When Norm Rice joined the Federal Home Loan Bank of Seattle in 1998, he brought political savvy to a relatively obscure bank in the low-risk...
When Norm Rice joined the Federal Home Loan Bank of Seattle in 1998, he brought political savvy to a relatively obscure bank in the low-risk business of lending money to its member banks.
Fresh from eight years as mayor of Seattle, Rice had plenty of people skills but little banking experience. His résumé included only two years in banking — managing corporate contributions for Rainier National Bank in the 1970s. He became head of the home-loan bank in 1999.
His background probably would have sufficed if the home-loan bank had stuck to its traditional business.
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Instead, it waded into the far riskier business of buying mortgages from banks, setting itself up as a pint-sized competitor to Fannie Mae and Freddie Mac.
By late 2003, miscalculations left it with billions of dollars that could not be profitably reinvested in mortgages. In a desperate measure to remedy those errors, the bank compounded its problems in 2004 with an unorthodox move to purchase a whopping $8 billion in debt from the home-loan bank system itself. That strategy set off alarm bells at the bank’s regulator, leading to a public rebuke and detailed scrutiny of its business.
“How did this transaction take place without red flags going up everywhere? The fact is, it did and it shouldn’t have and it’s a shame it did,” said David Bley, the bank’s new chief operating officer, who used to be executive vice president of products and services.
Federal Home Loan Bank of Seattle
What it is: One of 12 banks nationwide chartered by the federal government in 1932 to ensure financial institutions have access to money to lend to consumers for home mortgages.
Location: 1501 Fourth Ave., 19th floor
Interim CEO: James Faulstich, who previously ran the bank from 1979 to 1999
Assets: $48.1 billion
Employees: About 150, after planned layoffs of roughly 40 people
Source: Federal Home Loan Bank of Seattle
The missteps drove down the bank’s earnings by 42 percent last year to $82.7 million. At the end of the year, the bank still had about $260 million in paper losses that could drain earnings for years to come, and bank officials have warned members that it might post some quarterly losses over the next few years.
A broad picture of how the bank got into trouble last year emerged from interviews with the bank’s regulatory agency, officials at the Seattle home-loan bank and others, along with various filings by the bank.
But specific responsibility for the decisions that sank the bank’s mortgage program remains unclear.
Rice retired in March, and Chief Financial Officer Kelli Bono, a longtime employee of the bank, resigned with a generous severance package, according to people familiar with the situation. Rice declined to comment for this article, and Bono did not return phone calls.
Rice was a champion of the mortgage-purchase program, said several people familiar with the bank, but he probably did not know how extensively it had invested in the debt of the home-loan bank system. The mistake was having people with too little experience in complex mortgage and investment techniques driving that part of the bank.
An official at the Federal Housing Finance Board, which regulates the nation’s home-loan banks, said there was a breakdown in governance by senior management and the board, but declined to name individuals.
Asked whether anyone might be punished or sanctioned as a result of the bank’s problems, the agency declined to comment. “That would be a supervisory matter,” said Steve Cross, director of supervision for the board.
Risky venture backed
The home-loan bank system was formed in 1932 to restore confidence in the banking system by supplying banks with low-cost funds for mortgages.
Each of the 12 regional home-loan banks is owned by its members. The Seattle bank’s members include Washington Mutual, Washington Federal and HomeStreet Bank, as well as smaller institutions.
If a home-loan bank is healthy and profitable, members receive dividends on their stock.
Because they were created by Congress, the home-loan banks can borrow at low rates from the global bond markets. They lend the money at higher rates to their members, a simple business that brings in steady profits.
For such a low-risk investment, the Seattle bank’s dividends had been quite high — 5 to 7 percent in recent years, until earnings took a dive in 2004.
The bank entered the field of buying fixed-rate mortgages several years ago with support from its members, Bley said. Creating competition for mortgage-buying powerhouses Fannie Mae and Freddie Mac helped members receive better prices for their mortgages, and members liked having a local alternative.
Roy Whitehead, a director of the Seattle home-loan bank and chief executive of Washington Federal, said he had argued against the home-loan bank getting into the mortgage-buying business.
“I opposed it quite strongly for a variety of reasons. Most importantly was that, in my opinion, it entailed venture-capital risk characteristics that were inappropriate for a cooperative funded primarily by debt that carried the implied guarantee of the U.S. government,” Whitehead said.
The program was likely to benefit only a few large members, and the home-loan bank’s management had no experience in the mortgage business, he said.
“It’s a business that to an outsider looks extraordinarily simple, but managing the interest-rate risk associated with mortgage assets is in fact very complex and difficult,” Whitehead said.
The unwanted $8 billion
At first, the Seattle home-loan bank’s venture into buying mortgages performed beautifully.
But in 2003 it drew to a halt. Its officials and their computer models had incorrectly predicted how quickly people would pay off their mortgages.
With interest rates staying unexpectedly low and the refinancing boom continuing, the home-loan bank was stuck holding billions of dollars that were not earning much interest.
Other companies also were caught by interest rates staying low for so long. Last year, Washington Mutual’s flawed assumptions about interest rates hurt its profits.
For the Seattle home-loan bank, pumping money back into mortgages could have meant taking losses, because in general it would earn lower interest on them than it was paying on the money it had borrowed.
The bank had two choices for its unwanted $8 billion: Buy back stock from members or find a way to make money on it.
All home-loan banks are restricted in the categories of investments they can make. Most have pulled back on trying to make money through nonhousing-related investments, because it does not serve the system’s broader mission of serving banks and their mortgage customers.
But the Seattle bank had not been so altruistic and had already pushed its investments to the limit in all categories except the debt of other home-loan banks.
Taken literally, the system’s rules allowed investment in the debt of other home-loan banks. But it happened rarely and in small amounts.
The Seattle home-loan bank changed that in 2004. It plowed more than $8 billion into such debt, up 50-fold from its 2002 level of $160 million.
The other 11 members of the bank system collectively held only $900 million of that type of debt at the end of last year.
“It doesn’t advance the mission of the federal home-loan bank system” for banks to own the system’s debt, Cross said. “The banks were created to provide liquidity to their member institutions in order to finance the purchase or construction of homes.”
But the Seattle bank treated the debt like other investments, and used it to make another bet on interest rates by buying and issuing the debt with various maturities and other characteristics.
Again it was exposed to interest-rate risk, and again it guessed wrong.
At that point, the Federal Housing Finance Board intervened. It ordered the bank to hire outside experts to review its management and structure. The home-loan bank stopped its mortgage-purchase program and is cutting its staff members by about 25 percent, leaving around 150 employees. And the bank had to file a three-year business and capital-management plan outlining how it intends to improve operations.
Some observers say the bank’s regulator went further than it would have if Congress were not watching.
“They are trying to make everyone notice that they are paying attention,” said J. Edward Norris III, former head of the Federal Home Loan Bank of Atlanta and now chief executive of Plantation Federal Bank in South Carolina.
Norris says regulation throughout the system has tightened after accounting scandals at Fannie Mae and Freddie Mac.
Cross denies that politics had anything to do with the board’s decision to slap the Seattle bank, and earlier last year the Federal Home Loan Bank of Chicago, with rare so-called “written agreements” under which they are more closely supervised.
“This is not at all part of the political climate,” he said.
No one has suggested that home-loan bank officials did anything illegal or unethical. However, the bank’s board is investigating whether insider trading was involved in the October buyback of stock from three member institutions whose executives sit on the bank’s board.
With the home-loan bank warning that profits could be eroded for years, Standard & Poor’s Ratings Services last month revised its outlook to negative from stable. Moody’s Investors Service held its rating at stable.
“The credit risks of the institution are solid,” said Brian Harris, a senior analyst at Moody’s. Still, he said, the regulator’s intervention “isn’t something to be dismissed lightly.”
Whitehead said that despite the “near-term earnings issue,” the Seattle home-loan bank remains on a strong footing.
“The bank is fundamentally sound and well-capitalized,” he said.
Melissa Allison: 206-464-3312 or email@example.com