oversight

Merger of the Federal Home Loan Banks of Des Moines and Seattle: FHFA's Role and Approach for Overseeing the Continuing FHLBank

Published by the Federal Housing Finance Agency, Office of Inspector General on 2016-03-16.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

         Federal Housing Finance Agency
             Office of Inspector General




 Merger of the Federal Home Loan
 Banks of Des Moines and Seattle:
  FHFA’s Role and Approach for
Overseeing the Continuing FHLBank




 White Paper  WPR-2016-002  March 16, 2016
                 Executive Summary
                 The merger of the Federal Home Loan Banks (FHLBanks) of Des Moines and
                 Seattle, effective May 31, 2015, was the first voluntary merger of FHLBanks.
                 The merger was completed on schedule, with no interruption in service to
                 members. The continuing FHLBank, headquartered in Des Moines, is now the
WPR-2016-002     largest of 11 FHLBank regions in both geography and number of members.

March 16, 2016   Although the FHLBanks chose each other and negotiated the merger
                 agreement, the Federal Housing Finance Agency (FHFA or Agency) played
                 a decisive role in encouraging the Seattle FHLBank to find a merger partner
                 to address some of the Agency’s longstanding supervisory concerns with the
                 FHLBank.

                 By contrast to the Seattle FHLBank, for the past five years, FHFA found
                 the overall condition of the Des Moines FHLBank to be satisfactory. At the
                 same time, the Agency raised questions about the Des Moines FHLBank’s
                 operational risk, particularly with the FHLBank’s multiyear plan to upgrade
                 its core banking system. The merger compounded these operational risks.

                 FHFA officials generally intend to oversee the continuing FHLBank as they
                 would any other FHLBank, while closely monitoring the situation and adding
                 resources as necessary. In light of the post-merger challenges, the continuing
                 FHLBank merits ongoing focus.

                 This white paper describes:

                       The Seattle FHLBank’s challenges leading up to the merger;

                       FHFA’s role in encouraging the merger; and

                       FHFA’s approach for overseeing the continuing FHLBank.

                 It makes no recommendations.
TABLE OF CONTENTS ................................................................
EXECUTIVE SUMMARY .............................................................................................................2

ABBREVIATIONS .........................................................................................................................5

BACKGROUND .............................................................................................................................6
      FHFA Regulations for Approving Voluntary FHLBank Mergers ...........................................7

LOOKING BACK: THE SEATTLE FHLBANK FACED CHALLENGES AND FHFA
ENCOURAGED A MERGER ........................................................................................................8
      2008-2009: FHFA’s Early Supervisory Concerns with the Seattle FHLBank ........................8
      2010-2012: Consent Order and Continued Weak Performance ..............................................9
      2013: Merger Discussions with another FHLBank and Amended Consent Order ...............10
      2014 (January-September): Merger Discussions with the Des Moines FHLBank ................10
      2014 (October-December): Merger Application Submitted, Considered, and
      Approved ................................................................................................................................11
             Members .........................................................................................................................11
             Financial Impacts ............................................................................................................11
             Operational Risk .............................................................................................................12
             Corporate Governance ....................................................................................................12
             FHLBank System ............................................................................................................12
      2015: Completion of the Merger ...........................................................................................13

CURRENT STATUS: MERGER RESULTS TO DATE .............................................................13
      Key Features of the Continuing FHLBank .............................................................................13
      Results for the Continuing FHLBank .....................................................................................14
      Results for the FHLBank System ...........................................................................................14
      Lessons Learned for FHFA ....................................................................................................15

MOVING FORWARD: FHFA’S APPROACH FOR OVERSEEING THE
CONTINUING FHLBANK...........................................................................................................15
      Post-Merger Challenges for the Continuing FHLBank ..........................................................15
      FHFA’s Oversight of the Continuing FHLBank ....................................................................16


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CONCLUSIONS............................................................................................................................17

OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................18

APPENDIX A ................................................................................................................................19
      Timeline Leading to the Merger of the Des Moines and Seattle FHLBanks .........................19

ADDITIONAL INFORMATION AND COPIES .........................................................................21




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ABBREVIATIONS .......................................................................

CEO                   Chief executive officer

FHFA or Agency        Federal Housing Finance Agency

FHLBank               Federal Home Loan Bank

MBS                   Mortgage-backed securities

OIG                   Federal Housing Finance Agency Office of Inspector General




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BACKGROUND ..........................................................................

FHFA serves as the regulator and supervisor of the FHLBank System, which is now
comprised of 11 regional FHLBanks, as shown in Figure 1, and the Office of Finance.1 The
FHLBank System had 12 regional FHLBanks until the FHLBanks of Des Moines and Seattle
merged effective May 31, 2015. This was the first voluntary merger of FHLBanks and the
first FHLBank merger since 1946.2 Overseeing the merger and the continuing FHLBank
therefore represents uncharted waters for FHFA.

                                  FIGURE 1: MAP OF FHLBANK REGIONS




The FHLBank System is a government-sponsored enterprise, which is a business organization
chartered by the federal government. The FHLBanks are cooperatively owned by their more
than 7,000 members, including financial institutions such as commercial banks, thrift
institutions, insurance companies, and credit unions. Members must own capital stock
1
  For more information about the FHLBank System, see OIG, An Overview of the FHLBank System’s
Structure, Operations, and Challenges (Oct. 31, 2012) (online at
www.fhfaoig.gov//Content/Files/FHLBankSystemOverview.pdf).
2
 In 1946, the then-regulator of the FHLBanks required the FHLBanks of Portland and Los Angeles to merge,
becoming the FHLBank of San Francisco. In 1964, the FHLBank was again split, creating what became the
FHLBank of Seattle.



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in their FHLBank and may receive dividends on their stock from their FHLBank. Each
FHLBank has a board of directors comprised of officers or directors from member institutions
and independent directors.

The FHLBank System’s mission is to support residential mortgage lending and community
investment through its member financial institutions. To fulfill that mission, FHLBanks make
collateralized loans, called advances, to their members. The members, in turn, may use the
proceeds for residential mortgages, community investments, and other services for housing
and community development.3 FHLBanks also maintain investment portfolios for liquidity
purposes and to generate income. The investments may include mortgage-backed securities
(MBS). In the past, some FHLBanks incurred substantial losses on their investments in
private-label MBS, which are MBS that are not issued or guaranteed by Fannie Mae, Freddie
Mac, or a government entity. FHFA regulations limit FHLBanks’ investments in MBS.

The FHLBanks principally fund their activities through debt, known as consolidated
obligations, issued through the Office of Finance for all the FHLBanks in the System. Each
FHLBank is primarily liable for the payment of principal and interest on the portion of the
debt issued on its behalf. Each FHLBank also has “joint and several liability” for the payment
of principal and interest on all consolidated obligations across the FHLBank System.
Accordingly, if one FHLBank is financially weak and unable to make its payments, the other
FHLBanks must make the payments.

FHFA Regulations for Approving Voluntary FHLBank Mergers

The Housing and Economic Recovery Act, which created FHFA in 2008, required the Agency
to issue regulations establishing procedures for approving voluntary mergers of FHLBanks.4
FHFA issued these regulations in 2011.5 The regulations outlined at a high level the steps
that must be followed for a voluntary FHLBank merger. The required steps included:
(1) execution of a merger agreement authorized by each FHLBank’s board, (2) joint
submission of a merger application by the FHLBanks to FHFA, (3) approval of the merger
by the FHFA Director with any conditions, and (4) ratification by the merging FHLBanks’
members.


3
 By statute, generally: (1) long-term advances must be made for residential housing finance and (2) to
maintain access to long-term advances, members must meet standards of community investment and service.
For more information, see OIG, FHFA’s Oversight of Two Mission-Related Requirements for Federal Home
Loan Bank Long-Term Advances (Mar. 31, 2015) (ESR-2015-005) (online at
www.fhfaoig.gov/Content/Files/ESR-2015-005.pdf).
4
    See 12 U.S.C. § 1446(b)(1), (2).
5
 FHFA, Voluntary Mergers of Federal Home Loan Banks, 76 Fed. Reg. 72823 (Nov. 28, 2011) (final rule
codified at 12 C.F.R. Part 1278).



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FHFA retained flexibility in the regulations regarding how the Agency would evaluate
potential mergers. According to the regulations, in determining whether to approve a merger
of FHLBanks, FHFA must consider the financial and managerial resources of the FHLBanks,
the future prospects of the continuing FHLBank, and the effect of the proposed merger on the
safety and soundness of the continuing FHLBank and the FHLBank System. However, the
regulations do not specify how the Agency should consider those factors.


LOOKING BACK: THE SEATTLE FHLBANK FACED
CHALLENGES AND FHFA ENCOURAGED A MERGER ...................

2008-2009: FHFA’s Early Supervisory Concerns with the Seattle FHLBank

Beginning with its first annual report to Congress for 2008, FHFA reported supervisory
concerns with the Seattle FHLBank.6 In that report, the Agency said it considered that
FHLBank “less than satisfactory overall.” It found that weakened housing and financial
markets had affected several areas of the Seattle FHLBank. FHFA specifically noted
supervisory concerns with the FHLBank’s private-label MBS portfolio. Many of the
securities had been downgraded, some below investment grade. FHFA also found that this
FHLBank’s information systems were antiquated and relied heavily on user-developed
applications. User-developed applications are internally developed spreadsheets and
databases, which can add risk, including from manual errors.

Additionally, the Seattle FHLBank failed to meet risk-based capital standards as of year-end
2008. The Agency subsequently declared the FHLBank “undercapitalized” as of March 31,
2009, and required it to develop a capital restoration plan. (See Appendix A for a timeline of
events.) FHFA “locked down” capital at that FHLBank: it prohibited the Seattle FHLBank
from redeeming or repurchasing capital stock or paying dividends as a way to conserve the
FHLBank’s capital.7 Technically, the Seattle FHLBank met its capital requirements as of
September 30, 2009, but FHFA used its discretion to continue to classify the FHLBank as
undercapitalized. FHFA reported that it took this action due to the risk of further
deterioration in the FHLBank’s private-label MBS portfolio and the FHLBank’s lack of

6
 Prior to the 2008 creation of FHFA, the FHLBanks were overseen by the Federal Housing Finance Board.
For more information about the Seattle FHLBank’s challenges, see OIG, FHFA’s Oversight of Troubled
Federal Home Loan Banks (Jan. 11, 2012) (EVL-2012-001) (online at
www.fhfaoig.gov/Content/Files/Troubled%20Banks%20EVL-2012-001.pdf).
7
  FHLBanks have two classes of capital stock. Generally, Class A stock is redeemable at par six months after
submission of a written notice, and Class B stock is redeemable at par five years after submission of a written
notice. FHLBanks generally can repurchase excess stock—the excess above the amount that the members
must hold.



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adequate plans for addressing that risk. According to the Seattle FHLBank, FHFA also
expressed concern that the value of property underlying mortgages owned by the FHLBank
had decreased substantially.

The Seattle FHLBank reported full-year losses for both 2008 and 2009, primarily due to
investments in private-label MBS. At the same time, the FHLBank’s advance volume was
declining, falling 40 percent in 2009 after the FHLBank’s largest borrower was acquired and
its advances rolled off.

As early as 2009, FHFA encouraged the Seattle FHLBank to consider options to address the
Agency’s supervisory concerns. FHFA rejected the FHLBank’s initial capital restoration plan
in October 2009. In doing so, the Agency told the FHLBank to explore the full range of
options, including strategic alliances with other FHLBanks, as it developed a revised plan.

2010-2012: Consent Order and Continued Weak Performance

While the Seattle FHLBank met its capital requirements as of September 30, 2009, and
returned to profitability in 2010, its financial condition and performance remained weak.
FHFA took enforcement action. It entered into a consent order with the Seattle FHLBank on
October 25, 2010. The consent order required plans for mitigating risk, increasing advances,
and remediating examination findings. A related supervisory letter from FHFA set thresholds
for the FHLBank to meet to resume repurchasing or redeeming stock or paying dividends. In
its 2010 Report to Congress, FHFA said that the overall condition of the Seattle FHLBank
presented supervisory concerns. Key factors affecting the overall condition included
unacceptable levels of credit risk, substantial weaknesses in financial condition and
performance, and significant deficiencies in corporate governance. Other concerns included
insufficient information technology systems.

Over the next two years, FHFA continued to identify serious supervisory concerns with the
Seattle FHLBank. In its 2011 Report to Congress, FHFA reported that the overall condition
of that FHLBank presented supervisory concerns, noting low earnings, high credit risk
related to private-label MBS, and deficiencies in corporate governance. In its 2012 Report
to Congress, FHFA repeated that the overall condition of the Seattle FHLBank presented
supervisory concerns. The Agency noted that the FHLBank’s credit risk was high and its
earnings were low. FHFA also reported that improvement to the FHLBank’s infrastructure
would require significant resources. While advances in a healthy FHLBank would generate
sufficient earnings to support that FHLBank’s operations, consonant with its mission,
advances at the Seattle FHLBank had declined to an FHLBank System low, making that
FHLBank more reliant on investments to generate earnings. FHFA estimated that a return to
normal operations could take more than five years. FHFA reported that the Seattle FHLBank
continued to merit heightened supervisory attention.


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2013: Merger Discussions with another FHLBank and Amended Consent Order

In January 2013, FHFA officials met with Seattle FHLBank leadership, encouraging the
FHLBank to consider a range of strategic options to address its challenges. Between February
and November 2013, the Seattle FHLBank pursued a voluntary merger with another
FHLBank, without success.

In its 2013 Report to Congress, FHFA repeated supervisory concerns about the overall
condition of the Seattle FHLBank. Although that FHLBank had positive earnings, FHFA
advised that it had continuing concerns about the sustainability of earnings derived from the
FHLBank’s advance business. The Agency said that the small scale of advances coupled with
relatively high expenses contributed to uncertainty about that FHLBank’s ability to eventually
return to normal operations. Also, the FHLBank’s information technology infrastructure
continued to create an unacceptable level of operational risk. FHFA again found that the
FHLBank merited heightened supervisory attention.

In November 2013, FHFA amended the consent order, to reflect improvement in the
Seattle FHLBank’s situation as well as FHFA’s continuing supervisory concerns with the
FHLBank’s financial condition and operations. Prior to the amendment, FHFA deemed the
FHLBank to be adequately capitalized, approved a plan for repurchasing small amounts of
capital stock, and allowed payment of a nominal dividend for two quarters. However, FHFA
expressed continued concerns that the FHLBank’s capital position could be adversely affected
by negative changes in economic conditions and believed some restrictions on stock were still
needed. The amended consent order required FHFA’s non-objection before the Seattle
FHLBank paid dividends or repurchased or redeemed capital stock.

The Seattle FHLBank’s market value of equity exceeded the par value of its outstanding
capital stock by year-end 2013, and FHFA said that this made a merger a more viable option.8
The Acting FHFA Director, on behalf of FHFA, recommended to the Seattle FHLBank that it
find a merger partner.

2014 (January-September): Merger Discussions with the Des Moines FHLBank

The Des Moines FHLBank’s board chair had approached the Seattle FHLBank’s Chief
Executive Officer (CEO) in 2013 about the possibility of a combination. (Since 2010, FHFA
had found the overall condition of the Des Moines FHLBank to be satisfactory.) The Seattle
FHLBank’s CEO previously held a leadership position at the Des Moines FHLBank, and
both FHLBanks believed that they had compatible cultures. On February 4, 2014, the two


8
  The market value of equity is the estimated market value of assets less the estimated market value of
liabilities.



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FHLBanks’ board chairs and vice chairs agreed that their respective CEOs should discuss
a possible combination, with information technology collaboration as a potential first step.
On February 6, 2014, at the direction of the recently confirmed FHFA Director, FHFA set a
timeframe for action. On February 21, 2014, the Des Moines and Seattle FHLBanks entered
into a confidentiality agreement related to a potential merger. In April 2014, FHFA staff met
with the Seattle FHLBank’s board and CEO to discuss FHFA’s position that the FHLBank
must consider strategic alternatives, including a potential merger.

In the second half of 2014, with the continued involvement of FHFA, the Des Moines and
Seattle FHLBanks reached agreement on a merger. In September 2014, FHFA responded to
requests from the FHLBanks, such as that the board of the continuing FHLBank would
initially have all 29 directors from both FHLBanks, the consent order with the Seattle
FHLBank would be terminated at the time of a merger, and the FHLBanks’ Affordable
Housing Programs could remain separate for 2015. Within a week, the boards of the Des
Moines and Seattle FHLBanks unanimously approved the proposed merger. They executed
a merger agreement on September 25, 2014, subject to the approval of FHFA and the
FHLBanks’ members.

2014 (October-December): Merger Application Submitted, Considered, and Approved

The Des Moines and Seattle FHLBanks submitted their joint merger application to FHFA in
October 2014. The Agency considered a number of factors in approving the merger, pursuant
to its governing regulations. FHFA’s analysis included benefits to members, financial
impacts, operational risk, corporate governance, and benefits to the FHLBank System. 9

    Members

In analyzing the merger, FHFA anticipated that the merger would benefit the members of both
FHLBanks. After the merger, members of the Seattle FHLBank would receive dividends and
have their stock redeemed, which had been restricted for years, and members of the Des
Moines FHLBank would benefit from the cost savings and efficiencies of larger and more
diverse membership. Each FHLBank received an opinion from its financial advisor that the
terms of the merger were fair to stockholders from a financial perspective.

    Financial Impacts

Based on its analysis, FHFA projected that the continuing FHLBank would meet its capital
requirements and generate adequate earnings, and it would avoid costs to upgrade the Seattle

9
 FHFA also considered legal, accounting, and other matters. In addition to FHFA, other regulators were
pertinent to the merger, including the Securities and Exchange Commission for accounting treatment
applicable to the merger and the Federal Trade Commission for potential anti-trust considerations.



                                  OIG  WPR-2016-002  March 16, 2016                                    11
FHLBank’s information technology systems. In addition, with the approval of FHFA, the
Seattle FHLBank planned to replace private-label MBS with MBS backed by government
agencies in advance of the merger, reducing risk to the continuing FHLBank.

   Operational Risk

In most mergers, operational risk is a concern because of the integration of systems and
personnel. The Agency considered the planning and work stream integration efforts by both
FHLBanks that already were underway. Because the Des Moines FHLBank’s systems would
serve as the base for the continuing FHLBank and, in the view of FHFA examiners, the Des
Moines FHLBank had stronger information technology and operational risk management
systems than the Seattle FHLBank, the merger would address FHFA’s longstanding concerns
with the Seattle FHLBank’s systems. Separately, the Agency had expressed supervisory
concerns about operational risk for the Des Moines FHLBank caused in part by its multiyear
efforts to upgrade its core banking system. Those concerns would not be resolved by the
merger.

   Corporate Governance

FHFA also considered corporate governance matters associated with the merger. As noted
above, the Agency approved an initial board for the continuing FHLBank comprised of all
29 directors on the boards of both FHLBanks. While FHFA recognized that corporate
governance experts recommended smaller boards, it acknowledged factors working against a
smaller board. Based on the number of states in the combined FHLBank region, the statutory
minimum number of directors would be 22. FHFA took into account the proposal from the
FHLBanks for a committee structure for the combined board to bring efficiencies to the
operation of a large board. While FHFA projected that the board size for the continuing
FHLBank would be reduced over time, it determined that the board size of 29, upon
completion of the merger, was acceptable. Additionally, FHFA reviewed the proposed
bylaws for the continuing FHLBank.

   FHLBank System

FHFA also considered the impact of the merger on the FHLBank System as a whole. In
FHFA’s view, the FHLBank System would benefit from replacing a weaker FHLBank with
one that was likely, over the long term, to perform better than either of the FHLBanks would
have performed absent a merger. Because debt issued to fund FHLBank operations represents
a joint and several obligation of all the FHLBanks, FHFA found that the other FHLBanks
would benefit from such a merger.

In December 2014, FHFA approved the Des Moines and Seattle FHLBanks’ merger
application subject to conditions including ratification by the FHLBanks’ members.


                            OIG  WPR-2016-002  March 16, 2016                                12
2015: Completion of the Merger

Members of the Des Moines and Seattle FHLBanks began voting on the merger in January
2015, and the FHLBanks announced the ratification of the merger in February 2015. Both
FHLBanks worked together to plan and execute the merger work streams, test the efficacy
of the systems, and prepare for day-one readiness. FHLBank teams agreed that initial
integration testing identified fewer concerns than anticipated but, as a precaution, developed
high-level contingency plans. An FHFA official reported to us that more had been
accomplished than he anticipated.

FHFA conducted pre-merger field visits to assess the FHLBanks’ readiness for merger, with
teams on site at Seattle from January to February 2015 and at Des Moines from February to
March 2015. Generally, FHFA found that the FHLBanks’ preparations for systems readiness
were extensive.

The merger closed on May 31, 2015, and the continuing FHLBank commenced operation on
June 1, 2015. In this process, the FHLBanks selected their own partner and hammered out the
terms as part of a voluntary merger. As discussed, FHFA played a decisive role that was
critical to the fruition of the merger, and the merger resolved some longstanding FHFA
supervisory concerns with the Seattle FHLBank.


CURRENT STATUS: MERGER RESULTS TO DATE ........................

The continuing FHLBank has been in operation a relatively short time, and it is too early to
draw conclusions about the long-term implications of the merger. Upon the closing of the
merger, the continuing FHLBank operated without any interruptions in service, and to date
the merger has produced some positive results for the FHLBank System and provided
valuable lessons learned for FHFA.

Key Features of the Continuing FHLBank

The continuing FHLBank is headquartered in Des Moines with a small office in Seattle. Des
Moines now comprises the largest FHLBank region in membership and geography, serving
about 1,500 members in 13 states and the U.S. Pacific territories.10 As of June 30, 2015, the
continuing FHLBank was the third largest FHLBank in assets and fifth largest in advances.




10
  Before the merger, the Des Moines FHLBank had more members than any other FHLBank, and the Seattle
FHLBank district included more states than any other FHLBank district.



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The continuing FHLBank is led by individuals from both prior FHLBanks: the president
and CEO of the Des Moines FHLBank became CEO of the continuing FHLBank; and the
president and CEO of the Seattle FHLBank became president of the continuing FHLBank.
The current CEO of the continuing FHLBank is scheduled to retire by 2017, and the current
president will take on the additional CEO responsibilities.

Results for the Continuing FHLBank

As of June 1, 2015, the continuing FHLBank was operational, as scheduled, without
interruption in services to members. FHFA’s consent order for the Seattle FHLBank was
lifted, and there were no capital restrictions on the continuing FHLBank. Accordingly,
former Seattle FHLBank members could once again receive dividends and have their stock
redeemed. The continuing FHLBank filed its financial statements on time. As FHFA had
anticipated, most of the Seattle FHLBank’s legacy technology systems were eliminated and
the continuing FHLBank largely adopted the Des Moines FHLBank’s technology and
processes, removing a significant supervisory concern.

The merger produced cost efficiencies that could continue into the future. The continuing
FHLBank’s expenses for systems, staff, and office space were lower than what they would
have been for the two FHLBanks without a merger. The continuing FHLBank projected that
its 2016 operating expenses would be $35 million less than the combined expenses for the two
FHLBanks in 2014.11

Results for the FHLBank System

Beyond redrawing the district lines, the merger held other implications for the FHLBank
System, as FHFA considered when approving the merger. In FHFA’s view, the absorption
of a weaker FHLBank into a stronger FHLBank yields enhanced stability for the FHLBank
System and reduces risk to the other FHLBanks because, if the continuing FHLBank can meet
its obligations, the risk is reduced that the other FHLBanks will be called upon to make
payments under their joint and several liability.

FHFA advised us that it proceeded with care on a potential merger when the Seattle
FHLBank’s market value of equity was low because of possible significant adverse impacts
on the FHLBank System. The merger also demonstrated to the other FHLBanks that a
voluntary merger could be accomplished without disruption to members.




11
   Not surprisingly, both FHLBanks incurred costs in connection with the merger. The expenses totaled at
least $55 million.



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Lessons Learned for FHFA

FHFA reported to us that the merger of the Des Moines and Seattle FHLBanks went
smoothly. The Agency noted a number of elements contributing to its successful closing.
FHFA noted the benefit of extensive planning, including detailed work streams, simulations
to identify potential integration problems to address in advance of the merger, and frequent
communication between the two parties. FHFA advised us that it has a clear understanding of
the milestones necessary to complete a merger and the critical role of regulatory oversight of
systems integration.

FHFA advised us that some aspects of this merger were unique to the two FHLBanks and
would not likely be replicated in a future merger. For example, the president and CEO of
the Seattle FHLBank, who subsequently became president of the continuing FHLBank,
previously held a leadership position at the Des Moines FHLBank. As a result, he understood
the cultures of both organizations, as well as knew the boards and staff. Both FHFA and the
FHLBanks believed that the Des Moines and Seattle FHLBanks had compatible cultures.
Additionally, the same FHFA associate director covered the Des Moines and Seattle
FHLBanks, which meant the Agency had individual examiners who were familiar with both
FHLBanks.

In addition, this merger was aided by external events that may not occur in the future. For
example, the value of the Seattle FHLBank’s private-label MBS portfolio rose, which
facilitated the sale of the securities before the merger. In addition, the market value of the
Seattle FHLBank’s equity rose, making the merger more feasible.


MOVING FORWARD: FHFA’S APPROACH FOR OVERSEEING
THE CONTINUING FHLBANK......................................................

Post-Merger Challenges for the Continuing FHLBank

Through the efforts of the FHLBanks and FHFA, the merger closed on schedule and without
disruption to members. Nevertheless, the merger presents challenges for the continuing
FHLBank and FHFA going forward. Before the merger, FHFA had significant supervisory
concerns about operational risk for the Seattle FHLBank, and FHFA reported to us that the
merger largely resolved those concerns. Separately, the Agency had expressed supervisory
concerns about operational risk for the Des Moines FHLBank caused in part by the
FHLBank’s multiyear efforts to upgrade its core banking system. The merger compounded
the Agency’s existing concerns, for example, those upgrades were delayed as the FHLBank
diverted personnel to support the merger.


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Like most financial institutions, the continuing FHLBank relies heavily on its information
infrastructure to collect, store, and process data. In November 2015, the Des Moines
FHLBank’s Chief Business Technology Officer resigned effective in December 2015. The
turnover in this key position may complicate the systems and merger follow-up work that the
continuing FHLBank must complete. As of late January 2016, the FHLBank was conducting
a search to fill the position.

The merger also presents governance and other challenges for the continuing FHLBank. The
President of the continuing FHLBank recently observed that cultural integration is a challenge
for any merger. FHFA and the continuing FHLBank have acknowledged that the current
29-person board is large, and the FHLBank is finalizing a plan to reduce the size of the board
to the statutory minimum of 22. FHFA advised us that the large size of the continuing
FHLBank, geographically and in member count, may pose challenges in the future.

FHFA’s Oversight of the Continuing FHLBank

FHFA typically examines each FHLBank and the Office of Finance each year, and also
conducts periodic visits and off-site monitoring. FHFA was onsite for its first post-merger
examination of the continuing FHLBank from September to November 2015, and planned
to discuss the report of examination with the FHLBank’s board in February 2016. FHFA
intends to oversee the remaining integration of operations by the continuing FHLBank as part
of its supervisory activities.

FHFA officials advised us that FHFA is prepared to conduct extra site visits and add
resources, as needed, to oversee the continuing FHLBank. For example, FHFA must oversee
the reduction of the board size and the combination of Affordable Housing Programs and
continue to monitor the continuing FHLBank’s ongoing core banking system conversion. The
operational risks previously identified by FHFA, deferred technology upgrades, governance
challenges, and significant growth and change at the continuing FHLBank create additional
supervisory challenges for FHFA.




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CONCLUSIONS ..........................................................................

The merger of the Des Moines and Seattle FHLBanks—the first voluntary merger of
FHLBanks—went more smoothly than even FHFA officials expected. It was completed on
schedule without interruption of service to members. FHFA played a decisive role in urging
the Seattle FHLBank to explore a merger, and the merger resolved some longstanding FHFA
supervisory concerns with the FHLBank.

At the same time, the Agency had previously raised operational risk concerns about the Des
Moines FHLBank, particularly with the FHLBank’s multiyear upgrade of its core banking
system. The merger compounded these operational risks.

FHFA intends to oversee the continuing FHLBank much as it does the other ten FHLBanks,
standing ready to increase examination resources as needed. Considering the post-merger
challenges, the continuing FHLBank merits FHFA’s ongoing focus.




                            OIG  WPR-2016-002  March 16, 2016                              17
OBJECTIVE, SCOPE, AND METHODOLOGY .................................

The objective of this report was to describe:

      The Seattle FHLBank’s challenges leading up to the merger;

      FHFA’s role in encouraging the merger; and

      FHFA’s approach for overseeing the continuing FHLBank.

To achieve this objective, we interviewed personnel at FHFA with responsibilities for
FHLBank examination. We reviewed: publicly available documents, such as FHFA’s annual
reports to Congress and the public disclosures of the Des Moines and Seattle FHLBanks;
internal FHFA documents, such as the Agency’s reports of examination for the Des Moines
and Seattle FHLBanks; and other non-public information provided by FHFA. The
information spanned from FHFA’s first examination of the Seattle FHLBank in 2008 through
its first report of examination for the continuing FHLBank in 2016. In addition, we reviewed
information about the FHLBank merger in 1946 and the FHLBank split in 1964. We also
reviewed FHFA data on its staff resources for examinations of the Des Moines and Seattle
FHLBanks since 2014. We did not independently test the reliability of FHFA’s data.

Our work was conducted under the authority of the Inspector General Act of 1978 and in
accordance with the Council of the Inspectors General on Integrity and Efficiency’s Quality
Standards for Inspection and Evaluation (January 2012). These standards require us to plan
and perform a report based on evidence sufficient to provide reasonable bases to support its
findings. We believe that this report meets these standards. The performance period for this
report was from December 2015 to February 2016. We provided FHFA with the opportunity
to respond to a draft of this report.

This report was led by Beth Preiss, Senior Investigative Evaluator, in collaboration with
Omolola Anderson, Senior Statistician, and Christine Eldarrat, Senior Policy Advisor.
We appreciate the cooperation of FHFA staff, as well as the assistance of all those who
contributed to the preparation of this report.

This report has been distributed to Congress, the Office of Management and Budget, and
others and will be posted on our website, www.fhfaoig.gov.




                              OIG  WPR-2016-002  March 16, 2016                              18
APPENDIX A .............................................................................

Timeline Leading to the Merger of the Des Moines and Seattle FHLBanks

2009
August 3: The Seattle FHLBank received notice from FHFA that it was undercapitalized as of
March 31, 2009, and had to submit a capital restoration plan
October 1: FHFA rejected the Seattle FHLBank’s initial capital restoration plan and told the
FHLBank to explore the full range of options, including strategic alliances with other
FHLBanks

2010
October 22-23: The FHFA Acting Director and staff met with the Seattle FHLBank’s board
October 25: FHFA issued a consent order to the Seattle FHLBank

2013
January: FHFA met with Seattle FHLBank leadership about the FHLBank considering
strategic options
February: The Seattle FHLBank began considering a voluntary merger with another
FHLBank
August 6: The chair of the Des Moines FHLBank asked the president and CEO of the Seattle
FHLBank if the Seattle FHLBank would be interested in discussing a combination
November: The Seattle FHLBank determined that continued exploration of a transaction with
the other FHLBank was not in the Seattle FHLBank’s best interest
November 22: FHFA amended the consent order
December 16: FHFA’s Acting Director urged the Seattle FHLBank’s board chair to find a
merger partner

2014
January 6: Melvin Watt sworn in as Director of FHFA
February 6: FHFA set deadlines for the Seattle FHLBank to make progress on merger talks
February: The Des Moines and Seattle FHLBanks began serious discussions about a merger
April 16: FHFA staff met with the Seattle FHLBank’s board and discussed FHFA’s position
that the FHLBank must consider strategic alternatives, including a potential merger with
another FHLBank


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May 1: A letter from the Seattle FHLBank’s board chair to FHFA said the FHLBank is in
discussions with a potential merger partner
May 7: The Seattle FHLBank’s board authorized the Seattle FHLBank to develop a plan to
merge with the Des Moines FHLBank, and also requested additional information regarding
other potential merger partners
May 30: FHFA responded to the Seattle FHLBank’s May 1, 2014, letter, noting FHFA’s
expectation that the FHLBank make meaningful progress on merger discussions by mid-
August 2014
July 11: The Des Moines FHLBank sent a letter of intent that it had executed regarding a
merger to the Seattle FHLBank
July 17: The Seattle FHLBank executed the letter of intent
July 22: The FHFA Director and staff met with the presidents of the Des Moines and Seattle
FHLBanks to discuss the merger
July 31: The Des Moines and Seattle FHLBanks announced that they had entered into an
exclusivity arrangement to potentially merge the two FHLBanks
September 19: FHFA responded to requests from the Des Moines and Seattle FHLBanks
concerning certain aspects of the merger
September 23: The board of the Des Moines FHLBank unanimously approved the merger
September 24: The board of the Seattle FHLBank unanimously approved the merger
September 25: The boards of the two FHLBanks executed a merger agreement
October 31: The FHLBanks submitted a joint merger application to FHFA
December 19: FHFA approved the merger application subject to conditions including
ratification by the members of both FHLBanks

2015
January 12: The Des Moines and Seattle FHLBanks each sent information to members to
vote on the merger
February 27: The FHLBanks jointly announced the ratification of the merger by their
members
May 31: Merger closed
June 1: The continuing FHLBank was operational as one FHLBank




                            OIG  WPR-2016-002  March 16, 2016                              20
ADDITIONAL INFORMATION AND COPIES .................................


For additional copies of this report:

      Call: 202-730-0880

      Fax: 202-318-0239

      Visit: www.fhfaoig.gov



To report potential fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

      Call: 1-800-793-7724

      Fax: 202-318-0358

      Visit: www.fhfaoig.gov/ReportFraud

      Write:

                FHFA Office of Inspector General
                Attn: Office of Investigations – Hotline
                400 Seventh Street SW
                Washington, DC 20219




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