Bank Failures and Bailouts

August 7, 2008

Maria Tomchick

When the feds seized IndyMac bank on July 11th, the credit crisis reached new heights. As IndyMac customers lined up outside closed bank branches in Southern California, shouting and shoving to get their money back, scenes from 1930s films of The Depression went through my mind. How safe is our financial system? Will more banks fail?

What made the IndyMac situation even more surreal is that, although considered a small bank by today's standards, IndyMac was the third largest bank collapse in US history, rivaled only by the failure of American Savings & Loan Association in 1988 and the collapse of Illinois National Bank in 1984 during the height of the Savings & Loan Scandal. IndyMac had assets of $32 billion, but was felled when customers withdrew around $1.3 billion in cash from their accounts in the ten days leading up to July 11th.

IndyMac had plenty of assets, but those assets weren't liquid, and they didn't have enough cash on hand to cover all of their deposits. IndyMac was a major player in the mortgage market, ranked as the nation's ninth largest mortgage lender. They specialized in Alt-A mortgages, loans that are written for borrowers who aren't required to provide proof of their income and assets in order to get loans. These risky mortgages made up the bulk of IndyMac's assets, and when the market for mortgage-backed securities collapsed, they were unable to sell them to raise cash. With their assets composed of risky loans, IndyMac also had trouble borrowing cash from other banks to tide them over.

Which means, of course, that many other local and regional banks are in the same boat. In the week after IndyMac was seized by the federal government, similar banks took severe hits to their stock prices, effecting their ability to borrow money to cover their own debts and obligations to their customers. Downey Financial Corp., another Southern California bank specializing in "nontraditional loans," saw its stock price fall by 24%. Washington Mutual, formerly the third largest mortgage lender in the US and a major subprime lender, fell nearly 35%. Other Washington banks suffered, too: Sterling Financial Corp. fell 29%, Frontier Financial lost 13%, American West Bancorp fell 11%, and on and on. And on Friday, July 25th, two more regional banks--First National Bank of Nevada and First Heritage Bank of California--were seized by the Federal Deposit Insurance Corporation and their assets sold to a larger regional bank.

The FDIC, which also took over IndyMac's assets, will be disbursing money to IndyMac's customers, reimbursing deposits up to $100,000 per account. The FDIC is expected to pay out $4 to $8 billion to cover these claims. Nevertheless, about 20,000 of IndyMac's customers will lose part of what they deposited in their accounts.

After the Fed recently engineered a bailout for Bear Stearns investment bank--the first time in US history that the federal government prevented the collapse of a financial company catering only to investors--the collapse of IndyMac came as a shock. When the Fed rescued Bear Stearns, irate taxpayers were told that Bear Stearns was simply too big to be allowed to fail; in other words, its collapse would send a ripple through the economy that would lead to further bank failures. But after IndyMac, the question arises: where's the line? How big does a bank have to be in order to qualify as "too big to fail?"

A comparison should be made with the recent bailout plan for Fannie Mae and Freddie Mac, the mostly privatized federal institutions that write mortgage loans and repackage those loans into mortgage-backed securities. When the credit crisis erupted into full bloom last year, Congress passed legislation allowing Fannie Mae and Freddie Mac to borrow more money and expand the limits for the types of mortgages they could write. This followed years of gradual privatization and deregulation of both institutions, a move that's only contributed to the current crisis.

At the end of 2006, Fannie and Freddie accounted for about half the mortgage market in the US. Their role is now much bigger, and they've become literally the only institution that can sell mortgage-backed securities to investors. Investors will line up to buy Fannie and Freddie's securities while ignoring the securities issued by other banks because they believe those investments to be backed by the US government and to be safer than any other source of mortgage-backed bonds.

So in the wake of IndyMac's collapse, when investors began wildly dumping their financial stocks, and Fannie Mae and Freddie Mac saw their stock price drop by almost half, the Federal Reserve and the US Treasury had to step in and prop up Fannie and Freddie with a $300 billion line of credit. This dwarfs the $8 billion the FDIC will spend on IndyMac.

It gives us a glimpse of the sheer size of big banks today, and how dramatically the problems at one bank can literally shake the entire system. The week after the Fed announced a bailout of Fannie and Freddie, banks all over the world saw their stock prices plunge, especially in China and the rest of Asia. Asian banks hold a lot of US "agency" debt and, if Fannie and Freddie have trouble making payments on their debts to foreign banks, then those banks will suffer, too. Notably, economists have been looking to Asia for the economic growth that's supposed to pull the global economy out of the slump caused by the US credit crisis. But if Asian banks start to falter, the crisis will spread to those nations as well--just as it already has spread to Europe through the European banking system.

The International Monetary Fund--that institution activists love to hate--has plenty of experience evaluating the economic stability of underdeveloped nations, recognizing problems, and swooping in to offer loans with lots of strings attached. In its recent Global Financial Stability Report, the IMF expresses pessimism about the global economy, mainly due to the housing market and credit crisis in the US. The IMF estimates that the total losses reported by the financial system will eventually total more than $1 trillion. So far, banks have reported $469 billion in losses, which means we're not near the bottom yet. In fact, one year after the credit crisis first hit, we're not even to the half-way point.

Remember, the IMF's report is just an estimate. The lack of transparency in the US banking system has made it difficult to tell exactly how big the problem is or to know which banks own what types of mortgage debt. Some investors and economists have made predictions that sound very reasonable, if downright scary. Most agree now that the mortgage crisis is just getting started: right now we're riding the first wave, composed of subprime mortgage defaults. The second wave will be defaults on option adjustable rate mortgages (loans that allowed borrowers to pay less than their full interest on principal in the first two or three years of the loan, with payments that adjust radically upwards after that). The third wave will be Alt-A mortgages. The mortgage crisis could go on for another year to two years, or possibly longer. Nobody really knows for sure.

One thing we do know is how big a bank must be in order to be "too big to fail": it must owe hundreds of billions of dollars to banks all around the world. But if a bank's debt is merely owned by its customers (in the form of checking and savings accounts, retirement funds, and certificates of deposit) plus one or two US banks, then it's small enough to fail. Some economists expect between 50 to 100 more such "small banks" to fail before the credit crisis ends. Unfortunately, the FDIC currently has only $53 billion to cover bank failures, although they're lobbying Congress right now for more money.

The collapse of IndyMac and the bailout of Fannie and Freddie have revealed the true nature of our massive global financial system: it's a mega-mansion built on a mountain of debt. Which, I suppose, also describes the situation of many American families: big houses, big cars, and lots of unnecessary stuff all piled on a mountain of mortgage and credit card debt.

The mountain is starting to shift.

--Maria Tomchick



"US Treasury credit deal to shore up Freddie and Fannie," James Daley, The Independent, 7/14/08

"Banks hit by fallout from the crisis at IndyMac," E. Scott Reckard and Andrea Chang, Los Angeles Times, 7/15/08

"After IndyMac, are other bank at risk?" Associated Press, reprinted in The Seattle Times, 7/15/08

"US lender fear worst after two more fail," Stephen Foley, The Independent, 7/28/08

"Rumors, bank runs fueling anxiety," Louise Story and Eric Dash, The New York Times, reprinted in the Seattle Post-Intelligencer, 7/15/08

"Plenty of Pain to Go Around for Fannie, Freddie," John D. McKinnon and James R. Hagerty, Wall Street Journal, 7/15/08

"Europe's Economy Takes a Hit," Marcus Walker, Joellen Perry, and Jonathan House, Wall Street Journal, 7/16/08

"Fannie-Freddie Flu Hits Asian Banks," Yuka Hayashi, Laura Santini, and Neil Shah, Wall Street Journal, 7/16/08

"IMF: Credit crunch losses to hit $1trn," Sean O'Grady, The Independent, 7/29/08.