IndyMac: Too Big to Fail?

This post first appeared on Minyanville.

Federal regulators may soon be forced to decide if IndyMac Bank (IMB) is too big to fail.

IndyMac?

Spun out of Countrywide (CFC) in the late 1980s, IndyMac is a Southern California thrift and mortgage originator specializing in loans a couple of notches above subprime. Known as “Alt-A,” these mortgages thrived during the credit boom, when verifying a borrower's income was considered due-diligence overkill.

IndyMac aggressively issued these loans, along with billions in option adjustable rate mortgages, or option ARMs, to become the country’s second largest private mortgage lender. Countrywide is was number one.

Since the mortgage market stumbled last year, however, IndyMac's shares have plummeted. They now sit at just 70 cents per share, down from over $47 in December 2006.

Thanks to Senator Chuck Schumer, the Federal Reserve may need to decide whether IndyMac’s potential demise is too great a risk for the fragile financial system to bear. According to The Wall Street Journal, Schumer sent a letter to banking regulators last week suggesting that they look more closely into the bank’s financial strength - and the potential implications of its collapse.

The letter kicked off a small-scale bank run, with frightened customers yanking $100 million, or 0.5%, out of total deposits.

Yesterday, in a statement to the Securities and Exchange Commission, IndyMac said it hoped the stampede caused by Schumer’s letter would soon subside; branch traffic is already slowing. The bank claims to be working closely with the Federal Deposit and Insurance Corporation (FDIC) to strengthen its balance sheet.

At issue isn't whether another troubled mortgage company will go bust - IndyMac certainly wouldn’t be the first. But Schumer’s involvement is likely to force Chairman Bernanke’s hand, compelling him to determine which firms fall under the shadow of the Fed’s umbrella.

By orchestrating a bailout of Countrywide by Bank of America (BAC), as well as of Bear Stearns by JP Morgan (JPM), the Fed set a dangerous precedent. While there may have been sound arguments for saving these firms to prevent outright financial panic, can the same be said about IndyMac, a bank with a market capitalization of just $70 million?

And what about KeyCorp (KEY), Fifth Third (FITB) or Zions Bancorp (ZION), all of which have recently gone to the rapidly closing financing window?

These are questions regulators must answer, and soon.

Struggling companies -- especially banks -- need to go bust, in order to stimulate healthy new growth. The Fed's propping-up of doomed institutions only forestalls or hampers this process.

The financial system is bloated with firms that should go out of business - and it's time that it went on a diet.