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April 21, 2008

Two FHLBs End Merger Talks

BY BRIAN COLLINS

WASHINGTON -- The first consolidation in the 66-year history of the Federal Home Loan Bank System will have to wait now that the Chicago and Dallas FHLBanks have ended their merger talks.

The two banks began their discussions over seven months ago and they looked like ideal candidates for a marriage. Both banks are dealing with shrinking membership and high overhead. And the Chicago FHLBank needs help to readjust its mortgage portfolio and regain profitability.

But the deteriorating financial condition of the Chicago FHLBank apparently made it impossible to cut a deal that would benefit its member banks and thrifts.

"After extensive analysis and due diligence of the feasibility of combining the banks' business operations, the FHLB Chicago was unable to reach an agreement to merge with the Dallas bank that would have maximized value to FHLB Chicago members," chairman David Kuhl said in a letter to his fellow Chicago members.

Now the troubled Chicago bank has to get its house in order and find a new chief executive. Its president and CEO Mike Thomas submitted his resignation immediately after the merger talks collapsed.

Mr. Kuhl said the FHLBank is formulating a plan to operate on a "standalone" basis that will include a "new capital plan to stabilize the capital base and to restructure the balance sheet to improve long-term profitability."

Executive vice president Matthew Feldman will serve as acting president while a search is made to replace Mr. Thomas, who received a $1.1 million lump-sum severance payment.

Mr. Thomas was hired in August 2004 after a Federal Housing Financial Board placed the bank under supervisory restrictions and halted the growth of its mortgage purchase program.

Since then, the Chicago bank has operated under a series of supervisory orders and it no longer pays a dividend and members cannot redeem their stock. A Finance Board spokesman declined to comment on consequences of the busted merger talks.

A Washington consulting firm has suggested the Finance Board may need to arrange a "forced merger" or consider a conservatorship or other actions.

The Chicago FHLBank declined to comment on whether it is looking for a new merger partner.

Meanwhile, Standard & Poor's Ratings Services placed the FHLBank of Chicago's counterparty credit rating (AA+/A-1+) on CreditWatch with negative implications due to the termination of the merger discussions. "The development heightens our concerns regarding the strategic direction and financial condition" of the bank, S&P said.

S&P's rating on the Dallas FHLBank remained unchanged at AAA/A-1+ with a stable outlook.

The Chicago bank posted earnings of $98 million for 2007, down 50% from the previous year and it expects to report a loss in the first quarter. "Those losses will continue for some period of time," the Chicago FHLBank says in a securities filing.

The bank's $34.6 billion mortgage loan portfolio has become a serious drag on earnings and generated a $28 million loss in 2007.

Some FHLBank experts suggest the Chicago bank could follow the example of the Seattle FHLBank and work its way out of its problems. The Seattle bank ran into hedging problems on its mortgage portfolio in late 2004 and was placed under a supervisory order.

In 2005, it suffered some unprofitable quarters but rebuilt its advance business and mothballed its mortgage portfolio. The Seattle bank just reported net income of $70 million for 2007, compared to $25.8 million the previous year.

However, Seattle's mortgage portfolio totaled $10.1 billion in the first quarter of 2005, which represented slightly more than 20% of the bank's total assets.

The Chicago bank has $88.3 billion in total assets but its mortgage portfolio represents nearly 40% of total assets. In addition, the bank has to service $1 billion in subordinated debt it issued in June 2006, which is adding to the bank's interest expense. The Finance Board approved the unique issuance of subdebt to redeem excess stock.