Regulators Were Blind To Risk In Biggest U.S. Banking Failure

The most expensive banking failure in U.S. history was the closure of IndyMac Bank in July 2008.   The original estimated loss to the FDIC of $8.9 billion  has recently been increased to $10.7 billion or 33% of IndyMac’s assets at the time of closure.  The story of how IndyMac Bank was allowed by regulators to pursue its reckless strategy of rapid asset growth and risky lending is detailed in a recent report by the Office of Inspector General (OIG).

In its role as insurer, the FDIC identified and monitored risks that IMB presented to the Deposit Insurance Fund by participating with the OTS in on-site examinations of IMB in 2001, 2002, 2003, and again shortly before IMB failed in 2008 and through the completion of required reports and analysis of IMB based upon information from FDIC monitoring systems. FDIC risk committees also raised broad concerns about the impact that an economic slowdown could have on institutions like IMB that were heavily involved in securitizations and subprime lending. Nevertheless, FDIC officials consistently concluded that despite its highrisk profile, IMB posed an ordinary or slightly more than ordinary level of risk to the insurance fund. It was not until August 2007 that the FDIC began to understand the implications that the historic collapse of the credit market and housing slowdown could have on IMB and took additional actions to evaluate IMB’s viability.

IndyMac’s high risk business profile (as detailed below by the OIG) was well know by both of IndyMac’s primary regulators.   Despite this fact,  regulators did not recognize the risks until after the real estate markets had started to collapse and IndyMac’s subprime loans began to default.

Table 1: IMB’s Business Profile
Pursued an Aggressive GrowthPosture

− IMB pursued an aggressive growth posture from its
inception as an insured financial institution. Rapid growth
in lending was facilitated by increasingly lax underwriting
within a very competitive market, primarily southern
California.
− IMB grew to become the seventh largest savings
association and ninth largest servicer of mortgages in the
United States.
Focused on an Originate-to-Sell Platform
− Originated residential loans for the purposes of sale,
securitization, and its own portfolio. Because IMB’s
business market model was an “originate-to-sell” platform,
its aggressive posture is reflected more in its originations
than asset growth.
− During 2006, the bank originated $91.7 billion in loans. In
the first half of 2007, the bank originated $46 billion in
loans.
Relied on Alternative A Paper (Alt-A) Loan Production for Growth
− The bank’s Alt-A loans (a type of mortgage between prime
and subprime) were generally jumbo loans that were
underwritten largely based on the borrower’s credit score
and the loan-to-value ratio. Many of these loans did not
have a full verification of income or assets. These are
referred to as “no doc” or “low doc” loans.
Created High-Risk Asset Concentrations
− Concentrations included non-traditional mortgages with
negative amortization potential, Alt-A mortgage loans, and
geographic concentration of loans in California that were
rated high- or very high-risk by several mortgage companies.
Relied on Non-Core Funding
− To finance its operations, IMB relied heavily on non-core
funding from Federal Home Loan Bank (FHLB) borrowings and brokered deposits.
Source: OIG analysis of FDIC documents.

The non-core funding sources IMB relied upon increased the FDIC’s resolution costs at the time of failure because FHLB borrowings must be repaid first, and many brokered deposits are not transferred when the FDIC sells an institution’s assets. As of December 31, 2007, IMB had $11.2 billion in FHLB borrowings and $5.8 billion in brokered deposits for a total of $17 billion compared to total assets of $32.5 billion.

The Treasury IG’s material loss report stated that although OTS conducted timely and regular examinations of IMB and provided oversight through offsite monitoring, its supervision of the thrift failed to prevent a material loss to the Deposit Insurance Fund. The Treasury IG reported that IMB’s high-risk business strategy warranted more careful and much earlier attention. The report further stated that OTS viewed growth and profitability as evidence that IMB management was capable, and OTS gave IMB favorable CAMELS ratings right up to the time it failed. Moreover, the OTS did not issue an enforcement action until June 2008, less than 2 weeks before
IMB failed.

The report by the OIG provides scant assurance that future major banking failures will be prevented since current regulatory “reforms” are likely to keep intact the existing regulatory agencies – see Will Regulatory Reform Prevent Future Financial Crises?

The OTS and FDIC were not the only regulators oblivious to the risks of subprime, no doc and low doc mortgage lending.  The entire regulatory apparatus consistently turned a blind eye to repeated warnings of lending excesses and abuses until the financial crisis was upon them.   Consider  – As Subprime Lending Crisis Unfolded, Watchdog Fed Didn’t Bother Barking.

The visits had a ritual quality. Three times a year, a coalition of Chicago community groups met with the Federal Reserve and other banking regulators to warn about the growing prevalence of abusive mortgage lending.

They began to present research in 1999 showing that large banking companies including Wells Fargo and Citigroup had created subprime businesses wholly focused on making loans at high interest rates, largely in the black and Hispanic neighborhoods to the south and west of downtown Chicago.

The groups pleaded for regulators to act.

But during the years of the housing boom, the pleas failed to move the Fed, the sole federal regulator with authority over the businesses. Under a policy quietly formalized in 1998, the Fed refused to police lenders’ compliance with federal laws protecting borrowers, despite repeated urging by consumer advocates across the country and even by other government agencies.

But since its creation, the Fed has held a second job as a banking regulator, one of four federal agencies responsible for keeping banks healthy and protecting their customers.

During the boom, however, the Fed left those powers largely unused. It imposed few new constraints on mortgage lending and pulled back from enforcing rules that did exist.

The financial crisis has exposed how multiple regulators, responsible for ensuring safe and sound lending practices, all failed in their primary mission.  To date, there has been no fundamental restructuring of the financial regulatory agencies.   Those who believe that future crises can be averted by a “reformed”  financial regulatory system are not thinking clearly.

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