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III. HIGH RISK LENDING:
CASE STUDY OF WASHINGTON MUTUAL BANKB. Background
Washington Mutual Bank was a federally chartered thrift whose primary federal regulator was the Office of Thrift Supervision (OTS). As an insured depository institution, it was also overseen by the Federal Deposit Insurance Corporation (FDIC). Washington Mutual was a full service consumer and business bank. This Report focuses only on WaMu's home lending and securitization business. As part of that business, WaMu originated home loans, acquired home loans for investment and securitization, sold pools of loans, and also securitized pools of home loans that it had originated or acquired. It was also a leading servicer of residential mortgages.
From 2004 to 2008, WaMu had four major business lines. |107| The Home Loans Group handled WaMu's home mortgage originations, securitizations, and servicing operations. The Commercial Group handled apartment buildings and other commercial properties. The Retail Banking Group provided retail banking services to consumers and businesses across the country. The Card Services Group handled a credit card business purchased from Providian Financial Corporation.
For most of the five-year period reviewed by the Subcommittee, WaMu was led by its longtime Chairman of the Board and Chief Executive Officer (CEO) Kerry Killinger who joined the bank in 1982, became bank president in 1988, and was appointed CEO in 1990. Mr. Killinger was the moving force behind WaMu's acquisitions and growth strategy during the 1990s, and made the fateful decision to embark upon its High Risk Lending Strategy in 2005. Mr. Killinger stepped down as Chairman of the Board in June 2008, after shareholders opposed having the same person occupy the bank's two top positions. He was dismissed from the bank on September 8, 2008, the same day WaMu was required by its regulator, OTS, to sign a public Memorandum of Understanding to address its lending and securitization deficiencies. Two weeks later the bank failed.
Other key members of the bank's senior management included President Steve Rotella who joined the bank in January 2005; Chief Financial Officer Tom Casey; President of the Home Loans Division David Schneider who joined the bank in July 2005; and General Counsel Faye Chapman. David Beck served as Executive Vice President in charge of the bank's Capital Markets Division, oversaw its securitization efforts, and reported to the head of Home Loans. Anthony Meola headed up the Home Loans Sales effort. Jim Vanasek was WaMu's Chief Credit Officer from 1999 until 2004, and was then appointed its Chief Risk Officer, a new position, from 2004-2005. After Mr. Vanasek's retirement, Ronald Cathcart took his place as Chief Risk Officer, and headed the bank's newly organized Enterprise Risk Management Division, serving in that post from 2005 to 2007.
WaMu was one of the largest mortgage originators in the United States. |108| It originated and acquired residential mortgages through several methods, which it referred to as loan origination channels. WaMu referred to them as its retail, wholesale, subprime, correspondent, and conduit channels.
Retail Channel. In WaMu's parlance, "retail channel" loans were loans originated by WaMu employees, typically loan officers or sales associates operating out of WaMu branded loan centers. The prospective borrower typically communicated directly with the WaMu loan officer, who was often called a "loan consultant." WaMu considered all retail channel loans to be "prime" loans, regardless of the characteristics of the loan or the creditworthiness of the borrower, and sometimes referred to the retail channel as the "prime" channel. The retail channel originated significant numbers of Option ARM loans, which WaMu treated as prime loans, despite their inherent risks. According to the Inspectors General of the U.S. Treasury Department and the FDIC, who prepared a report on WaMu's failure (hereinafter "IG Report"), "Option ARMs represented as much as half of all loan originations from 2003 to 2007 and approximately $59 billion, or 47 percent, of the home loans on WaMu's balance sheet at the end of 2007." |109| The retail channel was also used to originate substantial numbers of home equity loans and home equity lines of credit.
Wholesale Channel. According to WaMu, its "wholesale channel" loans were loans that the bank acquired from third party mortgage brokers. These brokers, who were not WaMu employees, located borrowers interested in purchasing a home or refinancing an existing mortgage, and explained available loans that could be underwritten by WaMu. The borrower's primary, and sometimes sole, contact was with the mortgage broker. The mortgage broker would then provide the borrower's information to a WaMu loan officer who would determine whether the bank would finance the loan. If the bank decided to finance the loan, the broker would receive a commission for its efforts. Third party mortgage brokers typically received little guidance or training from WaMu, aside from receiving daily "rate sheets" explaining the terms of the loans that WaMu was willing to accept and the available commissions. WaMu treated wholesale loans issued under the WaMu brand as prime loans.
Subprime Channel. WaMu also originated wholesale loans through its subprime affiliate and later subsidiary, Long Beach Mortgage Company ("Long Beach"). Long Beach was a purely wholesale lender, and employed no loan officers that worked directly with borrowers. Instead, its account executives developed relationships with third party mortgage brokers who brought prospective loans to the company, and if Long Beach accepted those loans, received a commission for their efforts. WaMu typically referred to Long Beach as its "subprime channel." Later, in 2007, when the bank decided to eliminate Long Beach as a separate entity, it rebranded Long Beach as its "Wholesale Specialty Lending" channel.
At times, WaMu also acquired subprime loans through "correspondent" or "conduit" channels, which it used to purchase closed loans—loans that had already been financed—from other lenders for investment or securitization. For example, WaMu at times operated a correspondent channel that it referred to as "Specialty Mortgage Finance" and used to purchase subprime loans from other lenders, especially Ameriquest, for inclusion in its investment portfolio. In addition, in 2005, its New York securitization arm, Washington Mutual Capital Corporation, established a "subprime conduit" to purchase closed subprime loans in bulk from other lenders for use in securitizations. At the end of 2006, WaMu reported that its investment portfolio included $4 billion in subprime loans from Long Beach and about $16 billion in subprime loans from other parties. |110|
Other Channels. At times, WaMu also originated or acquired loans in other ways. Its "Consumer Direct" channel, for example, originated loans over the phone or internet; borrowers did not need to meet in person with a WaMu loan officer. In addition, in 2004, Washington Mutual Capital Corporation (WCC) set up a conduit to purchase closed Alt A loans in bulk from other lenders and use them in securitizations. WCC shut down both the Alt A and subprime conduits in April 2008, after it became too difficult to find buyers for new securitizations. |111|
The Treasury and the FDIC IG report examining the failure of WaMu found that, from 2003 to 2007, the bulk of its residential loans—from 48% to 70%—came from third party lenders and brokers. |112| That report also determined that, in 2007, WaMu had 14 full-time employees overseeing 34,000 third party brokers doing business with the bank nationwide, and criticized the Bank's oversight and staffing effort. |113|
WaMu had traditionally originated mortgages to well qualified prime borrowers. But in 1999, WaMu bought Long Beach Mortgage Company, |114| which was exclusively a subprime lender to borrowers whose credit histories did not support their getting a traditional mortgage. |115| Long Beach was located in Anaheim, California, had a network of loan centers across the country, and at its height had as many as 1,000 employees.
Long Beach made loans for the express purpose of securitizing them and profiting from the gain on sale; it did not hold loans for its own investment. It had no loan officers of its own, but relied entirely on third party mortgage brokers bringing proposed subprime loans to its doors. In 2000, the year after it was purchased by WaMu, Long Beach made and securitized approximately $2.5 billion in home loans. By 2006, its loan operations had increased more than tenfold, and Long Beach securitized nearly $30 billion in subprime home loans and sold the securities to investors. |116|
Long Beach's most common subprime loans were short term, hybrid adjustable rate mortgages, known as "2/28," "3/27," or "5/25" loans. These 30-year mortgages typically had a low fixed "teaser" rate, which then reset to a higher floating rate after two years for the 2/28, three years for the 3/27, or five years for the 5/25. |117| Long Beach typically qualified borrowers according to whether they could afford to pay the initial, low interest rate rather than the later, higher interest rate. |118| For "interest-only" loans, monthly loan payments were calculated to cover only the interest due on the loan and not any principal. After the fixed interest rate period expired, the monthly payment was typically recalculated to pay off the entire remaining loan within the remaining loan period at the higher floating rate. Unless borrowers could refinance, the suddenly increased monthly payments caused some borrowers to experience "payment shock" and default on their loans.
From 1999 to 2006, Long Beach operated as a subsidiary of Washington Mutual Inc., the parent of Washington Mutual Bank. Long Beach's loans repeatedly experienced early payment defaults, high delinquency rates, and losses, and its securitizations were among the worst performing in the market. |119| In 2006, in a bid to strengthen Long Beach's performance, WaMu received permission from its regulator, OTS, to purchase the company from its parent and make it a wholly owned subsidiary of the bank. WaMu installed new management, required the head of Long Beach to report to its Home Loans Division President, and promised OTS that it would improve Long Beach. When Long Beach's loans continued to perform poorly, in June 2007, WaMu shut down Long Beach as a separate entity, and took over its subprime lending operations, rebranding Long Beach as its "Wholesale Specialty Lending" channel. WaMu continued to issue and securitize subprime loans. After the subprime market essentially shut down a few months later in September 2007, WaMu ended all of its subprime lending.
From 2000 to 2007, Long Beach and WaMu together securitized tens of billions of dollars in subprime loans, creating mortgage backed securities that frequently received AAA or other investment grade credit ratings. |120| Although AAA securities are supposed to be very safe investments with low default rates of one to two percent, of the 75 Long Beach mortgage backed security tranches rated AAA by Standard and Poor's in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn. |121| In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more. |122|
Washington Mutual depended on the securitization process to generate profit, manage risk, and obtain capital to originate new loans. Washington Mutual and Long Beach sold or securitized most of the subprime home loans they acquired. Initially, Washington Mutual kept most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or securitizing those loans as well. From 2000 to 2007, Washington Mutual and Long Beach securitized at least $77 billion in subprime home loans. Washington Mutual sold or securitized at least $115 billion of Option ARM loans, as well as billions more of other types of high risk loans, including hybrid adjustable rate mortgages, Alt A, and home equity loans.
When Washington Mutual began securitizing its loans, it was dependent upon investment banks to help underwrite and sell its securitizations. In order to have greater control of the securitization process and to keep securitization underwriting fees in house, rather than paying them to investment banks, WaMu acquired a company able to handle securitizations and renamed it Washington Mutual Capital Corporation (WCC), which became a wholly owned subsidiary of the bank. |123| WCC was a registered broker-dealer and began to act as an underwriter of WaMu and Long Beach securitizations. |124| WCC worked with two other bank subsidiaries, Washington Mutual Mortgage Securities Corp. and Washington Mutual Asset Acceptance Corp., that provided warehousing for WaMu loans before they were securitized. WCC helped to assemble RMBS pools and sell the resulting RMBS securities to investors. At first it worked with other investment banks; later it became the sole underwriter of some WaMu securitizations.
WCC was initially based in Seattle with 30 to 40 employees. |125| In 2004, it moved its headquarters to Manhattan. |126| At the height of WCC operations, right before the collapse of the securitization market, WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago, with the majority of its personnel in New York. |127| WCC closed its doors in December 2007, after the securitization markets collapsed.
Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding company, Washington Mutual Inc. |128| From 1996 to 2002, WaMu acquired over a dozen other financial institutions, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach, expanding to become the nation's largest thrift and sixth largest bank. WaMu also became one of the largest issuers of home loans in the country. Washington Mutual kept a portion of those loans for its own investment portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to Fannie Mae or Freddie Mac. From 2001 to 2007, Washington Mutual sold approximately $430 billion in loans to Fannie Mae and Freddie Mac, representing nearly a quarter of its loan production during those years.
In 2006, WaMu took several major actions that reduced the size of its Home Loans Group. It sold $140 billion in mortgage servicing rights to Wells Fargo; sold a $22 billion portfolio of home loans and other securities; and reduced its workforce significantly. |129|
In July 2007, after the Bear Stearns hedge funds collapsed and the credit rating agencies downgraded the ratings of hundreds of mortgaged backed securities, including over 40 Long Beach securities, the secondary market for subprime loans dried up. In September 2007, due to the difficulty of finding investors willing to purchase subprime loans or mortgage backed securities, Washington Mutual discontinued its subprime lending. It also became increasingly difficult for Washington Mutual to sell other types of high risk loans and related mortgage backed securities, including its Option ARMs and home equity products. Instead, WaMu retained these loans in its portfolios. By the end of the year, as the value of its loans and mortgage backed securities continued to drop, Washington Mutual began to incur significant losses, reporting a $1 billion loss in the fourth quarter of 2007, and another $1 billion loss in the first quarter of 2008.
In February 2008, based upon increasing deterioration in the bank's asset quality, earnings, and liquidity, OTS and the FDIC lowered the bank's safety and soundness rating to a 3 on a scale of 1 to 5, signaling it was a troubled institution. |130| In March 2008, at the request of OTS and the FDIC, Washington Mutual allowed several potential buyers of the bank to review its financial information. |131| JPMorgan Chase followed with a purchase offer that WaMu declined. |132| Instead, in April 2008, Washington Mutual's parent holding company raised $7 billion in new capital and provided $3 billion of those funds to the bank. |133| By June, the bank had shut down its wholesale lending channel. |134| It also closed over 180 loan centers and terminated 3,000 employees. |135| In addition, WaMu reduced its dividend to shareholders. |136|
In July 2008, a $30 billion subprime mortgage lender, IndyMac, failed and was placed into receivership by the government. In response, depositors became concerned about Washington Mutual and withdrew over $10 billion in deposits, putting pressure on the bank's liquidity. After the bank disclosed a $3.2 billion loss for the second quarter, its stock price continued to drop, and more deposits left.
On September 8, 2008, Washington Mutual signed a public Memorandum of Understanding that it had negotiated with OTS and the FDIC to address the problems affecting the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million severance payment. |137| Allen Fishman was appointed his replacement.
On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on September 18, OTS and the FDIC lowered Washington Mutual's rating to a "4," indicating that a bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of the bank and its parent holding company. Over the span of eight days starting on September 15, nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained about $45 billion, an amount which could have been exhausted by the failure of a $300 billion institution like Washington Mutual. As the financial crisis worsened each day, regulatory concerns about the bank's liquidity and viability intensified.
Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to close the bank. Unable to wait for a Friday, the day on which most banks are closed, the agencies acted on a Thursday, September 25, 2008, which was also the 119th anniversary of WaMu's founding. That day, OTS seized Washington Mutual Bank, placed it into receivership, and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund. WaMu's parent, Washington Mutual, Inc., declared bankruptcy soon after.
Notes
107. 9/25/2008 "OTS Fact Sheet on Washington Mutual Bank," Dochow_Darrel-00076154_001. [Back]
108. See, e.g., "Mortgage Lender Rankings by Residential Originations," charts prepared by MortgageDaily.com (indicating WaMu was one of the top three issuers of U.S. residential mortgages from 2003 to 2005); "Washington Mutual to Acquire PNC's Residential Mortgage Business," Business Wire (10/2/2000), http://findarticles.com/p/articles/mi_m0EIN/is_2000_Oct_2/ai_65635032. [Back]
109. 4/2010 "Evaluation of Federal Regulatory Oversight of Washington Mutual Bank," report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, Hearing Exhibit 4/16-82 (hereinafter "IG Report"). [Back]
110. See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 56. [Back]
111. See 6/11/2007 chart entitled, "Capital Markets Division Growth," JPM_WM03409858, Hearing Exhibit 4/13- 47c. [Back]
112. See prepared statement of Treasury IG Eric Thorson, "Wall Street and the Financial Crisis: Role of the Regulators," before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter "April 16, 2010 Subcommittee Hearing"), at 5. [Back]
113. 4/2010 IG Report, at 11, Hearing Exhibit 4/16-82. [Back]
114. Washington Mutual Inc. actually purchased Long Beach Financial Corporation, the parent of Long Beach Mortgage Corporation, for about $350 million. [Back]
115. 12/21/2005 OTS internal memorandum from OTS examiners to Darrel Dochow, OTSWMS06-007 0001009, Hearing Exhibit 4/16-31 ("LBMC was acquired… as a vehicle for WMI to access the subprime loan market. LBMC's core business is the origination of subprime mortgage loans through a nationwide network of mortgage brokers."). [Back]
116. "Securitizations of Washington Mutual Subprime Home Loans," chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. [Back]
117. For more information about these types of loans, see Chapter II. [Back]
118. See April 13, 2010 Subcommittee Hearing at 50. [Back]
119. See 4/14/2005 email exchange between OTS examiners, "Fitch – LBMC Review," Hearing Exhibit 4/13-8a (discussing findings by Fitch, a credit rating agency, highlighting poor performance of Long Beach securities). [Back]
120. "Securitizations of Washington Mutual Subprime Home Loans," chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. [Back]
121. See Standard and Poor's data at www.globalcreditportal.com. [Back]
122. See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%). [Back]
123. See 6/11/2007 chart entitled, "Capital Markets Division Growth," JPM_WM03409858, Hearing Exhibit 4/13-47c. [Back]
124. Prepared statement of David Beck, April 13, 2010 Subcommittee Hearing at 2. [Back]
125. Subcommittee interview of David Beck (3/2/2010). [Back]
128. 9/25/2008 "OTS Fact Sheet on Washington Mutual Bank," Dochow_Darrel-00076154_001, at 002. Washington Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id. [Back]
129. Subcommittee interview of Steve Rotella (2/24/2010). See also 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 1 (Washington Mutual reduced its workforce from 60,789 to 49,824 from December 31, 2005 to December 31, 2006.); "Washington Mutual to cut 2,500 jobs," MarketWatch (2/15/2006), available at http://www.marketwatch.com/story/washington-mutual-cutting-2500-mortgage-jobs. [Back]
130. See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. [Back]
131. Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); and OTS West Region Office Director Darrel Dochow (3/3/2010); 4/2010 "Washington Mutual Regulators Timeline," prepared by the Subcommittee, Hearing Exhibit 4/16-1j. [Back]
132. Subcommittee interview of Tom Casey (2/20/2010). [Back]
133. 4/2010 "Washington Mutual Regulators Timeline," prepared by the Subcommittee, Hearing Exhibit 4/16-1j. [Back]
134. See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. [Back]
135. "Washington Mutual to Take Writedown, Slash Dividend," Bloomberg (12/10/2007), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNUz6NmbYZCQ. [Back]
137. "Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008," chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. [Back]
Back to Contents A. Subcommittee Investigation and Findings of Fact C. High Risk Lending Strategy
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