Bloomberg reports that the Seattle Federal Home Loan Bank is suspending dividends and “excess stock” repurchases due to regulatory capital requirement issues. It joins the San Francisco FHLB in this predicament. Moody’s says big problems are possible and conservatorship or other action might be required.

If all of this sounds a bit both arcane and at the same time familiar, join the crowd. I knew these things existed but didn’t figure they would be part of the problem or a new part of the problem. I also didn’t know much about them so I did a little digging. As for the familiar part, are you any less surprised than I that another government mortgage player is in hot water?

From what I can figure out without spending hours researching this, these banks are owned by their members-largely thrifts and commercial banks. They issue Agency debt and on-lend it to the members who post collateral, usually mortgages, for their loans. It looks as if they impose pretty substantial haircuts on the collateral they accept. If a bank wants to borrow more than it is entitled to given its percentage ownership in the relevant bank (the twelve banks carve up the country geographically and you belong to the one in your region) then it has to buy extra stock. When they repay the loan, the bank buys the extra stock back. It all looks like it should be hard to screw up. On its face, your biggest risk would be that a bank sold you a bunch of dodgy mortgages and then went bust. We know that hasn’t happened on any large scale so where did they go wrong?

I’m making some intuitive leaps here, but it appears as if these banks made some pretty good coin over the years and naturally made some wise investments. Er, maybe some not so wise investments. Like maybe they doubled down on the mortgage market and put their money into mortgages as in MBS and who knows what else. The inevitable investigation will probably uncover the dirt, but we can probably assume for our purposes that there is some there. Oh, and like their cousins Fannie and Freddie they seem to be addicted to leverage. The combined financial statement as of June 30, 2008 shows $1.3 trillion in assets supported by $56.6 billion in equity or leverage of about 23 to 1.

Is this ultimately a big deal? Who knows. They do have a combined $1.25 trillion in debt outstanding which isn’t a small number. Naturally, all of that is not at risk, since they have substantial assets and a lot of the debt is offset by loans to member banks which are probably money good. But there is some rot here and we should know by now that it’s usually worse than we think and will cost us more money than we expect. On top of that, these guys are an important source of cheap financing for the banks, specifically for their mortgage operation, so it could increase the banks cost of funds. The banks also stand to take a hit on their stock in these institutions if they are impaired. Something they can’t really afford right now.

Let’s hope we get off cheap on this one. Any guesses as to what it’s going to cost us? 

Some links if you want to delve in deeper: Bloomberg, Wikipedia-A good overview, FHLB Homepage, June 30th Financial Statements.