FHLB Deal's Demise Puts Chicago on the Clock

WASHINGTON — After at least nine months of tense negotiations, the merger of the Federal Home Loan banks of Chicago and Dallas fell apart Monday, raising questions about the future of the Illinois bank and the system itself.

Also gone, as of Friday, is the Chicago Home Loan bank's president, Mike Thomas.

The Chicago bank declined to explain what happened, while Terry Smith, the Dallas bank's president, would only say it became clear this weekend a merger would not occur.

"Both sides worked very, very hard," Mr. Smith said. "At the end of the day, we just couldn't get there."

The merger had seemed on track until very recently. In February, American Banker reported that both banks' boards had approved the deal, though the Chicago bank insisted that did not constitute a final agreement. The Chicago bank even took the unusual step of promising to continue paying three top executives if they were terminated for, among other reasons, having to move more than 50 miles.

It is probable that the two sides just could not agree on how much the Chicago bank is worth. In early March the Chicago Home Loan bank had pegged its value at more than $800 million, but by late last month rumors circulated the deal was in trouble and that number was once again in play.

The breakdown of talks leaves the future uncertain for the Chicago bank. While a spokeswoman for the bank declined to make Mr. Thomas available for an interview, in a letter to members, P. David Kuhl, the bank's chairman, said the focus would be on developing a new capital plan and restructuring its balance sheet.

Mr. Kuhl also said his bank would finalize a plan within 90 days that would outline how it could operate on a stand-alone basis. While observers floated the possibility of the bank seeking another merger partner, the spokeswoman for the bank said that was not under consideration.

But the more pressing matter will be finding a successor for Mr. Thomas, who leaves with a hefty $1.13 million lump-sum severance payment.

The Chicago bank named Matthew Feldman interim president and said it hopes to name a new permanent president within the next month and a half.

Such a search could be difficult. With diminished earnings and a restrictive cease-and-desist order, the bank has acknowledged it could lose key people.

"Employee retention may be difficult given the current challenges in our operating environment," the Chicago Home Loan bank said in its 2007 annual report. "The impacts of our plans to reduce our non-interest expenses and staffing levels in 2008, employee concerns related to the C&D order, and the possibility of a merger with the FHLB of Dallas may impede our retention efforts. If, despite our retention efforts, key employees resign, our ability to operate our business could be negatively impacted."

The Chicago bank's work force has already shrunk significantly — by 25% in 2007, to 337.

Also unclear is what impact the merger breakdown will have on the Home Loan Bank System. Since the merger talks first came to light in August, other Home Loan bank executives have looked to the developments in Chicago and Dallas for guidance on their own possible consolidations. Though the negotiations fell apart, many observers said mergers are still feasible.

"Mergers are always a possibility," said Allan Mendelowitz, a director at the Federal Housing Finance Board, which oversees the 12 Home Loan banks. "This doesn't mean there won't be other mergers."

Daris Meeks, a spokesman for the Finance Board, declined to make the agency's chairman, Ronald Rosenfeld, available for comment. But the Dallas bank's Mr. Smith said the termination of merger talks would not hobble future unions.

The announcement has "neither positive nor negative" implications for other mergers, he said.

Jim Vogel, the head of fixed-income research at First Horizon National Corp.'s FTN Financial Capital Markets Corp., said that was especially true as Home Loan banks grapple with the myriad problems facing the industry.

"I don't think this means the end of potential mergers down the road, because you have these extraordinary circumstances," he said. "It's tough to manage the Home Loan Bank system in normal times. When you add in turmoil among your members, it becomes a lot more difficult."

Home Loan Bank consolidation has often been discussed, but few mergers have actually occurred. The last one, in 1946, was done at the behest of regulators.

For their part, many members of the Chicago Home Loan bank, who have not received dividends in recent months, did not appear disheartened by Monday's news.

"The bottom line is people want a healthy system available to them," said Kurt Bauer, the president and chief executive of the Wisconsin Bankers Association. "They would like to receive a dividend but know the challenges the board is under."

Mr. Smith similarly showed few signs of disappointment Monday, even though the Dallas bank stood to gain more than 800 new members from the Chicago district that borrowed $30 billion in advances at yearend.

"The upside from Dallas' perspective," Mr. Smith said, "was to increase the value to both sets of membership from a stronger, larger district. Both districts have equivalent demographics if you look at size and shape of membership. We thought that creating a larger district would be best for both sets of members."

He said he expected the merger to happen until very late in the discussions.

"The issue from our side on this is we thought there was an opportunity here, and right up until the moment where the banks determined we couldn't go forward, we thought there was an opportunity," he said.

He acknowledged that the accounting was problematic but said the obstacles he faced in pursuing the deal were not unique.

"The challenges are those in any bank merger, reaching a transaction that is mutually beneficial to all parties and then executing the merger," he said. "Fundamentally, I don't know that this is any more complex than any other bank merger."

Mr. Smith said his bank, whose net income grew 6.2% in 2007, to $129.8 million, would remain successful. The Chicago bank's 2007 net income fell 49%, to $98 million.

"It was a nice opportunity, but we remain financially strong," Mr. Smith said.

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