PART 3

containing high risk, poor quality mortgages were not safe investments and were going to incur

losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying,

46

the value of the RMBS and CDO securities fell, and financial institutions around the world were

suddenly left with unmarketable securities whose value was plummeting. The financial crisis

was on.

Because of the complex nature of the financial crisis, this chapter concludes with a brief

timeline of some key events from 2006 through 2008. The succeeding chapters provide more

detailed examinations of the roles of high risk lending, federal regulators, credit ratings agencies,

and investment banks in causing the financial crisis.

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Financial Crisis Timeline104

104 Many of these events are based upon a timeline prepared by the Federal Reserve Bank of St. Louis, “The Financial

Crisis: A Timeline of Events and Policy Actions,” http://timeline.stlouisfed.org/index.cfm?p=timeline.

December 2006:

Ownit Mortgage Solutions bankruptcy

February 27, 2007:

Freddie Mac announces it will no longer buy the

most risky subprime mortgages

March 7, 2007:

FDIC issues cease & desist order against Fremont

for unsafe and unsound banking

April 2, 2007:

New Century bankruptcy

June 17, 2007:

Two Bear Stearns subprime hedge funds collapse

July 10 and 12, 2007:

Credit rating agencies issue first mass downgrades

of hundreds of RMBS and CDO securities

August 6, 2007:

American Home Mortgage bankruptcy

August 17, 2007:

Federal Reserve: “[M]arket conditions have

deteriorated…. downside risks to growth have

increased appreciably.”

August 31, 2007:

Ameriquest Mortgage ceases operations

December 12, 2007:

Federal Reserve establishes Term Auction Facility

to provide bank funding secured by collateral

January 2008:

ABX Index stops issuing new subprime indices

January 11, 2008:

Countrywide announces sale to Bank of America

January 30, 2008:

S&P downgrades or places on credit watch over

8,000 RMBS/CDO securities

March 24, 2008:

Federal Reserve Bank of New York forms Maiden

Lane I to help JPMorgan Chase acquire Bear Stearns

May 29, 2008:

Bear Stearns shareholders approve sale

July 11, 2008:

IndyMac Bank fails and is seized by FDIC

July 15, 2008:

SEC restricts naked short selling of some financial

stocks

September 7, 2008:

U.S. takes control of Fannie Mae & Freddie Mac

September 15, 2008:

Lehman Brothers bankruptcy

September 15, 2008

Merrill Lynch announces sale to Bank of America

September 16, 2008:

Federal Reserve offers $85 billion credit line to AIG;

Reserve Primary Money Fund NAV falls below $1

September 21, 2008:

Goldman Sachs and Morgan Stanley convert to bank

holding companies

September 25, 2008:

WaMu fails, seized by FDIC, sold to JPMorgan Chase

October 3, 2008:

Congress and President Bush establish TARP

October 12, 2008:

Wachovia sold to Wells Fargo

October 28, 2008:

U.S. uses TARP to buy $125 billion in preferred

stock at 9 banks

November 25, 2008:

Federal Reserve buys Fannie and Freddie assets

.

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III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK

Washington Mutual Bank, known also as WaMu, rose out the ashes of the great Seattle

fire to make its first home loan in 1890. By 2004, WaMu had become one of the nation’s largest

financial institutions and a leading mortgage lender. Its demise just four years later provides a

case history that traces not only the rise of high risk lending in the mortgage field, but also how

those high risk mortgages led to the failure of a leading bank and contributed to the financial

crisis of 2008.

For many years, WaMu was a mid-sized thrift, specializing in home mortgages. In the

1990s, WaMu initiated a period of growth and acquisition, expanding until it became the nation’s

largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300

branches in 15 states, and over 43,000 employees. In 2003, its longtime CEO, Kerry Killinger,

said he wanted to do for the lending industry what Wal-Mart and others did for their industries,

by catering to middle and lower income Americans and helping the less well off buy homes.105

Soon after, WaMu embarked on a strategy of high risk lending. By 2006, its high risk loans

began incurring record rates of delinquency and default, and its securitizations saw ratings

downgrades and losses. In 2007, the bank itself began incurring losses. Its shareholders lost

confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis. On

September 25, 2008, 119 years to the day of its founding, WaMu was seized by its regulator, the

Office of Thrift Supervision (OTS), and sold to JPMorgan Chase for $1.9 billion. Had the sale

not gone through, WaMu’s failure might have exhausted the $45 billion Deposit Insurance Fund.

Washington Mutual is the largest bank failure in U.S. history.

This case study examines how one bank’s strategy for growth and profit led to the

origination and securitization of hundreds of billions of dollars in poor quality mortgages that

undermined the U.S. financial system. WaMu had held itself out as a prudent lender, but in

reality, the bank turned increasingly to higher risk loans. Its fixed rate mortgage originations fell

from 64% of its loan originations in 2003, to 25% in 2006, while subprime, Option ARM, and

home equity originations jumped from 19% of the originations to 55%. Using primarily loans

from its subprime lender, Long Beach Mortgage Corporation, WaMu’s subprime securitizations

grew sixfold, increasing from about $4.5 billion in 2003, to $29 billion in securitizations in 2006.

From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime

loans. WaMu also increased its origination of Option ARMs, its flagship product, which from

2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone,

Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or

securitized at least $115 billion, including sales to the Federal National Mortgage Association

(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu

dramatically increased its origination and securitization of home equity loan products. By 2007,

105 “Saying Yes, WaMu Built Empire on Shaky Loans,” New York Times (12/27/2008)

http://www.nytimes.com/2008/12/28/business/28wamu.html?_r=1 (quoting Mr. Killinger: “We hope to do to this

industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to

their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.”).

49

home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase

from 2003.

At the same time that WaMu was implementing its High Risk Lending Strategy, WaMu

and Long Beach engaged in a host of shoddy lending practices that contributed to a mortgage

time bomb. Those practices included qualifying high risk borrowers for larger loans than they

could afford; steering borrowers to higher risk loans; accepting loan applications without

verifying the borrower’s income; using loans with teaser rates that could lead to payment shock

when higher interest rates took effect later on; promoting negatively amortizing loans in which

many borrowers increased rather than paid down their debt; and authorizing loans with multiple

layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their

lending standards; allowed excessive loan error and exception rates; exercised weak oversight

over the third party mortgage brokers who supplied half or more of their loans; and tolerated the

issuance of loans with fraudulent or erroneous borrower information. They also designed

compensation incentives that rewarded loan personnel for issuing a large volume of higher risk

loans, valuing speed and volume over loan quality.

WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight

produced hundreds of billions of dollars of poor quality loans that incurred early payment

defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the

highest rates of foreclosure in the industry and their securitizations were among the worst

performing. Senior WaMu executives described Long Beach as “terrible” and “a mess,” with

default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued.

WaMu management knew of evidence of deficient lending practices, as seen in internal emails,

audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described

“extensive fraud” from employees “willfully” circumventing bank policy. An internal review

found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at

least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside

from Long Beach, WaMu’s President Steve Rotella described WaMu’s prime home loan

business as the “worst managed business” he had seen in his career.

Documents obtained by the Subcommittee reveal that WaMu launched its High Risk

Lending Strategy primarily because higher risk loans and mortgage backed securities could be

sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant

they paid a higher coupon rate than other comparably rated securities, and investors paid a higher

price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and

appeared to insulate the bank from risk.

From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of

which were then resold to investment banks and other investors hungry for mortgage backed

securities. For a period of time, demand for these securities was so great that WaMu formed its

own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach

churned out a steady stream of high risk, poor quality loans and mortgage backed securities that

later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual

50

tried—and ultimately failed—to use the profits from poor quality loans as a stepping stone to

becoming a major Wall Street player.

Washington Mutual was far from the only lender that sold poor quality mortgages and

mortgage backed securities that undermined U.S. financial markets. The Subcommittee

investigation indicates that Washington Mutual was emblematic of a host of financial institutions

that knowingly originated, sold, and securitized billions of dollars in high risk, poor quality home

loans. These lenders were not the victims of the financial crisis; the high risk loans they issued

became the fuel that ignited the financial crisis.

A. Subcommittee Investigation and Findings of Fact

As part of its investigation into high risk lending and the Washington Mutual case study,

the Subcommittee collected millions of pages of documents from Washington Mutual, JPMorgan

Chase, OTS, the FDIC, eAppraiseIT, Lenders Service Inc., Moody’s, Standard & Poor’s, various

investment banks, Fannie Mae, Freddie Mac, and others. The documents included email,

correspondence, internal memoranda, reports, legal pleadings, financial analysis, prospectuses,

and more. The Subcommittee also conducted more than 30 interviews with former WaMu

employees and regulatory officials. The Subcommittee also spoke with personnel from the

Offices of the Inspector General at the Department of Treasury and the FDIC, who were engaged

in a joint review of WaMu’s regulatory oversight and the events leading to its demise. In

addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking,

accounting, regulatory, and legal issues. On April 13, 2010, the Subcommittee held a hearing

which took testimony from former WaMu officials and released 86 exhibits.106

In connection with the hearing, the Subcommittee released a joint memorandum from

Chairman Carl Levin and Ranking Member Tom Coburn summarizing the investigation to date

into Washington Mutual and the role of high risk home loans in the financial crisis. The

memorandum contained the following findings of fact, which this Report reaffirms.

1. High Risk Lending Strategy. Washington Mutual (“WaMu”) executives embarked

upon a High Risk Lending Strategy and increased sales of high risk home loans to

Wall Street, because they projected that high risk home loans, which generally

charged higher rates of interest, would be more profitable for the bank than low risk

home loans.

2. Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage

Company (“Long Beach”), used shoddy lending practices riddled with credit,

compliance, and operational deficiencies to make tens of thousands of high risk home

loans that too often contained excessive risk, fraudulent information, or errors.

106 “Wall Street and the Financial Crisis: The Role of High Risk Loans,” before the U.S. Senate Permanent

Subcommittee on Investigations, S.Hrg. 111-67 (April 13, 2010) (hereinafter “April 13, 2010 Subcommittee

Hearing”).

51

3. Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered

borrowers into home loans they could not afford, allowing and encouraging them to

make low initial payments that would be followed by much higher payments, and

presumed that rising home prices would enable those borrowers to refinance their

loans or sell their homes before the payments shot up.

4. Polluting the Financial System. WaMu and Long Beach securitized over $77

billion in subprime home loans and billions more in other high risk home loans, used

Wall Street firms to sell the securities to investors worldwide, and polluted the

financial system with mortgage backed securities which later incurred high rates of

delinquency and loss.

5. Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected

and securitized loans that it had identified as likely to go delinquent, without

disclosing its analysis to investors who bought the securities, and also securitized

loans tainted by fraudulent information, without notifying purchasers of the fraud that

was discovered.

6. Destructive Compensation. WaMu’s compensation system rewarded loan officers

and loan processors for originating large volumes of high risk loans, paid extra to

loan officers who overcharged borrowers or added stiff prepayment penalties, and

gave executives millions of dollars even when its High Risk Lending Strategy placed

the bank in financial jeopardy.

B. 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.

(1) Major Business Lines and Key Personnel

From 2004 to 2008, WaMu had four major business lines.107

107 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001.

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.

52

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.

(2) Loan Origination Channels

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

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.

53

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

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”).

110 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 56.

54

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

(3) Long Beach

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

111 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-

47c.

Long Beach typically qualified borrowers

according to whether they could afford to pay the initial, low interest rate rather than the later,

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.

113 4/2010 IG Report, at 11, Hearing Exhibit 4/16-82.

114 Washington Mutual Inc. actually purchased Long Beach Financial Corporation, the parent of Long Beach

Mortgage Corporation, for about $350 million.

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.”).

116 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing

Exhibit 4/13-1c.

117 For more information about these types of loans, see Chapter II.

55

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

(4) Securitization

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

118 See April 13, 2010 Subcommittee Hearing at 50.

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).

120 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing

Exhibit 4/13-1c.

121 See Standard and Poor’s data at www.globalcreditportal.com.

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%).

56

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.

(5) Overview of WaMu’s Rise and Fall

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.

123See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-47c.

124 Prepared statement of David Beck, April 13, 2010 Subcommittee Hearing at 2.

125 Subcommittee interview of David Beck (3/2/2010).

126 Id.

127 Id.

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.

57

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.

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.

130 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41.

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.

132 Subcommittee interview of Tom Casey (2/20/2010).

133 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j.

134 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41.

135 “Washington Mutual to Take Writedown, Slash Dividend,” Bloomberg (12/10/2007), available at

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNUz6NmbYZCQ.

136 Id.

58

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.

C. High Risk Lending Strategy

In 2004, Washington Mutual ramped up high risk home loan originations to borrowers

that had not traditionally qualified for them. The following year, Washington Mutual adopted a

high risk strategy to issue high risk mortgages, and then mitigate some of that risk by selling or

securitizing many of the loans. When housing prices stopped climbing in late 2006, a large

number of those risky loans began incurring extraordinary rates of delinquency as did the

securities that relied on those loans for cash flow. In 2007, the problems with WaMu’s High

Risk Lending Strategy worsened, as delinquencies increased, the securitization market dried up,

and the bank was unable to find buyers for its high risk loans or related securities.

The formal initiation of WaMu’s High Risk Lending Strategy can be dated to January

2005, when a specific proposal was presented to the WaMu Board of Directors for approval.138

137 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the

Subcommittee, Hearing Exhibit 4/13-1h.

WaMu adopted this strategy because its executives calculated that high risk home loans were

more profitable than low risk loans, not only because the bank could charge borrowers higher

interest rates and fees, but also because higher risk loans received higher prices when securitized

and sold to investors. They garnered higher prices because, due to their higher risk, the

securities paid a higher coupon rate than other comparably rated securities.

138 See 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board

of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a.

59

Over a five-year period from 2003 to 2008, Washington Mutual Bank shifted its loan

originations from primarily traditional 30-year fixed and government backed loans to primarily

higher risk home loans. This shift included increased subprime loan activity at Long Beach,

more subprime loans purchased through its Specialty Mortgage Finance correspondent channel,

and more bulk purchases of subprime loans through its conduit channel for use in securitizations.

WaMu also increased its originations and acquisitions of Option ARM, Alt A, and home equity

loans. While the shift began earlier, the strategic decision to move toward higher risk loans was

not fully articulated to regulators or the Board of Directors until the end of 2004 and the

beginning of 2005.139

In about three years, from 2005 to 2007, WaMu issued hundreds of billions of higher risk

loans, including $49 billion in subprime loans140 and $59 billion in Option ARMs.141 Data

compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007,

Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet and home

equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from

2003.142 According to an August 2006 internal WaMu presentation on Option ARM credit risk,

from 1999 until 2006, Option ARM borrowers selected the minimum monthly payment more

than 95% of the time.143 The data also showed that at the end of 2007, 84% of the total value of

the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper

debt rather than paying off their loan balances.144 In addition, by the end of 2007, stated income

loans—loans in which the bank had not verified the borrower’s income—represented 73% of

WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans.145 WaMu

also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount

exceeded 80% of the value of the underlying property. The Treasury and the FDIC Inspectors

General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home

equity loans had LTV ratios in excess of 80%.146 Still another problem was that WaMu had high

geographic concentrations of its home loans in California and Florida, states that ended up

suffering above-average home value depreciation.147

139 See, e.g., 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk

Management,” Washington Mutual Board of Directors Discussion, JPM_WM04107995-8008, Hearing Exhibit 4/13-

2b; 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of

Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a.

140 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing

Exhibit 4/13-1c.

141 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82.

142 Id. at 9-10.

143 See 8/2006 Washington Mutual internal report, “Option ARM Credit Risk,” chart entitled, “Borrower-Selected

Payment Behavior,” at 7, Hearing Exhibit 4/13-37. The WaMu report also stated: “Almost all Option ARM

borrowers select the minimum payment every month with very high persistency, regardless of changes in the interest

rates or payment adjustments.” Id. at 2.

144 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82.

145 Id. at 10.

146 Id.

147 Id. at 11.

60

(1) Strategic Direction

In 2004, WaMu set the stage for its High Risk Lending Strategy by formally adopting

aggressive financial targets for the upcoming five-year time period. The new earnings targets

created pressure for the bank to shift from its more conservative practices towards practices that

carried more risk. Mr. Killinger described those targets in a June 2004 “Strategic Direction”

memorandum to WaMu’s Board of Directors: “Our primary financial targets for the next five

years will be to achieve an average ROE [Return on Equity] of at least 18%, and average EPS

[Earnings Per Share] growth of at least 13%.”148 In his memorandum to the Board, Mr. Killinger

predicted continuing growth opportunities for the bank:

“In a consolidating industry, it is appropriate to continually assess if shareholder value

creation is best achieved by selling for a short-term change of control premium or to

continue to build long-term value as an independent company. We believe remaining an

independent company is appropriate at this time because of substantial growth

opportunities we see ahead. We are especially encouraged with growth prospects for our

consumer banking group. We would also note that our stock is currently trading at a

price which we believe is substantially below the intrinsic value of our unique franchise.

This makes it even more important to stay focused on building long-term shareholder

value, diligently protecting our shareholders from inadequate unsolicited takeover

proposals and maintaining our long held position of remaining an independent

company.”149

Mr. Killinger identified residential nonprime and adjustable rate mortgage loans as one of the

primary bank businesses driving balance sheet growth.150 Mr. Killinger also stated in the

memorandum: “Wholesale and correspondent will be nationwide and retooled to deliver higher

margin products.”151

(2) Approval of Strategy

After 2002, Washington Mutual stopped acquiring lenders specializing in residential

mortgages,152 and embarked upon a new strategy to push the company’s growth, focused on

increasing its issuance and purchase of higher risk home loans. OTS took note of this strategy in

WaMu’s 2004 Report on Examination:

148 6/1/2004 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic

Direction,” JPM_WM05385579 at 581.

149 Id. at 582.

150 Id.

151 Id. at 585.

152 The only new lender that Washington Mutual acquired after 2004 was Commercial Capital Bancorp in 2006.

61

“Management provided us with a copy of the framework for WMI’s 5-year (2005-2009)

strategic plan [which] contemplates asset growth of at least 10% a year, with assets

increasing to near $500 billion by 2009.”153

OTS directed the bank to spell out its new lending strategy in a written document that had to be

presented to and gain approval by the WaMu Board of Directors.154

In response, in January 2005, WaMu management developed a document entitled,

“Higher Risk Lending Strategy” and presented it to its Board of Directors for approval to shift

the bank’s focus from originating low risk fixed rate and government backed loans to higher risk

subprime, home equity, and Option ARM loans.155 The Strategy disclosed that WaMu planned

to increase both its issuance of higher risk loans and its offering of loans to higher risk

borrowers. The explicit reasoning for the shift was the increased profitability of the higher risk

loans, measured by actual bank data showing that those loans produced a higher “gain on sale”

or profit for the bank compared to lower risk loans. For example, one chart supporting the

Strategy showed that selling subprime loans garnered more than eight times the gain on sale as

government backed loans.156

The WaMu submission to the Board noted that, in order for the plan to be successful,

WaMu would need to carefully manage its residential mortgage business as well as its credit risk,

meaning the risk that borrowers would not repay the higher risk loans.157 During the Board’s

discussion of the strategy, credit officers noted that losses would likely lag by several years.158

153 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed

Exhibit].

These documents show that WaMu knew that, even if loan losses did not immediately come to

pass after initiating the High Risk Lending Strategy, it did not mean the strategy was free of

problems.

154 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely, OTSWME04-0000005357 at 61 (“Joint Memo #9

- Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483, Hearing

Exhibit 4/16-94 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to

Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our

Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo

9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”).

155 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at

JPM_WM00302978, Hearing Exhibit 4/13-2a; see also 4/2010 “WaMu Product Originations and Purchases by

Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i.

156 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894,

Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13; for 30-year, fixed rate loans

was 19; for option loans was 109; for home equity loans was 113; and for subprime loans was 150.).

157 See 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899,

Hearing Exhibit 4/13-3 (acknowledging that the risks of the High Risk Lending Strategy included managing credit

risk, implementing lending technology and enacting organizational changes).

158 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes,

JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington

Mutual Board of Directors, at JPM_WM00302987, Hearing Exhibit 4/13-2a (“Lags in Effects of Expansion,” chart

showing peak loss rates in 2007).

62

(3) Definition of High Risk Lending

As part of the 2005 presentation to the Board of Directors outlining the strategy, OTS

recommended that WaMu define higher risk lending.159 The January 2005 presentation

contained a slide defining “Higher Risk Lending”:

“For the purpose of establishing concentration limits, Higher Risk Lending

strategies will be implemented in a ‘phased’ approach. Later in 2005 an

expanded definition of Higher Risk Lending—encapsulating multiple risk

layering and expanded underwriting criteria—and its corresponding

concentration limit—will be presented for Board approval.

“The initial definition is ‘Consumer Loans to Higher Risk Borrowers’,

which at 11/30/04 totaled $32 Billion or 151% of total risk-based capital,

comprised of:

-Subprime loans, or all loans originated by Long Beach Mortgage

or purchased through our Specialty Mortgage Finance program

-SFR [Single Family Residential] and Consumer Loans to

Borrowers with low credit scores at origination.”160

A footnote on the slide defined “low credit scores” as less than a 620 FICO score for first lien

single family residence mortgages, home equity loans, and home equity lines of credit. It

defined low credit scores as less than 660 for second lien home equity loans (HEL) and lines of

credit (HELOC), and other consumer loans.161

While the January 2005 presentation promised to present a fuller definition of higher risk

loans for Board approval at some future date, a more complete definition had already been

provided to the Board a few weeks earlier in a December 21, 2004 presentation entitled, “Asset

Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management.”162

This presentation contained the same basic definition of higher risk borrowers, but also provided

a definition of higher risk loans.

Higher risk loans were defined as single family residence mortgages with a loan-to-value

(LTV) ratio of equal to or greater than 90% if not credit enhanced, or a combined-loan-to-value

159 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely (“Joint Memo #8 - Loans to ‘Higher-Risk

Borrowers’”), OTSWME04-0000005357 at 61.

160 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at

JPM_WM00302979, Hearing Exhibit 4/13-2a.

161 Id. at JPM_WM00302979.

162 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,”

Washington Mutual Board of Directors Presentation, at JPM_WM04107995-8008, Hearing Exhibit 4/13-2b.

63

(CLTV) ratio of 95%. These numbers are a notable departure from the 80% LTV ratio

traditionally required for a prime loan.163 For home equity loans and lines of credit, WaMu

considered a first lien to be high risk if it had a greater than 90% LTV ratio, and considered a

second lien to be high risk if had a greater than 80% CLTV ratio.164

The December 2004 presentation also defined higher risk lending on the basis of

expanded underwriting criteria and multiple risk layering:

“Expanded Criteria

-‘No Income’ loan documentation type

-All Manufactured Housing loans …

Multiple Risk Layering in SF[R] and 1st lien HEL/HELOC loans

-Higher A- credit score or lacking LTV as strong compensating factor and

-An additional risk factor from at least three of the following:

-Higher uncertainty about ability to pay or ‘stated income’

documentation type

-higher uncertainty about willingness to pay or collateral value”165

This document indicates that WaMu considered a mortgage to be higher risk if it lacked

documentation regarding the borrower’s income, described as a “no income” or “stated income”

loan.

WaMu held billions of dollars in loans on its balance sheet.166 Those assets fluctuated in

value based on the changes in the interest rate. Fixed rate loans, in particular, incurred

significant interest rate risk, because on a 30-year fixed rate mortgage, for example, WaMu

agreed to receive interest payments at a certain rate for 30 years, but if the prevailing interest rate

went up, WaMu’s cost of money increased and the relative value of the fixed mortgages on its

balance sheet went down. WaMu used various strategies to hedge its interest rate risk. One way

to incur less interest rate risk was for WaMu to hold loans with variable interest rates, such as

Hybrid ARMs typical of WaMu’s subprime lending, or Option ARMs, WaMu’s flagship “prime”

product. These adjustable rate mortgages paid interest rates that, after the initial fixed rate period

expired, were typically pegged to the Cost of Funds Index (COFI) or the Monthly Treasury

Average (MTA), two common measures of prevailing interest rates.

163 See, e.g., 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,”

http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm, and discussion of high LTV loans in section

D(2)(b), below.

164 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,”

Washington Mutual Board of Directors Presentation, JPM_WM04107995-8008 at 7999, Hearing Exhibit 4/13-2b.

165 Id. This slide lists only the two additional risk factors quoted, despite referring to “at least three of the

following.”

166 See 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001 (“Loans held:

$118.9 billion in single-family loans held for investment - this includes $52.9 billion in payment option ARMs and

$16.05 billion in subprime mortgage loans”).

64

(4) Gain on Sale

WaMu’s internal documents indicate that the primary motivation behind its High Risk

Lending Strategy was the superior “gain on sale” profits generated by high risk loans.167

Washington Mutual management had calculated that higher risk loans were more profitable

when sold or securitized. Prior to sale, higher risk loans also produced greater short term profits,

because the bank typically charged the borrowers a higher rate of interest and higher fees.

Higher risk home loans placed for sale were more profitable for WaMu, because of the

higher price that Wall Street underwriters and investors were willing to pay for them. The profit

that WaMu obtained by selling or securitizing a loan was known as the “gain on sale.” Gain on

sale figures for the loans produced by the bank were analyzed and presented to the WaMu Board

of Directors. On April 18, 2006, David Schneider, the President of WaMu Home Loans division,

provided the Board of Directors a confidential presentation entitled, “Home Loans

Discussion.”168 The third slide in the presentation was entitled, “Home Loans Strategic

Positioning,” and stated: “Home Loans is accelerating significant business model changes to

achieve consistent, long term financial objectives.”169 Beneath this heading the first listed

objective was: “Shift from low-margin business to high-margin products,”170 meaning from less

profitable to more profitable loan products. The next slide in the presentation was entitled:

“Shift to Higher Margin Products,” and elaborated on that objective. The slide listed the actual

gain on sale obtained by the bank, in 2005, for each type of loan WaMu offered, providing the

“basis points” (bps) that each type of loan fetched on Wall Street:

2005 WaMu Gain on Sale

Margin by Product

in bps171

Government 13

Fixed 19

Hybrid/ARM 25

Alt A 40

Option ARM 109

Home Equity 113

Subprime 150

167 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes at

JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington

Mutual Board of Directors, at JPM_WM00302977, Hearing Exhibit 4/13-2a

168 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu presentation, JPM_WM00690890-901,

Hearing Exhibit 4/13-3.

169 Id. at 893 [emphasis in original removed].

170 Id.

171 Id. at 894 [formatting as in the original].

65

Mr. Schneider told the Subcommittee that the numbers listed on the chart were not

projections, but the numbers generated from actual, historical loan data.172 As the chart makes

clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those

loans were typically purchased by government sponsored enterprises (GSEs) like Fannie Mae,

Freddie Mac, and Ginnie Mae which paid relatively low prices for them. Instead of focusing on

those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to

focus on the most profitable loans, which were the Option ARM, home equity, and subprime

loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a

fixed rate loan at 19 basis points and more than 10 times as profitable as government backed

loans.

The gain on sale data WaMu collected drove not only WaMu’s decision to focus on

higher risk home loans, but also how the bank priced those loans for borrowers. In determining

how much it would charge for a loan, the bank calculated first what price the loan would obtain

on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee:

“Because WaMu’s capital markets organization was engaged in the secondary mortgage

market, it had ready access to information regarding how the market priced loan

products. Therefore my team helped determine the initial prices at which WaMu could

offer loans by beginning with the applicable market prices for private or agency-backed

mortgage securities and adding the various costs WaMu incurred in the origination, sale,

and servicing of home loans.”173

(5) Acknowledging Unsustainable Housing Price Increases

In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk

Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices,

loosening lending standards, and the possible consequences. On September 2, 2004, just months

before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr.

Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal

staff, warning of a bubble in housing prices and encouraging tighter underwriting. The

memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject

heading, “Perspective,” Mr. Vanasek wrote:

“I want to share just a few thoughts with all of you as we begin the month of September.

Clearly you have gone through a difficult period of time with all of the changes in the

mortgage area of the bank. Staff cuts and recent defections have only added to the stress.

Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken

on some of you and have felt it is important to tell you that we recognize it has been and

continues to be difficult.

172 Subcommittee interview of David Schneider (2/16/2010).

173 April 13, 2010 Subcommittee Hearing at 53.

66

“In the midst of all this change and stress, patience is growing thin. We understand that.

We also know that loan originators are pushing very hard for deals. But we need to put

all of this in perspective.

“At this point in the mortgage cycle with prices having increased far beyond the rate of

increase in personal incomes, there clearly comes a time when prices must slow down or

perhaps even decline. There have been so many warnings of a Housing Bubble that we

all tend now to ignore them because thus far it has not happened. I am not in the business

of forecasting, but I have a healthy respect for the underlying data which says ultimately

this environment is no longer sustainable. Therefore I would conclude that now is not the

time to be pushing appraisal values. If anything we should be a bit more conservative

across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both

expressed renewed concern over this issue.

“This is a point where we should be much more careful about exceptions. It is highly

questionable as to how strong this economy may be; there is clearly no consensus on

Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and

inordinate numbers of exceptions will come back to haunt us.”174

Mr. Vanasek was the senior-most risk officer at WaMu, and had frequent interactions with Mr.

Killinger and the Board of Directors. While his concerns may have been heard, they were not

heeded.

Mr. Vanasek told the Subcommittee that, because of his predictions of a collapse in the

housing market, he earned the derisive nickname “Dr. Doom.”175 But evidence of a housing

bubble was overwhelming by 2005. Over the prior ten years, housing prices had skyrocketed in

an unprecedented fashion, as the following chart prepared by Paulson & Co. Inc., based on data

from the Bureau of Economic Analysis and the Office of Federal Housing Enterprise Oversight,

demonstrates.176

174 9/2/2004 Washington Mutual memorandum from Jim Vanasek, “Perspective,” Hearing Exhibit 4/13-78b.

175 Subcommittee interview of Jim Vanasek (12/18/2009).

176 “Estimation of Housing Bubble,” PSI-Paulson&Co-02-00003, Hearing Exhibit 4/13-1j.

67

Mr. Vanasek shared his concerns with Mr. Killinger. At the Subcommittee’s hearing,

Mr. Killinger testified: “Now, beginning in 2005, 2 years before the financial crisis hit, I was

publicly and repeatedly warning of the risks of a potential housing downturn.”177 In March

2005, he engaged in an email exchange with Mr. Vanasek, in which both agreed the United

States was in the midst of a housing bubble. On March, 10, 2005, Mr. Vanasek emailed Mr.

Killinger about many of the issues facing his risk management team, concluding:

“My group is working as hard as I can reasonably ask any group to work and in several

cases they are stretched to the absolute limit. Any words of support and appreciation

would be very helpful to the morale of the group. These folks have stepped up to fixing

any number of issues this year, many not at all of their own making.”178

Mr. Killinger replied:

“Thanks Jim. Overall, it appears we are making some good progress. Hopefully, the

Regulators will agree that we are making some progress. I suspect the toughest thing for

us will be to navigate through a period of high home prices, increased competitive

conditions for reduced underwriting standards, and our need to grow the balance sheet. I

177 April 13, 2010 Subcommittee Hearing at 85.

178 3/2005 WaMu internal email chain, Hearing Exhibit 4/13-78.

68

have never seen such a high risk housing market as market after market thinks they are

unique and for whatever reason are not likely to experience price declines. This typically

signifies a bubble.”

Mr. Vanasek agreed:

“I could not agree more. All the classic signs are there and the likely outcome is

probably not great. We would all like to think the air can come out of the balloon slowly

but history would not lean you in that direction. Over the next month or so I am going to

work hard on what I hope can be a lasting mechanism (legacy) for determining how

much risk we can afford to take ….”

Despite Mr. Killinger’s awareness that housing prices were unsustainable, could drop suddenly,

and could make it difficult for borrowers to refinance or sell their homes, Mr. Killinger

continued to push forward with WaMu’s High Risk Lending Strategy.

(6) Execution of the High Risk Lending Strategy

WaMu formally adopted the High Risk Lending Strategy in January 2005.179 Over the

following two years, management significantly shifted the bank’s loan originations towards

riskier loans as called for in the plan, but had to slow down the pace of implementation in the

face of worsening market conditions. In retrospect, WaMu executives tried to portray their

inability to fully execute the plan as a strategic choice rather than the result of a failed strategy.

For example, Mr. Killinger testified at the Subcommittee hearing that the bank’s High Risk

Lending Strategy was only contemplated, but not really executed:

“First, we had an adjustment in our strategy that started in about 2004 to gradually

increase the amount of home equity, subprime, commercial real estate, and multi-family

loans that we could hold on the balance sheet. We had that long-term strategy, but … we

quickly determined that the housing market was increasing in its risk, and we put most of

those strategies for expansion on hold.”180

Mr. Killinger’s claim that the High Risk Lending Strategy was put “on hold” is contradicted,

however, by WaMu’s SEC filings, its internal documents, and the testimony of other WaMu

executives.

Washington Mutual’s SEC filings contain loan origination and acquisition data showing

that the bank did implement its High Risk Lending Strategy. Although rising defaults and the

2007 collapse of the subprime secondary market prevented WaMu from fully executing its plans,

WaMu dramatically shifted the composition of the loans it originated and purchased, nearly

179 See 3/13/2006 OTS Report of Examination, at OTSWMS06-008 0001677, Hearing Exhibit 4/16-94 [Sealed

Exhibit].

180 April 13, 2010 Subcommittee Hearing at 88.

69

doubling the percentage of higher risk home loans from 36% to 67%. The following chart,

prepared by the Subcommittee using data from WaMu’s SEC filings, demonstrates the shift.181

In 2003, 64% of WaMu’s mortgage originations and purchases were fixed rate loans, and

only 19% were subprime, Option ARM, or home equity loans. In 2004, 31% of WaMu’s

mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option

ARM, or home equity loans. In 2005, 31% of WaMu’s mortgage originations and purchases

were fixed rate loans, and 56% were subprime, Option ARM, or equity loans. By 2006, only

25% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were

subprime, Option ARM, or home equity loans.182 Even after market forces began taking their

toll in 2007, and WaMu ended all subprime lending in the fall of that year, its higher risk

originations and purchases at 47% were double its fixed rate loans at 23%.183

181 4/2010 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the

Subcommittee, Hearing Exhibit 4/13-1i.

182 Id.

183 Id.

70

Mr. Killinger’s annual “Strategic Direction” memoranda to the Board in 2005, 2006, and

2007, also contradict his testimony that the strategy of expanding high risk lending was put on

hold. On the first page of his 2005 memorandum, Mr. Killinger wrote: “We continue to see

excellent long-term growth opportunities for our key business lines of retail banking, mortgage

banking, multi-family lending and sub-prime residential lending.”184 Rather than hold back on

WaMu’s stated strategy of risk expansion, Mr. Killinger told the Board that WaMu should

accelerate it:

“In order to reduce the impact of interest rate changes on our business, we have

accelerated development of Alt-A, government and sub-prime loan products, as well as

hybrid ARMs and other prime products, specifically for delivery through retail,

wholesale and correspondent channels.”185

The 2005 strategic direction memorandum also targeted Long Beach for expansion:

“Long Beach is expected to originate $30 billion of loans this year, growing to $36

billion in 2006. To facilitate this growth, we plan to increase account managers by 100.

We expect Long Beach to have 5% of the sub-prime market in 2005, growing to [a] 6%

share in 2006.”186

Despite warning against unsustainable housing prices in March 2005, Mr. Killinger’s

2006 “Strategic Direction” memorandum to the Board put even more emphasis on growth than

the 2005 memorandum. After reviewing the financial targets set in the five-year plan adopted in

2004, Mr. Killinger wrote: “To achieve these targets, we developed aggressive business plans

around the themes of growth, productivity, innovation, risk management and people

development.”187 His memorandum expressed no hesitation or qualification as to whether the

high risk home lending strategy was still operative in 2006. The memorandum stated:

“Finally, our Home Loan Group should complete its repositioning within the next twelve

months and it should then be in position to grow its market share of Option ARM, home

equity, sub prime and Alt. A loans. We should be able to increase our share of these

categories to over 10%.”188

Contrary to Mr. Killinger’s hearing testimony, the 2006 memorandum indicates an expansion of

WaMu’s high risk home lending, rather than any curtailment:

“We are refining our home loans business model to significantly curtail low margin

Government and conventional fixed rate originations and servicing, and to significantly

184 6/1/2005 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic

Direction,” JPMC/WM - 0636-49 at 36, Hearing Exhibit 4/13-6c.

185 Id. at 644.

186 Id. at 646.

187 6/6/2006 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic

Direction,” JPM_00808312-324 at 314, Hearing Exhibit 4/13-6d.

188 Id. at 315 [emphasis in original removed].

71

increase our origination and servicing of high margin home equity, Alt. A, sub prime and

option ARMs. Action steps include merging Longbeach sub prime and the prime

business under common management, merging correspondent activities into our

correspondent channel, getting out of Government lending, curtailing conventional fixed

rate production, expanding distribution of targeted high margin products through all

distribution channels and potentially selling MSRs [Mortgage Servicing Rights] of low

margin products. We expect these actions to result in significantly higher profitability

and lower volatility over time.”189

The April 16, 2006 “Home Loans Discussion” presentation by Home Loans President

David Schneider, discussed above, also confirms WaMu’s ongoing efforts to shift its loan

business toward high risk lending. Page four of that presentation, entitled, “Shift to Higher

Margin Products,” shows two pie charts under the heading, “WaMu Volume by Product.”190

One chart depicts loan volume for 2005, and the second chart depicts projected loan volume for

2008:

WaMu Volume By Product

$ In Billions191

These charts demonstrate WaMu’s intention to increase its loan originations over three

years by almost $30 billion, focusing on increases in high risk loan products. Subprime

originations, for example, were expected to grow from $34 billion in 2005 to $70 billion in 2008;

Alt A originations were projected to grow from $1 billion in 2005 to $24 billion in 2008; and

189 Id. at 319.

190 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu PowerPoint presentation,

JPM_WM00690890-901 at 894, Hearing Exhibit 4/13-3.

191 Id. [formatted for clarity].

Fixed

$69B

33%

Hyb/ARM

$28B

13%

Option ARM

$63B

31%

Subprime

$34B

16%

Home Equity

$4B

2%

Govt

$8B

4%

Alt-A

$1B

0%

2005 Fixed

$4B

2%

Hyb/ARM

$38B

17%

Option ARM

$63B

23%

Subprime

$70B

30%

Home Equity

$30B

13%

New Product

$13B

5%

Alt A

$24B

10%

2008

$206 Billion $232 Billion

72

Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008.

On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically.

Government backed loan originations, which totaled $8 billion in 2005, were projected to be

eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in

2005 to $4 billion in 2008.

The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well

after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged:

“For the past two years, we have been predicting the bursting of the housing bubble and

the likelihood of a slowing housing market. This scenario has now turned into a reality.

Housing prices are declining in many areas of the country and sales are rapidly slowing.

This is leading to an increase in delinquencies and loan losses. The sub-prime market

was especially rocked as many sub-prime borrowers bought houses at the peak of the

cycle and now find their houses are worth less and they are having difficulties refinancing

their initial low-rate loans.”192

While the memorandum’s section on home loan strategy no longer focused on overall growth, it

continued to push the shift to high risk lending, despite problems in the subprime market:

“Home Loans is a large and important business, but at this point in the cycle, it is

unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in

2006. … We need to optimize the sub-prime and prime distribution channels with

particular emphasis on growing the retail banking, home loan center and consumer direct

channels. We also expect to portfolio more of Home Loans’ originations in 2008,

including the new Mortgage Plus product. We will continue to emphasize higher-risk

adjusted return products such as home equity, sub-prime first mortgages, Alt A

mortgages and proprietary products such as Mortgage Plus.”193

The testimony of other WaMu executives further confirms the bank’s implementation of

its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the

company’s Chief Risk Officer, testified:

“The company’s strategic plan to shift its portfolios towards higher margin products was

already underway when I arrived at WaMu. Basically, this strategy involved moving

away from traditional mortgage lending into alternative lending programs involving

adjustable-rate mortgages as well as into subprime products. The strategic shift to

192 6/18/2007 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic

Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a.

193 Id. at 66 [emphasis in original removed]. See also 1/2007 Washington Mutual presentation, “Subprime Mortgage

Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS

securities that: “WaMu is focusing on higher margin products”).

73

higher-margin products resulted in the bank taking on a higher degree of credit risk

because there was a greater chance that borrowers would default.”194

Likewise, Steven Rotella, WaMu’s President and Chief Operating Officer, who began with the

bank in January 2005, testified before the Subcommittee:

“In particular, I want to be very clear on the topic of high-risk lending, this

Subcommittee’s focus today. High-risk mortgage lending in WaMu’s case, primarily

Option ARMs and subprime loans through Long Beach Mortgage, a subsidiary of WaMu,

were expanded and accelerated at explosive rates starting in the early 2000s, prior to my

hiring in 2005…. In 2004 alone, the year before I joined, Option ARMs were up 124

[percent], and subprime lending was up 52 percent.”195

In his testimony, Mr. Rotella took credit for curtailing WaMu’s growth and high risk

lending.196 Mr. Rotella’s own emails, however, show that he supported the High Risk Lending

Strategy. On October 15, 2005, Mr. Rotella emailed Mr. Killinger about WaMu’s 2006 strategic

plan: “I think our focus needs to be on organic growth of home eq, and subprime, and greater

utilization of [the Home Loans division] as we know it today to facilitate that at lower

acquisition costs and greater efficiency.”197

Mr. Killinger replied by email the next day: “Regarding Longbeach, I think there is a

good opportunity to be a low cost provider and gain significant share when the industry

implodes.”198 Responding to Mr. Rotella’s ideas about the Home Loans division, Mr. Killinger

wrote: “It makes sense to leverage the home loans distribution channels with home equity, sub

prime, and alt. A.”199 In this late 2005 email exchange, WaMu’s two senior-most executives

contemplate reducing prime lending, not subprime. Mr. Killinger wrote: “If we can’t make a

shift in our business model, we might be better off exiting the prime space.”200

Mr. Rotella replied to Mr. Killinger’s email later on October 16, 2005. He continued to

emphasize the importance of focusing on high risk lending, referring to his previous experience

as a mortgage banker at JPMorgan Chase:

“We did these kinds of analyses all the time at Chase which led us to run as fast as we

could into home eq, alt a, subprime (our investment banking brethren stopped us from

going too far here). We viewed prime as a source of scale benefits in servicing for the

other areas and a conduit of higher margin product and aimed to hold our prime servicing

194 April 13, 2010 Subcommittee Hearing at 18-19.

195 Id. at 83.

196 See id., e.g., at 83-84.

197 10/15/2005-10/16/2005 email from Steve Rotella to Kerry Killinger, JPM_WM00665373-75.

198 Id. at JPM_WM00665374.

199 Id.

200 Id.

74

flat to down. I feel strongly that where we need to land is a new home loan unit that

includes prime, heq, and subprime. It is a far superior model.”201

In July 2008, just two months before the collapse of WaMu, Home Loans President

David Schneider prepared an internal presentation entitled, “Home Loans Story, External &

Internal Views.”202 The presentation was retrospective, providing timelines of WaMu’s major

strategy, policy, and personnel changes. The first substantive page of the presentation bears the

heading, “Three fundamental business shifts occurred in Home Loans this millennium which

shaped its performance and position in a volatile competitive landscape”:

“2001 to 2005

‘Mono-line’ business model focused on generating high volume of low-margin, prime

products ….

2006

Targeted production franchise toward higher margin products to become a market leader

in specific product segments….

2007 & Beyond

Subprime mortgage implosion fuels credit and liquidity crisis and the non-agency

secondary market disappears[.]”

Mr. Scheider’s retrospective presentation of the changes that occurred at WaMu is

unambiguous: by 2006, WaMu had “targeted production franchise toward higher margin

products.”203 According to the same presentation, that model change also lowered earnings

volatility for WaMu by lessening exposure to Mortgage Servicing Rights.204 Later slides provide

more detail. A quarterly timeline is presented with the heading: “In an environment of internal

and external large-scale change, Home Loans took bold actions to redefine its business into a

sustainable model.” In the strategy section for the second quarter of 2006, Mr. Schneider wrote:

“New business model, high margin products.”205

Despite warnings by some within its management about the unsustainable housing price

bubble, WaMu pursued a High Risk Lending Strategy to generate short term profits from the

favorable gain-on-sale margins offered by Wall Street for high risk loans and securitizations, for

which the credit rating agencies continued to award AAA ratings. To succeed, the strategy was

premised upon borrowers being able to refinance or sell their homes to pay off their loans in the

event of a default. Stagnant or declining house prices made refinancing and home sales more

difficult.

201 Id. at JPM_WM00665373.

202 7/2008 “Home Loans Story, External & Internal Views,” Washington Mutual PowerPoint presentation, Hearing

Exhibit 4/13-80.

203 Id. at 1.

204 Id.

205 Id. at 4.

75

Effective implementation of the High Risk Lending Strategy also required robust risk

management. But while WaMu was incurring significantly more credit risk than it had in the

past, risk managers were marginalized, undermined, and subordinated to WaMu’s business units.

As a result, when credit risk management was most needed, WaMu found itself lacking in

effective risk management and oversight.

D. Shoddy Lending Practices

At the same time they increased their higher risk lending, WaMu and Long Beach

engaged in a host of poor lending practices that produced billions of dollars in poor quality loans.

Those practices included offering high risk borrowers large loans; steering borrowers to higher

risk loans; accepting loan applications without verifying the borrower’s income; using loans with

low teaser rates to entice borrowers to take out larger loans; promoting negative amortization

loans which led to many borrowers increasing rather than paying down their debt over time; and

authorizing loans with multiple layers of risk. WaMu and Long Beach also exercised weak

oversight over their loan personnel and third party mortgage brokers, and tolerated the issuance

of loans with fraudulent or erroneous borrower information.

(1) Long Beach

Throughout the period reviewed by the Subcommittee, from 2004 until its demise in

September 2007, Long Beach was plagued with problems. Long Beach was one of the largest

subprime lenders in the United States,206 but it did not have any of its own loan officers. Long

Beach operated exclusively as a “wholesale lender,” meaning all of the loans it issued were

obtained from third party mortgage brokers who had brought loans to the company to be

financed. Long Beach “account executives” solicited and originated the mortgages that were

initiated by mortgage brokers working directly with borrowers. Long Beach account executives

were paid according to the volume of loans they originated, with little heed paid to loan quality.

Throughout the period reviewed by the Subcommittee, Long Beach’s subprime home

loans and mortgage backed securities were among the worst performing in the subprime

industry. Its loans repeatedly experienced early payment defaults, its securities had among the

highest delinquencies in the market, and its unexpected losses and repurchase demands damaged

its parent corporation’s financial results. Internal documentation from WaMu shows that senior

management at the bank was fully aware of Long Beach’s shoddy lending practices, but failed to

correct them.

2003 Halt in Securitizations. For a brief period in 2003, Long Beach was required by

WaMu lawyers to stop all securitizations until significant performance problems were remedied.

While the problems were addressed and securitizations later resumed, many of the issues

returned and lingered for several years.

206 See 1/2007 Washington Mutual Presentation, “Subprime Mortgage Program,” Hearing Exhibit 4/13-5 (slide

showing Long Beach Annual Origination Volume).

76

The problems with Long Beach’s loans and securitizations predated the company’s

purchase by WaMu in 1999, but continued after the purchase. An internal email at WaMu’s

primary federal regulator, the Office of Thrift Supervision (OTS), observed the following with

respect to Long Beach’s mortgage backed securities:

“Performance data for 2003 and 2004 vintages appear to approximate industry average

while issues prior to 2003 have horrible performance. LBMC finished in the top 12 worst

annualized NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the

worst spot at top loser… in 2000 and placed 3rd in 2001.”207

In 2003, Long Beach’s performance deteriorated to the point that WaMu’s legal

department put a stop to all Long Beach securitizations until the company improved its

operations.208 An internal review of Long Beach’s first quarter 2003 lending “concluded that

40% (109 of 271) of loans reviewed were considered unacceptable due to one or more critical

errors.”209 According to a 2003 joint report issued by regulators from the FDIC and Washington

State: “This raised concerns over LBMC’s ability to meet the representations and warranty’s

made to facilitate sales of loan securitizations, and management halted securitization activity.”210

A Long Beach corporate credit review in August 2003 confirmed that “credit management and

portfolio oversight practices were unsatisfactory.”211

As a result of the halt in securitizations, Long Beach had to hold loans on its warehouse

balance sheet, which increased by approximately $1 billion per month and reached nearly $5

billion by the end of November 2003. Long Beach had to borrow money from WaMu and other

creditors to finance the surge.212 The joint visitation report noted that unless Long Beach

executed a $3 billion securitization by January 2004, “liquidity will be strained.”213 WaMu

initiated a review of Long Beach led by its General Counsel Faye Chapman.214 Her team

evaluated the loans that had accumulated during the halt in securitizations. The joint visitation

report noted that of 4,000 Long Beach loans reviewed by WaMu by the end of November 2003,

less than one quarter, about 950, could be sold to investors, another 800 were unsaleable, and the

rest—over half of the loans—had deficiencies that had to be remediated before a sale could take

place.215

207 4/2005 OTS internal email, Hearing Exhibit 4/13-8(a).

208 Subcommittee interview of Faye Chapman, WaMu General Counsel (2/9/2010). See also 12/21/2005 OTS

memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31.

209 1/13/2004 report on “Joint Visitation Dated October 14, 2003,” jointly prepared by the FDIC and the State of

Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b (citing a Long

Beach quality assurance report).

210 Id.

211 Id. (citing a Long Beach Corporate Credit Review report).

212 Id.

213 Id.

214 Subcommittee interview of Fay Chapman (2/9/2010).

215 1/13/2004 report on “Joint Visitation Dated October 14, 2003,” jointly prepared by the FDIC and the State of

Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b