WASHINGTON — Merger discussions between the Chicago and Dallas Federal Home Loan banks are gaining momentum and could result in a combination early next year, sources familiar with the situation said.
The two announced their merger negotiations in August after American Banker learned of the talks. But the discussions picked up traction after the Federal Housing Finance Board finalized a cease-and-desist order last month that imposed capital requirements and dividend restrictions on the Chicago bank.
The order changed the nature of the discussions from the theoretical to the practical, according to a source who requested anonymity to speak more freely. Though key issues remain to be settled, including deal price, dividend rates, and the future of the Mortgage Partnership Finance program, the two sides are motivated to reach an agreement, the source said.
A deal could help arrest the downward spiral of the Chicago bank, which has had sharp earnings declines over the past year and is subject to heightened scrutiny from the Finance Board. Its third-quarter report showed its profit fell 45% from a year earlier and revealed it was the only Home Loan bank to lose advance business during the liquidity crisis.
Observers privately said that the Chicago bank is trying to maintain at least an equal hand in the merger talks.
The Dallas bank did not immediately respond to a request for comment, while the Chicago bank declined to comment. The Chicago Home Loan Bank acknowledged in its earnings report, however, that discussions were continuing.
"The boards and management … have been engaged in detailed negotiations and extensive due diligence regarding various business, regulatory, financial, operational, accounting and governance issues related to a possible merger of the two banks," the report said. "The banks have not reached an agreement and it is possible that the banks will not finalize any agreement to combine the banks."
The Finance Board, which has historically supported Home Loan bank consolidation, is encouraging the merger, though sources said the agency is not pressuring the banks to combine.
But nuts-and-bolts obstacles remain, sources said. One is how a merged entity would pay dividends to its members.
Despite persistently weak earnings and advances, until the third quarter the Chicago bank continued to pay members modest dividends. The cease-and-desist, however, bars it from paying dividends without the approval of the Finance Board and — in the aftermath of its earnings drop — the agency was reportedly reluctant to sign off on any dividend payment for the third quarter. The bank's board ultimately decided to forgo dividends for the period.
With merger prospects becoming more realistic, the parties are discussing how dividends would resume and are close to an agreement that would segregate the stock, according to a source familiar with the situation.
Such an arrangement would allow members of the Dallas bank to continue receiving dividends despite problems in the former Chicago district. Stock held by members of the Chicago bank would remain subject to restrictions from the Finance Board, including prior approval for dividend payments, the source said.
That structure would effectively leave the Finance Board in control of the Chicago district's dividends and undercut its ability to negotiate on that issue.
Other areas of concern are still up for debate. Perhaps the biggest is the price of a merger. Since Home Loan bank stock is not traded publicly, it is more difficult to judge the precise value of the bank to allow a merger to proceed. But both banks are reviewing accounting policies and procedures to determine how much the Chicago bank would cost.
Meanwhile, both banks need to agree on how the MPF program would continue to operate once a merger took effect. The Finance Board has scrutinized that program this year for its interest rate risk management and its volume has declined with weakness in the housing market. Options being considered for the program range from selling the mortgages held in portfolio and disbanding it to repackaging those loans, the source said.
When merger talks began, some said a combination could simply result in a consolidation of back-room business. But that prospect appears to be fading as the Home Loan banks are actively discussing operational issues, including where the new bank would be headquartered. In one likely scenario it would be based in Dallas but maintain a Chicago branch, according to the source.
The merger talks, which cost the Chicago bank $2 million in the third quarter, are moving forward as the bank's performance continues to sour.
The credit crunch that began in August sent many financial institutions scrambling to the Home Loan banks to take advantage of one of the few remaining sources of affordable liquidity. Advances at the 12 Home Loan banks are up 28.6% since the end of 2006, to $824 billion.
Advances at the Chicago bank, however, fell 6.3% since Dec. 31, to $24.5 billion. In its third-quarter earnings report it said that stiffer competition remained a concern and that it was further hurt when two of its largest borrowers paid down their advances during the quarter.
"We face challenges in maintaining and growing our advance volume as our larger members have access to competitive alternative funding sources and the financial services industry faces further consolidations," the report said.
Like many Home Loan banks, the Chicago bank is grappling with membership losses as the financial services industry consolidates. It will likely lose two large borrowers with National City Corp. having bought MidAmerica Bank's parent, MAF Bancorp Inc., in September and Bank of America Corp. having bought LaSalle Bank Corp. from ABN Amro in October.
Advance growth could be further hampered by the cease-and-desist order, which essentially curbs the ability of member banks to withdraw or redeem their stock from the Chicago Home Loan bank. Without that flexibility, the Home Loan bank acknowledged its members may be reluctant to buy enough stock to borrow more advances.
"The potential for delays or denials of capital stock redemptions in connection with membership withdrawals or terminations and the outlook for our future dividend levels may make members reluctant to purchase new capital stock to support larger advance borrowings," the bank said in its earnings report.
Still, the Chicago bank said that in October it received four requests to withdraw stock, which would have resulted in a redemption worth $6 million.
The bank said it would pass along the request to the Finance Board, which has already approved a $1.6 million capital redemption for a member leaving the Chicago district. The profit news was also dim: a 45.5% decline in the third quarter. The drop was blamed on debt funding the MPF program that matured and was replaced with funds carrying a higher interest rate combined with hedging costs and larger balances in lower-yielding investments. The bank again warned that its financial picture probably would not brighten soon.
"We expect that increased debt costs and the amortization of prior period hedging costs and capitalized software costs will significantly lower our future net income and we may experience losses in the fourth quarter of 2007 and in 2008," the earnings report said.
