Banks in Trouble: Is IndyMac a Sign of the Times?

The mortgage lending crisis has claimed another victim. On July 11, 2008, the Federal Government stepped in to take control of Pasadena-based IndyMac, a lending institution specializing in creative loan products such as payment-option home loans.  It is estimated that the Federal Deposit Insurance Corporation will be forced to pay out 4.5-8 Billion dollars to depositors, some proportion of which will be recovered if a buyer can be found for a company whose principal asset is a portfolio of troubled mortgages. This is either the second or third-largest failure of an FDIC-insured institution in history.

A notable feature of the collapse is the rapidity with which it occurred.  On June 26, Senator Charles Schumer publicly notified the FDIC that the bank was on the verge of failing, prompting depositors to withdraw 1.5 billion dollars over the next 11 days and stocks in the company, which had already lost 90% of their peak value, to become essentially worthless.  A bank spokesman labeled fears “overblown” on June 30. The Federal Government formally took control July 11.

The collapse of this one regional bank will put a nontrivial dent in the 53 billion available to the United States Government to settle all FDIC claims.  Who is insuring the insurer in the event that a major national banking chain fails?

Such a scenario is far from wildly improbable. Wachovia Corporation, the U.S.’s fourth-largest bank, is showing signs of the same type of slide seen with IndyMac earlier in the year.  Its stock has plummeted from a high of $52 a share in August, 2007 to $9.48 in mid-July, 2008.  The company’s troubles began with its 2006 acquisition of Golden West Financial, another California lender cashing in on the real estate bubble by specializing in payment-option loans.  Wachovia is also heavily involved in student loans, increasing numbers of which are defaulting.

According to analysts at Oppenheimer, an underlying problem at Wachovia , and to a lesser extent its larger cousins Bank of America, J.P. Morgan Chase, and Citigroup, lies in the Housing Price Appreciation (or depreciation) figure used in mortgage asset valuation, which in turn is used to demonstrate compliance with Federal Banking regulations, including participation in the FDIC.  Wachovia has been using a 12.9% peak to trough housing decline figure, leading to an unrealistically low estimate of mortgage default rates and serious underestimate of risk to depositors. Bank of America uses 30%, J.P. Morgan Chase 24%, and Citigroup 20%.  According to Oppenheimer analysts, even 30% is unrealistically low.

Wachovia currently carries 445 billion dollars in deposits representing 15 million households.  The enterprise value of the company, an estimate of its current value to a purchaser, is 131 billion. What happens if investors begin transferring money out of Wachovia in large numbers?

There are several possible scenarios, none pretty.  The Federal Government could simply renege on insurance payments under the FDIC, leaving depositors in the lurch.  In that case, no one in his right mind would entrust funds to a United States Bank.  Alternatively, the Federal Government could freeze funds and delay paying claims, which would also seriously damage public confidence.  A third possibility would be to borrow money – but from whom, and upon what terms?  Finally, our government could simply print more money (or its equivalent, making more credit available to large financial institutions), a sure recipe for runaway inflation.

Of course, if current efforts by Congress to halt the downward spiral in home values and epidemic of foreclosures succeed, financial institutions with heavy home loan exposure will have a far better prognosis. If this were the only major threat to the integrity of our banking system, there might be cause for optimism.  There are, however, several ominous trends only peripherally related to the subprime mortgage crisis, of which large numbers of student loans borne by people approaching retirement and increasing numbers of people withdrawing funds from IRAs and 401K plans to keep the wolf from the door are only two examples.

Related posts:

1. BankUnited Fails – What does that mean to you?
2. The banks and our government continue to cover up the fraud
3. GSE Default Means Trouble For Home Buyers