IndyMac and the Office of Thrift Supervision

Looking Back at the IndyMac Collapse

(Analyzed from a principles framework)

Background

During the summer of 2008, IndyMac (one of the nation’s largest subprime mortgage loan originators) collapsed as a result of its deteriorated asset quality.  Internally, many employees were aware of the impending collapse before it actually occurred, but the larger investing public was less aware.  This was in part (albeit small part) due to IndyMac’s relationship with their regulator, the Office of Thrift Supervision (OTS).  During the quarter ended March 31, 2008, IndyMac’s external auditors, Ernst &Young (E&Y), noticed some capital deficiencies (unbeknownst to IndyMac) during their review of the financial statements.  These capital deficiencies were large enough that they would cause IndyMac to lose their OTS-designated ‘well-capitalized’ status.  If IndyMac lost its well-capitalized status, it would not be able to accept any brokered deposits from third parties, which at the time comprised a large portion of their deposit portfolio.  More than a month after the quarter ended, in light of the potential impact, IndyMac requested that the OTS allow them to backdate a capital infusion from their parent company so they could maintain their well-capitalized status (even though they were not well-capitalized).  The OTS, led by western regional director Darrel Dochow, obliged and allowed IndyMac to post the backdated entry, which effectively misled investors even further.[1]

Facts of the case

Applicable facts (assumptions are noted as such) surrounding the case include the following:

• IndyMac was a large bank heavily involved in subprime lending that started suffering financially when the economy began its downturn in 2007-08.
• IndyMac’s external accountants discovered capital deficiencies during its quarterly review.
• If unaddressed, IndyMac’s capital deficiencies would result in IndyMac losing its ‘well-capitalized’ status, making it ineligible to not accept brokered deposits.
• IndyMac’s primary regulator (OTS) allowed it to backdate a capital infusion a month after its quarter-end in order to preserve its well-capitalized status.
• Investors were unaware of any capital deficiencies at any time.
• A loss of the well-capitalized status would have accelerated the collapse of IndyMac (assumption).
• Allowing backdated capital infusions was not common practice by the OTS (assumption).

Ethical issue

Is it ethical to allow financially unstable institutions to mislead their stakeholders?

Stakeholders

Primary and secondary stakeholders (and why they are considered such) of this case include the following:

Primary Stakeholders:

• IndyMac (and its parent company) – a direct party to the transaction; needs a backdated capital infusion in order to remain operational.
• OTS – IndyMac’s regulator; has to decide whether or not to allow IndyMac to backdate a capital infusion.
• IndyMac’s employees – longevity of their job is dependent upon OTS ruling.
• E&Y (external auditors) – duty is to ensure financial statements are accurate regardless of circumstances.  If IndyMac collapses, E&Y will lose revenue.

Secondary Stakeholders:

• IndyMac’s customers – if IndyMac ceases operations, customers will have no access to their personal accounts.
• IndyMac’s investors – both debt and equity holders will likely suffer if IndyMac goes under.
• Federal Deposit Insurance Corporation (FDIC) regulated institutions – in the event of a collapse, FDIC insurance premiums charged to other insured financial institutions will likely increase as a result of the FDIC insuring IndyMac’s deposit accounts.
• Communities that IndyMac serves – all services provided by IndyMac will cease to exist, including any charitable contributions.

Identifying the relevant principles

Two major moral principles associated with deontological theories are:  (1) do no harm and (2) Kant’s Categorical Imperative.   The most appropriate moral principle to use when analyzing this case is Kant’s Categorical Imperative.  In the Foundations of the Metaphysics of Morals (1785), Kant expressed the Categorical Imperative as follows:  “Act only according to that maxim by which you can at the same time will that it should become a universal law.”  In reference to the IndyMac/OTC case, by allowing IndyMac to improperly backdate a capital infusion, the OTS created an obligation to allow any and all businesses to improperly adjust their financial statements in order to exhibit financial health.  In a world where this maxim becomes a universal law, our entire financial system and the stock market ceases to function properly.  Financial statements will hold no weight as they are assumed to be materially misstated.  Additionally, reasonable valuations will be impossible.  Therefore, we can conclude that allowing all financial institutions to backdate a capital infusion becomes a universal maxim, then the financial system is harmed through wide-spread distrust and disbelief of financial statements.

Cognitive barriers/biases

The primary cognitive bias that prevented the OTS from making a good ethical judgment was possibly their illusion of optimism toward IndyMac.  This was unchartered territory for the OTS as IndyMac was one of the first major subprime lenders to fail.  The OTS knew that IndyMac’s parent company was going to make a capital infusion during the subsequent quarter (which is perfectly fine), so it was optimistic IndyMac would continue to remain financially healthy.  Additionally, the OTS was probably able to morally disengage itself in this situation because of the euphemistic language that surrounded the transaction.  In the world of financial reporting, the term “backdate” is extremely common and does not hold a negative connotation.  If IndyMac had instead requested that the OTS allow them to “change their financial statements in order to mislead the public,” then the OTS (hopefully) would have rejected the request.

Proposed solution

Based on the deontological (principles) framework, the OTS’s action was unethical because the obligation (maxim) created is not one that can feasibly be willed to become a universal law.  The sole purpose of the OTS is to ensure established rules/laws are adhered to and that financial institutions consistently remain compliant.  An alternative solution that IndyMac and the OTS could have implemented would have been to file an 8-K (current report) when quarterly financials were released.  The 8-K would inform the investing public of the pending transaction (capital infusion).  This would likely (temporarily) alleviate fears that IndyMac was under-capitalized and at the same time avoid any deception.

Contributed by: Phil Whalen