Both GSEs also
changed their senior management.
“Well, like all big mortgage lenders, Senator, Fannie Mae and Freddie Mac were
important .... [T]here was a substantial amount of production that was sold off to either
Fannie or Freddie. ... [A]ny mortgage lender that is in the mortgage business, given the
government advantages and the duopoly that Fannie and Freddie had, needed to do
business with them. It would be very difficult to be a mortgage player without them.”517
510 See 4/28/2006 email exchange between WaMu executives, JPM_WM02521921, Hearing Exhibit 4/16-89
(celebrating contract that “David Schneider signed today”).
513 See “Freddie Mac Raises its Estimate of Errors,” Associated Press (9/26/2003).
514 See “Freddie to Settle with Fat Civil Fine,” Associated Press (12/11/2003). In 2007, Freddie Mac paid an
additional $50 million civil fine to the SEC to settle civil charges of securities fraud, without admitting or denying
wrongdoing. “Freddie Mac to Pay $50 million,” Associated Press (9/28/2007).
515 9/17/2004 Office of Federal Housing Enterprise Oversight Report of Findings to Date, “Special Examination of
Fannie Mae,” available at http://www.fhfa.gov/Preview-
516 See 2004 10-K filing with the SEC. Fannie Mae paid the $400 million civil fine in May 2006, to settle
accounting fraud charges brought by OFHEO and SEC. See also “Fannie Settles Fraud Charges,” National
Mortgage News (5/29/2006).
517 April 13, 2010 Subcommittee Hearing at 105, Senator Coburn question to Mr. Rotella.
Loan Sales to Fannie and Freddie. During the years examined by the Subcommittee,
WaMu sold a variety of loans to both Fannie Mae and Freddie Mac, including 15, 20, and 30-
year fixed rate mortgages; Option ARMs; interest-only ARMs; and hybrid ARMs.518
A September 2005 chart prepared by WaMu, identifying the loans it sold to Fannie Mae
and Freddie Mac during the first part of that year, details the types and volumes of loans
involved.519 The chart showed, for example, that the largest category of loans that WaMu sold to
Fannie and Freddie at that point in 2005 was fixed rate loans, which together totaled nearly
140,000 loans with a collective, total loan amount of about $24.3 billion.520 The next largest
category of loans was Option ARMs, which WaMu sold only to Freddie Mac and which
consisted of 35,421 loans with a total loan amount of about $7.9 billion.521 The third largest
category was interest-only ARMs, totaling about 8,400 loans with a total loan amount of about
$2 billion.522 The fourth largest category was hybrid ARMs, totaling 6,500 loans with a total
loan amount of about $1.4 billion.523 WaMu also sold other loans to Fannie and Freddie which
included 6,020 loans of various types bearing a total loan amount of about $2 billion.524
The chart showed that, altogether by September 2005, WaMu had sold Fannie and
Freddie about 196,000 loans with a total loan amount of $36.5 billion.525 About 70% were fixed
rate loans;526 about 20% were Option ARMs;527 and other types of loans made up the final 10%.
In addition to those single family mortgages, WaMu had an active business with Fannie and
Freddie regarding loans related to multifamily apartment buildings.528 The 2005 loan data
indicates that WaMu sold twice as many loans to Fannie and Freddie as it did to all other buyers
518 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit
4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). For more information on these types of
loans, see Chapter II, above. WaMu did not sell loans directly to Ginnie Mae which, instead, guaranteed certain
government backed mortgages when they were securitized by one of its approved securitizers. The WaMu chart
showed that, in 2005, WaMu originated 35,291 loans with a total loan amount of about $4.6 billion that were
securitized with Ginnie Mae guarantees. Id.
Most of those loans were fixed rate mortgages, but they also included the higher
520 Id. The WaMu chart showed that WaMu sold 31,460 fixed rate loans with a total loan amount of about $5.2
billion to Fannie Mae, and 108,246 loans with a total loan amount of about $19.1 billion to Freddie Mac.
522 Id. The WaMu chart showed that WaMu sold 5,350 interest-only ARMs with a total loan amount of about $1.3
billion to Fannie Mae, and 3,016 interest-only ARMs with a total loan amount of $724 million to Freddie Mac.
523 Id. The WaMu chart showed that WaMu sold 3,250 hybrid ARMs with with a total loan amount of nearly $700
million to Fannie Mae, and 3,303 hybrid ARMs with a total loan amount of nearly $700 million to Freddie Mac.
524 Id. See chart for more detail.
525 Id. The chart showed that, altogether, WaMu sold about 45,000 loans with a total loan amount of $7.9 billion to
Fannie Mae and 151,000 loans with a total loan amount of about $28.6 billion to Freddie Mac.
526 By loan number, the percentage is 71%; by loan amount, the percentage is 67%.
527 By loan number, the percentage is 18%; by loan amount, the percentage is 22%.
528 See, e.g., 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at
JPM_WM02405461, JPM_WM02405467, Hearing Exhibit 4/16-86 (chart entitled, “Overview of the Alliance,” and
“WaMu was responsible for 34.7% of Fannie Mae’s Multifamily business”).
529 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit
4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). During the same time period in 2005,
WaMu sold about 99,000 loans with a total loan amount of about $35 billion to buyers other than Fannie and
risk Option ARMs. In 2005, for example, WaMu sold three times as many Option ARMs to
Freddie Mac than to all of its other buyers combined.530
The amount and variety of the loans that WaMu sold to the GSEs fluctuated over time.
For example, the following chart, which is taken from data compiled by Inside Mortgage
Finance, presents the total dollar volume of loans sold by WaMu to Fannie and Freddie from
2000 until 2008 when WaMu was sold, as well as the percentage those loans represented
compared to WaMu’s total loan originations.531
Year Sold to Freddie Mac
Sold to Fannie Mae
Percent of Total WaMu
Originations Sold to GSEs
2000 $ 0 $ 7.1 14%
2001 $ 1.4 $ 35.3 20%
2002 $ 0.2 $ 95.7 29%
2003 $ 2.2 $ 174.3 40%
2004 $ 1.1 $ 25.9 10%
2005 $ 34.6 $ 20.3 20%
2006 $ 32.3 $ 11.2 23%
2007 $ 31.8 $ 8.2 29%
2008 $ 20.8 $ 2.1 70%
TOTAL $ 124.4 $ 380.1 27.3%
Source: Inside Mortgage Finance
The data indicates that, in total, WaMu sold more than half a trillion dollars in loans to the two
GSEs in the nine years leading up to the bank’s collapse, accounting for more than a quarter of
all of the loans WaMu originated.
The documents obtained by the Subcommittee indicate that, from 2004 to 2008, Fannie
Mae and Freddie Mac competed to purchase billions of dollars in WaMu’s residential mortgage
loans, and WaMu used that competition to negotiate better terms for its loan sales. Twice during
that period, WaMu successfully played one GSE off the other to sell more high risk Option
ARM loans under better terms to Freddie Mac.
Freddie. The two largest categories of loans sold to buyers other than Fannie or Freddie were jumbo loans (43,758
loans with a total loan amount of $26.9 billion) and government backed loans sold to Ginnie Mae (35,291 loans with
a total loan amount of $4.6 billion). Id.
530 Id. The chart indicates that WaMu sold over 17,000 loans with a total loan amount of nearly $4 billion to Freddie
Mac, but only 5,841 Option ARMs with a total loan amount of $1.2 billion to all other buyers. It is possible,
however, that the data on Option ARMs sold to other buyers is understated if some portion of the loans categorized
on the chart as “jumbo” loans were, in fact, also Option ARMs. See, e.g., Id. at JPM_WM02575611, Hearing
Exhibit 4/16-91 (interpretive note below chart); 8/2006 WaMu chart entitled, “WaMu Originations Product Mix,” at
JPM_WM00212644, Hearing Exhibit 4/13-37 (showing that WaMu used Option ARMs in both conforming and
jumbo loans). In addition to selling Option ARMs to Freddie Mac and others, WaMu kept a portion of the Option
ARMs it originated in its investment portfolio and securitized still others.
531 “Historical Data from Inside Mortgage Finance, Inside Mortgage Finance, www.imfpubs.com/data.
F. Destructive Compensation Practices
Washington Mutual and Long Beach’s compensation practices contributed to and
deepened its high risk lending practices. Loan officers and processors were paid primarily on
volume, not primarily on the quality of their loans, and were paid more for issuing higher risk
loans. Loan officers and mortgage brokers were also paid more when they got borrowers to pay
higher interest rates, even if the borrower qualified for a lower rate—a practice that enriched
WaMu in the short term, but made defaults more likely down the road. Troubling compensation
practices went right to the top. In 2008, when he was asked to leave the bank that failed under
his management, CEO Kerry Killinger received a severance payment of $15 million.532
(1) Sales Culture
WaMu’s compensation policies were rooted in the bank culture that put loan sales ahead
of loan quality. As early as 2004, OTS expressed concern about WaMu’s sales culture: “The
overt causes for past underwriting concerns were many, but included: (1) A sales culture
focused heavily on market share via loan production, (2) extremely high lending volumes.”533 In
early 2005, WaMu’s Chief Credit Officer complained to Mr. Rotella that: “[a]ny attempts to
enforce [a] more disciplined underwriting approach were continuously thwarted by an
aggressive, and often times abusive group of Sales employees within the organization.”534 The
aggressiveness of the sales team toward underwriters was, in his words, “infectious and
In late 2006, as home mortgage delinquency rates began to accelerate and threaten the
viability of WaMu’s High Risk Lending Strategy, Home Loans President David Schneider
presided over a “town hall” meeting to rally thousands of Seattle based employees of the WaMu
Home Loans Group.536
532 See “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by
the Subcommittee, Hearing Exhibit 4/13-1h.
At the meeting, Mr. Schneider made a presentation, not just to WaMu’s
sales force, but also to the thousands of risk management, finance, and technology staff in
533 5/12/2004 OTS Safety & Soundness Examination Memo 5, “SFR Loan Origination Quality,” at 1, Hearing
534 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current
Conditions, and Future Opportunities,” JPM_WM00783315 (a legal pleading states this draft memorandum was
prepared for Mr. Rotella by WaMu’s Chief Credit Officer in or about February or March 2005; FDIC v. Killinger,
Case No. 2:2011cv00459 (W.D. Wash.), Complaint (March 16, 2011), at ¶ 35).
535 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current
Conditions, and Future Opportunities,” JPM_WM00783315, at JPM_WM00783322.
536 Mr. Schneider told the Subcommittee that this meeting was held in early 2007, but Ms. Feltgen’s end of 2006
email to her staff quotes Mr. Schneider’s language from this presentation. 1/3/2007 email from Ron Cathcart to
Cheryl Feltgen, Hearing Exhibit 4/13-73.
attendance.537 The title and theme of his presentation was: “Be Bold.”538 One slide
demonstrates the importance and pervasiveness of the sales culture at WaMu:539
When asked about this presentation, Mr. Schneider told the Subcommittee it was an appropriate
message, even for WaMu’s risk managers.540
The sales culture was also promoted through WaMu’s “President’s Club,” which
sponsored an annual all-expense-paid gala and retreat in an exotic locale, such as Hawaii or the
Bahamas, where the top producing loan officers were feted and lavished with gifts and
plaudits.541 Only a limited number of top producing loan officers were made members of the
club, and the President’s Club trips were used to incentivize sales volume. Loan officers were
encouraged to look up their sales rankings on the company’s intranet to see if they would qualify
for a trip.
In November 2006, as subprime mortgages began to incur delinquencies, Mr. Schneider
sent a letter about the President’s Club to WaMu loan consultants. Under a photo of the Grand
Hyatt Kauai in Hawaii and the banner headline, “President’s Club – Take the Lead!,” Mr.
537 Subcommittee interview of David Schneider (2/17/2010).
538 “Way2Go, Be Bold!,” WaMu presentation prepared by David Schneider, Home Loans President, at 28, Hearing
539 Id. at 30 [recreated by the Subcommittee staff from an image].
540 Subcommittee interview of David Schneider (2/17/2010).
541 Subcommittee interviews of Brian Minkow (2/16/2010), David Schneider (2/17/2010), and Kerry Killinger
“I attended WaMu’s President’s Club last year for the first time and had an awesome
time getting to know the stars of our sales force. You work hard, but you know how to
have a good time too….
“At the first-class awards dinner, I looked around the room and felt honored to be with so
many talented people. Congratulations to those of you who were repeat President’s Club
honorees. Of those of you who have not yet reached the President’s Club, I want each
and every one of you to believe you have the potential to achieve this great reward.
“Now is the time to really kick it into high gear and drive for attending this awesome
event! Rankings are updated and posted monthly on the DashBoards (under reports) and
on WaMu.net: President’s Club Rankings. Where do you rank? What can you do to take
your business [to] the next level? Your management team is here to help.”542
At the April 13 Subcommittee hearing, Mr. Schneider testified:
“As housing prices peaked, the economy softened, and credit markets tightened, WaMu
adopted increasingly conservative credit policies and moved away from loan products
with greater credit risk. ... During my time at WaMu, we reduced and then entirely
stopped making Alt A loans and Option ARM loans.”543
However, his November 2006 letter to WaMu loan consultants showed no reticence about the
High Risk Lending Strategy. The letter went on to say:
“As you know, growth is a key area of focus for WaMu and Home Loans. I am
extremely proud of the achievements in Production so far this year—and I know it’s been
tough. I’m especially pleased with your ability to change with the market and
responsibly sell more higher-margin products—Option ARM, Home Equity, Non-prime,
and Alt A. I also know that you—truly the best sales team in the industry—are up to the
challenge of doing even more by year end. ...
“I hope to see you in Kauai!”544
The 2005 President’s Club retreat had taken place in Maui. The awards night was hosted
by Magic Johnson. An excerpt of the script from the evening gives a sense of the proceedings:
Good evening ladies and gentleman and welcome to your President’s Club 2005
Awards Night program!
Please welcome the host of President’s Club, the President of the Washington
Mutual Home Loans Group, Mr. David Schneider!
542 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62.
543 Prepared statement of David Schneider, April 13, 2010 Subcommittee Hearing.
544 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62.
FOR DAVID SCHNEIDER
Thank you ladies and gentlemen, and welcome to this very special Awards
Wow, could you feel the energy and excitement tonight out on the Red Carpet?!
Talk about star power!
And it was great fun to learn so much more about some of you during the
interviews … and at the bar.
But don’t worry. I’m told that the age-old tradition here at Washington Mutual is,
‘What happens at President’s Club stays at President’s Club.’ And who am I to
mess with tradition?
Tonight we are gathered together to pay the highest respects and honors to those
who deserve them the most, the President’s Club Class of 2005. …
And of course I want to pay special homage to all of you astonishing returning
champions of President’s Club. You multiple award-winning superstars clearly
lead our entire industry as the standard others can only attempt to match. You
folks really do make this feel like the academy awards tonight because
everywhere I turn I see another star of another box office sensation.”545
This 2005 awards ceremony was attended by WaMu loan officers Luis Fragoso and Thomas
Ramirez at the same time they were under investigation for fraud. Both were members of the
President’s Club in 2005 and 2006.
When asked about the sales culture at the bank, Mr. Vanasek testified at the hearing that
he tried in vain to counter it. He recalled one occasion at an annual management retreat in 2004,
in which the bank was promoting a new advertising slogan called, “The Power of Yes”:
“I stood in front of thousands of senior Washington Mutual managers and executives in
an annual management retreat in 2004 and countered the senior executive ahead of me on
the program who was rallying the troops with the company's advertising line, ‘The power
of yes.’ The implication of that statement was that Washington Mutual would find some
way to make a loan. The tag line symbolized the management attitude about mortgage
lending more clearly than anything I can tell you.
545 2005 “President’s Club 2005 - Maui, Awards Night Show Script,” Washington Mutual, Home Loans Group,
Hearing Exhibit 4/13-63a.
“Because I believed this sent the wrong message to the loan originators, I felt compelled
to counter the prior speaker by saying to the thousands present that the power of yes
absolutely needed to be balanced by the wisdom of no. This was highly unusual for a
member of the management team to do, especially in such a forum. In fact, it was so far
out of the norm for meetings of this type that many considered my statement exceedingly
risky from a career perspective.”546
The President’s Club annual trip was the pinnacle of WaMu awards to its top producing
loan consultants. One loan consultant interviewed by the Subcommittee described it as an
incredible experience, with first class airfare, daily gifts, lavish food, and top entertainment for
both employees and their spouses.547 It was also an opportunity to meet WaMu’s top executives,
including Mr. Killinger, Mr. Rotella, and Mr. Schneider. It sent a powerful message about the
priority that WaMu placed on loan volume and sales of higher risk loans.
(2) Paying for Speed and Volume
The Long Beach and Washington Mutual compensation systems encouraged high
volumes of risky loans but provided little or no incentive to ensure high quality loans that
complied with the bank’s credit requirements. WaMu loan officers or their sales associates
typically interacted directly with customers interested in obtaining loans. Some also were
allowed to accept loans brought to them by third party lenders or mortgage brokers. Long Beach
account executives dealt only with third party lenders or mortgage brokers; they did not deal
directly with customers. After reaching agreement on a loan, the WaMu or Long Beach loan
officers or executives completed the loan application and sent it to a loan processing center
where the application was reviewed by an underwriter and, if approved, underwent further
processing and brought to a loan closing.
Long Beach and Washington Mutual loan officers received more money per loan for
originating higher risk loans and for exceeding established loan targets. Loan processing
personnel were compensated according to the speed and number of the loans they processed.
Loan officers and their sales associates received still more compensation if they charged
borrowers higher interest rates or points than required in bank rate sheets specifying loan prices,
or included prepayment penalties in the loan agreements. That added compensation created
incentives to increase loan profitability, but not loan quality. A 2008 OTS review elaborated:
“[T]he review defines an origination culture focused more heavily on production volume
rather than quality. An example of this was a finding that production personnel were
allowed to participate in aspects of the income, employment, or asset verification process,
a clear conflict of interest. … Prior OTS examinations have raised similar issues
546 April 13, 2010 Subcommittee Hearing at 16-17.
547 Subcommittee interview of Brian Minkow (2/16/2010).
including the need to implement incentive compensation programs to place greater
emphasis on loan quality.”548
(a) Long Beach Account Executives
Despite the years of internal and external audits that found a lack of internal controls at
Long Beach that led to some of the worst rates of loan delinquency in the subprime industry,
Long Beach continued to incentivize production volume over sound lending. The Subcommittee
obtained a presentation of the Long Beach 2004 Incentive Plan.549 The plan outlines four
compensation tiers based on volume, creating a system where the largest producers not only
make more money by issuing more loans, but rather, as producers climb more of the tiers, they
earn a higher rate of commission as well. Tier 1 Long Beach account executives, those who
closed 1-6 loans or funded up to $899,000 in loans per month, received 40 basis points (bps)
commission for each broker sourced loan.550 Tier 2 Long Beach account executives, those who
closed 7-12 loans or funded between $900,000 and $2,499,999 in loans per month, received 50
bps commission for each broker sourced loan plus $30 per loan in additional compensation. Tier
3 Long Beach account executives, those who closed 13-26 loans or funded between $2,500,000
and $4,999,999 in loans per month, received 55 bps commission for each broker sourced loan
plus $30 additional per loan. Tier 4 Long Beach account executives, those who closed more than
26 loans or funded more than $5,000,000 in loans per month, received 60 bps commission for
each broker sourced loan.551
The 2004 Long Beach Incentive Plan also introduced a contingent compensation program
called, “Long Term Cash Incentive Program,” which provided bonuses tied to the performance
of WaMu stock and could be converted to cash over a three-year period. Top producing Long
Beach account executives received the Long Term Cash Incentive bonus calculated as a small
percentage of overall volume. Like the tier system, as volume increased so did the percentage
used to calculate the bonus. Account executives ranked in the top 25% in volume received a five
bps bonus on their total production, account executives in the top 15% received a 7.5 bps bonus,
and account executives in the top 5% received a 10 bps bonus. These bonuses could add up to
tens of thousands, if not hundreds of thousands of dollars.552
In addition, in 2004, the top 40 Long Beach account executives were rewarded with a trip
to the President’s Club. Long Beach used a point system to calculate the top account executives
for this purpose. Three points were awarded for each loan unit funded for first mortgages, two
548 6/19/2008 OTS Findings Memorandum, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13-
549 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59a.
550 Id. The “units” referred to in the document are “loans.” Subcommittee interview of Brian Minkow (2/16/2010).
By awarding “basis points” the compensation system ensured that the account executives got a percentage of the
loan amounts that they successfully issued after receiving loan information from a broker, incentivizing them to
maximize the dollar amount of the loans they issued. Some were also paid a per loan fee, incentivizing them to sell
as many loans as possible.
points were awarded for each purchase unit funded (as opposed to a refinance), and two points
were awarded for each $100,000 funded. The point system created a competition that focused
primarily on volume. The 2004 incentive plan makes no reference to loan quality.553
Long Beach regularly made changes to the compensation plan, but the basic volume
incentives remained. In the 2007 incentive plan, which took effect after the collapse of the
subprime market, the volume requirements were even greater than 2004 requirements. In 2007,
the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13
qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans
and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or
(b) WaMu Loan Consultants
Like Long Beach, at WaMu loan officers were compensated for the volume of loans
closed and loan processors were compensated for speed of loan closing rather than a more
balanced scorecard of timeliness and loan quality. According to the findings and
recommendations from an April 2008 internal investigation into allegations of loan fraud at
“A design weakness here is that the loan consultants are allowed to
communicate minimal loan requirements and obtain various verification
documents from the borrower that [are] need[ed] to prove income,
employment and assets. Since the loan consultant is also more intimately
familiar with our documentation requirements and approval criteria, the
temptation to advise the borrower on means and methods to game the
system may occur. Our compensation and reward structure is heavily
tilted for these employees toward production of closed loans.”555
An undated presentation obtained by the Subcommittee entitled, “Home Loans Product
Strategy, Strategy and Business Initiatives Update,” outlines WaMu’s 2007 Home Loans
Strategy and shows the decisive role that compensation played, while providing still more
evidence of WaMu’s efforts to execute its High Risk Lending Strategy:
“2007 Product Strategy
Product strategy designed to drive profitability and growth
-Driving growth in higher margin products (Option ARM, Alt A,
Home Equity, Subprime) …
554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b.
555 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name
redacted],” at 11, Hearing Exhibit 4/13-24.
-Recruit and leverage seasoned Option ARM sales force, refresh
existing training including top performer peer guidance
-Maintain a compensation structure that supports the high margin
The presentation goes on to explain the Retail Loan Consultant incentive plan: “Incentive Tiers
reward high margin products … such as the Option ARM, Non-Prime referrals and Home Equity
Loans …. WaMu also provides a 15 bps ‘kicker’ for selling 3 year prepayment penalties.”557
In order to promote high risk, high margin products, WaMu paid its loan consultants
more to sell them. WaMu divided its products into four categories: “W,” “A,” “M,” and “U.”
WaMu paid the highest commissions for “W” category products, and in general, commissions
decreased though the other categories. “W” products included new Option ARMs, “Non-prime”
referrals, and home equity loans. “A” products included Option ARM refinancings, new hybrid
ARMs, new Alt A loans, and new fixed rate loans. Like Long Beach, WaMu also created four
compensation tiers with increasing commissions based on volume. The tiers were called:
“Bronze,” “Silver,” “Gold,” and “Platinum.”558 Even in 2007, WaMu’s compensation plan
continued to incentivize volume and high risk mortgage products.
In 2007, WaMu also adopted a plan to pay “overages,” essentially a payment to loan
officers who managed to sells mortgages to clients with higher rates of interest than the clients
qualified for or were called for in WaMu’s daily rate sheets. The plan stated:
“Overages … [give a] Loan Consultant [the] [a]bility to increase compensation [and]
[e]nhance compensation/incentive for Sales Management …. Major national competitors
have a similar plan in place in the market. ”559
Under the 2007 plan, if a loan officer sold a loan that charged a higher rate of interest than
WaMu would have accepted according to its rate sheet, WaMu would split the additional profit
with the loan officer.560 This compensation practice, often referred to as awarding “yield spread
premiums,” has been barred by the Dodd-Frank Act implementing financial reforms.561
556 2007 WaMu Home Loans Product Strategy, “Strategy and Business Initiatives Update,” JPM_WM03097217,
Hearing Exhibit 4/13-60a [emphasis in original].
559 12/6/2006 WaMu Home Loan Credit Risk F2F, JPM_WM02583396-98, Hearing Exhibit 4/13-60b (The proposal
to pay overages , adopted in 2007, increased compensation for loan officers who sold loans with a higher interest
rate or more points than required on WaMu’s daily rate sheet.)
560 Subcommittee interview of David Schneider (2/17/2010).
561 Section 1403 of the Dodd-Frank Act (prohibiting “steering incentives”).
(c) Loan Processors and Quality Assurance Controllers
At Long Beach and WaMu, volume incentives were not limited to the sales people. Back
office loan processors and quality control personnel were also compensated for volume. While
WaMu executives and senior managers told the Subcommittee that quality control was
emphasized and considered as part of employee compensation, the back office staff said
otherwise.562 Diane Kosch worked as a Quality Assurance Controller in a Long Beach Loan
Fulfillment Center (LFC) in Dublin, California, east of San Francisco Bay. She told the
Subcommittee that the pressure to keep up with the loan volume was enormous. Each month the
LFC would set volume goals, measured in dollar value and the number of loans funded. At the
end of each month the pressure to meet those goals intensified. Ms. Kosch said that at month’s
end, she sometimes worked from 6:00 a.m. until midnight reviewing loan files. Monthly rallies
were held, and prizes were awarded to the underwriters and loan processors who had funded the
Documents obtained by the Subcommittee confirm Ms. Kosch’s recollections. A
September 2004 email sent to all Dublin LFC employees with the subject line, “Daily
Productivity – Dublin,” by the area manager uses creative formatting to express enthusiasm:
“Less than 1 week and we have a long way to go to hit our 440M!
including today, we have 4 days of fundings to end the Quarter
with a bang! With all the new UW changes, we will be swamped
next month, so don’t hold any back!
4 days…..it’s time for the mad dash to the finish line! Who is in
Loan Set Up – Phuong is pulling away with another 18 files set
up yesterday for 275 MTD! 2nd place is held by Jean with
243…can you catch Phuong? Get ready Set Up – come October,
it’s going to get a little crazy!
Underwriting – Michelle did it! She broke the 200 mark with 4
days left to go! Nice job Michelle! 2nd place is held by Andre
with 176 for the month! Way to go Andre! Four other UW’s had
solid performances for the day as well including Mikhail with 15!
Jason and Chioke with 11 and June with 10 – The double digit
562 Subcommittee interview of Mark Brown (2/19/2010). Mr. Brown, WaMu National Underwriting Director, told
the Subcommittee that incentives for loan processors were based on quality standards and monthly volume.
563 Subcommittee interview of Diane Kosch (2/18/2010).
564 9/2004 Long Beach processing center internal email, Hearing Exhibit 4/13-61. In the email, “UW” stands for
Underwriting or Underwriter, and “SLC” stands for Senior Loan Coordinator.
Ms. Kosch told the Subcommittee that from late 2005 until early 2007, loan volume
increased and loan quality remained very poor. She said that just about every loan she reviewed
was a stated income loan, sloppy, or appeared potentially fraudulent. Yet she was not given the
resources or support to properly review each loan. Ms. Kosch said that she was told by a Quality
Control manager that she should spend 15 minutes on each file, which she felt was insufficient.
Yet, because Quality Assurance Controllers received a bonus on the basis of the number of loans
they reviewed, she said some of her colleagues spent only ten minutes on each file.565
Ms. Kosch found that often, when she tried to stop the approval of a loan that did not
meet quality standards, it would be referred to management and approved anyway. She said
good Quality Assurance Controllers were treated like “black sheep,” and hated because they got
in the way of volume bonuses. She said certain brokers were identified as “elite,” and the Dublin
LFC employees were told to, “take care of them.” Ms. Kosch even suspected some underwriters
were getting kickbacks, in part, because of the clothes they wore and cars they drove, which she
believed would have been unaffordable to even the top back office employees. She reported her
suspicions to her supervisor, but she was not aware of any action taken as a result.
As it turns out, Ms. Kosch’s concerns about fraud were not unfounded. The Daily
Productivity email quoted above also lauds the work of a Senior Loan Coordinator (SLC) named
“SLC – This one is still tight with Sandy holding on to the first place slot! Sandy
funded 4 more on Friday for a MTD total of 46! 2nd place is John Ngo with 4 fundings
on Friday and 44 MTD – only 2 back!”
About a year after this email was sent, the FBI began to question Mr. Ngo about a scheme to buy
houses in Stockton, California with fake documents and stolen identities. According to court
records, the FBI had uncovered documents that showed Mr. Ngo had received more than
$100,000 in payments from a mortgage broker, allegedly bribes to approve bad loans. Mr. Ngo’s
estranged wife told the FBI that she didn’t know how he could afford their $1.4 million home for
which he made a down payment of $350,000. At the time, his salary at Long Beach was
Mr. Ngo later pled guilty to perjury and agreed to testify against his Long Beach sales
associate, Joel Blanford. Long Beach paid Mr. Blanford more than $1 million in commissions
each year from 2003-2005. According to the Department of Justice:
“NGO admitted in his plea agreement that most of the payments were to ensure
that fraudulent loan applications were processed and funded. NGO also admitted
he received payments from Long Beach Mortgage sales representatives to push
applications through the funding process. He knew many of these applications
565 Subcommittee interview of Diane Kosch (2/18/2010).
566 “At Top Subprime Mortgage Lender, Policies Were an Invitation to Fraud,” Huffington Post Investigative Fund
were fraudulent, and he and others took steps to ‘fix’ applications by creating
false documents or adding false information to the applications or the loan
(3) WaMu Executive Compensation
Questionable compensation practices did not stop in the loan offices, but went all the way
to the top of the company. WaMu’s CEO received millions of dollars in pay, even when his high
risk loan strategy began unraveling, even when the bank began to falter, and even when he was
asked to leave his post. From 2003 to 2007, Mr. Killinger was paid between $11 million and $20
million each year in cash, stock, and stock options. In addition, WaMu provided him with four
retirement plans, a deferred bonus plan, and a separate deferred compensation plan. In 2008,
when he was asked to leave to leave the bank, Mr. Killinger was paid $25 million, including $15
million in severance pay. Altogether, from 2003 to 2008, Washington Mutual paid Mr. Killinger
nearly $100 million, on top of multi-million-dollar corporate retirement benefits.568
As WaMu began losing billions of dollars due to the declining value of its loans and
mortgage backed securities, top management paid significant attention to ensuring that they
would be well compensated despite the crisis. In January 2008, Mr. Killinger sent Mr. Rotella an
email with the subject “comp,” seeking input on formulating compensation recommendations for
the Board of Directors’ Human Resources Committee. The email discussed compensation for
WaMu’s top executives. Mr Killinger wrote: “Our current thinking is to recommend that equity
grants be in options this year. … I am considering an additional restricted stock grant which
would help a bit on retention and to help offset the low bonus for 2007.” 569
Mr. Rotella responded that he thought WaMu executives would want more of their
bonuses in cash:
“[T]he feeling people will have about this is tied to the level of pain on the cash bonus
side …. Unfortunately more than a few feel that our stock price will not easily recover,
that it is highly dependent on housing and credit and they can’t influence that at all. This
will come on the heels of what will be a terrible fourth qtr, and likely very poor results in
the first half along with continued bad news in the environment. So we will have some
people thinking, ‘this is nice but I don’t see the upside in a time frame that works.’ Also,
as you know folks feel very burned by the way their paper was tied to performance
targets that they now see as unrealistic and tied to housing and have a jaundiced view of
paper. … People want more certainty now with some leverage, not a high dose of
leverage with low cash.”570
567 6/19/2008 Department of Justice press release, “Federal Authorities Announce Significant Regional Federal
Mortgage Fraud Investigations and Prosecutions Coinciding with Nationwide ‘Operation Malicious Mortgage’
568 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the
Subcommittee, Hearing Exhibit 4/13-1h.
569 1/3/2008 email chain between Kerry Killinger and Steve Rotella, JPM_WM01335818, Hearing Exhibit 4/13-65.
Mr. Killinger replied: “In short, the success of the comp program is up to you and me. I think
we are putting the right economics and opportunities on the table. But we have to convince our
folks that they will all make a lot of money by being with WaMu.”571
In February 2008, the Human Resources Committee approved a bonus plan for executive
officers that tried to shield the executive bonuses from any impact caused by WaMu’s mounting
mortgage losses. The Committee established a formula consisting of four weighted performance
measures, but took steps to exclude mortgage losses. The first performance measure, for
example, set a goal for WaMu’s 2008 net operating profit, but adjusted the profit calculation to
exclude: “(i) loan loss provisions other than related to our credit card business and (ii) expenses
related to foreclosed real estate assets.”572 The second performance measure set a target limiting
WaMu’s 2008 noninterest expense, but excluded expenses related to: “(i) business resizing or
restructuring and (ii) foreclosed real estate assets.”573
WaMu filed its executive compensation plan with the SEC, as required. The exclusion of
mortgage related losses and expenses in the plan attracted notice from shareholders and the
press. One March 5, 2008 article entitled, “WaMu Board Shields Executives’ Bonuses,”
reported: “The board of Washington Mutual Inc. has set compensation targets for top executives
that will exclude some costs tied to mortgage losses and foreclosures when cash bonuses are
calculated this year.”574 WaMu employees circulated the article through company email.575
Investors and analysts raised concerns.
Mr. Killinger sought to respond to the controversy in a way that would placate investors
without alienating executives. His solution was to eliminate bonuses for the top five executives,
and make cash payments to the other executives, without making that fact public. In July, Mr.
Killinger emailed Steve Frank, the Chairman of the Board of Directors, with his proposal:
“We would like to have the HR [Human Resources] committee approve excluding the
exec com [Executive Committee] from the 2008 bonus and to approve the cash retention
grants to the non NEOs [Named Executive Officers]. This would allow me to respond to
questions next week regarding the bonus plan on the analyst call. And it would help calm
down some of the EC [Executive Committee] members.”576
In other words, WaMu would announce publicly that none of the Executive Committee members
would receive bonuses in 2008, while quietly paying “retention grants” rather than “bonuses” to
the next tier of executives. Mr. Frank replied, “Sounds OK to me.” Mr. Killinger followed up
with the explanation: “We would disclose the exclusion of EC [Executive Committee] members
from the bonus plan. There would be no disclosure of the retention cash payments. Option
572 2/28/2008 email from David Schneider, “FW: 2008 Leadership Bonus,” JPM_WM02446549.
574 “WaMu Board Shields Executives’ Bonuses,” Wall Street Journal (3/5/2008), Hearing Exhibit 4/13-67.
576 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.
grants would be held off until whenever other comp. actions were done.”577 At WaMu’s annual
meeting with shareholders, the Board indicated that it had “reversed” the decision to exclude
mortgage losses when calculating executive bonuses and made no mention of the cash retention
payments planned for some executives.578
When WaMu failed, shareholders lost all of their investments. Yet in the waning days of
the company, top executives were still well taken care of. On September 8, 2008, Mr. Killinger
walked away with $25 million, including $15 million in severance pay. His replacement, Allen
Fishman, received a $7.5 million signing bonus for taking over the reins from Mr. Killinger in
September 2008.579 Eighteen days later, WaMu failed, and Mr. Fishman was out of a job.
According to his contract, he was eligible for about $11 million in severance pay when the bank
failed.580 It is unclear how much of the severance he received.
G. Preventing High Risk Lending
Washington Mutual was a $300 billion, 120-year-old financial institution that was
destroyed by high risk lending practices. By 2007, stated income loans—loans in which
Washington Mutual made no effort to verify the borrower’s income or assets—made up 50% of
its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. Nearly half of
its loans were Option ARMs of which 95% of the borrowers were making minimum payments
and 84% were negatively amortizing. Numerous loans had loan-to-value ratios of over 80%, and
some provided 100% financing. Loans issued by two high volume loan offices in the Los
Angeles area were found to have loan fraud rates of 58, 62, and even 83%. Loan officer sales
assistants were manufacturing borrower documentation. The bank’s issuance of hundreds of
billions of dollars in high risk, poor quality loans not only destroyed confidence in the bank, but
also undermined the U.S. financial system.
The consequences of WaMu’s High Risk Lending Strategy and the proliferation of its
RMBS structured finance products incorporating high risk, poor quality loans provide critical
lessons that need to be learned to protect the U.S. financial system from similar financial
disasters. A number of developments over the past two years hold promise in helping to address
many of the problems identified in the Washington Mutual case history.
(1) New Developments
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),
P.L. 111-203, which the President signed into law on July 21, 2010, contains a number of
changes in law that will be implemented over the course of 2011. The Dodd-Frank changes
577 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.
578 See, e.g., “Shareholders Score at WaMu,” Bloomberg BusinessWeek (4/15/2008) (“And perhaps most notable:
WaMu reversed a much-criticized decision to leave out the company’s mortgage related losses when calculating
profits that determine executive bonuses for the year ahead.”).
579 “WaMu Creditors could Challenge Payments to Killinger, Others,” Seattle Times (10/1/2008), Hearing Exhibit
580 “WaMu CEO: 3 Weeks Work, $18M,” CNNMoney.com (9/26/2008).
include banning stated income loans; restricting negative amortization loans; requiring lenders to
retain an interest in high risk loan pools that they sell or securitize; prohibiting lenders from
steering borrowers to poor quality, high risk loans; and re-evaluating the role of high risk,
structured finance products in bank portfolios.
Ban on Stated Income Loans. Multiple witnesses at the Subcommittee’s April 16, 2010
hearing on the role of bank regulators expressed support for banning stated income loans. The
FDIC Chairman Sheila Bair testified: “We are opposed to stated income. … We think you
should document income.”581 When asked for his opinion of stated income loans, the FDIC
Inspector General Jon Rymer responded: “I do not think they should be allowed,”582 stressing
the fraud risk: “I really can see no practical reason from a banker’s perspective or a lender’s
perspective to encourage that. … That is just, to me, an opportunity to essentially encourage
fraud.” 583 Treasury Inspector General Eric Thorson also criticized stated income loans,
explaining: “[T]he problem is, you can’t assess the strength of the borrower and that has got to
be at the foundation of underwriting, risk assessment, risk management.”584 Even the former
head of OTS called stated income loans an “anathema” and expressed regret that OTS had
The Dodd-Frank Act essentially bans stated income loans by establishing minimum
standards for residential mortgages in Title XIV of the law. Section 1411 establishes a new
Section 129C of the Truth in Lending Act (TILA) prohibiting lenders from issuing a residential
mortgage without first conducting a “good faith and reasonable” determination, based upon
“verified and documented information,” that a borrower has a “reasonable ability to repay the
loan” and all applicable taxes, insurance, and assessments. Subsection 129C(a)(4) states the
lender “shall verify” the borrower’s income and assets by reviewing the borrower’s W-2 tax
form, tax returns, payroll receipts, financial institution records, or “other third-party documents
that provide reasonably reliable evidence” of the borrower’s income or assets. In addition,
Section 1412 of the Dodd-Frank Act adds a new Subsection 129C(b) to TILA establishing a new
category of “qualified mortgages” eligible for more favorable treatment under federal law. It
states that, in all “qualified mortgages,” the “income and financial resources” of the borrower
must be “verified and documented.”
These statutory requirements, by prohibiting lenders from issuing a residential mortgage
without first verifying the borrower’s income and assets, essentially put an end to stated income
581 April 16, 2010 Subcommittee Hearing at 88.
582 Id. at 27.
583 Id. at 15.
584 Id. at 15.
585 Id. at 42, 142.
586 The Federal Reserve is charged with issuing regulations to implement Section 1411. Federal Reserve regulations
issued in July 2008, under the authority of the Home Ownership and Equity Protection Act (HOEPA) of 1994,
which took effect in October 2009, already require lenders issuing certain high cost mortgages to verify a borrower’s
ability to repay the loan. 73 Fed. Reg. 147, at 44543 (7/30/2008). Since the Dodd-Frank Act applies to all types of
Restrictions on Negative Amortization Loans. Witnesses at the Subcommittee’s April
16 hearing also criticized WaMu’s heavy reliance on Option ARM loans. These loans provided
borrowers with a low initial interest rate, which was followed at a later time by a higher variable
rate. Borrowers were generally qualified for the loans by assuming they would pay the lower
rather than the higher rate. In addition, borrowers were allowed to select one of four types of
monthly payments, including a “minimum payment” that was less than the interest and principal
owed on the loan. If the borrower selected the minimum payment, the unpaid interest was added
to the unpaid loan principal, which meant that the loan debt could increase rather than decrease
over time, resulting in negative amortization.
At the Subcommittee hearing, the FDIC Inspector General Jon Rymer warned that
negative amortization loans are “extraordinarily risky” for both borrowers and banks.587 The
FDIC Chairman Sheila Bair testified:
“We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed
rate. You should document the customer’s ability to repay, not just the initial
introductory rate, but if it is an adjustable product, when it resets, as well.”588
The Dodd-Frank Act does not ban negatively amortizing loans, but does impose new
restrictions on them. Section 1411 amends TILA by adding a new Section 129C(6) that requires,
for any residential mortgage that allows a borrower “to defer the repayment of any principal or
interest,” that the lender vet potential borrowers based upon the borrower’s ability to make
monthly loan payments on a fully amortizing schedule—meaning a schedule in which the loan
would be fully repaid by the end of the loan period—instead of evaluating the borrower’s ability
to make payments at an initial teaser rate or in some amount that is less than the amount required
at a fully amortized rate. The law also requires the lender, when qualifying a borrower, to “take
into consideration any balance increase that may accrue from any negative amortization
provision.” This provision essentially codifies the provisions in the 2006 Nontraditional
Mortgage Guidance regarding qualification of borrowers for negatively amortizing loans.
In addition, Section 1414 of the Dodd-Frank Act adds a new Section 129C(c) to TILA
prohibiting lenders from issuing a mortgage with negative amortization without providing certain
disclosures to the borrower prior to the loan. The lender is required to provide the borrower with
an explanation of negative amortization in a manner prescribed by regulation as well as describe
its impact, for example, how it can lead to an increase in the loan’s outstanding principal
balance. In the case of a first-time home buyer, the lender must also obtain documentation that
the home buyer received homeownership counseling from a HUD-certified organization or
counselor. Finally, Section 1412 of the Dodd-Frank Act, establishing the new favored category
of “qualified mortgages,” states those mortgages cannot negatively amortize.
mortgage loans, the Federal Reserve is expected to issue revised regulations during 2011, expanding the verification
requirement to all mortgage loans.
587 April 16, 2010 Subcommittee Hearing at 16.
588 Id. at 88.
Together, these borrower qualification and disclosure requirements, if well implemented,
should reduce, although not eliminate, the issuance of negative amortization mortgages.
Risk Retention. One of the root causes of the financial crisis was the ability of lenders
like Washington Mutual to securitize billions of dollars in high risk, poor quality loans, sell the
resulting securities to investors, and then walk away from the risky loans it created. At the April
16 Subcommittee hearing, the FDIC Chairman Bair testified:
“[W]e support legislation to require that issuers of mortgage securitizations retain some
‘skin in the game’ to provide added discipline for underwriting quality. In fact, the FDIC
Board will consider … a proposal to require insured banks to retain a portion of the credit
risk of any securitizations that they sponsor.”589
Section 941(b) of the Dodd-Frank Act adds a new section 15G to the Securities Exchange
Act of 1934 to require the federal banking agencies, SEC, Department of Housing and Urban
Development, and Federal Housing Finance Agency jointly to prescribe regulations to “require
any securitizer to retain an economic interest in a portion of the credit risk for any residential
mortgage asset that the securitizer, through the issuance of an asset-backed security, transfers,
sells, or conveys to a third party.”590 The retained economic interest must be “not less than 5
percent of the credit risk” of the assets backing the security, with an exception made for
“qualified residential mortgages,” to be further defined by the regulators. The regulators issued a
proposed rule early in 2011, which is currently the subject of a public comment period.
In the meantime, the FDIC has issued a new regulation, effective September 30, 2010,
that imposes a range of disclosure, risk retention, and other obligations on all insured banks that
issue asset backed securitizations.591 One of the provisions imposes a 5% risk retention
requirement on all asset backed securitizations issued by an insured bank, whether backed by
mortgages or other assets. The provision states that the bank sponsoring the securitization must:
“retain an economic interest in a material portion, defined as not less than five (5)
percent, of the credit risk of the financial assets. This retained interest may be either in
the form of an interest of not less than five (5) percent in each of the credit tranches sold
or transferred to the investors or in a representative sample of the securitized financial
assets equal to not less than five (5) percent of the principal amount of the financial assets
at transfer. This retained interest may not be sold or pledged or hedged, except for the
hedging of interest rate or currency risk, during the term of the securitization.”592
The provision also states that this risk retention requirement applies only until the “effective
589 Id. at 81.
590 Section 941(b) also imposes risk retention requirements on other types of asset backed securities and
collateralized debt obligations.
591 12 CFR § 360.6.
592 12 CFR § 360.6(b)(5)(i).
date” of the regulations to be issued under Section 941 of the Dodd-Frank Act.
The FDIC risk retention requirement, followed by the risk retention requirement to be
developed under the Dodd-Frank Act, should, if well implemented, end the ability of banks to
magnify risk through issuing asset backed securities and then walking away from that risk.
Instead, banks will be required to keep “skin in the game” until each securitization concludes.
Ban on Steering. The Washington Mutual case history also exposed another problem:
compensation incentives that encouraged loan officers and mortgage brokers to steer borrowers
to higher risk loans. Compensation incentives called “overages” at WaMu and “yield spread
premiums” at other financial institutions also encouraged loan officers and mortgage brokers to
charge borrowers higher interest rates and points than the bank would accept, so that the loan
officer or mortgage banker could split the extra money taken from the borrower with the bank.
To ban these compensation incentives, Section 1403 of the Dodd-Frank Act creates a new
Section 129B(c) in TILA prohibiting the payment of any steering incentives, including yield
spread premiums. It states: “no mortgage originator shall receive from any person and no person
shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the
terms of loan (other than the amount of the principal).” It also states explicitly that no provision
of the section should be construed as “permitting any yield spread premium or other similar
compensation.” In addition, it directs the Federal Reserve to issue regulations to prohibit a range
of abusive and unfair mortgage related practices, including prohibiting lenders and brokers from
steering borrowers to mortgages for which they lack a reasonable ability to repay.
The Dodd-Frank provisions were enacted into law shortly before the Federal Reserve, in
September 2010, promulgated new regulations prohibiting a number of unfair or abusive lending
practices, including certain payments to mortgage originators.593 In its notice, the Federal
Reserve noted that its new regulations prohibit many of the same practices banned in Section
1403 of the Dodd Frank Act, but that it will fully implement the new Dodd-Frank measures in a
High Risk Loans. Still another problem exposed by the Washington Mutual case history
is the fact that, in the years leading up to the financial crisis, many U.S. insured banks held
highly risky loans and securities in their investment and sale portfolios. When those loans and
securities lost value in 2007, many banks had to declare multi-billion-dollar losses that triggered
shareholder flight and liquidity runs.
Section 620 of the Dodd-Frank Act requires the federal banking regulators, within 18
months, to prepare a report identifying the activities and investments that insured banks and their
affiliates are allowed to engage in under federal and state law, regulation, order, and guidance,
and analyzing the risks associated with those activities and investments. The federal banking
agencies are also asked to make recommendations on whether each allowed activity or
593 75 Fed. Reg. 185 (9/24/2010).
594 Id. at 58509.
investment is appropriate, could negatively affect the safety and soundness of the banking entity
or the U.S. financial system, and should be restricted to reduce risk.
To further strengthen standards and controls needed to prevent high risk lending and
safeguard the Deposit Insurance Fund, this Report makes the following recommendations.
1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their
regulatory authority to ensure that all mortgages deemed to be “qualified residential
mortgages” have a low risk of delinquency or default.
2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk
retention requirement under Section 941 by requiring the retention of not less than a
5% credit risk in each, or a representative sample of, an asset backed securitization’s
tranches, and by barring a hedging offset for a reasonable but limited period of time.
3. Safeguard Against High Risk Products. Federal banking regulators should
safeguard taxpayer dollars by requiring banks with high risk structured finance
products, including complex products with little or no reliable performance data, to
meet conservative loss reserve, liquidity, and capital requirements.
4. Require Greater Reserves for Negative Amortization Loans. Federal banking
regulators should use their regulatory authority to require banks issuing negatively
amortizing loans that allow borrowers to defer payments of interest and principal, to
maintain more conservative loss, liquidity, and capital reserves.
5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the
Section 620 banking activities study to identify high risk structured finance products
and impose a reasonable limit on the amount of such high risk products that can be
included in a bank’s investment portfolio.
IV. REGULATORY FAILURE:
CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION
Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in
deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest
thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight
largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The
bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing,
accelerating the unraveling of the financial markets. WaMu’s collapse also marked one of the
most spectacular failures of federal bank regulators in recent history.
In 2007, many of WaMu’s home loans, especially those with the highest risk profile,
began experiencing increased rates of delinquency, default, and loss. After the subprime
mortgage backed securities market collapsed in September 2007, Washington Mutual was unable
to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth
quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu
lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and
a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of
Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac,
Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG,
and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From
2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank,
triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into
receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion.
Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s
entire $45 billion Deposit Insurance Fund.
OTS records show that, during the five years prior to its collapse, OTS examiners
repeatedly identified significant problems with Washington Mutual’s lending practices, risk
management, and asset quality, and requested corrective action. Year after year, WaMu
promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond
with meaningful enforcement action, choosing instead to continue giving the bank inflated
ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly
gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators
that WaMu was fundamentally sound.
Federal bank regulators are charged with ensuring that U.S. financial institutions operate
in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed
to prevent Washington Mutual’s increasing use of high risk lending practices and its origination
and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to
adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS
regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems
identified by OTS with minimal regulatory intervention, and expressed reluctance to interfere
with even unsound lending and securitization practices. OTS displayed an unusual amount of
deference to WaMu’s management, choosing to rely on the bank to police itself. The reasoning
appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then
rely on WaMu’s assurances that problems were corrected, with little need for tough enforcement
actions. It was a regulatory approach with disastrous results.
Over the five-year period reviewed by the Subcommittee, OTS examiners identified over
500 serious deficiencies in WaMu operations. Yet OTS did not once, from 2004 to 2008, take a
public enforcement action against Washington Mutual, even when the bank failed to correct
major problems. Only in late 2008, as the bank incurred mounting losses, did OTS finally take
two informal, nonpublic enforcement actions, requiring WaMu to agree to a Board Resolution in
March and a Memorandum of Understanding in September, but neither action was sufficient to
prevent the bank’s failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator,
for stronger measures and even impeded FDIC oversight efforts at the bank. Hindered by a
culture of deference to management, demoralized examiners, and agency infighting, OTS
officials allowed the bank’s short term profits to excuse its risky practices and failed to evaluate
the bank’s actions in the context of the U.S. financial system as a whole.
OTS not only failed to prevent Washington Mutual from engaging in unsafe and unsound
lending practices, it gave its tacit approval and allowed high risk loans to proliferate. As long as
Washington Mutual was able to sell off its risky loans, neither OTS nor the FDIC expressed
concerns about the impact of those loans elsewhere. By not sounding the alarm, OTS and the
FDIC enabled WaMu to construct a multi-billion-dollar investment portfolio of high risk
mortgage assets, and also permitted WaMu to sell hundreds of billions of dollars in high risk,
poor quality loans and securities to other financial institutions and investors in the United States
and around the world. Similar regulatory failings by OTS, the FDIC, and other agencies
involving other lenders repeated these problems on a broad scale. The result was a mortgage
market saturated with risky loans, and financial institutions that were supposed to hold
predominantly safe investments but instead held portfolios rife with high risk, poor quality
mortgages. When those loans began defaulting in record numbers and mortgage related
securities plummeted in value, financial institutions around the globe suffered hundreds of
billions of dollars in losses, triggering an economic disaster. The regulatory failures that set the
stage for these losses were a proximate cause of the financial crisis.
A. Subcommittee Investigation and Findings of Fact
To analyze regulatory oversight of Washington Mutual, the Subcommittee subpoenaed
documents from OTS, the FDIC, and WaMu, including bank examination reports, legal
pleadings, reports, internal memoranda, correspondence, and email. The Subcommittee also
conducted over two dozen interviews with OTS, FDIC, and WaMu personnel, including the
FDIC Chairman, OTS Director, OTS and the FDIC senior examiners assigned to Washington
Mutual, and senior WaMu executives. The Subcommittee also spoke with personnel from the
Offices of the Inspector General (IG) at the FDIC and the Department of Treasury, who were
engaged in a joint review of WaMu’s failure. In addition, the Subcommittee spoke with nearly a
dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 16,
2010, the Subcommittee held a hearing at which OTS, the FDIC, and IG officials provided
testimony; released 92 hearing exhibits; and released the FDIC and Treasury IGs’ joint report on
In connection with the hearing, the Subcommittee released a joint memorandum from
Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the
role of the regulators overseeing WaMu. That memorandum stated:
“Federal bank regulators are supposed to ensure the safety and soundness of individual
U.S. financial institutions and, by extension, the U.S. banking system. Washington
Mutual was just one of many financial institutions that federal banking regulators allowed
to engage in such high risk home loan lending practices that they resulted in bank failure
and damage to financial markets. The ineffective role of bank regulators was a major
contributor to the 2008 financial crisis that continues to afflict the U.S. and world
On March 16, 2011, the FDIC sued the three top former executives of Washington
Mutual for pursuing a high risk lending strategy without sufficient risk management practices
and despite their knowledge of a weakening housing market.596
“Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating
The FDIC complaint states:
Officer Stephen J. Rotella (“Rotella”), and Home Loans President David C. Schneider
(“Schneider”) caused Washington Mutual Bank (“WaMu” or “the Bank”) to take extreme
and historically unprecedented risks with WaMu’s held-for-investment home loans
portfolio. They focused on short term gains to increase their own compensation, with
reckless disregard for WaMu’s longer term safety and soundness. Their negligence, gross
negligence and breaches of fiduciary duty caused WaMu to lose billions of dollars. The
FDIC brings this Complaint to hold these three highly paid senior executives, who were
chiefly responsible for WaMu’s higher risk home lending program, accountable for the
595 See “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
596 The Federal Deposit Insurance Corporation v. Kerry K. Killinger, Stephen J. Rotella, David C. Schneider, et al.,
Case No. 2:11-CV-00459 (W.D. Wash.), Complaint (March 16, 2011), at
http://graphics8.nytimes.com/packages/pdf/business/conformedcomplaint.pdf (hereinafter “FDIC Complaint
Against WaMu Executives”).
The Levin-Coburn memorandum contained joint findings of fact regarding the role of
federal regulators in the Washington Mutual case history. Those findings of fact, which this
Report reaffirms, are as follows.
1. Largest U.S. Bank Failure. From 2003 to 2008, OTS repeatedly identified
significant problems with Washington Mutual’s lending practices, risk management,
and asset quality, but failed to force adequate corrective action, resulting in the largest
bank failure in U.S. history.
2. Shoddy Lending and Securitization Practices. OTS allowed Washington Mutual
and its affiliate Long Beach Mortgage Company to engage year after year in shoddy
lending and securitization practices, failing to take enforcement action to stop its
origination and sale of loans with fraudulent borrower information, appraisal
problems, errors, and notoriously high rates of delinquency and loss.
3. Unsafe Option ARM Loans. OTS allowed Washington Mutual to originate
hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages,
knowing that the bank used unsafe and unsound teaser rates, qualified borrowers
using unrealistically low loan payments, permitted borrowers to make minimum
payments resulting in negatively amortizing loans (i.e., loans with increasing
principal), relied on rising house prices and refinancing to avoid payment shock and
loan defaults, and had no realistic data to calculate loan losses in markets with flat or
declining house prices.
4. Short Term Profits Over Long Term Fundamentals. OTS abdicated its
responsibility to ensure the long term safety and soundness of Washington Mutual by
concluding that short term profits obtained by the bank precluded enforcement action
to stop the bank’s use of shoddy lending and securitization practices and unsafe and
5. Impeding FDIC Oversight. OTS impeded FDIC oversight of Washington Mutual
by blocking its access to bank data, refusing to allow it to participate in bank
examinations, rejecting requests to review bank loan files, and resisting the FDIC
recommendations for stronger enforcement action.
6. FDIC Shortfalls. The FDIC, the backup regulator of Washington Mutual, was
unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the
Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to
limit its examination authority, and did not initiate its own enforcement action against
the bank in light of ongoing opposition by the primary federal bank regulators to
FDIC enforcement authority.
7. Recommendations Over Enforceable Requirements. Federal bank regulators
undermined efforts to end unsafe and unsound mortgage practices at U.S. banks by
issuing guidance instead of enforceable regulations limiting those practices, failing to
prohibit many high risk mortgage practices, and failing to set clear deadlines for bank
8. Failure to Recognize Systemic Risk. OTS and the FDIC allowed Washington
Mutual and Long Beach to reduce their own risk by selling hundreds of billions of
dollars of high risk mortgage backed securities that polluted the financial system with
poorly performing loans, undermined investor confidence in the secondary mortgage
market, and contributed to massive credit rating downgrades, investor losses,
disrupted markets, and the U.S. financial crisis.
9. Ineffective and Demoralized Regulatory Culture. The Washington Mutual case
history exposes the regulatory culture at OTS in which bank examiners are frustrated
and demoralized by their inability to stop unsafe and unsound practices, in which
their supervisors are reluctant to use formal enforcement actions even after years of
serious bank deficiencies, and in which regulators treat the banks they oversee as
constituents rather than arms-length regulated entities.
At the time of its collapse, Washington Mutual Savings Bank was a federally chartered thrift
with over $188 billion in federal insured deposits. Its primary federal regulator was OTS. Due
to its status as an insured depository institution, it was also overseen by the FDIC.
(1) Office of Thrift Supervision
The Office of Thrift Supervision was created in 1989, in response to the savings and loan
crisis, to charter and regulate the thrift industry.597 Thrifts are required by their charters to hold
most of their assets in mortgage lending, and have traditionally focused on the issuance of home
loans.598 OTS was part of the U.S. Department of the Treasury and headed by a presidentially
appointed director. Like other bank regulators, OTS was charged with ensuring the safety and
soundness of the financial institutions it oversaw. Its operations were funded through
semiannual fees assessed on the institutions it regulated, with the fee amount based on the size,
condition, and complexity of each institution’s portfolio. Washington Mutual was the largest
thrift overseen by OTS and, from 2003 to 2008, paid at least $30 million in fees annually to the
agency, which comprised 12-15% of all OTS revenue.599
597 Twenty years after its establishment, OTS was abolished by the Dodd-Frank Wall Street Reform and Consumer
Protection Act, P.L. 111-203, (Dodd-Frank Act) which has transferred the agency’s responsibilities to the Office of
the Comptroller of the Currency (OCC), and directed the agency to cease all operations by 2012. This Report
focuses on OTS during the time period 2004 through 2008.
598 6/19/2002 OTS Regulatory Bulletin, “Thrift Activities Regulatory Handbook Update” (some educational loans,
SBLs, and credit card loans also count towards qualifying as a thrift), http://files.ots.treas.gov/74081.pdf.
599 See April 16, 2010 Subcommittee Hearing at 11 (testimony of Treasury IG Eric Thorson).
In 2009, OTS oversaw about 765 thrift-chartered institutions.600
During the years reviewed by the Subcommittee, the OTS Executive Director was John
Reich; the Deputy Director was Scott Polakoff; the Western Region Office Director was Michael
Finn and later Darrel Dochow; and the Examiners-in-Charge at WaMu were Lawrence Carter
and later Benjamin Franklin.
OTS supervised its
thrifts through four regional offices, each led by a Regional Director, Deputy Director, and
Assistant Director. Regional offices assigned an Examiner-in-Charge to each thrift in its
jurisdiction, along with other supporting examination personnel. Approximately three-quarters
of the OTS workforce reported to its four regional offices, while the remaining quarter worked at
OTS headquarters in Washington, D.C. Washington Mutual, whose headquarters were located in
Seattle, was supervised by the Western Region Office which, through the end of 2008, was based
in Daly City, California.
(2) Federal Deposit Insurance Corporation
WaMu’s secondary federal regulator was the FDIC. The FDIC’s mission is to maintain
stability and public confidence in the nation’s financial system by insuring deposits, examining
and supervising financial institutions for safety and soundness and consumer protection, and
managing failed institutions placed into receivership.601
To minimize withdrawals from the Deposit Insurance Fund, the FDIC is assigned backup
supervisory authority over approximately 3,000 federally insured depository institutions whose
primary regulators are the Federal Reserve, OCC, and, until recently, OTS. Among other
measures, the FDIC is authorized to conduct a “special examination” of any insured institution
“to determine the condition of such depository institution for insurance purposes.”
The FDIC administers the Deposit
Insurance Fund, which is the primary mechanism used to protect covered deposits at U.S.
financial institutions from loss. The Deposit Insurance Fund is financed through fees assessed
on the insured institutions, with assessments based on the amount of deposits requiring
insurance, the amount of assets at each institution, and the degree of risk posed by each
institution to the insurance fund.
facilitate and coordinate its oversight obligations with those of the primary bank regulators and
ensure it is able to protect the Deposit Insurance Fund, the FDIC has entered into an inter-agency
agreement with the primary bank regulators.603
600 2009 OTS Annual Report, “Agency Profile,”
The 2002 version of that agreement, which was
in effect until 2010, stated that the FDIC was authorized to request to participate in examinations
of large institutions or higher risk financial institutions, recommend enforcement actions to be
taken by the primary regulator, and if the primary regulator failed to act, take its own
enforcement action with respect to an insured institution.
601 See “FDIC Mission, Vision, and Values,” http://www.fdic.gov/about/mission/index.html.
602 12 U.S.C. § 1820(b)(3).
603 The interagency agreement is entitled, “Coordination of Expanded Supervisory Information Sharing and Special
Examinations.” During the time period of the Subcommittee’s investigation, the 2002 version of the interagency
agreement, signed by the FDIC, Federal Reserve, OCC, and OTS, was in effect. In July 2010, the federal financial
regulators agreed to adopt a stronger version, discussed later in this Report.
For the eight largest insured institutions at the time, the FDIC assigned at least one
Dedicated Examiner to work on-site at the institution. The examiner’s obligation is to evaluate
the institution’s risk to the Deposit Insurance Fund and work with the primary regulator to lower
that risk. During the period covered by this Report, Washington Mutual was one of the eight and
had an FDIC-assigned Dedicated Examiner who worked with OTS examiners to oversee the
During the years examined by the Subcommittee, the FDIC Chairman was Sheila Bair;
the Acting Deputy Director for the FDIC’s Division of Supervision and Consumer Protection’s
Complex Financial Institution Branch was John Corston; in the San Francisco Region, the
Director was John Carter and later Stan Ivie, and the Assistant Director was George Doerr. At
WaMu, the FDIC’s Dedicated Examiner was Stephen Funaro.
(3) Examination Process
The stated mission of OTS was “[t]o supervise savings associations and their holding
companies in order to maintain their safety and soundness and compliance with consumer laws,
and to encourage a competitive industry that meets America’s financial services needs.” The
OTS Examination Handbook required “[p]roactive regulatory supervision” with a focus on
evaluation of “future needs and potential risks to ensure the success of the thrift system in the
To carry out its mission, OTS traditionally conducted an examination of each of the
thrifts within its jurisdiction every 12 to 18 months and provided the results in a Report of
Examination (“ROE”). In 2006, OTS initiated a “continuous exam” program for its largest
thrifts, requiring its examiners to conduct a series of specialized examinations during the year
with the results from all of those examinations included in an annual ROE. The Examiner-in-
Charge led the examination activities which were organized around the CAMELS rating system
used by all federal bank regulators. The CAMELS rating system evaluates a bank’s: (C) capital
adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to
market risk. A CAMELS rating of 1 is the best rating, while 5 is the worst. In the annual ROE,
OTS provided its thrifts with an evaluation and rating for each CAMELS component, as well as
an overall composite rating on the bank’s safety and soundness.
OTS, like other bank regulators, had special access to the financial information of
the thrifts under its regulation, which was otherwise kept confidential from the market and other
At Washington Mutual, OTS examiners conducted both on-site and off-site activities to
review bank operations, and maintained frequent communication with bank management through
emails, telephone conferences, and meetings. During certain periods of the year, OTS examiners
604 2004 OTS Examination Handbook, Section 010.2, OTSWMEF-0000031969, Hearing Exhibit 4/16-2.
605 A 1 composite rating in the CAMELS system means “sound in every respect”; a 2 rating means “fundamentally
sound”; a 3 rating means “exhibits some degree of supervisory concern in one or more of the component areas”; a 4
rating means “generally exhibits unsafe and unsound practices or conditions”; and a 5 rating means “exhibits
extremely unsafe and unsound practices or conditions” and is of “greatest supervisory concern.” See chart in the
prepared statement of Treasury IG Eric Thorson at 7, reprinted in April 16, 2010 Subcommittee Hearing at 107.
had temporary offices at Washington Mutual for accessing bank information, collecting data
from bank employees, performing analyses, and conducting other exam activities. Washington
Mutual formed a Regulatory Relations office charged with overseeing its interactions and
managing its relationships with personnel at OTS, the FDIC, and other regulators.
During the year, OTS examiners issued “findings memoranda,” which set forth particular
examination findings, and required a written response and corrective action plan from WaMu
management. The memoranda contained three types of findings. The least severe was an
“observation,” defined as a “weakness identified that is not of regulatory concern, but which may
improve the bank’s operating effectiveness if addressed. … Observations may or may not be
reviewed during subsequent examinations.” The next level of finding was a “recommendation,”
defined as a “secondary concern requiring corrective action. … They may be included in the
Report of Examination … Management’s actions to address Recommendations are reviewed at
subsequent or follow-up examinations.” The most severe type of finding was a “criticism,”
defined as a “primary concern requiring corrective action … often summarized in the ‘Matters
Requiring Board Attention’ … section of the Report of Examination. … They are subject to
formal follow-up by examiners and, if left uncorrected, may result in stronger action.”606
The most serious OTS examination findings were elevated to Washington Mutual Bank’s
Board of Directors by designating them as a “Matter Requiring Board Attention” (MRBA).
MRBAs were set forth in the ROE and presented to the Board in an annual meeting attended by
OTS and FDIC personnel. Washington Mutual tracked OTS findings, along with its own
responses, through an internal system called Enterprise Risk Issue Control System (ERICS).
ERICS was intended to help WaMu manage its relationship with its regulators by storing the
regulators’ findings in one central location. In one of its more unusual discoveries, the
Subcommittee learned that OTS also came to rely largely on ERICS to track its dealings with
WaMu. OTS’ reliance on WaMu’s tracking system was a unique departure from its usual
practice of separately tracking the status of its past examination findings and a bank’s
The FDIC also participated in the examinations of Washington Mutual. Because WaMu
was one of the eight largest insured banks in the country, the FDIC assigned a full-time
Dedicated Examiner to oversee its operations. Typically, the FDIC examiners worked with the
primary regulator and participated in or relied upon the examinations scheduled by that regulator,
rather than initiating separate FDIC examinations. At least once per year, the FDIC examiner
performed an evaluation of the institution’s risk to the Deposit Insurance Fund, typically relying
primarily on the annual Report on Examination (ROE) issued by the primary regulator and the
ROE’s individual and composite CAMELS ratings for the institution. After reviewing the ROE
as well as other examination and financial information, the FDIC examiner reviewed the
CAMELS ratings for WaMu to ensure they were appropriate.
606 Descriptions of these terms appeared in OTS findings memoranda. See, e.g., 6/19/2008 OTS Findings
Memorandum of Washington Mutual Bank, at Bisset_John-00046124_002, Hearing Exhibit 4/16-12a.
607 See April 16, 2010 Subcommittee Hearing at 21 (information supplied by Treasury IG Thorson for the record).
In addition, for institutions with assets of $10 billion or more, the FDIC had established a
Large Insured Depository Institutions (“LIDI”) Program to assess and report on emerging risks
that may pose a threat to the Deposit Insurance Fund. Under that program, the FDIC Dedicated
Examiner and other FDIC regional case managers performed ongoing analysis of emerging risks
within each covered institution and assigned it a quarterly risk rating, using a scale of A to E,
with A being the best rating and E the worst. In addition, senior FDIC analysts within the
Complex Financial Institutions Branch analyzed specific bank risks and developed supervisory
strategies. If the FDIC viewed an institution as imposing an increasing risk to the Deposit
Insurance Fund, it could perform one or more “special examinations” to take a closer look.
C. Washington Mutual Examination History
For the five-year period, from 2004 to 2008, OTS repeatedly identified significant
problems with Washington Mutual’s lending practices, risk management, appraisal procedures,
and issued securities, and requested corrective action. WaMu promised to correct the identified
deficiencies, but failed to do so. OTS failed, in turn, to take enforcement action to ensure the
corrections were made, until the bank began losing billions of dollars. OTS also resisted and at
times impeded FDIC examination efforts at Washington Mutual.
(1) Regulatory Challenges Related to Washington Mutual
Washington Mutual was a larger and more complex financial institution than any other
thrift overseen by OTS, and presented numerous regulatory challenges. By 2007, Washington
Mutual had over $300 billion in assets, 43,000 employees, and over 2,300 branches in 15 states,
including a securitization office on Wall Street, a massive loan portfolio, and several lines of
business, including home loans, credit cards, and commercial real estate.
Integration Issues. During the 1990s, as described in the prior chapter, WaMu
embarked upon a strategy of growth through acquisition of smaller institutions, and over time
became one of the largest mortgage lenders in the United States. One consequence of its
acquisition strategy was that WaMu struggled with the logistical and managerial challenges of
integrating a variety of lending platforms, information technology systems, staff, and policies
into one system.
OTS was concerned about and critical of WaMu’s integration efforts. In a 2004 Report
on Examination (ROE), OTS wrote:
“Our review disclosed that past rapid growth through acquisition and unprecedented
mortgage refinance activity placed significant operational strain on [Washington Mutual]
during the early part of the review period. Beginning in the second half of 2003, market
conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past
mortgage banking acquisitions, address operational issues, and realize expectations from
certain major IT initiatives exposed the institution’s infrastructure weaknesses and began
to negatively impact operating results.”608
Long Beach. One of WaMu’s acquisitions, in 1999, was Long Beach Mortgage
Company (Long Beach), a subprime lender that became a source of significant management,
asset quality, and risk problems. Long Beach’s headquarters were located in Long Beach,
California, but as a subsidiary of Washington Mutual Inc., the parent holding company of
Washington Mutual Bank, it was subject to regulation by the State of Washington Department of
Financial Institutions and the FDIC. Long Beach’s business model was to purchase subprime
loans from third party mortgage brokers and lenders and then sell or securitize the loans for sale
For the first seven years, from 1999 to 2006, OTS had no direct jurisdiction over Long
Beach, since it was a subsidiary of WaMu’s parent holding company, but not a subsidiary of the
bank itself. OTS was limited to reviewing Long Beach indirectly by examining its effect on the
holding company and WaMu. In late 2003, OTS examiners took greater notice of Long Beach
after WaMu’s legal department halted Long Beach’s securitizations while it helped the company
strengthen its internal controls. As many as 4,000 Long Beach loans were of such poor quality
that three quarters of them could not be sold to investors. In 2005, Long Beach experienced a
surge in early payment defaults, was forced to repurchase a significant number of loans, lost over
$107 million, and overwhelmed its loss reserves. Washington Mutual requested permission to
make Long Beach a division of the bank, so that it could assert greater control over Long
Beach’s operations, and in March 2006, OTS approved the purchase with conditions. In 2006,
Long Beach experienced another surge of early payment defaults and was forced to repurchase
additional loans. When Long Beach loans continued to have problems in 2007, Washington
Mutual eliminated Long Beach as a separate operation and rebranded it as a Washington Mutual
“Wholesale Specialty Lending” division. In August 2007, after the collapse of the subprime
secondary market, WaMu stopped offering subprime loans and discontinued the last vestiges of
the Long Beach operation.
High Risk Lending. In 2004, Washington Mutual shifted its strategy toward the
issuance and purchase of higher risk home loans. OTS took note of the strategic shift in WaMu’s
“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.”609
608 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed
Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share
to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity
issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been
609 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed
OTS recommended, and the bank agreed, to spell out its new lending strategy in a written
document that had to be approved by the WaMu Board of Directors.610
The result was the bank’s January 2005 High Risk Lending Strategy, discussed in the
prior chapter, in which WaMu management obtained the approval of its Board to shift its focus
from originating lower risk fixed rate and government backed loans to higher risk subprime,
home equity, and Option ARM loans.611 The High Risk Lending Strategy also outlined WaMu’s
plans to increase its issuance of higher risk loans to borrowers with a higher risk profile. The
purpose of the shift was to maximize profits by originating loans with the highest profit margins,which were usually the highest risk loans. According to actual loan data analyzed by WaMu,