Consumer Law

Looming Alt-A Bank Failure

By Alan White

By Alan White

IndyMac Bancorp is a bit like Northern Rock, the UK bank that was nationalized a few months ago. Unlike many leading mortgage lenders, it is an actual bank with actual depositors, whose deposits are insured by the FDIC. Unlike the large national bank holding companies who participated in the subprime frenzy, like Wells Fargo and Citigroup, IndyMac had a relatively small deposit base and relied on brokered deposits and aggresive marketing of CDs to raise capital. For those banking law geeks who remember the savings and loan crisis of the 1980s, these are familiar. Brokered deposits are deposits obtained from outside the bank's service area, attracted by above-market interest rates. Paying these higher rates squeezes the bank's yield spread, and more importantly, brokered deposits are short-term and can evaporate quickly when a bank gets in trouble.

IndyMac was not really a subprime lender; it specialized more in Alt-A loans, which had interest rates more akin to prime mortgages, but were either jumbo loans, no-doc loans, interest-only loans or some combination of these. The Alt-A portion of the mortgage market grew at an astonishing rate to become a major sector in 2006 and 2007, and represents the next wave of defaults and foreclosures.

IndyMac's stock has plummetted over the past 12 months as a result of the steady increase in mortgage defaults and the general unease about the mortgage market, and the company now trades at less than $1 per share. Its capital has eroded to well below required levels, and it has now fallen victim to a classic run on the bank. Depositors are lining up daily and the bank is rapidly losing cash. The Implode-o-Meter declared it imploded as of about a week ago.

There are two kinds of run-on-the-bank situations. In one case, the bank's assets are sound, but are not liquid (e.g. long-term conventional mortgages) and the problem can be solved with an injection of liquidity. That is the role of the Federal Reserve as lender of last resort. On the other hand, the bank's capital and assets may be insufficient to pay its depositors, either now or later, meaning that the bank is insolvent. IndyMac appears to be at or near this point. Because the FDIC insures its deposits, the FDIC is entitled to order IndyMac to recapitalize, change the management, arrange a sale of the bank's assets and liabilities to another bank, or seize the assets and sell them, while paying off depositors the shortfall from the insurance fund. Rumors on the blogosphere are that the sale has been tried and has not worked, and that the FDIC will have its first major bank failure for 2008. Reuters reports that IndyMac's insured deposits of $17 billion will take a big chunk out of the $53 billion FDIC fund. This usually means that the FDIC will collect a special assessment from all insured institutions to replenish the fund.

I was very interested to learn from a colleague here in the UK (I am teaching in Cambridge this month, which explains the 3 a.m. postings) that prior to the Northern Rock collapse, British depositors did not have the equivalent of 100% FDIC insurance of deposits. Instead, bank deposits here were insured in full only to a very low limit, about $4,000, and then insured at 90% up to a limit of about $60,000. The Northern Rock depositors quite rationally started a run for fear of losing the uninsured 10%. In response the UK banking authorities have reconsidered and decided to extend 100% insurance to depositors up to about $70,000. This represents an implicit acknowledgment of defeat for the partisans of consumer responsibility and market discipline. The notion that consumers can shop around for the most solvent bank before entrusting their deposits, by carefully reviewing balance sheets and asset quality, and in so doing drive out the weaker banks by this careful consumer shopping process, has been consigned to the dustbin of history, as they say.

Full post as published by CL&P Blog on July 11, 2008 (boomark / email).