Trevor Fung 1 41482425 IndyMae Bank Describe the events leading up to this failure Identify the main weaknesses

ses in risk management Identify any deficiencies in the prudential regulation (or implementation of this regulation) which allowed this failure to occur. On July 11, 2008, the Office of Thrift Supervision (OTS) closed the $32 billion IndyMac Bank, FSB, and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver in the third largest bank failure in United States history. Various aspects of the failure of IndyMac will be examined closely over the next few months as bank regulators and the banking industry brace for many more banks to fail over the next year. In the near term, the failure of IndyMac and continued volatility among other banks provides immediate lessons to participants in the financial services industry IndyMac is a case study in the rise and fall of Americas mortgage market. Its story offers a body of evidence that discredits the notion that the mortgage crisis was caused by rogue brokers or by borrowers who lied to bankroll the purchase of bigger homes or investment properties. CRLs investigation indicates many of IndyMacs problems were spawned by top-down pressures that placed short-term growth ahead of borrowers and shareholders interests over the long haul. IndyMacs lending volume and profits soared during the mortgage boom. Loan volume tripled in three years, approaching $90 billion in 2006. It grew far faster than most of its competitors; its share of the national mortgage market increased from 0.77% to 3.30% over that span. Profits more than doubled over those three years, hitting $343 million in 2006. In 2007 and 2008, however, it suffered a dramatic reversal of fortune. IndyMacs nonperforming assets bankspeak for loans that have gone bad have been growing at a steep rate. The firms dollar volume of non-performing assets exploded 11-fold in 15 months going from$184 million (0.63% of assets) at the close of 2006 to $2.1 billion (6.51% of assets) at the end of the first quarter of 2008.18 IndyMac generally defines non-performing assets as loans that are at least 90 days overdue or in foreclosure. As a result of the growing numbers of bad loans and a drop in mortgage originations, IndyMac posted a $615 million loss in 2007, and a $184 million loss in the first three months of 2008. That combined loss of nearly $800 million over 15 months means that it has more than given back all of the $636 million in profits it posted in 2005-2006, at the height of the mortgage boom. Meanwhile,

Trevor Fung 2 41482425 IndyMacs stock price, which hit its highest level ever at the end of 2006, topping$45, has plummeted, falling below one dollar as of June 26, 2008. Long-time shareholders have lost some 95% of their value in just over two years. The company has eliminated riskier products such as low documentation Alt-A loans and piggyback loans, and Michael Perry continues to express optimism that the company will turn things around once the housing market improves. Alt-A empire IndyMacs record is also worth scrutinizing because of the ways it differs from many lenders involved in the mortgage mess. For one thing, IndyMacs specialty as not subprime loans, but so-called Alt-A loans. While subprime loans were supposed to go to borrowers with the weakest credit profiles, Alt-A loans were generally supposed to be aimed at borrowers who had better credit but couldnt document all their income or assets. These borrowers paid higher rates than traditional prime borrowers, but lower rates than subprime borrowers. No lender was more steeped in the Alt-A market than IndyMac. In 2006, IndyMac ranked number one in the nation among Alt-A lenders, producing $70 billion in volume, or 17.5% of the Alt-A market. Nearly four-fifths of IndyMacs mortgage volume during that span involved Alt-A loans. Market Statistical Annual Volume I, Inside Mortgage Finance. According to Inside Mortgage Finance, Countrywide was close behind in Alt-A volume, at $68 billion, but that figure represented a much smaller slice -- 15% -- of Countrywides mortgage production. Over the past year, much attention has been focused on subprime loans, with references to catch phrases such as subprime meltdown. Alt-A lenders struggled to distance themselves from subprime. In early 2007, Perry argued that Alt-A lenders were being unfairly lumped in with subprime. But many of the practices prevalent in the subprime market including bait-and-switch salesmanship and slapdash underwriting also appear to have been common in the Alt-A sector. Rising defaults have shown that the Alt-A business wasnt as immune from problems as its proponents argued. As of February 2008, roughly one in seven Alt-A loans nationwide on owner occupied homes were at least 30 days late, in foreclosure, or already in repossession, according to the Federal Reserve Bank of New York.

Taxpayers at risk? IndyMac is also worthy of note because it didnt rely as heavily on Wall Street financing as many of the lenders that got into trouble. IndyMac did sell the vast majority of its loans to Wall Street so they could

Trevor Fung 3 41482425 be packaged into mortgage-backed securities investment deals. However, it depended less than many lenders on up-front lines of credit from Wall Street to bankroll its loans before they were sold to investors. Instead, IndyMac has increasingly relied on federally-insured customer deposits and borrowings from the Federal Home Loan Bank (FHLB) system: 1. Its deposits jumped from $4.4 billion at the end of 2003 to $18.9 billion as of March 31, 2008. 2. Its FHLB borrowings grew from $4.9 billion at the end of 2003 to $10.4 billion as of March 31, 2008. 3. Together, those two sources of funding represented roughly 94% of its total liabilities on March 31, 2008, up from 79% in March 2007.

Initially, IndyMacs use of federally-guaranteed sources of funds made the company less vulnerable to the credit crunch than many other lenders, which went under when Wall Street firms cut-off their lines of credit. However, IndyMacs reliance on capital from the Federal Home Loan Bank system, and on deposits that are backed by the FDIC, puts the federal government in the position of bankrolling loans that may be abusive. It also puts the system at risk of significant losses as loans go bad. U.S. Senator Charles Schumer has told federal regulators that hes concerned that IndyMacs financial deterioration poses significant risks to both taxpayers and borrowers and that the regulatory community may not be prepared to take measures that would help prevent the collapse of IndyMac or minimize the damage should such a failure occur. Federal regulators have pointed out that many of the lenders accused of bad practices, such as Ameriquest, were under state rather than federal supervision. However, IndyMacs record, as well as Countrywides, raises questions about whether federal regulators turned a blind eye to improper practices among the lenders they licensed. Amid the overheated atmosphere of the mortgage boom, IndyMac and lenders of many different stripes appear to have abandoned sound decision-making and sustainable growth strategies. Instead, they chose to take unreasonable risks and reach for spectacular levels of growth that produced short-term profits but ended in pain for borrowers, shareholders, and communities. It didnt have to happen this way. Federal authorities including the Office of Thrift Supervision should have kept a closer eye on IndyMacs business model and practices. They had leverage over IndyMac, given that the company operated as a federally-chartered thrift supported by deposit insurance and borrowings from the FHLB system. IndyMacs story suggests that, in the absence

Trevor Fung 4 41482425 of rigorous oversight, theres little to stop lenders from getting swept up by market frenzies and embracing reckless practices. This should be uppermost in policymakers and citizens minds as federal and state governments work to clean up the mortgage mess and to design rules that will prevent such disasters from happening again IndyMac and Subprime Spillover At first glance; IndyMac was not a likely candidate for collapse. Although the subprime lending market was in a freefall, IndyMac specialized in making Alt-A loans. These loans are riskier than prime loans, but are less risky than subprime loans. Traditionally Alt-A loans are extended to borrowers with good credit, as most Alt-A loans require a credit score of at least 620; however, most Alt-A borrowers do not provide full documentation of assets and income. These loans were very popular during the recent housing boom, accounting for fifteen percent of mortgage originations in the first half of 2007, compared with just two percent in all of 2003.Alt-A loans generally performed better than subprime loans. After examining five years of data from 2002 to 2006, First American Loan Performance found that the loss rate for subprime loans was over ten times that of Alt-A loans. IndyMacs Alt-A loans performed even better than the industry average. As the subprime meltdown continued, however, the problems in subprime loans began to spill over to what had been thought to be safer mortgages. In April 2007, lenders found they were no longer able to sell Alt-A mortgages at enough of a premium to cover the costs of origination. Instead, lenders were forced to sell the loans at par or lower. American Home Mortgage, another Alt-A lender unaffiliated with IndyMac, was hit particularly hard, and reduced its 2007 second quarter dividend to $.70 per share from $1.12 per share in the first quarter. This reduction was accompanied by an announcement that the company had earned only about half as much per share as it had expected, largely due to having to write-down many of its Alt-A loans. This decline in the performance of Alt-A loans, which surfaced first with American Home Mortgage, would soon affect other Alt-A mortgages and was instrumental in bringing down IndyMac. Short Selling On March 14, 2007, about a month before the subprime crisis began to spill over into the Alt-A market, financial analyst Jim Cramer sounded the first warning for IndyMac, naming it as the number one stock being sold short.

Trevor Fung 5 41482425 Cramer wrote I would not own a single one of these *securities+ myself . . . . The IndyMac people are adamant theyre not in trouble, but so were the Accredited people, a reference to a company Cramer claimed was struggling mightily. Cramer made specific reference to liquidity issues, foreshadowing what would be listed as the cause of death on the OTSs autopsy of IndyMac. Cramer and the short sellers were proved right as the price of IndyMac fell from a high of $36.66 on June 5, 2007, to $19.00 on August 15, 2007. Although the stock would rebound briefly, the overall trend remained downward. Three months later, Thestreet.com, a financial news and advice web site, claimed that while the subprime meltdown is already well under way, problems with Alt-A loans, or so-called liars mortgages, are only starting to rear their heads and named IndyMac as an institution in particular trouble. The article cited severe pressure on the Alt-A lenders caused by lower gains on sale margins. These lower gains would be potentially disastrous for IndyMac, which had greater exposure to Alt-A loans than any other lender. Financial analyst Robert Lacoursiere wrote that a collapse of two leverage mortgage funds managed by Bear Stearns was a harbinger of difficult times at IndyMac. He believed the collapse of the funds indicated a decline in the Alt-A market, and that such a decline that would hit IndyMac hard, considering its large Alt-A exposure. He believed that risk of Alt-A market decline was not reflected in IndyMacs current stock price and advocated selling IndyMac stock. IndyMac dismissed the concerns by distinguishing itself from Bear Stearns. Officials noted that the failed Bear Stearns funds were comprised of very risky collateralized debt obligations (CDOs). IndyMac, however, did not own any CDOs. The IndyMac response also contrasted the loans made by the Bear Stearns funds with those made by IndyMac: Bear Stearns problem is with subprime securities, and subprime lending accounted for only *four percent+ of IndyMacs loan originations in 2006 and Q1 07. In the higher credit quality segment of the market that IndyMac primarily participates in, conditions, though difficult, are substantially better than in the subprime market. Not all analysts shared bearish concerns. Sahul Sharma, writing in response to Lacoursiere, attempted to show that IndyMac was not a stock investors needed to sell. He claimed that IndyMac had learned its lesson during a liquidity crunch in 1998, and because of that would be well-positioned to continue operations through the current downturn. Although the failure of an individual bank is nothing new, there may be something distinctive about the questions raised by the IndyMac failure. The most obvious questionis IndyMac only the tip of the icebergseems to be well on its way to being answered. The subsequent failure of Washington Mutual and near death experience of Wachovia suggest that IndyMac was only the first in line. The FDICs handling of the failure calls into question how adequately the institution communicates with the public.

Trevor Fung 6 41482425 The whole idea behind deposit insurance is that it will prevent bank runs by ensuring ordinary depositors will not lose any money. That was clearly not the case after the failure of IndyMac. Whether the continuation of the bank run after the FDIC stepped in resulted from inadequate communication by the agency, poor dissemination of information by the mass media, or ordinary depositors having a poor understanding of what FDIC insurance meant, it is clear the mechanism is broken somewhere.