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The Death of IndyMac

The credit crisis might go down in two distinct chapters: A rise in foreclosures that wrestles homeowners into submission, as we've seen in the past year and a half, and a second phase that up until now hasn't received as much attention: Bank failures.

Over the weekend, California-based IndyMac (NYSE: IMB  ) was seized by the FDIC, the government organization that insures bank deposits, in what could go down as one of the costliest bank failures ever. Once the smoke clears, the FDIC could be on the hook for between $4 billion and $8 billion. That's a seriously scary chunk of the $53 billion it has set aside for such episodes.

Fire in the hole!
The final blow to IndyMac came when Sen. Charles Schumer notified the FDIC and the Office of Thrift Supervision that the bank was in some seriously deep doodoo. That triggered a good ol' run on the bank, with customers yanking out more than $1.3 billion in deposits in the ensuing 11 business days. IndyMac tried to kill the run by offering CDs at interest rates that blew away the competition, but it didn't do the trick. IndyMac woke up Monday morning with a depressing new name: IndyMac Federal Bank.

Should Schumer be blamed for IndyMac's demise, as a handful of pundits continue to insist? He's undoubtedly responsible for the timing of the collapse, but it's silly to blame him entirely. IndyMac killed itself; Schumer just organized the funeral.

It seemed like a great idea at the time ...
IndyMac was a huge pusher of so-called Alt-A mortgages, which don't conform to the highest lending standards, but have a bit more merit than what would be considered subprime. Alt-A mortgages were a perfect tool for borrowers who couldn't document their income or assets, and chose to simply state their financial standing. From the get-go, you can see the obvious flaw in this practice: The quality of the loan relies on the honesty of the borrower, which is completely outside IndyMac's control.

As reported in the FBI Mortgage Fraud Report, as many as 70% of borrowers in early default significantly misrepresented information on their mortgage application. Think about that: 70%. When real estate values soar and easy fortunes abound, fudging the numbers might have just been too tempting to pass up. Give someone a huge financial incentive to bend the truth, and the results shouldn't be surprising.

The trouble is, the honesty of the buyer and the health of the real estate market had to stay in sync for things to work out. If homeowners can't pay their mortgage, but the property can be sold for more than the value of the loan, everything's cool. If real estate values plunge, but the owner can keep making monthly payments, everything's cool. If one of these two parts falls out of whack, you've got problems. When both get completely flushed down the toilet -- like we're seeing today -- it's bye-bye, banks. Done. Failed. Finito. Sayonara.

In hindsight, it seems all too apparent: Lend money to people who can't pay it back, and secure it with blatantly inflated assets, and bad things will happen. At the height of their glory, alternative lenders like IndyMac had to be in one of two positions: Either they had divine wisdom over borrowers that traditional lending standards had dismissed, or they were running around with sticks of dynamite. We now know it was the latter.

What does this mean for the industry?
Bear Stearns got picked up by JPMorgan Chase (NYSE: JPM  ) , Countrywide got adopted by Bank of America (NYSE: BAC  ) , and Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) are getting propped up by the government. The prevailing wind over the past six months seems to have been consolidation and assistance, rather than downright failure.

IndyMac's collapse could mark a turning point in the already hammered banking sector. While it wasn't the first to go, it's been the highest-profile casualty that didn't get either bought out or bailed out. Now that the industry knows the "too big to fail" motto isn't a universal standard, the severity of uncertainty gets kicked up a notch. Names like Washington Mutual (NYSE: WM  ) , Wachovia, and Zions Bancorp (NYSE: ZION  ) suffered massive losses on Monday as investors shifted attention from losses and writedowns to complete failures.

Surely, more banks will fail, and more than a few names will pop up on the radar. Who's next on the hit list? More on that tomorrow.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.

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