Home-Loan Banks Struggle to Maintain Capital

By JAMES R. HAGERTY

The Federal Home Loan Banks, which have thrived on obscurity for more than seven decades, are moving uncomfortably into the spotlight as souring mortgage investments threaten to leave some of them below their capital requirements.

The 12 regional home-loan banks are a major source of funding for thousands of commercial banks, thrifts and credit unions across the country. As other sources of credit dried up, they increased their lending to financial institutions to about $1 trillion as of Sept. 30 from $641 billion at the end of 2006. In recent weeks, however, several of the home-loan banks have suspended dividends or warned that they may fall short of capital requirements.

That raises the possibility that some of the home-loan banks may have to curtail their lending, charge more for credit or sell some of their financial assets. If bond investors get too jittery, the home-loan banks may have to tap an emergency credit line established by the Treasury Department for them in September, though that doesn't appear imminent.

"The overall [home-loan bank] system is strong," James Lockhart, director of the Federal Housing Finance Agency, which regulates the banks, said in an interview. He said they should be able to continue making loans at a normal pace, though it is "prudent" for some of them to conserve capital.

"This is not an emergency that requires an over-a-weekend response," said Jim Vogel, an analyst at FTN Financial Capital Markets. Even so, the negative headlines are likely to keep buyers of home-loan bank debt on edge.

Congress chartered the home-loan banks in 1932 as a way of propping up thrift institutions ravaged by the Great Depression. Although created by Congress, the home-loan banks are cooperatives owned by more than 8,000 commercial banks, thrifts, credit unions and insurers, known as members. The home-loan banks make loans, called advances, to their members, with collateral frequently consisting of home mortgages or related securities.

Some of the home-loan banks are conserving capital by suspending their usual practice of buying back stock from members who want to sell. One risk is that the members eventually may have to write down the value of that stock. "It's a discussion you have to have with your accountants and auditors," Kristina Williams, chief financial officer of the Pittsburgh home-loan bank, said in a conference call with members Friday.

Because investors generally believe the U.S. government would rescue the home-loan banks in a crisis, they have long borrowed on favorable terms in global bond markets. As of Sept. 30, their combined borrowings were about $1.3 trillion, making them one of the world's biggest debtors.

The core business of making advances to members has continued to perform fairly well, though profit margins have shrunk. But several of the home-loan banks have run into trouble because in recent years they invested heavily in "private label" mortgage securities. Such securities aren't guaranteed by the government or by U.S.-backed mortgage investors Fannie Mae and Freddie Mac.

The 12 home-loan banks own $76.2 billion of private-label mortgage securities, according to Moody's Investors Service. As of Sept. 30, the banks had recorded $13.5 billion of unrealized losses on these securities, whose market value continued to fall in the fourth quarter. The home-loan banks held total capital of $57 billion as of Sept. 30. Analysts at Barclays Capital have estimated that eventual losses on the securities "could amount to just shy of $5 billion."

The home-loan banks say they plan to hold these securities until maturity and don't expect to realize major losses on them. Even so, accounting rules require them to mark the securities to the estimated market value at a time when very few investors are willing to buy private-label mortgage securities. If the drop in value is deemed "other than temporary," the banks need to record losses, eroding their capital.

Last week, the Federal Home Loan Bank of Pittsburgh said it may have to ask its members to provide more capital if auditors and regulators require a major write-down. "I know you don't want to hear this any more than I want to say it," said John Price, the bank's chief executive, in a conference call. In an interview later, Mr. Price said the home-loan banks are being hurt by "Alice in Wonderland" accounting rules that exaggerate the likely size of eventual losses on the mortgage securities.

The Federal Home Loan Bank of Indianapolis said Friday it will defer a decision on whether to declare a fourth-quarter dividend until it determines whether it needs to mark down mortgage securities. The Pittsburgh and Seattle home-loan banks already have eliminated dividends, an important source of income for many of their members.

The struggle to maintain adequate capital could spur home-loan banks to consider merging with one another, said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. The Chicago and Dallas home-loans banks held merger talks last year but failed to agree on terms.

Write to James R. Hagerty at bob.hagerty@wsj.com