IndyMac: Not Such 'A Wonderful Life'
The most recent panic story about the US economy came a few days ago, when the IndyMac bank failed, following a classic run on the bank. Pretty well everyone knows a run on the bank is a bad thing: older readers will remember having heard about the bank runs that were the opening act of the Great Depression -- which, of course, makes the phrase "bank run" all the more frightening.
Reading about it in the papers, listening to the legacy media talk about it, it has become clear that people know a bank run is a bad thing, but they don't know just what a bank run is.
To understand a bank run, the first thing we need to do is think about how a bank works as a business. What banks do is loan money, charging interest. To do that, they have to have money: that comes from the bank's stockholders to start with, then is followed by money from depositors; the bank pays the depositors interest, and then if all goes well, they make a profit to pay back to the stockholders.
To keep this to a reasonable sized article, we're going to think about a really simple bank -- the Bailey Savings and Loan of Bedford Falls. It's a small, family-run savings and loan in a mill town. In addition to the investment of the stockholders -- primarily the Bailey family members themselves -- there are a lot of small depositors. The depositors have savings accounts (this is an old-fashioned S&L, no checking accounts) and the bank loans money on mortgages and real-estate. People get mortgages in order to buy homes. This lets them pay for the home over a long time, while paying the Bailey S&L interest. The income from mortgage interest lets the Baileys pay the depositors and, with luck, keep a little for themselves.
Bailey S&L, like other banks, has to do a bit of a balancing act. They want to loan out as much money as they can, because the more they loan out, the more revenue they get. That's what they make money on.
On the other hand, when they loan out the money, it goes to builders and plumbers and the people who sell homes. It's not in a swimming pool in the basement where George Bailey can play Scrooge McDuck with it. So when a depositor comes in and wants some of their savings back for Christmas presents, Bailey S&L needs to have some cash -- not a swimming pool full, but at least maybe a bathtub's full. So the Bailey S&L keeps a cash reserve, say five percent of their total deposits. The other ninety-five percent is in their part ownership of houses and businesses through those mortgages. This is called fractional reserve banking, and it's the way all banks, credit unions and similar institutions work.
This fractional reserve is what makes a bank run possible. For whatever reason, the rumor gets around that the Bailey S&L has financial problems. The people who have their savings in the bank (perfectly reasonably) don't want to lose their money, and go to see George Bailey asking for their money back. If enough people do this, the bank becomes "illiquid," which just means the bathtub is empty. When that cash reserve is exhausted, the bank has to shut down until it can get more, and since the other ninety-five percent of its money is in real estate mortgages, it can't do that easily. So someone has to come along and buy the assets, providing cash for the panicky depositors, and since it's a forced sale, the odds are good they'll buy the assets at a discount. Someone gets the assets cheaply, but the Bailey S&L (and the Bailey family) is ruined, and the depositors may not get all their savings back either.
The thing about a bank run is that it can happen to a bank that is in perfectly good financial shape: all it takes is a bit of a panic. So when Mr Potter makes a public announcement that he knows the Bailey S&L is in trouble, if he's able to get it publicized, and people believe him, the resulting bank run can ruin a perfectly good bank. Even more so, if the bank is in some trouble -- missing some cash through a cashier’s error, let’s say -- but not actually insolvent, a bank run can force the bank into insolvency because now they don't have a chance to do anything else like sell stock or look for a buyer before that cash reserve runs out. That's a bank run. Unlike in the 30's, now we have government deposit insurance, so most of the depositors won't be hurt -- they'll get their money back, their ATM cards will work, their checks will continue to clear. The few that are hurt are the really big depositors, the ones who had more than the $100,000 limit in the one bank.
IndyMac was a classic bank run. The bank certainly had balance sheet troubles. Like a lot of banks, they had some mortgages on property that wasn't worth as much as they had loaned against it, so their real-estate mortgages were over-valued. In the normal course of things, a bank in this position can do a number of things as long as they can continue operating. And they can continue operating as long as they have enough cash on hand to satisfy their depositors' normal demands. But when Senator Potter started to publicly question the bank's solvency, from his position as a Senator, depositors started withdrawing their money, and before too long, they didn't have even $2 in cash; they were forced to close their doors.
Why would Mr Potter want to start a bank run? Well, maybe he doesn't like the competition. Maybe he wants the Bailey's assets, knowing that if he can force them out of business, he can buy the mortgages cheaply. Maybe he's running for re-election as the Senator from Bedford Falls, against George Bailey, the popular upstart. If he bankrupts Bailey S&L and ruins George Bailey, that has to hurt him. If the police start to investigate as well, why, he's a shoo-in for the election, isn't he?