LOS ANGELES, TORONTO, NEW YORK -- Patricia Ramirez's home, which sits on a ragged dead-end street at the edge of East Los Angeles in the shadow of an elevated freeway, cost $445,000 (U.S.) when she and her husband bought it in February, 2007.
Mrs. Ramirez, an office manager at a tortilla maker, and Mr. Ramirez, a truck driver, together make $48,000 a year. When a relative of theirs bought a house a few years ago, his real estate agent told the Ramirezes they could afford a house too. They had dreamed of owning a home for years, and jumped at the chance, scraping together a $5,000 down payment, or 1 per cent.
They moved into the one-storey, three-bedroom beige house in a working-class neighbourhood that was bid up in value during the boom, because while it's on the edges of the rougher parts of town, it's not too far from downtown or the ocean. A pleasant green cemetery is half a block away and the nearby main streets are colourful, lined by eclectic shops and strolling families, most of whom are Hispanic.
Today, the Ramirez home, with its rusted basketball hoop in the driveway and yellowed lawn, is worth just $360,000 - a drop of 20 per cent in less than a year and a half.
Yet their monthly mortgage payments have moved rapidly in the opposite direction, escalating to $4,500 from the $2,500 payment they originally made - a sum they believed was fixed for five years.
Their mortgage, a type known as an Alt-A that became hugely popular in the U.S., allows borrowers to secure financing without providing proof of their incomes.
It may sound like a foolish business model, but for IndyMac Bancorp Inc. of Pasadena, Calif., it has been a catalyst for spectacular growth. Or at least it was, until eight days ago, when the bank was seized by the federal government.
It was the second-largest banking failure in U.S. history, and its collapse can be viewed as a cautionary tale: Not just of how America recklessly embraced subprime mortgages, but of how these questionable home loans have ripped through the wider economy, shredding confidence in the markets and inciting a global credit crisis.
Much of the problem dates to 2003, a pivotal time for both IndyMac and the credit markets in general. Unusually low interest rates had made large investors, like pension and hedge funds, hungry for higher-yielding products. At the same time, banks were more aggressively pursuing a new business model - one in which they originated loans, like mortgages, and then immediately sold them in products such as collateralized debt obligations, or CDOs, to these big investors to limit their risk.
IndyMac, seeing an opportunity, headed straight for this intersection. It developed new, custom types of mortgages such as the Alt-A, whose lax credit standards opened the door for a flood of potential new home buyers like the Ramirezes.
IndyMac could provide these mortgages to people with sketchy credit histories, and then pass off the risk by selling the loans to investment banks. The banks then packaged these loans with others of higher quality, and in turn sold chunks of these packages to large investors.
"IndyMac and others helped pioneer that market to bring those people into the fold and to allow them to buy homes, buy second homes, do a whole bunch of other stuff," says Guy Cecala, publisher of Inside Mortgage Finance.
The problem is, because each party was passing on the risk to someone else, the level of diligence and scrutiny suffered. That was fine as long as housing prices continued to climb, but when they reversed, the results were disastrous. Major banks and broker-dealers have already written off more than $300-billion worth of bad loans, and have been savaged in the equity markets. New lending has slowed to a crawl, threatening economic growth and forcing U.S. regulators to orchestrate several rescue plans for Wall Street.
Now, with IndyMac's failure - and news of a probe by the Federal Bureau of Investigation - there are fresh concerns. For one thing, many of the securities it backed are still lurking in investment portfolios - potential ticking time bombs.
As painful as this will be for some investors, the size of the bank's holdings aren't large enough to threaten the entire economy. But the replayed image of hundreds of customers, lining up outside IndyMac's branches in a classic run on the bank, just may be.
Confidence is the underpinning of the markets, and IndyMac's failure shows just how fragile this underpinning is - no sooner had it collapsed than shock waves reverberated, pounding the shares of regional banks, investment dealers, and government-chartered mortgage giants Fannie Mae and Freddie Mac.
Bank of Nova Scotia chief executive officer Rick Waugh, who helped spearhead an international report this week on reforming the financial system, says the real issue is contagion, and how, in such an interconnected market, one small problem can quickly beget a larger one, leading to calamitous effects the world over.
"Last year, the issue was subprime mortgages, which in the scheme of things was not a very large asset class. But then, of course, it built from that into CDOs, and other derivatives, and what have you," he explained. "The issue at IndyMac should be contained but we're in a globalized market - funding is global, investing is global," Mr. Waugh said in an interview this week. "And because we're in this period of uncertainty, we can't be complacent."
This uncertainty extends to IndyMac's customers, like the Ramirezes.
Facing payments they couldn't afford, they tried to keep up, paying $4,000, for two months. On April 15, a letter threatening imminent foreclosure came in the mail. Fearing the inevitable end, they stopped paying. They waited. And then: Nothing.
"We called the bank, there was no answer," Mrs. Ramirez, 43, who moved to the U.S. from Mexico in the late 1980s, said in Spanish in an interview at her workplace. "We are not getting any bills. We don't know how much longer we'll be there."
The Kindling
IndyMac prospered during a time of deregulation, low interest rates and a willingness by investors to shoulder greater risks.
In 1985, the firm that became IndyMac Bancorp - a contraction of International National Mortgage Corp. - was created as an arm of Countrywide Financial Corp., and evolved into a lender with a thrift charter that allowed it to take in deposits as a source of cheap funds.
The bank started small. Michael Perry, the company's long-time chief executive who was ousted this month when the government took over, joined IndyMac in 1993 when "we had four employees, had no business and were losing money."
But Mr. Perry had big ambitions. In 2000, when IndyMac ranked as the 28th-biggest lender in the country, the CEO called his bank a "leading Web-based consumer lender." He drew a salary of more than $750,000, with an allowance for club dues and a car. Already, the bank was making a name for itself in the new custom mortgage market; these mortgages didn't rely on the standard credit scores that are a core part of the traditional mortgage application.
Conditions were flourishing for the bank's growth. The bursting of the tech bubble led Federal Reserve chairman Alan Greenspan to slash the benchmark interest rate toward 1 per cent, and with rates that low, institutions such as pension funds that depended on conservative investments like Treasury bonds suddenly found themselves in a difficult place.
Wall Street, seeing an avenue of demand, used existing tools and rushed to package new products for their customers, buying up mortgages, securitizing them and selling them as asset-backed securities. Odd initials were stamped on the packages, such as CDOs. But mass securitizations didn't really explode in popularity until after the dot-com meltdown. The crucial difference this time was that banks actively worked with credit agencies to design products that could be stamped with a stellar triple-A rating, even though they contained some riskier subprime loans.
Record-low interest rates made borrowing and buying homes more affordable than ever. The American Dream of owning one's own home was suddenly in reach of tens of millions of people that would have never qualified for a mortgage before.
Mr. Perry's aggressive push to transform the bank into a big name from a bit player started to show results. IndyMac produced $30-billion worth of loans and earned a record profit of $171-million in 2003, claiming a 0.8 per cent stake in the U.S. mortgage business. Mr. Perry's pay rose to $7,163,410 in 2003, including a $5-million deferred compensation credit as his old job contract expired.
That year, mortgage interest rates hit a 50-year low and virtually every borrower who could refinance a mortgage did so that year, says Mr. Cecala, the Inside Mortgage Finance publisher. In 2003, U.S. house prices had their biggest one-year jump in more than two decades, pricing many lower-income Americans out of the market. Mortgage lenders faced a challenge: They needed to find new borrowers.
For banks such as IndyMac, one option was to find borrowers who had never traditionally qualified for mortgages, such as people who couldn't document their income. Alt-A looked like the answer.
IndyMac - "raise your expectations" was its slogan - made this category its niche. Alt-A loans are mortgages for home buyers who have better credit than subprime borrowers but don't have fully documented income, such as pay stubs.
Alt-As were originally conceived for wealthy people with erratic incomes, such as the self-employed, small-business owners or the rich who had low base salaries but large bonuses. Over time, the product aimed increasingly at lower-income borrowers like the Ramirezes, who would otherwise have taken out subprime mortgages.
IndyMac had hit a sweet spot. In 2001, Alt-A claimed 2 per cent of the overall U.S. mortgage market with $55-billion in loan production; but by 2006, with the target market expanding, it was 13 per cent, worth $400-billion annually, according to Inside Mortgage Finance.
In the three years after 2003, despite the forecast of an industry slowdown, IndyMac grew by leaps and bounds. "Much of its rapid growth since 2003 was based on the fact that they were very much in the hottest area of the residential mortgage market, which was the Alt-A market," Mr. Cecala said.
And by 2006, IndyMac was the most prolific, ranking as the No. 1 lender in the category at $70-billion in Alt-A volume - almost 80 per cent of its business. The bank's total market share rose rapidly to 3.3 per cent by the height of the housing bubble in 2006 - $90-billion in new loans.
The bank continued to bundle and sell the majority of its mortgages, which worked their way through the financial system into the hands of debt investors around the world. In this way, bond investors became exposed to the company's lending standards.
When a $650-million offering of triple-A-rated bonds backed by roughly 3,000 IndyMac mortgages - many of which were interest-only mortgages - came to market in June of 2005, more than a dozen investors from Europe, Asia and the U.S. stepped up. The bonds typically yield 0.75 to 1.15 percentage points more than comparable Treasuries.
"There's this insatiable appetite for mortgage-backed securities worldwide," Andrew Sciandra, who was a senior vice-president at IndyMac, told The Wall Street Journal. He said he'd met with investors from Germany to Abu Dhabi, and that Asian investors accounted for about 10 to 20 per cent of mortgage securities sold by IndyMac.
Spreading the risk
Investors in Abu Dhabi and Germany had little knowledge of the assets in California, Florida and elsewhere backing their securities. They didn't know that IndyMac's mortgage application software allowed borrowers to fill out an online form that could be analyzed within minutes.
IndyMac and its rivals, such as Countrywide and Washington Mutual, were creating ever-more-exotic customized mortgages, luring buyers with low introductory interest rates (that would shoot up after a year), or sometimes the option to skip payments, paying interest only, at least up front, and handing out mortgages without confirming incomes.
Alt-As aren't necessarily a disaster. A lender, instead of requiring a tax return, can ask for at least a bit of proof of income, like one pay stub.
But as the boom intensified, they came to be called "liar's loans" - with the Mortgage Asset Research Institute finding that almost all borrowers exaggerated their incomes by at least a little bit and half of prospective homeowners raised their numbers by more than 50 per cent.
Among IndyMac's most popular offerings was the FlexPay, an ARM (adjustable-rate mortgage) with various payment options, where the bright shiny lure in 2005 was a 1 per cent starting rate - generating a third of its business that year. The Ramirezes bought their $445,000 house with such a mortgage. FlexPay, an IndyMac website advertised, was "about choices." Beyond actually paying the normal amount, there was a minimum payment option - "which saves you the most cash" - and interest-only payments - "keeps your payment low but still pays all interest due."
All of this helped drive housing prices higher with added demand, and delivered ever-more mortgages in packages to Wall Street to resell.
As investors clamoured for more of these highly rated, high-yielding securities backed by mortgages, the investment banks needed more product. That created a vicious circle, inciting lenders like IndyMac to burrow further down the risk chain in search of home buyers.
Indeed, the total value of CDOs issued in 2004 ballooned to $157-billion. The following year it had almost doubled to $271-billion. And in 2006, it soared to $552-billion, according to the Securities Industry and Financial Market Association. New issuance was on pace for a record once again in the first half of last year, before the carnage coursed through the subprime sector and CDO sales ground to a halt.
A primary lender wouldn't normally give away money to a person unlikely to pay it back. But that didn't seem to matter when a chain of financial players passed the buck down the line. "The securitization requirements were less rigid than a traditional bank would have for loans on its balance sheet," said Craig Emrick, a vice-president at Moody's Investors Service in New York, "The banks knew that they could essentially move the risk."
Although some were already warning in early 2005 that the property bubble was nearing the bursting point, the entire industry raced on.
IndyMac continued to churn out residential mortgage-backed securities. In May of 2005, IndyMac priced an $834.7-million home equity deal led by Morgan Stanley and UBS. In September, UBS Securities led a $686-million IndyMac home equity deal.
The packaged mortgage pools IndyMac sent to Wall Street weakened. Out of a $354-million pool in June, 2006, more than 90 per cent of the value was Alt-A stated income loans, according to a regulatory filing. In the first quarter of 2007 - when the Ramirez family bought their home - four out of five loans IndyMac sold were Alt-A. The percentage of Alt-A mortgages of the total sold in the U.S. peaked at 18.4 per cent between April and June of 2007.
The fire
By 2006, as real estate values flattened out, any house that could be refinanced had already been and anyone with relatively good credit already had a mortgage with a great rate. Lenders like IndyMac had to hunt harder. In its quest for more mortgage buyers, IndyMac, according to lawsuits filed in California and New York, went beyond simply pursuing the poor, the elderly and minority groups and engaged in predatory lending.
In a report issued on June 30 this year, a North Carolina advocacy group, the Center for Responsible Lending, chronicled IndyMac activity in cases similar to the Ramirez situation in detail by an investigative journalist, criticizing the bank's Alt-A odyssey as "unsound and abusive" lending.
Then, last summer, the credit crisis began. The Alt-A market quickly began to dry up, falling by more than half to 8.8 per cent in July-September from its height of more than 18 per cent in the spring.
By January-March this year, Alt-As were at 0.1 per cent of the total mortgages sold. IndyMac, scrambling for survival and having abandoned its niche business, tried to remake itself as a traditional lender.
Mr. Perry remained upbeat. "Talk of the 'subprime contagion' spreading to the Alt-A sector of the mortgage market is, in our view, overblown," he said in March of 2007. In August, as credit markets melted down, he said IndyMac had "limited exposure" to the crisis.
As recently as May 12, IndyMac said it was trying to raise new capital. "I'm confident IndyMac will be a survivor," Mr. Perry said as about 4,000 layoffs were announced, more than half the remaining work force.
But not everyone was convinced. On June 26, a letter written by Democratic Senator Charles Schumer of New York to regulators, expressing concern that IndyMac "could face a failure," was leaked.
Thus began a walk-run on the bank, with $1.3-billion withdrawn by the time the U.S. government, through the Federal Deposit Insurance Corp., took over IndyMac as the sun set on Friday, July 11, listing assets as of March 31 of $32-billion and deposits of $19-billion, most of them insured by Washington.
The failure will cost American taxpayers $8-billion.
"There was likely nothing that could have saved them," said Gary Townsend, CEO of Hill-Townsend Capital LLC. Without Mr. Schumer, "maybe the timing would have been different."
Who's Next?
The failure of IndyMac has already spawned a sort of death watch among banking analysts, who quickly amassed lists predicting which bank might be next. Some other large players in the mortgage market, like Washington Mutual, National City Corp. and Wachovia Corp., were particularly hard hit in markets - so much so that some officials were forced to make public statements to nervous investors, insisting that their financial health remained sound.
While the full impact of IndyMac's collapse on financial confidence and the greater economy has yet to be measured, the trail of debris it left in California is easy to follow.
The bank was reopened last Monday by federal officials to long lines and angry, agitated customers, sweating under the summer sun.
For Mrs. Ramirez, the dream of home ownership that so hypnotized her and her husband a couple of years ago now seems like a terrible trap.
She has four children at home, one of whom is soon to go to the hospital for an operation on his pancreas. Her husband is struggling with diabetes. "I feel tricked," Mrs. Ramirez said. "We are so stressed. We feel betrayed."
By the numbers
$12-trillion
Approximate value of the U.S. mortgage market.
2.5 million
Number of U.S. homes that could be hit with foreclosure this year, according to U.S. Treasury Secretary Henry Paulson.
1 in 501
Number of U.S. households that received a foreclosure filing in June, up 53 per cent from a year earlier.
0.99 per cent
Number of U.S. loans that entered the foreclosure process in the first three months of 2008, compared to 0.58 per cent a year earlier.
400
Number of U.S. real estate industry players that have been indicted since March following investigations of mortgage fraud.
53,000
Number of suspected mortgage fraud cases reported by U.S. banks last year, up from 37,000 a year earlier and about 10 times the level of reports in 2001 and 2002, according to the U.S. Treasury Department.
Mortgage Bankers Association, RealtyTrac, AP, Reuters
© The Globe and Mail
