Bank Failures Push Gold Prices

By Patrick A. Heller

The price of gold has been going up every day for the last week, despite several obvious attempts to manipulate the price downward. As the banks get into deeper trouble, I expect that will persuade more individuals to buy gold.

On Friday, July 11, the Federal Deposit Insurance Corporation shut down and assumed control of IndyMac Bank of Pasadena, Calif. With assets of $32 billion, IndyMac is the second largest bank failure in U.S. history. FDIC is expected to spend $4-$8 billion of its $52 billion in assets to settle claims for this bank.

The bank has been in difficulties over the past year from its position as one of the nation's largest mortgage issuers of subprime mortgages.

Two federally chartered private mortgage banks known by the nicknames of Fannie Mae and Freddie Mac had already written off billions of dollars of bad mortgages. It has been evident for some time that there were far more losses yet to be acknowledged from among the $5 trillion of mortgages the two companies are carrying, probably more than the reserve capital of the companies would cover. Late last week, the stock values of both companies fell sharply, especially after Treasury Secretary Paulson said Friday that the U.S. government would not bail them out.

These two companies hold roughly half the real estate mortgage debt in the United States. If they were to fail, the residential real estate market would more or less ground to a halt. It was obvious to almost everyone that Paulson's remarks were not the final word. On Sunday, government officials announced a series of measures to bail out Fannie Mae and Freddie Mac (but not their shareholders). Although the terms were couched to make it sound like the federal government was not really going to be on the hook for significant funds, they really were a guarantee that the huge losses incurred by these two companies will eventually be covered by taxpayer money.

Monday morning IndyMac reopened as IndyMac Federal Bank. Depositors started lining up outside branches as early as 4 a.m. to withdraw their accounts as soon as the bank opened.
The IndyMac Bank failure, compounded by the Fannie Mae and Freddie Mac troubles, has had fallout on other banks. I polled some local banks Monday and found that some were receiving a number of calls from concerned account holders who were wondering if their funds on account were guaranteed by FDIC or if they should be coming to withdraw their funds. Only one bank I called (about 11 a.m.) claimed that they did not receive any such calls yet.

The federal government/taxpayer bailout of Fannie Mae and Freddie Mac has temporarily lulled some investors into thinking that the worst may be over. Nothing could be further from the truth.

The American banking system is getting ready for a major onslaught of lawsuits over the mortgage crisis. First off, if the banks that issued mortgages neglected to satisfy 100 percent of the disclosure requirements of the 1968 Truth in Lending Act, then the borrowers can successfully sue the bank to cancel the loan. The borrower does not have to prove that they were defrauded or misled or suffered any damages, only that the disclosures were defective! A small survey by one California bankruptcy attorney found disclosure violations in half the loans reviewed.

The second large area of lawsuits is coming from investors in mortgage-backed securities sold by banks. Many such contracts contain clauses where the banks must take back loans that default unusually quickly or have any indications of mistakes or fraud. State and local governments are leading the way with such suits, with Massachusetts, California and the city of Cleveland getting the most publicity.

The bottom line for banks is that they have a high degree of risk of ending up having to absorb a lot of the mortgage losses (which may total another $1 trillion above what has already been recorded) which will swamp the less than $50 billion in assets that FDIC will have after paying off IndyMac's account holders.

I fear that we are close to seeing a nationwide run on banks. I don't see what the federal government could now do to reassure account holders to prevent it. If widespread bank runs start occurring, expect the federal government to quickly slap on restrictions limiting the ability to withdraw funds from bank accounts.

I don't want to be in the same league with Sen. Charles Schumer, D-N.Y., whom the Office of Thrift Supervision is blaming for his June 26 remarks as sparking the run on IndyMac. But, it might be time now to move some funds outside of the banking system just in case.

Some of those pulling the funds out of banks are buying gold and pushing the price towards $1,000.