IndyMac Bank's failure, and the cleanup that followed, were shocking, but not unprecedented in the structured finance market.
Failed bank IndyMac had $200 billion in outstanding loans in its mortgage servicing portfolio at the end of 1Q08 and a sizable presence in the trust-preferred securities (TruPS) CDO market, and thus, the implications of its downfall could be particularly troublesome for the ABS market.
Industry participants are fretting over the size of IndyMac's servicing portfolio and the concentration of its risk, since a majority of its pool had been securitized. In fact, approximately $184 billion out of the $200 billion in IndyMac's pool of loans were sold or securitized with servicing retained by IndyMac, Credit Suisse said in a recent report.
Of the loans in the servicing portfolio, 43% were originated in California. In the overall pool, 33% were hybrid arms and 39% were fixed rate. As of June, private-label MBS made up about $75 billion of the pool, with $11 billion in home equity ABS, including second liens and subprime loans, Credit Suisse said. More than $60 billion are loans backing Fannie Mae and Freddie Mac MBS.
Part of the worry regarding IndyMac's loan book is what will happen to these assets under the Federal Deposit Insurance Corp.'s (FDIC) conservatorship.
During the savings-and-loan crisis that started in the 1980s, the market used securitization technology to repackage loans and the risks associated with them. The Resolution Trust Corp. and other institutions sold securities that were backed by them.
"This was arguably part of what spawned the whole world of structured finance and securitization as we know it today," said Paul Jorissen, co-chair of the finance practice at Mayer Brown.
However, this time it's quite a bit different, Jorissen said. This is partly because of the array of financial products involved and the new players participating in the securitization industry, including private equity investors, hedge funds and proprietary trading desks at investment banks, "all of whom are interested in attractive ways to acquire or finance this risk that is sitting on the books of these financial institutions," he said.
As a result, the structured finance market has deployed a whole arsenal of techniques to sell or shift the risk of the assets held by these institutions, Jorissen said. "Some of the deals are structured as straight investments, and others use financing techniques including synthetic structures where you are entering into derivatives to shift some of the risk to investors," he said.
In the meantime, the ultimate amount of delinquencies and losses in IndyMac's outstanding pool of loans has yet to be realized.
Another Hit for CDOs
IndyMac is also a heavy player in the TruPS CDO market, which is expected to be hit hard as a result of the bank's failure.
One victim, Alesco Financial, a specialty REIT that invests in trust-preferred securities, said that it will take a tax loss of about $86 million, which represents its proportionate share of $125 million in IndyMac securities, which Alesco holds in eight CDOs. This will "significantly offset Alesco's expected taxable income for the year ending Dec. 31, 2008," the company said in a recent statement.
But Alesco is not the only fund that could be facing losses from IndyMac's receivership.
"It appears quite likely that the trust-preferred securities will be wiped out, given that they are obligations of the holding company," said Kathleen Shanley, an analyst at GimmeCredit.
The parent company depleted much of the holding company's liquidity by contributing $88 million to the bank in the first quarter, Shanley said. And since the FDIC is projecting losses of $4 billion to $8 billion, and there are $1 billion in uninsured deposits, the trust-preferred securities could receive a distribution from the bank only if all these claims are settled, which seems unlikely, she said.
Others agreed. "The TruPS at IndyMac are at the lower bottom of the capital receivership; they are just above the equity stocks," said Maggie Wang, an analyst at JPMorgan Securities. "While there could be some recovery by the FDIC for TruPS, we think it is very limited."
Furthermore, IndyMac's steady issuance in the TruPS CDO market makes potential widespread losses a concern. "Based on the sample of 35 deals we surveyed, which is probably one-third of the whole TruPS CDO universe, we find IndyMac is the top issuer in hybrid TruPS CDOs, with a 2% concentration on average, and is also the third-largest issuer in bank TruPS CDOs," Wang said.
Losses may also be more severe in TruPS CDOs where IndyMac exposure is comparable to, or higher than, modeled U.S. bank failure rates. Historically, bank failures averaged 0.25% per year, 1% to 2% for broad commercial banks and 5% to 10% for savings and loans in times of crisis, according to a JPMorgan report.
We Cover the Banks That Cover You
The good news is that the FDIC is doing what it is supposed to, sources agree. The FDIC will continue to operate the bank and collect the money on its assets, which are predominantly mortgages in this case.
What the FDIC really does is protect depositors, said Bart Narter, senior analyst at Celent.
"The FDIC does not want to be in the bank operation business. In the short term, it operates the bank, but it is going to want to sell IndyMac to another bank or mortgage company," Narter said. This will be at a discount because of the risk involved that more mortgages will default. "It is an insurance company and this is a loss, but that is why banks pay premiums into the system to cover this," he said.
A sale, in this case, could take up to a year, Narter said, because of the amount of due diligence and risk assessment that is required for IndyMac's mortgage portfolio. "In this market, valuing a mortgage is a tough thing to do," he said.
Other firms in similar situations include subprime mortgage lender Fremont General Corp., which filed for bankruptcy in June, and sold $5.6 billion in deposits and 22 bank branches to CapitalSource. CapitalSource is using the assets to form a California industrial bank. Fremont also sold its commercial real estate loans to the company at a 3% discount.
Some asset sales are already in the works for IndyMac. Before the bank's failure, Prospect Mortgage had entered into an agreement with the bank to purchase up to 80 of IndyMac's mortgage retail branches nationwide, and said it will carry out the transaction despite the FDIC conservatorship. Prospect will also hire 750 IndyMac employees as part of the deal, which is slated to close on Aug. 7. The branches acquired in the transaction will remain in operation throughout the integration, funding loans and accepting new business, the company said.
John Johnston and Ron Bergum, co-heads of the retail branch group at IndyMac, will remain in their positions and report to Mark Filler, chief executive officer at Prospect. Loan officers and other employees that move to Prospect will continue to work with their borrowers, Prospect said.
Overseeing the Process
However, further asset sales are still up in the air. The FDIC tapped Thacher Proffitt & Wood last week to serve as counsel in its conservatorship. While the exact role of Thacher Proffitt has not yet been determined, a lot will rest on the FDIC's resolution decisions for IndyMac.
"I believe our firm was tapped as a primary legal resource because of the combination of our extensive experience with the type of assets on the IndyMac balance sheet, including the different products in the loan portfolio and their extensive servicing portfolio, and our extensive experience representing financial institutions," said Robert Azarow, partner in the corporate and financial institutions group. He will lead the team along with Stephen Kudenholdt, chair of the structured finance practice group.
Azarow said that since most of the assets being serviced by IndyMac are in securitization structures, Thacher's experience in securitization is key. The firm was also active in the banking and thrift crises in the late 1980s and early 1990s, representing financial institutions that had been buyers of these types of assets.
The firm will also have to sort through the reams of lawsuits that have arisen from the troubled loans that IndyMac issued. Last month, bond insurer XL Capital Assurance filed a complaint against IndyMac. The bank had dismissed the monoline's request to inspect IndyMac's origination files and servicing records for Home Equity Mortgage Loan Asset-Backed Trust, Series 2006-H3, a $501 million home-equity mortgage loan securitization that XL Capital Assurance had guaranteed, after the monoline found that IndyMac had breached representations and warranties within the pool.
Radian also filed a complaint last month against IndyMac - as well as other banks such as Deutsche Bank - alleging that the loans the guarantor wrapped also breached reps and warranties within the securitization. Radian claimed that IndyMac knew the reps and warranties were either not true when they made them or were made "in bad faith."
Meanwhile, last week, Milberg announced that it was investigating possible illegal conduct at IndyMac Bank. The firm is accusing the bank of violating the Employee Retirement Income Security Act of 1974.
In this case, Milberg said IndyMac knew or should have known that it had a growing portfolio of nonperforming assets, including pay-option adjustable-rate mortgages and its home builder construction portfolio. This has made IndyMac common stock an "imprudent, inappropriate and risky investment" for the plan's participants, Milberg said.
Azarow could not comment on IndyMac litigation directly.
As of April 2008, there had been 132 securities lawsuits related to subprime and credit issues, 56 of which were filed since January 2008, according to a recent NERA Economic Consulting report. New York has the most filings, with 48%, while California followed with 14% and Florida with 7%. Filings in other states range between 1% and 5%, NERA said.
Right now, market participants are anxiously waiting to see how IndyMac resolves its current problems, as well as how the rest of the mortgage market fares.
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