The Housing Bubble and Indy Mac Bank - Case Study Example

The housing bubble and Indy Mac bank Executive Summary The Indy Mac bank collapsed in July 2008 is regarded as the most expensive failure in the history of US. Indy Mac Bank exclusively dealt in Alt-A mortgage loans which were considered to have the highest credit rating and was safer than the subprime loans. However during the boom period Indy Mac bank provided loans to the customers without much documentation or verification of their income strengths. Indy Mac was and its profitability was rising considerably due to increasing disbursing of loans. The property prices were high, so if the customers failed to pay the loan back, the possession of the house or property was taken and sold to investors for pooling the money, but this bubble busted and the price of the houses fell considerably. Moreover, many borrowers could not pay the loan back, as the bank did not check the authenticity of the borrower before disbursing the loans. So the bad loans accumulated with the bank. The bank had no such provision to sell the property and pool money because the purchasing power of the buyers in the market had reduced considerably and no one was willing to buy property. This was the situations which like the other bank Indy Mac Bank also faced, which led to its failure. Finally it was acquired by FDIC and Indy Mac became Indy Mac federal Bank. Table of Contents Executive Summary 2 INTRODUCTION 4 ANATOMY OF THE FAILURE 6 The Subprime Mortgage crisis 6 Subprime Spill and Indy Mac Bank 7 Initial Signs of Warning 7 THE AFTER EFFECTS OF FAILURE 8 CONCLUSION 9 Work Cited 11 Date: November 19, 2012 To: **************** From: **************** RE: Analysis of the failure of Indy Mac bank with respect to housing bubble of 2008. According to CNN Money, July 13 2008, the fall of the Indy Mac Bank, the most important mortgage lender, was the most expensive collapse in the history. This proved again that crisis still existed. The Indy Mac Bank was acquired by the Federal Regulators. It was said that about 95 percent of the bank deposits were insured. This means about $1billion were not covered under the FDIC cover or guarantee. This could have affected about 10,000 customers of the bank and they could have lost half of their deposits. However, the failure of the IndyMac would charge the Insurance Funds around $4-$8 billion. This was regarded as one of most costly failures ever (Clifford, and Isidore “The Fall of IndyMac”). INTRODUCTION Bank failures are not new phenomenon. There was just two years from 1934 to 2007, when none of the banks collapsed or failed. During the 1990s when the world economy was going through extreme loan and savings crisis, at an interval of 1.38 days 1 bank failed. However during 2007 crisis this rate slowed down to 2 banks. Around thirty-two bank collapsed during this time as stated by Federal Deposit Insurance Corporation (FDIC). However, in July 2008, Indy Mac Bank, which was the third largest bank in USA, failed. Though during 2007, the bank showed signs of survival by focusing on a growth based business model, and maintaining capitalization level high to face the storm. Indy Mac grew swiftly during the boom of real estate and housing. The customers or buyers were asked for few or no evidences of their earnings and allowed loans to buy property such as houses. Since the house prices were increasing, so when a buyer could not pay back his/ her loan, the bank took possession of the home and found investors for it to pool money. However, when this housing bubble burst, the price of the real estate began to fall and the losses for the bank begin increasing. The loans that were taken became bad and bank had to suffer losses because there were not enough buyers in the market to buy those properties and pool money for the bank. Indy Mac lost about $184.2 million in its first quarter of 2008 and it was expecting higher loses in their second quarter. The bank also lost about $614 million in 2007 by focusing on Alt-A sector of mortgage. However, finally the bank authorities accepted that it could no longer accept the deposits that were brokered as they were no longer though to be well capitalized. The stock prices of Indy Mac had dropped almost over 95 percent within these two years, and the market capitalization reduced about $3.5 billion. This increasing level of Alt A and subprime mortgage were the indicators that the crisis had moved on beyond the control of the weak borrowers. In this situation, the securitization market also failed or collapsed. So this closed Indy Mac’s options to get its bad loans off its records (Federal Deposit Insurance Corporation “Failed Bank Information”). The Chairman of Indy Mac Bank was Steven Mnuchin, and the CEO was Joseph Otting. The non-employee directors of the bank who were included in the board of directors of the company were paid an annual remuneration of $50,000. The non-employee directors who were the part of the audit committee received $20,000 as remuneration. Apart from this, the presiding director received an additional $20,000. These non-employee directors were exclusively on the board of the bank. All the other reimbursements and requirements of the directors were paid from the account of Indy Mac Bank. The non-employee directors received $2,500 as fees to attend the board meeting of Indy Mac Bank. ANATOMY OF THE FAILURE The Subprime Mortgage crisis The Subprime Mortgage crisis has a significant role in the occurrence of Global Financial Crisis in 2008. The crisis situation is a consequence of the subprime lending and not caused due to over lending by banks. The credit status relative to the borrowers is referred to as subprime. It is not the interest rate corresponding to the loan itself. Subprime is referred to any type of loans which does not satisfy the prime guidelines of a loan. Subprime lending is also called by different other names like B-paper, second-chance lending, near prime, etc. Subprime lending is referred to as the process of making loans or lending money to the borrowers who are not qualified to be given loan at the market interest rates because of their credit ratings being low (Holt). The Subprime mortgage crisis was institutional in the US market in 2007. Subprime lending in US market was around 9% in the year 1996, which rose up to 21% in the year 2004 (Blackburn, 2008, p. 64). As a result of securitization and the demand of mortgage-backed securities (MBS), it gave rise to origination of loans with a high rate of default risks associated with it. The rating agencies involved in this process started providing investment grade rating for these MBS. It was observed that the prices of houses rose by around 124% between the years 1997 and 2006. This was a result of the housing bubble existent during that time in the US housing market. The owners of houses started taking this opportunity to refinance their houses with much lower interest rates and then by taking a second type of mortgage against the value that have been added to the value of the houses. This was done to facilitate consumer spending using those funds. However, in the late 2006, the house prices started falling considerably and the mortgage industry in US entered into the global meltdown or recession scenario. This is all about mortgage crisis (Blackburn “The Subprime Crisis”). Subprime Spill and Indy Mac Bank Indy Mac was a strong player of the mortgage lending market. Though the subprime lending market was spilling over, but Indy Mac was a specialist in Alt- A loans. These were riskier than the prime loans but were less risky that subprime loans. Previously the Alt-A loans were given to those who had good credit scores such as 620 at least. The documentation of income and asset of the borrower were not checked thoroughly recently, especially during the housing boom. So it became quite popular among people. The performance of the Alt-A loans was better than the subprime loans. The Alt-A loans of Indy Mac performed much better than the averages of the industry. However, in the year 2007, the lenders of Alt-A loans found that they were not receiving enough premium even to cover their cost, leave alone profits. So these loans were sold away at par. American Home Mortgage another Alt-A loan company had to face the heat and it reduced its dividend to $0.70 per share from about $1.12 per share. Similarly Indy Mac also faced such situations when it’s Alt-A loans went bad and kept on accumulating in their books (Baker “The Housing Bubble and the Financial Crisis”). Initial Signs of Warning In 2007 March, financial analyst Jim Cramer first warned that Indy Mac’s stocks are among the top in the list whose shares would be sold short. The authorities of the bank were forcibly not accepting this fact. Cramer specified liquidity issues to be the reason for such downfall. So in August 2007, the shares of Indy Mac fell to $19 from $36, and it kept on decreasing. After this the subprime melt down was declared and also revealed that Alt-A loans were facing serious issues. Robert Lacoursiere, another financial analyst declared leverage mortgage funds which are regulated by Indy Mac and Bear Stearns were going through their most difficult phase, but the Indy Mac officials refused by differentiating themselves from Bear Stearns. In 2007 June two types of Residential Asset Securitization Trust (RAST) bonds by Indy Mac were considered in the Watch Negative section of Fitch Ratings. However the Vice President of Indy Mac said that they performed than the expectations. In August 2007, S&P placed 207 RAST bonds with negative implications. It was seen that all of these 207 bonds were Alt-A mortgage backed. Among them 17 were issued by the Indy Mac and they still owned 10 of them which amounted to $8.6 million. In spite of receiving adequate signs of warning, Indy Mac’s officials did not respond seriously to these issues. In 2007 June the bank downsized by 4000, which was about 4 percent of the total employees. Indy Mac also kept of cutting down their cost through different means with the expectation of saving $30 million per year. Finally it revealed that it could not cover about $100 billion loan amount with only $33 million present in its balance sheet (Levy, and Mildenberg “IndyMac Seized by U.S. Regulators; Schumer Blamed for Failure”). THE AFTER EFFECTS OF FAILURE In July 2008, the price of Indy Mac’s share was less than a dollar. Just three days later the bank opened as Indy Mac federal Bank, which was a bridge bank controlled by FDIC and has acquired Indy Mac. FDIC estimated that the failure cost was around $4 to $8 billion. Indy Mac Federal Bank guaranteed to pay about $100,000 per account. The customers who were worried about their deposits, waited in long queue to withdraw their money. The failure of the Indy Bank created a situation of anxiety and utter lawlessness in the country. However, FDIC stabilized the situation with the depositors of Indy Mac and also took care of the mortgage loans. FDIC also formulated plans to rehabilitate the distraught mortgage loans. They decided to utilized the reduced interest rates and extend to amortization. This program of FDIC proved to be a success. Apart from this an investigation team was also set to investigate, whether any fraudulent practice was involved in such a failure or not. The FBI was given the responsibility to make detailed investigation regarding this issue. The incident of Indy Mac was not the only collapse. It was one of the many failures that took place in the time span of two years (LaCapra “IndyMacs Failure: A Year Later”). CONCLUSION Though the failure of a single bank was nothing compared to the huge number of collapses, but there are few specific reasons which raised Indy Mac’s failure. This is because Indy Mac stated the trend which continued with the collapse of Washington Mutual, then Wachovia, etc. The motive of insuring the deposits was to secure the depositors’ interest, which proved to be wrong in case of Indy Mac. The collapsed mechanism involved FDIC’s insurance commitments, communication by the mass media or agents, poor broadcasting of relevant information, and poor understanding of the norms of FDIC. The sustainability of FDIC was also in question because even before Indy Mac failed, as FDIC had a reserve of only $45 billion dollar. On top of such situation the officials of Indy Mac continuously rejected the indications of collapse by stating reasons through their growth business model. The failure of Indy Mac Bank was one of the biggest and most expensive failures. The customers received only claims till 100,000 for each account. Work Cited Baker, Dean. “The Housing Bubble and the Financial Crisis.” Real-World Economics Review, 2008. Web. 19 November 2012. Blackburn, Robin. “The Subprime Crisis.” New Left Review, April 2008. Web. 19 November 2012. Clifford, Catherine, and Chris Isidore. “The Fall of IndyMac.” CNN Money, 13 July 2008. Web. 19 November 2012. Federal Deposit Insurance Corporation. “Failed Bank Information.” FDIC, 28 August 2008. Web. 19 November 2012. Holt, Jeff. “A Summary of the Primary Causes of the Housing Bubble and the Resulting Credit Crisis: A Non-Technical Paper.” The Journal of Business Inquiry, 8.1 (2009): 120-129. Web. 19 November 2012. LaCapra, Lauren Tara. “IndyMacs Failure: A Year Later.” The Streets, 7 October 2009. Web. 19 November 2012. Levy, Ari and David Mildenberg. “IndyMac Seized by U.S. Regulators; Schumer Blamed for Failure.” Bloomberg, 12 July 2008. Web. 19 November 2012. Read More