WASHINGTON — When the Federal Home Loan Bank of Chicago unveiled the Mortgage Partnership Finance program in 1997, it was meant to be the evolution of the Home Loan Bank System and give Fannie Mae and Freddie Mac a run for their money.
That was then.
Last week the Chicago bank said it would stop purchasing loans under the program on July 31, and on Monday it warned of a $78 million loss for the first quarter, largely because of volatility from the program's interest rate risk.
How the program fell from the promise of the system to the scourge of the most troubled Home Loan bank is a story of misjudgments and miscalculations.
Observers blame the Chicago bank for doing too much too fast, while others say regulators at the Federal Housing Finance Board were inconsistent and should have allowed the system to securitize the bank's mortgage holdings.
"This was a good idea surrounded by a lot of bad action, and the Federal Home Loan Bank of Chicago got caught," said Diane Casey-Landry, the senior executive vice president and chief operating officer of the American Bankers Association.
To be sure, the Chicago bank's decision does not affect the ability of the banks in Boston, Dallas, Des Moines, New York, Pittsburgh, and Topeka to make purchases under the program. But the Chicago bank invented the program and has made the most purchases, so the termination there is a blow.
The first mistake may have been high expectations. There was a sense in the system that advances, the traditional business of the Home Loan banks, would not secure the system's future.
"At the time that the program was being rolled out, it was viewed that advances were not something banks would need, because the mortgage market was changing," said Mike Wilson, the chief business officer of the Federal Home Loan Bank of Des Moines and the chairman of the system's MPF committee. "But over the years, and over the last several months, advances have proven their value."
As the credit markets have seized since August, advance business at the 12 Home Loan banks has increased dramatically, jumping 36.6% in 2007, to $875 billion.
Beyond the worry over advances, the program's creator, Alex Pollock, said in the early days that it could compete with Fannie and Freddie. "We tell our member institutions that they are going to win three ways if they sign up with MPF," Mr. Pollock, then the chief executive of the Chicago Home Loan bank, said in a 2000 interview. "No. 1, you get a better deal than you do selling to Fannie or Freddie. No. 2, you will get a better deal from them because they'll cut their rates to compete. No. 3, the Home Loan bank will make more money, and who owns the Home Loan bank? The member banks."
Al DelliBovi, the president of the Federal Home Loan Bank of New York, was long skeptical that the MPF program was a road to riches for his bank and said he doubted the program could compete with Fannie and Freddie.
"I never saw us going head to head with Fannie and Freddie, because I always knew Fannie and Freddie had the ability to use their pricing power to crush the MPF program if that's what they wanted to do," he said.
Mr. Pollock, now a resident fellow at the American Enterprise Institute, continues to defend the program. Use of the program should be widened, he said.
"It is obvious as a matter of strategy that now is the time to expand MPF," he said in an interview last week. "Fannie and Freddie are back in the mortgage market and raising fees, so if you want to add value to the Home Loan bank members, you need to give them an alternative to Fannie and Freddie."
But many said a flaw was apparent with MPF from its very beginning. While the program allowed the Home Loan banks to buy members' mortgages, it did not allow them a way to get them off their balance sheet. The Chicago and Seattle Home Loan banks both pursued ways to securitize, but found only limited success. The result was that the Home Loan banks had no way to get the mortgages off their books.
"You can't run this kind of system indefinitely and have illiquid assets on your book," said Bruce Morrison, who chaired the Finance Board at the time of the MPF's introduction. "That outlet was never developed."
Mr. Morrison said he tried to open the door to securitization during his time as chairman, but "you've got to walk before you can run," he said. "It had to go through the pilot stage."
He now blames his successors for "choking the baby in the crib" by not creating a mechanism for securitization.
"We trusted our successors to be as willing as we were to use the regulatory authority to provide the results, and our successors were not willing to take that step," he said.
Ronald Rosenfeld, the current chairman of the Finance Board, declined to comment for this story. But in a January 2007 interview he reiterated his wariness of securitization. "Securitization doesn't really affect the inherent risk in mortgages," he said. "It passes the risk on to someone else."
Still, Geoff Bacino, a director on the Finance Board, acknowledged the agency should have included some type of securitization mechanism. "It was a good concept that should have had securitization attached to it from the outset."
The Finance Board is also charged with inconsistently regulating the Chicago Home Loan bank. Though Mr. Morrison enthusiastically supported the program, his successors were increasingly lukewarm and had differing views on capital. The agency initially gave the same capital treatment to the program as it did to advances, even though advances are virtually risk-free. But by 2006 the Finance Board reversed course, implementing a proposal that effectively required the banks to hold more capital against their mortgage assets.
"You want them to do the program, then you don't want them to do it," Ms. Casey-Landry said. "Regulatory inconsistency really created the problem."
But most observers did not let the Chicago bank off the hook, either. One of its biggest errors may have been a reliance on member stock that could be redeemed within six months.
The Gramm-Leach-Bliley Act of 1999 required the Home Loan banks to convert to five-year stock, but the Chicago bank has never made the transition. Remaining on the six-month stock structure left the bank particularly vulnerable to members who wished to redeem their capital quickly.
Mr. Pollock "believed using six-month stock was OK," Mr. Morrison said. "I think it was a fatal error and it doomed the program."
The Finance Board slapped the Chicago Home Loan bank with a cease-and-desist order in October that, among other things, required the bank to develop a plan to convert to five-year stock. The bank said this week that it expects the Finance Board to approve its new capital plan soon.
For its part, a spokeswoman for the Chicago bank said the MPF program has been beneficial.
"Many smaller financial institutions have especially benefited from access to the secondary market that might not be available to them otherwise," she said. "Overall, the structure has worked very well. The issue is the impact on the balance sheet, especially given the volatility in the market, which is why we are working on the alternative investor approach."
Others say the bank's MPF portfolio grew too large too quickly. Though the portfolio has always paled in comparison to holdings at Fannie and Freddie, holding more than $45 billion as recently as 2004 left the bank vulnerable, observers said.
"It was just inevitable in terms of the size," said Brian Harris, an analyst at Moody's Investors Service Inc. "There's a tremendous amount of volatility ... and it has been more recently that the bank has been discovering the income implications."
The portfolio rested at $34.6 billion at yearend. Mr. DelliBovi, whose bank held $1.5 billion in its MPF portfolio at yearend, agreed that the portfolios could only grow so big.
"We just did not see this as a business that could have grown to be anywhere near as large as our advance business safely," he said
