase program, and return to its roots by focusing on advances.

The chain of events started in 2002, when the bank started focusing on mortgage purchases and stopped offering competitive pricing on advances - the traditional asset of Home Loan banks - to its largest members.

In 2003, however, the surge in refinancing activity to unexpectedly high levels exposed the Seattle bank's inexperience in the asset class. Mortgages for which the bank had paid premiums were repaid long before anticipated, and longer-term debt was left on the books.

So the bank pulled back by ceasing its purchases of mortgages from its largest members; it planned to retool its risk management and then start buying again.

At the same time, the Seattle bank's advance business shrunk quickly as the outstanding balances of big members that also belonged to other Home Loan banks (and had other funding options) matured. Small members stepped up their borrowings, but not enough to make up for the loss of business from Washington Mutual Inc. and other big members.

The 12 Home Loan banks vary in the amount of stock they require to be a member, draw advances, or sell mortgages, and in how much they let members hold in excess stock. (Some banks, unlike the Seattle one, let members count stock that must purchased for membership toward activity-based requirements.) Usually the reason for allowing an excess is to make it easier for members to park money for future advances.

The Seattle bank's rules on excess stock are among the loosest in the Home Loan Bank System; it lets members hold up to $50 million, or 100% more than required, of the class of stock that pays full dividends. Quarterly adjustments to excess stock allowances lag changes in member activity.

However, even that limit (part of the capital plan its board created in 2002 in response to the Gramm-Leach-Bliley Act) had been a compromise that kicked out more than $500 million of stock. Previously, members were allowed to hold an unlimited amount of excess stock.

By last summer, between the mortgage prepayments and the maturation of large members' advances, the members had a boatload of excess stock they no longer needed to support their activity, and they were not redeeming that stock. They wanted to avoid the tax consequences of redemption (dividends are paid with stock), and they liked the dividend, which from 2001 to 2003 yielded 5.2% to 6.9% - especially attractive considering the low risk weighting.

At that point, the Seattle bank's board could have taken steps to force members to reduce their excess stock. Redemptions would have alleviated the pressure to generate profits to split among stockholders. Or the bank could have planned to cut dividends, then invested in safer, low-yield assets.

"In hindsight, what we should have done was dealt with the excess capital situation" by returning the capital, said Steve Horton, the bank's interim chief financial officer since October.

Mike Daly, the vice chairman of the bank's board and the chairman and CEO of First State Bank of Wheatland, Wyo., agreed with that assessment. "Any time you make decisions in business that don't go the way that you expect them to go, all of a sudden your 20/20 hindsight gets real clear."

By mid-2004 the Seattle bank had already run up against regulatory constraints on further purchases of mortgage bonds, and on the debt of Fannie Mae and Freddie Mac, so it pursued the only other high-yield investment available.

Its investments in the consolidated obligations of the Home Loan banks jumped 120% last year, to $8 billion. (At the end of 2002, the figure had totaled just $160 million.)

This strategy was not the only reason for the asset-liability mismatch on the bank's balance sheet at yearend, but, to many observers, it was the most appalling.

It contributed to a $260 million unrecognized fair-value loss at yearend, much of which the bank expects to recognize over time. (As of Jan. 1 it had $2.1 billion of capital.) Basil Petrou, a managing partner with Federal Financial Analytics Inc., said the Seattle bank chose to "double down" on interest rate risk after finding its ability to manage such risk lacking. "This was the critical decision."

As the Fed raised rates, the short-term funding became more expensive, and interest income was squeezed. The drop in long-term rates raised the possibility that the other banks would call their debt. Lockout periods prevented that from happening last year, but the Seattle bank's executives expect some of the securities to be called soon if rates stay low.

Another problem: The investment strategy skirted the edge of the rules. In November the Finance Board informed the bank that the purchases apparently violated regulations barring the direct placement of debt issued for one Home Loan bank with another. Last month the regulator advised all the Home Loan banks more firmly that buying the consolidated obligations at the time of issuance is prohibited.

The other Home Loan banks have from time to time bought the system's consolidated obligations, but the Seattle bank's purchases were by far the largest.

Another open issue: According to the bank's April 5 report, three members with executives on its board redeemed a big chunk of stock in October, before its supervisory agreement with the Finance Board. (The three were not identified.) After another member complained about possible trading on inside information, a committee of independent directors began looking at the issue. It filed an initial report to the bank's board, which has made no decisions.

Ironically, the bank now needs to conserve capital, as the forecast for paltry earnings or possible losses makes it unattractive for members to buy more stock. It is limiting redemptions for now, and seeking to amend its capital plan to let members use for advances the base amount of stock they hold for membership. The membership stock could support up to $16 billion of new borrowings. Eventually, the bank wants advances to account for about 80% of its assets, executives said. It submitted a three-year plan to its regulator this month. This year it has reinstated a policy of pricing advances to large members competitively, and executives say such advances are growing.

This year the Seattle bank spent $17 million on hedges, and it is reducing the risk profile of its funding to keep things from getting worse. "We're confident we're on the path to stability," Mr. Horton said. Several observers agreed that the bank is not facing solvency concerns. "It faces an earnings storm, but one that it is able to weather," said John von Seggern, the president of the Council of Federal Home Loan Banks.

Stephen M. Cross, the director of the Finance Board's Office of Supervision, said that the board, which in 2003 asked the banks to use retained earnings for more of their capital, may take a second look at how much leeway they get with other aspects of their capital plans. "We now have, for most of the banks, a couple of years experience under our belt, so it's prudent regulatory practice to look at what has worked, and what hasn't," he said.

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