Future of Home Loan Banks Tied to Seattle-Des Moines Merger Talks

WASHINGTON — The future of the Federal Home Loan Bank System may rest on merger talks between its Des Moines and Seattle banks.

The two announced last week they were exploring a merger, surprising many observers who thought a voluntary combination of Home Loan banks had become impossible.

The banks would have to resolve complicated governance issues and other logistical matters to get the deal done. But if they can, other Home Loan banks may move quickly to consolidate, potentially reshaping the system.

"There will be a substantial number of mergers if it's shown that this can work," said Stephen Cross, a former top examiner for the Home Loan banks at the Federal Housing Finance Agency. "If this merger goes through, it is a great development for the Home Loan Bank System because you will end up with larger, stronger and more efficient banks."

Consolidation of the 12 Home Loan banks has long been seen as necessary, yet a lack of political will and unavoidable technical issues have prevented it from happening.

Created in the 1930s, the system was meant to provide banks with funding to make mortgages. But some banks have struggled in more recent years to maintain their traditional "advance" business because of massive industry consolidation and the Federal Reserve Board's low-interest-rate policy. The level of advances systemwide rose 8% in the second quarter, reaching $538 billion, but much of that stemmed from the borrowing of a few large commercial banks, according to the banks' Office of Finance.

"The basic business of the Home Loan Bank System is, in the current interest rate environment and the current mortgage market, a low-volume, low-profit business," Karen Shaw Petrou, managing partner of Federal Financial Analytics, said in an interview.

In a report issued to clients, Petrou said that "big lenders are also still driving a hard deal" on borrowing from the Home Loan banks, with net interest margins for the entire system at 41 basis points as of midyear, down from 45 basis points at the same point last year.

Meanwhile, the Home Loan banks' attempt to expand their business lines, including directly purchasing mortgages from member institutions, has proved disastrous. The mortgage programs partly caused severe financial problems at the Seattle and Chicago banks.

The decline in advances and financial problems caused by the mortgage programs help explain why the Seattle bank is now considering merging with Des Moines. The Seattle bank's advance business struggled after the 2008 failure of Washington Mutual, its largest borrower. Though the Seattle region covers eight states, the bank has comparatively few large members. Its biggest borrower is Bank of America, which makes up roughly 30% of its advance business, according to company filings.

As a result, the level of advances at Seattle relative to its overall size has continued to decline in recent years. Advances fell 6%, to $10.2 billion, from yearend to June 30, and they make up only 28% of its assets. Only one other Home Loan bank, Chicago, has a lower level of advances to total assets.

That is important because the FHFA in recent years has become increasingly worried that the Home Loan banks have drifted far from their mission. The agency has emphasized that the banks need to have a high ratio of mission-related advance assets, Cross said.

"As long as those regulatory expectations continue, Seattle is going to be too small on its own," said Cross, who is now a senior director at Wolters Kluwer Financial Services. "But Seattle has eight states; there are great prospects there. Merging them with another bank makes a lot of sense."

A spokeswoman for the FHFA said the proposed merger is "voluntary," but that the FHFA has "encouraged the Seattle Federal Home Loan Bank to consider ways to reduce operating costs and to remain viable for the long-term; pursuing a merger is one possible option."

The Des Moines bank is in better shape than the Seattle bank. Its advance business grew 13% during the first half of 2014, reaching $51.7 billion and making up 63% of its assets. Earnings also rose 80%, to $27 million, from a year earlier.

The combined bank would be on even better footing, spanning 13 states and serving more than 1,500 banks, credit unions and insurance companies. (Des Moines' 1,100 members are already the most in the system.)

It would have assets of $118 billion, roughly half of which are mission-related. It would be the fourth-largest Home Loan bank in terms of advances.

The two banks began talks in February but didn't disclose them until last week; they will now conduct due diligence to see whether a combination makes sense. The merged bank, if approved by both banks' boards and the FHFA, would be based in Des Moines, according to joint answers provided to American Banker.

Other issues, including who would run the bank and how its board would be structured, remain up in the air.

"These are issues that are currently pending discussion," the banks said in response to questions. "Both the Des Moines and Seattle banks are committed to ensuring that all decisions provide value and are in the best interest of our member-owners."

Those issues are critical. A proposed merger of the Chicago and Dallas Home Loan banks fell apart six years ago because the two could not overcome various technical challenges. In that case, it appeared Chicago's far lower market value, spurred in part by its accounting problems at the time, played a strong role in killing the deal.

Market valuations do not seem to be an issue with regard to the Des Moines and Seattle banks, and the banks are optimistic they can address any obstacles.

"Des Moines and Seattle also see eye to eye on a number of overarching issues that often cause mergers to fail," the banks said. "We are in complete alignment, for example, on the purpose of an FHLBank, which is to be a stable and reliable source of liquidity and funding to its members. We also agree that the benefits of this merger are strategic. Given the nature of our stock, there is no immediate stock price appreciation to be realized by either set of shareholders, which is typical for corporate mergers."

Also helping the merger is the fact that the two CEOs involved have worked closely together in the past. Mike Wilson, the president of the Seattle bank, was the chief business officer of the Des Moines bank until January 2012. He worked under Richard Swanson, the Des Moines bank's CEO. Their relationship could make leadership issues easier to resolve.

Whatever the outcome, it's clear the rest of the Home Loan banks will be watching proceedings closely. Given the changes in the market, other mergers will soon be necessary, several observers said.

"Given the shrinkage in community banks, the consolidation of big banks, and the slim prospects for near-term FHFA approval of any FHLB ventures, it may well be time for the more vulnerable FHLBs to follow Seattle into the arms of a sister bank," Petrou wrote in her report.