What IndyMac's Failure Portends For the Market

Friday afternoon, Alt-A mortgage lender IndyMac was seized by the FDIC after panicked depositors withdrew funds totaling $1.3 billion within a few days.  The bank did not have adequate liquidity to continue to meet depositors demands for withdrawals and was forced to shut down.  The FDIC will now take over and attempt to perform an orderly liquidation or a sale.  The Office of Thrift Supervision (OTS) pointed the finger at Senator Charles Schumer accusing the Democratic Senator of causing the panic by leaking a letter to the press expressing concerns over the bank's solvency.  Mr. Schumer defended his actions claiming that the OTS should have done a better job of policing the thrift.  While Mr. Schumer has a point, I'm going to have to side with the OTS on this one.  What exactly is the point of sending an incendiary letter in a time when investors and markets are in a complete panic over the solvency of the US banking system?  What was Mr. Schumer doing when IndyMac was busy handing out no-doc loans in the housing frenzy of 2005-2007?  Holding hearings over baseball steroid abuse?    Yes that was a far more important issue than investigating significant anecdotal evidence of rapidly deteriorating lending standards in the mortgage industry.  

The failure of IndyMac was preceded by a week of extremely volatile trading in financial stocks.  By "volatile," I mean financials were on an incessant downward trajectory with barely an uptick.  Stocks of investment banks, thrifts, commercial banks, as well as Fannie and Freddie were all pummeled relentlessly on what some attributed to "malicious rumors" spread by short-sellers.  While perhaps rumormongering always persists in periods of tremendous uncertainty, I firmly believe that the plunge in financials was due more to mounting realization of the possibility of some very frightening scenarios.  Many have questioned Fannie and Freddie's solvency in the past, but for the first time last week, investors started to believe it and headed for the exists en masse.  The failure of Fannie or Freddie has massive implications for Wall Street, as well as Main Street.  It is why the government won't allow it.  Central banks are huge buyers of Fannie and Freddie's debt as are investment banks.  Investment banks also securitize Fannie and Freddie mortgage loans into MBS and trade derivatives with the housing behemoths.  I don't even need to mention that Fannie and Freddie guarantee nearly half of all mortgages outstanding.  If Fannie and Freddie weren't buying conforming mortgage loans right now, nobody could buy a house, unless you happen to have the cash for a 100% purchase.  Without financing, the housing market would collapse entirely.  

Arguments that the selling was overdone and the evil short-sellers should be prosecuted by the SEC fell flat on their face after the close Friday when IndyMac was seized by regulators.  The fears of bank failures are clearly not unfounded.  Many banks are still staring large losses in the face and will more than likely need to raise additional capital.  It is impossible to raise capital if investors are in a panic.  Confidence needs to return to the market before buyers will step in again.  The risks of a rapid failure of any financial institution is just too high for many to wade in to the market.  What will it take to restore confidence?  I have a few ideas:

• Fannie and Freddie have to halt all dividends to common shareholders.  They must appear as if they are if they are actively preserving capital and not just issuing pointless press releases claiming they are adequately capitalized.  The market doesn't believe them.
• The Fed should make a formal announcement that Fannie and Freddie can borrow from the discount window if necessary.  Why?  Because the stocks rallied significantly when this rumor reverberated around Wall Street on Friday and then fell when the rumor was debunked.  Any step that can restore a measure of confidence in the market should be taken.  The mere possibility of borrowing from the discount window has kept Lehman from succumbing to Bear Stearns' fate for the past three months.  Who knows what Lehman's future holds, but the discount window staved off sheer panic for at least three months, buying the company time to raise more capital and shed assets.  Lehman's chances of survival improved markedly because of this. 
• Regulations should change to allow private equity to take larger than a 10% stake in banks without coming under regulatory scrutiny.  There are many good reasons why this regulation is in place, but most of the reasons are superseded by the fact that banks need capital and private equity has hinted that they are willing investors.  I have expressed much cynicism towards private equity here at Mock The Market, so perhaps some of my regular readers wonder if I've changed my tune.  Not exactly.  I'm still skeptical of the business model of piling loads of debt onto any company just because foolish lenders are willing to lend you money to lay off employees and pay yourself a dividend.  However, the market has clearly changed.  Dividend recaps are a things of the past, and private equity will really need to roll up their sleeves and enact real changes to turn the banks' fortunes around.  Frankly, if they have the money, are willing to take the risk, and want to work hard, I say let them.  The reality is, the alternatives are just too frightening.