The Federal Home Loan Bank of Seattle is likely to breach a critical regulatory capital requirement due to the deteriorating value of its investments in mortgage bonds not guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE), which have been at the heart of the housing crisis.

The bank, which enjoys the backing of the federal government as a branch in the FHLB system, said it could report a capital shortfall as of Dec. 31, 2008, according to a filing with the Securities and Exchange Commission. It has asked its regulator, the Federal Housing Finance Agency, to ease the capital requirement.

Officials at the FHFA declined to comment.

Breach of this level means the bank can't pay out dividends since it will be forced to conserve capital.

The Seattle bank is part of a regional system of 12 home-loan banks that is a cousin to housing finance giants Fannie Mae and Freddie Mac. But unlike Fannie and Freddie, the FHLB branches act as a prime source of funding for U.S. banks rather than for home mortgages. Because investors assume the U.S. government would rescue the home-loan banks in a crisis, the FHLB System can borrow at favorable terms in global bond markets.

The problem at the Seattle branch centers on its investment portfolio, which has dedicated $6 billion of its holdings to riskier mortgage bonds known as private label securities as of Sept. 30, 2008. The bank reported that the fair value of these securities was about $4.57 billion as of Sept. 30, 2008. The depreciation of assets increases the amount of capital the bank needs to set aside to cover any potential losses.

The FHLB argues, however, that, because these investments will be held to maturity, potential losses are being overstated by prices depressed by extraordinary market conditions.

"We believe that the calculation of risk-based capital under the current rules significantly overstates our market risk in the current market environment," the bank's Chief Executive Richard Riccobono said in a letter to member banks filed with the SEC.

Brian Harris, a senior vice president and lead analyst of FHLBs at Moody's Investors Service, said potential losses to the bank's investment portfolio are unlikely to pose a substantial risk since actual losses from these holdings will be minimal if these bonds are held to maturity.

These pressures, however, aren't unique to the Seattle FHLB, noted Harris, who expects other branches to feel the squeeze.

Last week, he said in a report that the 12 Federal Home Loan Banks faced possible write-downs on their $76 billion portfolio of private-label mortgage bonds. In a worst-case scenario, the total capital requirement at just four of the FHL Banks would remain above regulatory minimums, although the ratings agency said that was unlikely.

He mentioned in the report that the Seattle bank as well as the Chicago FHLB branch had already posted losses on their mortgage holdings.

The Seattle bank didn't return phone calls seeking further comment.

A spokeswoman at FHLB Chicago said the bank hasn't announced any potential for capital shortfalls, and declined to comment further.

Michael Ciota, spokesman for the FHLB system, said that "the FHLBanks are working together to meet the challenges of the current distressed market and plan on providing enhanced financial disclosure during first quarter so interested parties can better assess our current condition."

In its the filing, the Seattle FHLB CEO said the bank holds $2.8 billion in permanent capital, which is sufficient cover risks in its balance sheet. He also noted that the bank recalculates the value of its portfolio on a monthly basis so it's possible it could be compliant with existing regulatory requirements in the future.

However, an immediate result of the likely shortfall in the risk capital is that the Seattle bank won't be able to redeem or buy back any of its outstanding Class A or Class B stock. According to federal regulations, a Federal Home Loan Bank that fails to meet any regulatory capital requirement can't declare a dividend or repurchase stock.

However, the bank already has been in a capital conservation mode and didn't issue any dividend in the third quarter of last year, and said it doesn't plan to pay one in the fourth quarter either.

-By Prabha Natarajan, Dow Jones Newswires; 201-938-5071; prabha.natarajan@dowjones.com

(Kerry E. Grace contributed to this report.)

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