Jan. 13 (Bloomberg) -- The Federal Home Loan Bank of Seattle said it will suspend dividends and “excess” stock repurchases, becoming the second of the government-chartered lending cooperatives to say its capital may be running low.

The likely capital shortfall as of Dec. 31 was caused by “unrealized market value losses” on residential mortgage bonds without government backing, the bank said in a U.S. Securities and Exchange Commission filing today. Washington Mutual Inc. and Merrill Lynch & Co. had been the biggest stakeholders and borrowers in the Seattle Federal Home Loan Bank, or FHLB.

Seattle joins the San Francisco FHLB in taking steps to guard its reserves after the U.S. housing market collapse sent mortgage-backed bonds tumbling. The declines may leave as many as eight of the 12 FHLBs below capital requirements, Moody’s Investors Service has said, eroding a below-market rate source of about $1 trillion in financing for Citigroup Inc., JPMorgan Chase & Co. and other companies that participate in the cooperatives.

“Systemic weakness in the FHLBs, which may require federal action, could have a number of implications for U.S. banks and thrifts, including: higher costs of FHLB borrowings, reduced value of FHLB stock, and increased demand for alternative sources of liquidity,” Frederick Cannon, an analyst at Keefe, Bruyette & Woods in San Francisco, wrote in the report to clients yesterday.

The San Francisco FHLB reported Jan. 8 that it was suspending dividends and repurchases of shares in excess of what is required for members’ current loans because of losses on so- called private-label, or non-agency, mortgage bonds. It didn’t say whether it expects to still be above capital requirements.

Fannie, Freddie

The FHLBs collectively are the largest U.S. borrowers after the federal government, bigger than either government-seized mortgage-finance company Fannie Mae or Freddie Mac. Moody’s said it’s unlikely to cut the FHLB system’s Aaa grades because the banks have government support, and are unlikely to suffer actual losses as large as those reported under accounting rules.

“The problems at the home loan banks are far smaller than they were at Fannie and Freddie,” Rajiv Setia, a fixed-income strategist at Barclays Capital in New York, said in an interview today. Fannie and Freddie, the largest sources of U.S. mortgage- financing in 2008, were seized Sept. 6 by regulators, which promised to inject as much as $100 billion of capital into each.

The FHLBs’ actual losses on mortgage bonds without government guarantees or affiliation will probably total between $3 billion and $4 billion, Setia said. That figure compares with the system’s unrealized losses of about $14 billion and capital of $55 billion on Sept. 30. The banks may also face losses under accounting rules on derivatives used to hedge against changes in interest rates, Keefe, Bruyette’s Cannon wrote in his report, citing a December disclosure by the New York FHLB.

Looking for Relief

Seattle FHLB Chief Executive Officer Richard Riccobono wrote in a letter yesterday to members that the calculation of its “risk-based” capital needs, the measure by which it is failing regulatory tests, “significantly overstates our market risk.”

It is required to maintain extra reserves equal to 130 percent of the amount by which the price of its assets falls below 85 percent of book value, he wrote. Riccobono said the bank has “communicated our concerns regarding the current risk-based capital methodology to our regulator and have requested that they review the regulation, but we have not yet received a final determination as to whether or not there will be any relief.”

The Federal Housing Finance Agency, the FHLBs’ regulator, is considering the request, Stefanie Mullin, a spokeswoman, wrote in an e-mailed statement.

Legislation that created the agency last year “gave FHFA the ability to set new risk-based capital standards for Fannie Mae, Freddie Mac and the Federal Home Loan Banks,” she said. “We continue to work on that.”

Borrowing Costs

The Seattle FHLB calculates its risk-based capital requirements monthly, so the bank may see the shortfall reversed and remains “in compliance with all of our other regulatory capital requirements, specifically our capital-to-assets ratio and our leverage capital ratio,” Riccobono wrote.

The regional FHLBs lend the money they raise as a group in the so-called agency debt market to more than 8,000 thrifts, credit unions, insurers and commercial banks at below-market rates, mainly to finance their mortgage holdings.

The FHLBs’ borrowing costs have been little changed over the last week, with a 4 percent FHLB note maturing in 2013 yielding 0.11 percentage point more than a similar-maturity Freddie note at 5:00 p.m. in New York. That compares with a five-month low of 0.04 percentage point on Jan. 9 and a high of 0.31 percentage point in October, Bloomberg data show. The gap between yields on the FHLB note and five-year Treasuries climbed 0.06 percentage point from a three-month low today to 0.87 percentage point.

Member Use

Washington Mutual, Merrill and Bank of America Corp. were the largest users of the Seattle FHLB’s secured loans as of Sept. 30, borrowing 59 percent of its $46.3 billion, according to a November securities filing. Seattle-based Washington Mutual filed for bankruptcy Sept. 26, the day after its banking units were seized by regulators and sold to JPMorgan for $1.9 billion. New York-based Merrill was bought by Bank of America on Jan. 1 for $33 billion after struggling with mortgage-related writedowns.

Citigroup, JPMorgan and Wachovia Corp., which Wells Fargo & Co. acquired this month, were the largest borrowers from the Federal Home Loan Bank of San Francisco on Sept. 30, with $178.5 billion of so-called advances, according to Cannon’s report.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: January 13, 2009 17:24 EST