This Weekend's Contemplation #2 - Hope is Not a Strategy

I periodically correspond with Lon Witter in Lousiville that does investment advising for a living. I first saw an Op/Ed piece that he wrote for Barron's about 2 years ago so we have communicated off and on over that period. He recently sent me the piece below so I thought some of my readers might be interested in his comments. For completeness I have included Lon's advertising at the end. Text in bold is my emphasis. So with Lon's permission:

By now, most investors should realize that traditional, long-only investment managers, mutual funds, and buy and hold investors are in serious trouble. They "hope" that the market will soon recover and go back to new highs as it did from 1985 to 2007. That is entirely unlikely and "hoping" is not a strategy. The economic environment today is vastly different from the one that prevailed from the early 1980's to 2007.

So what makes today so different from the past 25 years? Let’s go back to 1985 to compare. In 1985, interest rates, inflation, and taxes were beginning a 23 year downtrend. Free trade was in its infancy. The greatest credit expansion in history had just begun. There was no trade deficit. The dollar was strong. Budget deficits turned to surpluses by the late 1990's. Owning a home was the American dream as the value of a home only appreciated. In 1985, we were in the beginning of a great expansionary economic period. Is it any wonder why the stock market would always recover and reach new highs in such a positive economic environment? Today, these positive economic trends have reversed. Why would an investor expect the stock market to recover like it did for the past 25 years when the economic environment is so different?

We are not in a business recession; we are in a consumer recession. All recessions since World War II have been business recessions. Business recessions occur when businesses over-expand and over-hire in good times, then have to retract until the inventory build-up dissipates. Then the business cycle begins again. Consumer recessions occur when the consumer is no longer able to spend the amount needed to maintain economic growth.

The American consumer is 67% of our economy and 20% of the world's economy. The American consumer is the engine that drives the world’s economy. If the engine breaks down, the world’s economic train grinds to a halt. The American consumer must increase his spending annually by approximately 3.3% to keep the world's economic train on track. This has not been a problem since World War II, until today. For many years, the salary of the American consumer increased 3.3%. In the years that salary did not increase by at least 3.3%, the American consumer could tap into savings, use a credit card or borrow against home equity to make up the difference. For the past 60 years, the American consumer had no problem increasing his spending by 3.3% a year.

2008 will be the first year the American consumer leads the world’s economy into a recession because spending fails to increase by 3.3%. For the past few years, the average salary increase has only been 1.7%. The consumer cannot tap into savings because the savings rate has been 0. Banks are responding to the credit crisis by restricting credit at the same time home prices are declining; therefore, increased borrowing is not a viable option for consumers. To make matters worse, the skyrocketing energy, food, and health care costs leave Americans with fewer dollars for discretionary spending.

To get out of this recession, one of the following four things must occur: 1) Salaries must go up at a rate greater than 3.3%, 2) Banks must extend credit to the average consumer and make terms easier, 3) Home prices must significantly recover lost market value or 4) The cost of energy, food, and health care must decrease significantly. Unfortunately, none of the above is likely in the near future.

It took the stock market 25 years to recover from of the excesses of the industrial revolution, 15 years to recover from the excesses of the roaring twenties, and 12 years to recover from the inflation/oil crisis of the early 70's. How long do you think it will take the stock market to digest the excesses of a housing bubble, credit expansion and rising food and oil prices, all at the same time?

Optimists will agree that the long range returns from the stock market are unlikely to be better than 5½% plus dividends. From 1985 through 2007, the S&P 500 earned 11% plus dividends. If the stock market averages 0% plus dividends for the next 23 years, it would merely bring us back to the expected long range returns. Is your portfolio prepared for the stock market to average 0% plus dividends for the next 23 years? I believe that traditional mutual fund managers and investment advisors will be the farriers of the 21st century.

Witter & Westlake Investments Programs Update
Witter & Westlake’s ProFunds Original and Gold Programs are now being monitored by Theta Investment Research. Theta Investment Research independently verifies the returns of investment managers by monitoring the daily returns of an actual traded account. I am pleased to announce that our 6-month returns for the ProFunds Original program were 10.67% after fees and that our 12-month returns were 27.38%. Our 12 month risk adjusted rate of return was in the 99th percentile. Our 6-month returns for the Gold Program were 16.14% after fees and our 12 month returns were 39.36%. Our 12-month risk adjusted rate of return was in the 96th percentile. All numbers were as of 06/30/08.

If you would like to view our record at Theta Investment Research, please contact Witter & Westlake Investments at (502) 339.8840 or by email at lon@witterwestlake.com.

This Weekend's Contemplation - The Summer of 1931

Many people believe that the stock market crash of 1929 caused the Great Depression. The crash of 1929 is probably a symptom and not the cause of the Great Depression. Based on the book I am reading by Charles Kindleberger the World Depression much of the cause and continued severity of the Great Depression was a credit issue (sound familiar) and 1931 was the breaking point. The book a a tough slog in places because it is very detailed and includes the whole world, not just the US, but it is worth a read. There are too many similarities to be ignored.

Back the article. The following is again from the UK Telegraph and goes into the similarities between the current state of affairs and 1931.

It feels like the summer of 1931. The world's two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution.

The International Monetary Fund has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7pc to 4.1pc growth, whilst warning of a "chance of a global recession". Plainly, the IMF cannot or will not offer any useful insights.

Its "mean-reversion" model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True "mean-reversion" would imply debt deflation on such a scale that would, if abrupt, threaten democracy.

The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.

The eurozone is falling into recession before the US itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9pc to 1.8pc.

The US may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest. US bank credit has contracted for three months. Real US wages fell at almost 10pc (annualised) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch.

No doubt the rescue of Fannie Mae and Freddie Mac - $5.3 trillion pillars of America's mortgage market - stinks of moral hazard. The Treasury is to buy shares: the Fed has opened its window yet wider. Risks have been socialised. Any rewards will go to capitalists.

Alas, no Scandinavian discipline for Wall Street. When Norway's banks fell below critical capital levels in the early 1990s, the Storting authorised seizure. Shareholders were stiffed.

But Nordic purism in the vast universe of US credit would court fate. The Californian lender IndyMac was indeed seized after depositors panicked on the streets of Encino. The police had to restore order. This was America's Northern Rock moment.

IndyMac will deplete a tenth of the $53bn reserve of the Federal Deposit Insurance Corporation. The FDIC has some 90 "troubled" lenders on watch. IndyMac was not one of them.

The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the US could always get out of trouble by monetary stimulus "à l'outrance", and letting the dollar slide. He has learned that the world is a more complicated place.

Oil has queered the pitch. So has America's fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the US national debt from German 'AAA' levels to Italian 'AA-' levels.

China, Russia, petro-powers and other foreign states own $985bn of US agency debt, besides holdings of US Treasuries. Purchases of Fannie/Freddie debt covered a third of the US current account deficit of $700bn over the last year. Alex Patelis from Merrill Lynch says America faces the risk of a "financing crisis" within months. Foreigners have a veto over US policy.

Japan did not have this problem during its Lost Decade. As the world's supplier of credit, it could let the yen slide. It also had a savings rate of 15pc. Albert Edwards from Société Générale says this has fallen to 3pc today. It has cushioned the slump. Americans are under water before they start.

My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6pc in Holland and 5.5pc in Sweden.

The coalitions in Belgium and Austria have just collapsed. Germany's left-right team is fraying. One German banker told me that the doctrines of "left Nazism" (Otto Strasser's group, purged by Hitler) had captured the rising Die Linke party. The Social Democrats are picking up its themes to protect their flank.

This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain.

Finance minister Pedro Solbes said Spain is facing the "most complex" economic crisis in its history. Actually, it is very simple. The country was lulled into a trap by giveaway interest rates of 2pc under EMU, leading to a current account deficit of 10pc of GDP.

A manic property bubble was funded by foreigners buying covered bonds and securities. This market has dried up. Monetary policy is now being tightened into the crunch by the ECB, hence the bankruptcy last week of Martinsa-Fadesa (€5.1bn). With Franco-era labour markets (70pc of wages are inflation-linked), the adjustment will occur through closure of the job marts.
China, India, East Europe and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own "inter-temporal overdrafts".

If we are lucky, America will start to stabilise before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble.

Survey of Investors by Merrill Lynch

The following from my favorite English writer (Stephen Ambrose-Pritchard) summarizes a survey of investors recently done by Merrill Lynch. You can take from it what you like (I do not agree with everything), but most investors consider a worldwide recession to be their major problem. From the UK Telegraph:

Fund managers across the world are dumping stocks and retreating to cash in a mood of extreme pessimism, fearing that the looming economic crunch is an even greater threat than inflation.

The latest survey of investors by Merrill Lynch shows that an unprecedented 41pc now think that a world recession is either likely or very likely. The majority dismiss hopes of double-digit earnings growth next year as "fantasy".

"People are a lot more scared about the macro-outlook. The survey has never seen anything like this before since it began a decade ago," said David Bowers, the organiser of the report.

"Recession risk has taken over from inflation risk. Fund managers believe the global economy is deteriorating so fast that a wage-spiral is never going to happen, at least in developed markets," he said. The survey is based on 191 funds managing assets worth $610bn (£305bn).

The US is emerging as the one bright spot in the global gloom, despite the credit mayhem. A net 7pc of investors are overweight in US equities, clearly betting that most of the bad news is already in Wall Street prices. The figure was negative in May.

With the tailwind of 2pc interest rates and a cheap dollar, America stands to benefit from the "first-in, first-out" principle. Others have yet to take their full punishment from the cycle.
"The US has now become the country of cheap manufacturing. You've got 20pc wage inflation in emerging markets so FDI (foreign direct investment) is flowing back there," said Karen Olney, Merrill's chief European equity strategist.

The investor love affair with India, China, and Asian markets over the last nine months has turned sour.

"That trade is off," said Mrs Olney. A net 75pc are underweight Indian equities as the country's inflation reaches double digits. Chile (-69), Taiwan (-50), Korea (-50), Malaysia (-44) are not far behind.

Mr Bowers said investors had woken up to the nasty reality that emerging markets have let rip with inflation and will now have to jam on the brakes.

Those with dollar pegs or dirty floats like China have, in effect, been "destabilised" by the US Federal Reserve's rate cuts.

"These countries have used the Fed as their anchor. Rates of 2pc have challenged their economic models," he said.

Russia (+75) remains the darling of the emerging universe, but for how long? Almost two thirds of investors say oil is fundamentally overvalued. They appear to be hanging on to their oil and gas exposure as a late-cycle "momentum play".

A net 42pc think the Bank of England has kept interest rates too high given the housing slump and the consumer squeeze. Not a single respondent thinks that the UK is going to get better over the next year. They are ditching bank stocks (-83) and property (-92).

Europe is not faring much better. Some 96pc think the economy will get worse over the next year, up sharply from the June survey. A majority believe inflation will fall, and a net 24pc say the European Central Bank is engaging in overkill. Not surprisingly, a record 32pc are now underweight eurozone equities.

Few see stocks as cheap even after the rude sell-off this summer. "Investors think earnings are going into a free-fall," said Mrs Olney. "Healthcare companies offer immunity from the three horrors that are bugging investors: a rising oil price, the slowing economic cycle and the credit crisis."

Japan is sneaking back into favour after years in the wilderness, if only by default. "Japanese banks are the winner from the credit crunch. Japan now has the capacity to be the monopoly supplier of capital to the world once again," said Merrill Lynch.

Indy Mac Could Drain 10% of FDIC's Insurance Fund

Indy Mac is a real hit the FDIC Insurance Fund. This is going to be a story worth following over the next few months, until the next big bank seizure. As an historical note, I guess I worked for the bank at the time of its failure which is still the largest bank failure in US history. From the WSJ:

IndyMac Bank, a prolific mortgage specialist that helped fuel the housing boom, was seized Friday by federal regulators, in the third-largest bank failure in U.S. history.

IndyMac is the biggest mortgage lender to go under since a fall in housing prices and surge in defaults began rippling through the economy last year -- and it likely won't be the last. Banking regulators are bracing for a slew of failures over the next year as analysts say housing prices have yet to bottom out.

The collapse is expected to cost the Federal Deposit Insurance Corp. between $4 billion and $8 billion, potentially wiping out more than 10% of the FDIC's $53 billion deposit-insurance fund.

The Pasadena, Calif., thrift was one of the largest savings and loans in the country, with about $32 billion in assets. It now joins an infamous list of collapsed banks, topped by Continental Illinois National Bank & Trust Co., which failed in 1984 with $40 billion of assets. The second-largest failure was American Savings & Loan Association of Stockton, Calif., in 1988.

The director of the Office of Thrift Supervision, John Reich, blamed IndyMac's failure on comments made in late June by Sen. Charles Schumer (D., N.Y.), who sent a letter to the regulator raising concerns about the bank's solvency. In the following 11 days, spooked depositors withdrew a total of $1.3 billion. Mr. Reich said Sen. Schumer gave the bank a "heart attack."

"Would the institution have failed without the deposit run?" Mr. Reich asked reporters. "We'll never know the answer to that question."

Mr. Schumer quickly fired back.

"If OTS had done its job as regulator and not let IndyMac's poor and loose lending practices continue, we wouldn't be where we are today," Sen. Schumer said. "Instead of pointing false fingers of blame, OTS should start doing its job to prevent future IndyMacs."

IndyMac had been troubled for months, and investors were concerned about its possible downfall well before Sen. Schumer's comments. It specialized in Alt-A loans, a type of mortgage that can often be offered to borrowers who don't fully document their incomes or assets. The company sold most of the loans it originated, but continued to hold some on its books. As defaults piled up, IndyMac's finances deteriorated.

The bank will be run by the FDIC and reopen Monday. The FDIC typically insures up to $100,000 per depositor. IndyMac had roughly $19 billion of deposits. Nearly $1 billion of those deposits were uninsured, affecting about 10,000 people, the FDIC said.

IndyMac's arc -- rapid growth, followed by an even more rapid descent -- is a microcosm of the mortgage industry. It boomed in the first part of this decade, as investors were willing to fund loans on ever-looser terms, then hit hard times when the housing market began to turn down in late 2006.

Small mortgage lenders started going under quickly, with the number of failures climbing into the hundreds. Now the fallout has spread world-wide, bringing down some of America's largest financial institutions. Bear Stearns Cos., which suffered losses on mortgage-related investments, underwent a meltdown in March and had to be rescued by J.P. Morgan Chase & Co.

Countrywide Financial Corp., at one time the nation's largest mortgage lender, saw its stock price plunge this year and was forced to sell itself to Bank of America Corp. at a firesale price.

IndyMac, in a last-ditch effort to fend off collapse after it failed to raise fresh capital, said this past week it was firing more than half its work force and closing most of its lending operations. While its shares had been tumbling since early 2007, the move was nonetheless jarring for a company that ranked as the ninth-largest U.S. mortgage lender last year in terms of loan volume, according to trade publication Inside Mortgage Finance.

IndyMac is one of the few federally insured banks to fail in recent years. Banking regulators are bulking up their staff of bank examiners and taking a tough approach toward banks that are seen as risky.

Mr. Reich, the thrift regulator, noted that the IndyMac case had some "unique" features, including the involvement of Sen. Schumer and the rapid fall in its deposits. Officials said most of the recent withdrawals came from depositors at branches, rather than those making deposits at IndyMac's online bank.

IndyMac was set up by Countrywide in 1985, but the two companies severed ties in 1997 and became direct competitors. The company's name stands for Independent National Mortgage. It was created to specialize in jumbo mortgages -- those that are too big to be sold to government-backed Fannie Mae and Freddie Mac. In 1997, under the direction of Chief Executive Michael Perry, a protege of Countrywide chief Angelo Mozilo, IndyMac set off on its own.

The company grew quickly, pioneering the issuance of so-called Alt-A mortgages to people with blemished credit histories. The loans have gained notoriety as an example of the type of lax lending that came to characterize much of the mortgage industry.

Early last year, Mr. Perry remained optimistic about IndyMac's future, insisting that the company had the resources to remain independent. At the time, IndyMac's stock was trading for about $45 a share.

But the combination of the frozen credit markets and mounting defaults on IndyMac loans steadily sapped investor confidence in the company. In February, IndyMac reported the first annual loss in its 23-year history. By this week, its shares, which ended last year at less than $7 each, were trading for 28 cents apiece.

The company was desperate for more capital but couldn't find investors willing to put fresh funds into what looked like a crippled institution.

The failure could be felt across the entire banking industry, as the FDIC will likely have to raise insurance assessments for all banks to build up government reserves. "It takes a big chunk out of the FDIC insurance fund," said Chip MacDonald, a banking lawyer at law firm Jones Day. He said that if the FDIC hikes insurance fees, that will add to already-intense pressure on bank profits.

The OTS and FDIC didn't secure any outside firm to acquire the bank's assets. The FDIC will temporarily run the bank through a new bank it has created, called IndyMac Federal Bank, FSB.

The Weekend’s Contemplation – The BIS Thinks We Are Near a Tipping Point

In case you found the news about Fannie, Freddie, and Indy Mac this last week a little hum-drum the Bank of International Settlements (BIS) believes we are near a “tipping point”. Three decades of watching the banking industry leads me to believe that most of us cannot grasp how serious the situation is. Do you know where your money is? Text in bold is my emphasis. From the UK Telegraph:

A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. This has proved frighteningly accurate.

The venerable body, the ultimate bank of central bankers, said years of loose monetary policy had fuelled a dangerous credit bubble that would entail "much higher costs than is commonly supposed".

In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to "clean up" once property bubbles have burst.

If only we had all listened to the BIS a long time ago. Ensconced in its Swiss lair, it has fired off anathemas for years, struggling to uphold orthodoxy against the follies of modern central banking.

Bill White, the departing chief economist, has now penned his swansong, the BIS's 78th Annual Report, released today. It is a disconcerting read for those who want to hope the global crisis is over.

"The current market turmoil is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point," it said.

"These fears are not groundless. The magnitude of the problems yet to be faced could be much greater than many now perceive," it said. "It is not impossible that the unwinding of the credit bubble could, after a temporary period of higher inflation, culminate in a deflation that might be hard to manage, all the more so given the high debt levels."

Given the constraints under which the BIS must operate, this amounts to a warning that monetary overkill by the Fed, the Bank of England, and above all the European Central Bank could prove dangerous at this juncture.

European banks have suffered worse losses on US property than American banks. Their net dollar liabilities are $900bn, mostly short-term loans that have to be rolled over, a costly business with spreads still near panic levels. Mortgage and consumer credit has "demonstrably worsened".

The BIS cautions the ECB to handle its lending data with great care. "The statistics may understate the contraction in the supply of credit," it said.

The death of securitisation has forced banks to bring portfolios back on to their balance sheets, while firms in need are drawing down pre-arranged credit lines. This is a far cry from a lending recovery.

Warning signs are flashing across Eastern Europe (ex-Russia) where short-term foreign debt is 120pc of reserves, mostly in euros and Swiss francs. Current account deficits are 14.6pc of GDP.
"They could find it difficult to secure foreign funding if global financing conditions were to tighten more severely," it said. Swedish, Austrian and Italian banks have drawn on wholesale markets to lend heavily to subsidiaries across the region. This could "dry up".

China is not immune, although the BIS has dropped last year's comment that growth is "unstable, unbalanced, unco-ordinated and unsustainable".

The US accounts for 20pc of China's exports, but that does not capture the inter-links across Asia that ultimately depend on US shopping malls. "There is a risk that China's imports overall could slow down sharply should the US economy weaken further," it said.

Global banks - with loans of $37 trillion in 2007, or 70pc of world GDP - are still in the eye of the storm.

"Inter-bank money markets have failed to recover. Of greatest concern at the moment is that still tighter credit conditions will be imposed on non-financial borrowers.

"In a number of countries, commercial property prices are beginning to soften, traditionally bad news for lenders. These real-financial interactions are potentially both complex and dangerous," it said.

Do not count on a fiscal rescue. "Explicit and implicit debts of governments are already so high as to raise doubts about whether all non-contractual commitments will be fully honoured."

Dr White says the US sub-prime crisis was the "trigger", not the cause of the disaster. This is not to exonerate the debt-brokers. "It cannot be denied that the originate-to-distribute model (CDOs, CLOs, etc) has had calamitous side-effects. Loans of increasingly poor quality have been made and then sold to the gullible and the greedy," he said.

Nor does it exonerate the watchdogs. "How could such a huge shadow banking system emerge without provoking clear statements of official concern?"

But there have always been excesses in booms. What has made this so bad is that governments set the price of money too low, enticing the banks into self-destruction.

"The fundamental cause of today's emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low," he said.

The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning.

They could get away with this as long as cheap goods from Asia kept a cap on inflation. It seduced them into letting asset booms get out of hand. This is where the central banks made their colossal blunder.

"Policymakers interpreted the quiescence in inflation to mean that there was no good reason to raise rates when growth accelerated, and no impediment to lowering them when growth faltered," said the report.

After almost two decades of this experiment - more or less the Greenspan years - the game is over. Debt has reached extreme levels, and now inflation has come back to life.

The easy trade-off has metamorphosed into a vicious trade-off. This was utterly predictable, and was indeed forecast by the BIS, which plaintively suggested in this report that central banks might like to think of an "exit strategy" next time they try such ploys.

In effect, this is an indictment of rigid inflation targets (such as Britain's), which prevent central banks from launching a pre-emptive strike against asset bubbles. In the 1990s, they should have torn up the rule-book and let inflation turn negative in light of the Asia effect.

The BIS suggests that a mix of "systemic indicators" should be used. The crucial objective is to slow credit growth and make sure that the punchbowl is taken away before the drunks run riot. "We need policy measures to lean against credit-drive excess," it said.

If there are going to be more bail-outs on both sides of the Atlantic - as there will be - the "socialised risks" should be taken on by political systems, and not dumped on the books of central banks.

"Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.

"To deny this through the use of gimmicks and palliatives will only make things worse in the end," he said.

Let us all cheer Dr White off the stage.

Well, Well, The First of the Banks is Seized by the Federal Regulators

Many familiar with the business were wondering which bank would be seized first. Looks like it is Indy Mac. From Yahoo News:

U.S. banking regulators swooped in to seize mortgage lender IndyMac Bancorp Inc (IMB.N) on Friday after withdrawals by panicked depositors led to the third-largest banking failure in U.S. history.

California-based IndyMac, which specialized in a type of mortgage that often required minimal documents from borrowers, became the fifth U.S. bank to fail this year as a housing bust and credit crunch strain financial institutions.

The federal takeover of IndyMac capped a tumultuous day for U.S. markets that saw stocks slide on a surging oil price and renewed fears about the stability of the top two home financing providers, Fannie Mae (FNM.N) and Freddie Mac (FRE.N).

IndyMac will reopen fully on Monday as IndyMac Federal Bank under Federal Deposit Insurance Corp supervision, but tensions ran high as customers at a branch at its Los Angeles-area headquarters read a notice in the window saying it was closed.

At another branch down the road, a man who said he had more than $200,000 in an account -- twice what is normally FDIC guaranteed -- argued with a security guard who was closing up.

The FDIC, which will seek a buyer for IndyMac, estimated the cost of the bank's failure to its $53 billion insurance fund at between $4 billion and $8 billion.

"IndyMac is a company that was pretty much 100 percent invested in mortgage assets, and we're in a bad mortgage market, and it had no capital. It's not complicated," said Adam Compton, co-head of global financial stock research at RCM in San Francisco, which manages about $150 billion.

IndyMac joins top bank failures headed by the 1984 collapse of Continental Illinois National Bank & Trust Co.

The Office of Thrift Supervision (OTS) insisted IndyMac's failure was the second-largest bank failure based on FDIC figures. But the FDIC said its data showed it was third behind the collapse of First RepublicBank Corp in 1988.

The OTS, IndyMac's primary regulator, blamed comments by New York Democratic Sen. Charles Schumer for causing a run on deposits at the largest independent publicly traded U.S. mortgage lender.

Schumer responded quickly on Friday, blaming the OTS for not doing its job and allowing IndyMac's loose lending practices. "OTS should start doing its job to prevent future IndyMacs," he said in a statement.

Schumer questioned IndyMac's ability to survive the housing crisis in late June, and over the next 11 business days, depositors withdrew more than $1.3 billion, the OTS said.

"This institution failed today due to a liquidity crisis," OTS Director John Reich said. "Although this institution was already in distress, I am troubled by any interference in the regulatory process."

IndyMac was founded in 1985 by David Loeb and Angelo Mozilo, who also founded Countrywide, another big mortgage lender whose loans helped fuel the housing boom. Countrywide was taken over last week by Bank of America Corp (BAC.N).

FDIC spokesman David Barr said agency officials arrived at IndyMac's headquarters in Pasadena at 3 p.m. (2200 GMT).

The successor FDIC-run bank opens for business on Monday. Over the weekend, depositors will have access to their funds by ATM, other debit card transactions, or by writing checks, but no access via online banking and phone services until Monday.

Yet many customers were in the dark as branches shut on Friday. "I'm pissed. They should have let me know," said Elizabeth Ortega, a 29-year-old hairdresser who has a checking account with IndyMac.

IndyMac had said earlier in the week it was unable to raise new capital, would slash staff by 60 percent and had stopped making home loans. Its stock then tumbled, last trading at 28 cents on the New York Stock Exchange, down 95 percent in 2008.

The FDIC insures up to $100,000 per deposit and up to $250,000 per retirement account at insured banks.

At the time of closing, IndyMac had about $1 billion of potentially uninsured deposits held by about 10,000 depositors. The FDIC said it would pay those depositors an advance dividend equal to 50 percent of the uninsured amount.

The OTS told a conference call with reporters that it did not expect significant market impact from IndyMac's closure as the firm is not a systemic institution and does not have numerous counterparties. Reich also said he did not expect a larger thrift to fail.

Four small banks have already been closed this year and the FDIC is hiring more staff in preparation for more failures. The agency has boosted its list of troubled banks to 90 and has said an increasing number of banks face high exposure to deteriorating conditions in commercial real estate and construction lending. Last year, just three banks failed.

"IndyMac's takeover by the FDIC is one of many to come," predicted Daniel Alpert, an investment banker at Westwood Capital in New York.

Former FDIC official Ann Graham said it was not unprecedented for the FDIC to start running a bank after it fails. "It happens when they need to move more swiftly with the closing than they can move with a potential sale," said Graham, a law professor at Texas Tech University.

"They don't have to sell the institution over the weekend," she said. "They have the time to shop around."

Graham said the FDIC has the authority to operate an institution for two years but expected the agency would dispose of it much sooner than that.

The Time for the RBS Projections Are Here!

In case you did not see this, an RBS analyst is projecting a 300 point fall in the S&P 500 starting sometime in early- to mid-July (we are here) and lasting through September. Well, earnings season starts tomorrow so this could be the kick-off to this projection. I have no idea what will happen, but make no mistake the economy and the banking system are in bad shape and this is bleeding into Europe. Text in bold is my emphasis. From the UK Telegraph on June 22:

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks. "A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist. A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

Such a slide on world bourses would amount to one of the worst bear markets over the last century.

RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the "Crossover" index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.

"I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names.

"Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.

"Globalisation was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said.

US Federal Reserve and the European Central Bank both face a Hobson's choice as workers start to lose their jobs in earnest and lenders cut off credit.

The authorities cannot respond with easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. "The ugly spoiler is that we may need to see much lower global growth in order to get lower inflation," he said.

"The Fed is in panic mode. The massive credibility chasms down which the Fed and maybe even the ECB will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets," he said.

Kit Jukes, RBS's head of debt markets, said Europe would not be immune. "Economic weakness is spreading and the latest data on consumer demand and confidence are dire. The ECB is hell-bent on raising rates.

"The political fall-out could be substantial as finance ministers from the weaker economies rail at the ECB. Wider spreads between the German Bunds and peripheral markets seem assured," he said.

Ultimately, the bank expects the oil price spike to subside as the more powerful force of debt deflation takes hold next year.

This Weekend's Contemplation - Paulson Calls for Regulatory Changes

The implications of comments from the Secretary of the Treasury are far reaching. 1) He wants to include financial institutions other than banks under a regulatory umbrella like the FDIC. 2) He wants Presidential approval for the use of taxpayer funds to bail out a financial firm. The first comment clearly indicates to me that there is still considerable risk for the investment banks and some insurance companies. The second comment has so many pitfalls I don't even know where to start. For example, how do you handle the potential failure of some one like Bear Stearns, not agree to give them the money and watch the markets collapse?

Are you beginning to feel that somebody know something that we do not? Text in bold is my emphasis.From the LA Times:

U.S. Treasury Secretary Henry M. Paulson Jr. on Wednesday called for regulatory changes that would allow financial firms to fail without threatening broader market stability.

The Treasury chief also proposed steps providing for the president to approve of any use of taxpayer funds to aid a financial company. In a speech in London on Wednesday, Paulson identified a legal gap that leaves unspecified how to deal with failures of companies that don't take deposits, such as investment banks.

Paulson's proposals aim to tighten supervisors' oversight of lenders and dealers while at the same time discourage companies from depending on a government rescue if their bets go wrong. His speech comes a week before a congressional hearing to debate a regulatory overhaul in the wake of the credit crisis that caused the near-bankruptcy of Bear Stearns Cos.

"We need to create a resolution process that ensures the financial system can withstand the failure of a large, complex financial firm," Paulson said in the speech at Chatham House, an international affairs research organization.

The Treasury chief noted that while there is a resolution mechanism for commercial banks, there is no such process for securities firms. Federal Deposit Insurance Corp. Chairwoman Sheila Bair has also urged that an agency be given power to take over and liquidate investment banks in an orderly manner. The FDIC has that power over lenders whose deposits it insures.

"We will need to give our regulators additional emergency authority to limit temporary disruptions," Paulson said. "Any commitment of government support should be an extraordinary event that requires the engagement of the executive branch."

Paulson participated in the talks that led to the Fed's assistance to Bear Stearns. His remarks Wednesday indicated he favors a formal process for the administration's consent to use taxpayer funds.

"That's a big signal," Arthur Levitt, former chairman of the Securities and Exchange Commission, said in a Bloomberg Television interview. Telling Wall Street that government aid would be subject to presidential approval "is pretty powerful medicine," he said.

The Fed invoked emergency powers as lender of last resort to give Bear Stearns a temporary loan in March and then to agree to take on $30 billion of the company's assets to secure its takeover by JPMorgan Chase & Co.

Some central bankers and former officials have said those actions, and the Fed's opening of direct loans to primary U.S. government bond dealers, created the danger of spurring more reckless lending by providing a backstop.

"Two concerns underpin expectations of regulatory intervention to prevent a failure," Paulson said. "They are that an institution may be too interconnected to fail or too big to fail. We must take steps to reduce the perception that this is so -- and that requires that we reduce the likelihood that it is so.

"The Treasury chief stressed that officials' first task "clearly" was ensuring market stability. Analysts see little chance of a regulatory overhaul being enacted by Congress this year, before a new administration takes office in January.

Paulson reiterated that the U.S. economy was in a "rough period."