higher risk loans, such as subprime, Option ARM, and home equity loans, produced a higher
“gain on sale” or profit for the bank compared to lower risk loans. For example, a presentation
supporting the High Risk Lending Strategy indicated that selling subprime loans garnered more
than eight times the gain on sale as government backed loans.612
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.613 During the Board’s
discussion of the strategy, credit officers noted that losses would likely lag by several years.614
WaMu executives knew that even if loan losses did not immediately materialize, the strategy
presented potentially significant risks down the road. OTS did not object to the High Risk
Lending Strategy, even though OTS noted that the bank’s five-year plan did not articulate a
robust plan for managing the increased risk.615
610 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 [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.”).
611 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at
JPM_WM00302978, Hearing Exhibit 4/13-2a; see also “WaMu Product Originations and Purchases by Percentage –
2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i.
612 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 basis points (bps); for 30-year,
fixed rate loans was 19 bps; for Option ARMs was 109 bps; for home equity loans was 113 bps; and for subprime
loans was 150 bps.)
613 The Home Loans presentation to the Board acknowledged that risks of the High Risk Lending Strategy included
managing credit risk, implementing lending technology and enacting organizational changes. 4/18/2006
Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899, Hearing Exhibit
4/13-3.
614 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes,
JPM_WM06293964-68 at 67; see also 1/2005 Washington Mutual, Higher Risk Lending Strategy Presentation, at
JPM_WM00302987, Hearing Exhibit 4/13-2a (chart showing peak loss rates in 2007).
615 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed
Exhibit].
172
Even before it received formal Board approval, Washington Mutual had begun shifting
its loan originations toward higher risk loans. By 2007, rising defaults and the collapse of the
subprime secondary market prevented WaMu from fully implementing its plans, but it did have
time to shift the composition of the loans it originated and purchased, increasing the percentage
of higher risk home loans from at least 19% in 2003, to over 47% in 2007.616
Over the course of nearly three years, from 2005 to 2007, WaMu issued and securitized
hundreds of billions of high risk loans, including $49 billion in subprime loans617 and $59 billion
in Option ARMs.618 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, of which about 56% of the borrowers were making the minimum payment
amounts.619 The data also showed that 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.620
616 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee,
Hearing Exhibit 4/13-1i.
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
617 “Securitizations of Washington Mutual and Long Beach Subprime Home Loans,” chart prepared by the
Subcommittee, Hearing Exhibit 4/13-1c.
618 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
(hereinafter “Treasury and FDIC IG Report”), at 9, Hearing Exhibit 4/16-82.
619 Id. An August 2006 WaMu internal presentation indicated that over 95% of its Option ARM borrowers were
making minimum payments. See 8/2006 chart, “Borrower-Selected Payment Behavior,” in WaMu internal
presentation entitled, “Option ARM Credit Risk,” JPM_WM00212646, Hearing Exhibit 4/13-37.
620 See Treasury and FDIC IG Report, at 9, Hearing Exhibit 4/16-82.
Fixed
64%
Other ARM
17%
Option
ARM
7%
Subprime
5%
Home
Equity
7%
2003
Fixed
23%
Other
ARM
30%
Option
ARM
18%
Subprime
5%
Home
Equity
24%
2007
173
ARMs, 50% of its subprime loans, and 90% of its home equity loans.621 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 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%.622 Still another problem was that WaMu had high concentrations of its home loans in
California and Florida, states that ultimately suffered above-average home value depreciation.623
WaMu issued loans through its own retail loan offices, through Long Beach, which
issued subprime loans initiated by third party mortgage brokers, and through correspondent and
conduit programs in which the bank purchased loans from third parties. The Treasury and the
FDIC Inspectors General observed that, from 2003 to 2007, 48 to 70% of WaMu’s residential
mortgages came from third party mortgage brokers, and that only 14 WaMu employees were
responsible for overseeing more than 34,000 third party brokers, requiring each WaMu employee
to oversee more than 2,400 third party brokers.624
When the subprime market collapsed in July 2007, Washington Mutual was left holding a
portfolio saturated with high risk, poorly performing loans. Prior to the collapse, WaMu had
sold or securitized the majority of the loans it had originated or purchased, undermining the U.S.
home loan mortgage market with hundreds of billions of dollars in high risk, poor quality loans.
OTS documentation shows that WaMu’s regulators saw what was happening, identified the
problems, but then took no enforcement actions to protect either Washington Mutual or the U.S.
financial system from the bank’s shoddy lending practices.
(2) Overview of Washington Mutual’s Ratings History and Closure
An overview of Washington Mutual’s ratings history shows how OTS and the FDIC were
required to work together to oversee Washington Mutual, which the two agencies did with
varying levels of success. At times, the relationship was productive and useful, while at others
they found themselves bitterly at odds over how to proceed. As Washington Mutual’s problems
intensified, the working relationship between OTS and the FDIC grew more dysfunctional.
From 2004 to 2006, Washington Mutual was a profitable bank and enjoyed a 2 CAMELS
rating from both agencies, signifying it was a fundamentally sound institution. In late 2006, as
housing prices began to level off for the first time in years, subprime loans began to experience
delinquencies and defaults. In part because borrowers were unable to refinance their loans, those
delinquencies and defaults accelerated in 2007. The poorly performing loans began to affect the
payments supporting subprime mortgage backed securities, which began to incur losses. In July
2007, the subprime market was performing so poorly that the major credit rating agencies
suddenly downgraded hundreds of subprime mortgage backed securities, including over 40
issued by Long Beach. The subprime market slowed and then collapsed, and Washington
Mutual was suddenly left with billions of dollars in unmarketable subprime loans and securities
621 Id. at 10.
622 Id.
623 Id. at 11.
624 See Thorson prepared statement, at 5, April 16, 2010 Subcommittee Hearing at 105.
174
that were plummeting in value. WaMu stopped issuing subprime loans. In the fourth quarter of
2007, WaMu reported a $1 billion loss.
As housing prices slowed and even began declining in some parts of the country, high
risk prime loans, including hybrid adjustable rate mortgages, Alt A, and Option ARMs, also
began incurring delinquencies and defaults.625 By March 2008, the total delinquency rate for
prime/Alt A loans underlying WaMu and Long Beach securitizations was 8.57%, more than
twice the industry average.626 In 2008, WaMu did not issue any new high risk, nonconforming
mortgage securitizations due to, in the words of OTS, “continued market illiquidity, deterioration
in the financial condition of the market, and the poor performance of WaMu’s outstanding
securitizations.”627
In the first quarter of 2008, WaMu continued to incur losses as the value of its loan
portfolio and mortgage backed securities continued to drop. In February 2008, OTS downgraded
Washington Mutual for the first time, changing its CAMELS rating from a 2 to a 3, signifying
that the bank was in trouble. Unfortunately, OTS did not follow up with a suitable enforcement
action. Consistent with its own practice, OTS should have required WaMu to enter into a public
Memorandum of Understanding specifying the measures WaMu would take to remedy its
problems. Instead, in March, OTS allowed WaMu to issue a nonpublic Board Resolution in
which the WaMu Board generally promised to address various problems, but did not identify any
specific actions or deadlines.628
Also in March 2008, at the urging of the FDIC, OTS required Washington Mutual to
allow potential buyers of the bank to conduct due diligence of its assets and operations.629
In June 2008, as a result of the bank’s financial and deposit losses, the FDIC downgraded
WaMu to its lowest internal LIDI rating, an E, indicating “serious concern” that the bank would
Several institutions participated, and JPMorgan Chase made an offer to buy the bank which
Washington Mutual turned down. By the end of the first quarter of 2008, Washington Mutual
had lost another $1 billion. In April 2008, to reassure the market and its depositors, the holding
company raised additional capital of $7 billion from the private sector and provided $3 billion of
those funds to the bank. But by the end of the second quarter, WaMu lost another $3.2 billion.
Its stock price plummeted, and depositors began withdrawing substantial sums from the bank.
625 WaMu’s Chief Credit Officer informed the Board of Directors that WaMu was “heavily concentrated” in
residential mortgages and high risk products as well as in “highly stressed” geographic markets, which negatively
affected WaMu’s portfolio performance. See 2/25/2008 Credit Risk Overview Report to the Board of Directors,
prepared by John McMurray, WaMu Chief Credit Officer, JPM_WM02548447, at 28-29. He reported that WaMu’s
mortgages were 1366% of its common tangible equity, the highest percentage of any of the top 20 banks. He also
informed the Board that the bank’s residential mortgages “performed very poorly” and WaMu had “generally
retained higher risk products (e.g., Option ARMS, 2nd Liens, Subprime, Low Doc).”
626 OTS Fact Sheet 12, “Securitizations,” Dochow_Darrel-00001364_001.
627 Id.
628 3/17/2008 letter from Kerry Killinger to Darrel Dochow with enclosed Board Resolution, OTSWMS08-015
0001216. See also Treasury and FDIC IG Report at 31.
629 Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); WaMu Controller Melissa
Ballenger (2/14/2010); and OTS Western Region Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington
Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j.
175
cause a loss to the Deposit Insurance Fund. It also initiated a special insurance examination of
WaMu, which it conducted concurrently with ongoing OTS examination efforts.630
Other financial institutions were also failing, compounding the concern of those who
worried whether the Deposit Insurance Fund had sufficient funds. In July 2008, IndyMac Bank,
another thrift with high risk loans, failed and was taken over by the FDIC.631 In response,
Washington Mutual depositors began to withdraw more funds from the bank, eventually
removing over $10 billion.632 The Federal Home Loan Bank of San Francisco also began to
limit WaMu’s borrowing, further straining its liquidity.633
In the final three months before WaMu’s collapse, tensions increased further between
OTS and the FDIC as they disagreed on the course of action. On July 3, 2008, the head of OTS
sent an email to the CEO of WaMu informing him that the agency had decided to require the
bank to issue a nonpublic Memorandum of Understanding (MOU).
The parent holding company supplied
an additional $2 billion in capital to the bank.
634 On July 15, OTS and the
FDIC met with the WaMu Board of Directors to discuss the latest examination findings and
formally advise the Board of the OTS decision to require the MOU. On July 21, 2008, the FDIC
sent a letter to OTS urging it to take tough supervisory action in the MOU, including by
requiring WaMu to increase its loan loss reserves, begin providing regular financial updates, and
raise an additional $5 billion in capital.635 OTS rejected the FDIC’s advice.636 On July 31, 2008,
both OTS and FDIC officials met with WaMu’s Board. An FDIC official suggested at the Board
meeting that WaMu look for a strategic partner to buy or invest in the bank; OTS expressed
anger that the FDIC had raised the issue without first clearing it with OTS.637
On August 1, 2008, the FDIC informed OTS that it thought WaMu should be
downgraded to a 4 CAMELS rating, signaling it was a troubled bank exhibiting unsafe and
unsound practices.638 OTS strongly disagreed.639
630 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.
Also on August 1, OTS provided WaMu with
the proposed MOU. The proposed MOU would require the bank to correct lending and risk
management deficiencies identified in a June 30 examination report, develop a capital
contingency plan (rather than, as the FDIC originally urged, raise additional capital), submit a 3-
year business plan, and engage a consultant to review its underwriting, risk management,
631 For more information on IndyMac Bank, see section E(2), below.
632 See undated charts prepared by FDIC on “Daily Retail Deposit Change,” FDIC-PSI-01-000009.
633 See, e.g., 12/1/2008 “WaMu Bank Supervisory Timeline,” prepared by OTS Examiner-in-Charge Benjamin
Franklin, at Franklin_Benjamin-00035756_001, at 032 (7/22/2008 entry: “Although they have $60 billion in
borrowing capacity, the FHLB is not in a position to fund more than about $4 to $5 billion a week”). See also FDIC
LIDI Report for the Second Quarter of 2008, at FDIC_WAMU_000014991 [Sealed Exhibit].
634 7/3/2008 email from John Reich to Kerry Killinger, “MOU vs. Board Resolution,” Hearing Exhibit 4/16-44.
635 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.
636 7/22/2008 letter from OTS to FDIC, OTSWMS08-015 0001312, Hearing Exhibit 4/16-60.
637 See 8/1/2008 email exchange among FDIC colleagues, FDIC-EM_00246958, Hearing Exhibit 4/16-64.
638 8/1/2008 email exchange among OTS officials, Hearing Exhibit 4/16-62. The FDIC had performed a capital
analysis earlier in the summer and had been pushing for a downgrade for weeks. See 7/21/2008 letter from FDIC to
OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.
639 8/1/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, Hearing Exhibit 416-63.
176
management, and board oversight. On August 4, WaMu asked OTS to drop the requirement that
the consultant review the Board’s oversight efforts, and OTS agreed.
On August 6, the FDIC Chairman asked the OTS Director to discuss contingency plans
for an emergency closure of the bank. The OTS Director reacted negatively and sent an email
criticizing the FDIC Chairman for acting as if it were the primary regulator of the bank.640
By August 25, OTS and WaMu reached agreement on the terms of the MOU, but it was
not actually signed until September 7, 2008.
As
the agencies argued amongst themselves, the bank’s condition continued to deteriorate.
641 Apart from the capitalization plan, OTS Deputy
Director Scott Polakoff described the final MOU as a “benign supervisory document,”642
meaning it would not bring about meaningful change at WaMu.643
On September 10, 2008, the FDIC Chairman, Sheila Bair, informed WaMu that there was
a ratings disagreement between the FDIC and OTS, and that the FDIC was likely to downgrade
WaMu to a 4. When she informed the OTS Director, John Reich, of her conversation with
WaMu, he sent an internal email to his deputy, Scott Polakoff, venting his frustration that she
had not discussed the matter with him first and allowed OTS to break the news to the bank: “I
cannot believe the continuing audacity of this woman.”644
Six days later, on September 16, 2008, Lehman Brothers declared bankruptcy, triggering
another run on Washington Mutual. Over the next eight days, depositors pulled $17 billion in
cash from WaMu’s coffers, leading to a second liquidity crisis.645 On September 18, the FDIC
downgraded the bank to a 4 rating, and OTS agreed to the lower rating. Within days, because of
the bank’s accelerating liquidity problems, portfolio losses, share price decline, and other
problems, OTS and the FDIC decided they had to close the bank.646
Due to the bank’s worsening liquidity crisis, the regulators abandoned their customary
practice of waiting until markets closed on Friday, and on Thursday, September 25, 2008, OTS
closed Washington Mutual Bank and appointed the FDIC as receiver. The FDIC immediately
sold the bank to JPMorgan Chase for $1.9 billion. If the sale had not gone through, Washington
Mutual’s $300 billion failure might have exhausted the entire $45 billion Deposit Insurance
Fund.
640 See 8/6/2008 email from John Reich, OTS Director, to Sheila Bair, FDIC Chairman, “Re: W,” FDICEM_
00110089, Hearing Exhibit 4/16-66.
641 9/11/2008 OTS document, “WaMu Ratings,” Hearing Exhibit 4/16-48.
642 7/28/2008 email from OTS Deputy Director Scott Polakoff to Timothy Ward, “Re: WAMU MOU,”
Polakoff_Scott-00060660_001, Hearing Exhibit 4/16-45.
643 Subcommittee interview of Tim Ward, OTS Deputy Director of Examinations, Supervision and Consumer
Protection (2/12/2010).
644 9/10/2008 email from OTS Director John Reich to OTS Deputy Director Scott Polakoff, Polakoff_Scott-
00065461_001, Hearing Exhibit 4/16-68.
645 See undated charts prepared by FDIC on “Daily Retail Deposit Change,” FDIC-PSI-01-000009.
646 See IG Report at 13.
177
(3) OTS Identification of WaMu Deficiencies
During the five-year period reviewed by the Subcommittee, from 2004 through 2008,
OTS examiners identified over 500 serious deficiencies in Washington Mutual’s lending, risk
management, and appraisal practices.647
(a) Deficiencies in Lending Standards
OTS examiners also criticized the poor quality loans
and mortgage backed securities issued by Long Beach, and received FDIC warnings regarding
the bank’s high risk activities. When WaMu failed in 2008, it was not a case of hidden problems
coming to light; the bank’s examiners were well aware of and had documented the bank’s high
risk, poor quality loans and deficient lending practices.
From 2004 to 2008, OTS Findings Memoranda and annual Reports of Examination
(ROE) repeatedly identified deficiencies in WaMu’s lending standards and practices. Lending
standards, also called “underwriting” standards, determine the types of loans that a loan officer
may offer or purchase from a third party mortgage broker. These standards determine, for
example, whether the loan officer may issue a “stated income” loan without verifying the
borrower’s professed income, issue a loan to a borrower with a low FICO score, or issue a loan
providing 90% or even 100% of the appraised value of the property being purchased.
When regulators criticize a bank’s lending or “underwriting” standards as weak or
unsatisfactory, they are expressing concern that the bank is setting its standards too low, issuing
risky loans that may not be repaid, and opening up the bank to later losses that could endanger its
safety and soundness. When they criticize a bank for excessively high lending or underwriting
“errors,” regulators are expressing concern that the bank’s loan officers are failing to comply
with the bank’s standards, such as by issuing a loan that finances 90% of a property’s appraised
value when the bank’s lending standards prohibit issuing loans that finance more than 80% of the
appraised value.
In addition to errors, regulators may express concern about the extent to which a bank
allows its loan officers to make “exceptions” to its lending standards and issue a loan that does
not comply with some aspects of its lending standards. Exceptions that are routinely approved
can undermine the effectiveness of a bank’s formal lending standards. Another common
problem is inadequate loan documentation indicating whether or not a particular loan complies
with the bank’s lending standards, such as loan files that do not include a property’s appraised
value, the source of the borrower’s income, or key analytics such as the loan-to-value or debt-toincome
ratios. In the case of Washington Mutual, from 2004 to 2008, OTS examiners routinely
found all four sets of problems: weak standards, high error and exception rates, and poor loan
documentation.
2004 Lending Deficiencies. In 2004, OTS examiners identified a variety of problems
with WaMu’s lending standards. In May of that year, an OTS Findings Memorandum stated:
647 See IG Report at 28.
178
“Several of our recent examinations concluded that the Bank’s single family loan
underwriting was less than satisfactory due to excessive errors in the underwriting
process, loan document preparation, and in associated activities.”648
After reviewing an OTS examination of a loan sample, the FDIC examiner wrote that the loans:
“reflected inconsistencies with underwriting and documentation practices, particularly in
the brokered channel. Additionally, examiners noted that Washington Mutual’s SFR
[Single Family Residential] portfolio has an elevated level of risk to a significant volume
of potential negative amortization loans, high delinquency and exception rates, and a
substantial volume of loans with higher risk characteristics, such as low FICO scores.”649
A few months later, in September, an OTS review of a sample of 2003 WaMu loans
found “critical error rates as high as 57.3%”:
“[Residential Quality Assurance]’s review of 2003 originations disclosed critical error
rates as high as 57.3 percent of certain loan samples, thereby indicating that SFR [Single
Family Residential] underwriting still requires much improvement. While this group has
appropriately identified underwriting deficiencies, it has not been as successful in
effecting change.”650
The same OTS Report of Examination observed that one of the three causes of underwriting
deficiencies was “a sales culture focused on building market share.” It also stated:
“Notwithstanding satisfactory asset quality overall, some areas still require focused
management and Board attention. Most important is the need to address weaknesses in
single-family residential (SFR) underwriting, which is an ongoing issue from prior
exams.”651
The OTS ROE concluded: “Underwriting of SFR loans remains less than satisfactory.”652
The next month, when OTS conducted a field visit to follow up on some of the problems
identified earlier, it concluded:
“The level of SFR [Single Family Residential] underwriting exceptions in our samples
has been an ongoing examination issue for several years and one that management has
found difficult to address. The institution instituted a major organizational/staffing
648 5/12/2004 OTS Memo 5, “SFR Loan Origination Quality,” OTSWME04-0000004883.
649 5/20/2004 FDIC-DFI Memo 3, “Single Family Residential Review,” OTSWME04-0000004889.
650 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001498, Hearing Exhibit 4/16-94 [Sealed Exhibit].
651 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001492, Hearing Exhibit 4/16-94 [Sealed Exhibit].
652 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001497, Hearing Exhibit 4/16-94 [Sealed Exhibit].
179
realignment in September 2003 and has continued to make additional adjustments since
that time to address accumulating control issues.”653
2005 Lending Deficiencies. In early 2005, OTS elevated the problems with the bank’s
lending standards to the attention of the WaMu Board of Directors. In a letter to the Board, OTS
wrote:
“SFR Loan Underwriting – This has been an area of concern for several exams. As
management continues to make change in organization, staffing, and structure related to
SFR loan underwriting, delays in meeting target dates become inevitable. The board
should closely monitor these delays to ensure they do not become protracted.”654
OTS officials attended a Board meeting to address this and other concerns. Yet a few months
later, in June, an OTS examiner wrote: “We continue to have concerns regarding the number of
underwriting exceptions and with issues that evidence lack of compliance with Bank policy.”655
The examination findings memorandum also noted that, while WaMu tried to make changes,
those changes produced “only limited success” and loan underwriting remained “less than
satisfactory.”656
In August 2005, the OTS ROE for the year indicated that the lending standards problem
had not been resolved:
“[W]e remain concerned with the number of underwriting exceptions and with issues that
evidence lack of compliance with bank policy …. [T]he level of deficiencies, if left
unchecked, could erode the credit quality of the portfolio. Our concerns are increased
with the risk profile of the portfolio is considered, including concentrations in Option
ARM loans to higher-risk borrowers, in low and limited documentation loans, and loans
with subprime or higher-risk characteristics. We are concerned further that the current
market environment is masking potentially higher credit risk.”657
2006 Lending Deficiencies. The same problems continued into 2006. In March 2006,
OTS issued the same strong warning about WaMu’s loan portfolio that it had provided in August
2005:
“We believe the level of delinquencies, if left unchecked, could erode the credit quality of
the portfolio. Our concerns are increased when the risk profile of the portfolio is
considered, including concentrations in Option ARMS to higher-risk borrowers, in low
and limited documentation loans, and loans with subprime or higher-risk characteristics.
653 10/18/2004 OTS Field Visit Report of Examination, at OTSWMEF-0000047576-78, Hearing Exhibit 4/16-94
[Sealed Exhibit].
654 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention,
OTSWMEF-0000047591 [Sealed Exhibit].
655 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan Review,” OTSWME05-004
0000392, Hearing Exhibit 4/16-26.
656 Id. at OTSWME05-004 0000392.
657 8/29/2005 OTS Report of Examination, at OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit].
180
We are concerned further that the current market environment is masking potentially
higher credit risk.”658
Two months later, in May 2006, an OTS examiner wrote:
“During the prior examination, we noted numerous instances of underwriters exceeding
underwriting guidelines, errors in income calculations, errors in debt-to-income (DTI)
calculations, lack of sufficient mitigating factors for credit-quality related issues, and
insufficient title insurance coverage on negative amortization loans. . . . . [U]nderwriting
errors [] continue to require management’s attention.”659
While OTS was documenting its concerns, however, it is apparent in hindsight that the
agency tempered its criticism. The OTS examiner who authored the memo found that in his
review, none of the negatively amortizing loans he analyzed for safety and soundness carried an
“exception,” meaning it “probably should not have been made.”660
Another OTS Findings Memorandum the same month concluded: “Overall, we
concluded that the number and severity of underwriting errors noted remain at higher than
acceptable levels.”
Many of the loans made in
this time period would later default.
661
The 2006 OTS ROE for the year concluded:
“Subprime underwriting practices remain less than satisfactory. . . . [T]he number and
severity of underwriting exceptions and errors remain at higher than acceptable levels. . .
. The findings of this judgmental sample are of particular concern since loans with risk
layering . . . should reflect more, rather than less, stringent underwriting.”662
2007 Lending Deficiencies. In 2007, the problems with WaMu’s lending standards were
no better, and the acceleration of high risk loan delinquencies and defaults threatened serious
consequences.
By July 2007, the major credit rating agencies had begun mass ratings downgrades of
hundreds of mortgage backed securities, the subprime secondary market froze, and WaMu was
left holding billions of dollars worth of suddenly unmarketable subprime and other high risk
loans. In September, the OTS ROE for the year concluded:
“Underwriting policies, procedures, and practices were in need of improvement,
particularly with respect to stated income lending. Based on our current findings, and the
658 3/14/2006 OTS Report of Examination, at 19, OTSWMEF-0000047030, Hearing Exhibit 4/16-94 [Sealed
Exhibit].
659 5/23/2006 OTS Findings Memorandum, “Home Loan Underwriting,” OTSWMS06-008 0001299, Hearing
Exhibit 4/16-33.
660 Id.
661 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06-
008 0001243, Hearing Exhibit 4/16-35.
662 8/26/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit].
181
fact that a number of similar concerns were raised at prior examinations, we concluded
that too much emphasis was placed on loan production, often at the expense of loan
quality.”663
The ROE also reported on an unsatisfactory review of loans that had been originated by Long
Beach and warned that, if the problems were not promptly corrected, “heightened supervisory
action would be taken”:
“Based on our review of 75 subprime loans originated by [Long Beach], we concluded
that subprime underwriting practices remain less than satisfactory . . . . Given that this is
a repeat concern and MRBA [Matter Requiring Board Attention], we informed
management that underwriting must be promptly corrected, or heightened supervisory
action would be taken, including limiting the Bank’s ability to continue SFR subprime
underwriting.”664
In the fourth quarter of 2007, WaMu’s loan portfolio lost $1 billion in value. Despite that
loss, and the strong language in the 2007 examinations, OTS took no enforcement action against
the bank that would result in WaMu’s tightening its lending standards or strengthening
compliance with the standards it had.
2008 Lending Deficiencies. In the first six months of 2008, WaMu continued to incur
billions of dollars in losses, as its high risk loan portfolio lost value and its share price fell. In
July 2008, about two months before the bank failed, OTS met with the WaMu Board of Directors
to discuss, among other matters, the bank’s deficient lending standards. While the presentation
to the Board reiterated the concerns from past years, it failed to convey a sense of urgency to a
bank on the verge of collapse. Instead, the presentation focused on long term corrective action
that WaMu should take. The OTS written presentation to the Board included the following:
“High SFR [Single Family Residential] losses due in part to downturn in real estate
market but exacerbated by: geographic concentrations[,] risk layering[,] liberal
underwriting policy[,] poor underwriting. … Discontinuing higher risk lending and
tightened underwriting policy should improve asset quality; however, actions should have
been taken sooner. …
Significant underwriting and process weaknesses noted again in the Home Loans
Group[.] ... Reducing higher risk lending products and practices should have been done
sooner.”665
Failure to Correct Deficient Lending Practices. In various reports for nearly five
consecutive years, OTS criticized WaMu’s lending standards, error and exception rates, and loan
documentation, and directed the bank to improve its performance. When WaMu failed to
improve during that span, OTS failed to take action, such as requiring a board resolution,
663 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046679, Hearing Exhibit 4/16-94 [Sealed Exhibit].
664 9/18/2007 OTS Report of Examination, at OTSWMEF-0000047146, Hearing Exhibit 4/16-94 [Sealed Exhibit].
665 7/15/2008 OTS Presentation to WaMu Board of Directors based on Comprehensive Examinations,
Polakoff_Scott-00061303_007, 012, 027, Hearing Exhibit 4/16-12b.
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memorandum of understanding, or cease and desist order compelling WaMu to tighten its
lending standards and increase oversight of its loan officers to reduce underwriting error and
exception rates and improve loan documentation. The result was that WaMu originated or
purchased hundreds of billions of dollars of high risk loans, including stated income loans
without verification of the borrower’s assets or ability to repay the loan; loans with low FICO
scores and high loan-to-value ratios; loans that required interest-only payments; and loan
payments that did not cover even the interest owed, much less the principal.
(b) Deficiencies in Risk Management
Over the same five-year period, from 2004 to 2008, in addition to identifying deficiencies
associated with WaMu’s lending practices, OTS repeatedly identified problems with WaMu’s
risk management practices. Risk management involves identifying, evaluating, and mitigating
the risks that threaten the safety, soundness, and profitability of an institution. At thrifts, the
primary risk issues include setting lending standards that will produce profitable loans, enforcing
those standards, evaluating the loan portfolio, identifying home loans that may default,
establishing adequate reserves to cover potential losses, and advising on measures to lower the
identified risks. When regulators criticize a bank’s risk management practices as weak or
unsatisfactory, they are expressing concern that the bank is failing to identify the types of risk
that threaten the bank’s safety and soundness and failing to take actions to reduce and manage
those risks.
Within WaMu, from 2004-2005, oversight of risk management practices was assigned to
a Chief Risk Officer. In 2006, it was assigned to an Enterprise Risk Management (ERM)
Department headed by a Chief Enterprise Risk Officer. ERM employees reported, not only to
the department, but also to particular lines of business such as the WaMu Home Loans Division,
and reported both to the Chief Risk Officer and to the head of the business line, such as the
president of the Home Loans Division. WaMu referred to this system of reporting as a “Double-
Double.”666
As with the bank’s poor lending standards, OTS allowed ongoing risk management
problems to fester without taking enforcement action. From 2004 to 2008, OTS explicitly and
repeatedly alerted the WaMu Board of Directors to the need to strengthen the bank’s risk
management practices.
2004 Risk Management Deficiencies. In 2004, prior to the bank’s adoption of its High
Risk Lending Strategy, OTS expressed concern about the bank’s risk management practices,
highlighted the issue in the annual ROE, and brought it to the attention of the WaMu Board of
Directors. The 2004 ROE stated:
666 Subcommittee interviews of Ronald Cathcart (2/23/2010), David Schneider (2/17/2010), and Cheryl Feltgen
(2/6/2010).
183
“Board oversight and management performance has been satisfactory … but … increased
operational risks warrant prompt attention. These issues limit the institution’s flexibility
and may threaten its ability to remain competitive and independent.”667
At another point, the ROE warned: “Ensure cost-cutting measures are not impacting critical risk
management areas.”668
Another OTS examination that focused on WaMu’s holding company identified multiple
risks associated with Long Beach: “[P]rimary risks associated with Long Beach Mortgage
Company remain regulatory risk, reputation risk, and liquidity of the secondary market in
subprime loans.”669
Its concern about WaMu’s risk management practices prompted, in part, OTS’
requirement that WaMu commit its high risk lending strategy to paper and gain explicit approval
from the Board of Directors.
2005 Risk Management Deficiencies. In 2005, after adoption of the High Risk Lending
Strategy, OTS again highlighted risk management issues in its examination reports and again
brought the matter to the attention of WaMu’s Board of Directors.
In March 2005, OTS observed that WaMu’s five-year strategy, which increased credit
risk for the bank, did not “clearly articulate the need to first focus on addressing the various
operational challenges before embarking on new and potentially more risky growth
initiatives.”670 OTS also wrote: “We discussed the lack of a clear focus in the plan on resolving
operational challenges with CEO Killinger and the Board.”671 OTS continued to express
concerns about the bank’s weak risk management practices for the rest of the year, yet took no
concrete enforcement action to compel the bank to address the issue. In June 2005, OTS
described risk management weaknesses within WaMu’s Corporate Risk Oversight group, a subgroup
within the ERM Department responsible for evaluating credit and compliance risk. OTS
wrote that it had deemed its comments as “criticisms” of the bank, because of the significance of
the risk management function in addressing ongoing problems with the bank’s lending standards
and loan error rates:
“Most of the findings are considered ‘criticisms’ due to the overall significance of CRO
[Corporate Risk Oversight] activities and the fact that we have had concerns with quality
assurance and underwriting processes within home lending for several years.”672
In August 2005, in its annual Report on Examination, OTS urged the WaMu Board to
obtain progress reports from the ERM Department and ensure it had sufficient resources to
667 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001504, Hearing Exhibit 4/16-94 [Sealed Exhibit].
668 Id. at OTSWMS04-000001488.
669 4/5/2004 OTS Report of Examination, at OTSWMEF-0000047477, Hearing Exhibit 4/16-94 [Sealed Exhibit].
670 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit].
671 Id.
672 6/1/2005 OTS Findings Memorandum, “Corporate Risk Oversight,” OTSWMS05-005 0002046, Hearing Exhibit
4/16-23.
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become an effective counterweight to the increased risk-taking entailed in the High Risk Lending
Strategy:
“Monitor and obtain reports from management on status of [Enterprise Risk
Management] in terms of effectiveness and resource adequacy. … ERM provides an
important check and balance on the company’s profit-oriented units and warrants
ongoing strong Board commitment given the institution’s current strategic direction.”673
The same ROE noted that the bank did not have effective procedures in place to evaluate the
many exceptions being granted to allow loan officers to issue loans that failed to comply with the
bank’s lending standards, and urged attention to the risks being established:
“Until full exception data collection, reporting, and follow-up processes are in place and
stabilized, senior management and the Board cannot fully assess whether quality
assurance processes are having a meaningful impact on line activities, including loan
underwriting. We are particularly concerned with the establishment of good quality
assurance process for SFR underwriting, which has been an issue for the past several
examinations.”674
A follow-up field examination, conducted in September 2005, stated:
“We criticized the lack of Trend and Dashboard Report to senior management and the
board, without which it is impossible to determine whether line functions are performing
acceptably and, more specifically, whether the quality assurance process is having a
meaningful impact on improving loan underwriting.”675
2006 Risk Management Deficiencies. In 2006, OTS again expressed concern about
WaMu’s risk management practices, but took no further steps to compel improvements. The
annual ROE urged the Board of Directors to:
“[c]ontinue to monitor and obtain reports from management on the status of ERM to
ensure its effectiveness and adequacy of resources. . . . ERM should provide an
important check and balance on profit-oriented units … particularly given the bank’s
current strategy involving increased credit risk.” 676
The 2006 ROE also commented that: “[w]ithin ERM, fraud risk management at the enterprise
level is in the early stage of development. … Currently, fraud management is decentralized and
does not provide a streamlined process to effectively track fraud events across all business lines.
In addition, consistent fraud reporting capabilities are not in place to consolidate data for
analysis, reporting, and risk management at the enterprise level.”677
673 8/29/2005 OTS Report of Examination, at OTSWMS05-003 0001783, Hearing Exhibit 4/16-94 [Sealed Exhibit].
674 Id. at OTSWMS05-004 0001792.
675 10/3/2005 OTS Field Visit Report of Examination, at OTSWMEF-0000047602, Hearing Exhibit 4/16-94 [Sealed
Exhibit].
676 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001671, Hearing Exhibit 4/16-94 [Sealed Exhibit].
677 Id. at OTSWMS06-008 0001687, 91.
185
2007 Risk Management Deficiencies. In 2007, as high risk loan delinquencies and
defaults accelerated and WaMu began to incur losses, OTS examiners used harsher language to
describe the deficiencies in WaMu’s risk management practices, criticizing the bank’s failure to
institute stronger risk controls and procedures at an earlier date, as recommended.
In June 2007, for example, OTS examiners completed a review critical of WaMu
procedures to oversee the loans it purchased from third party mortgage brokers.678 From 2003 to
2007, 48 to 70% of WaMu’s loans were purchased from third parties.679 An OTS memorandum
noted that Washington Mutual had only 14 full-time employees overseeing more than 34,000
third party brokers submitting loans to the bank for approval. OTS also criticized the scorecard
used to rate those brokers which, among other problems, did not include the rate at which
significant lending or documentation deficiencies were attributed to the broker, the rate at which
its loans were denied or produced unsaleable loans, or an indication of whether the broker was
included in industry watchlists for misconduct. After describing these and other problems, rather
than lower WaMu’s safety and soundness scores for its poor oversight, however, the OTS
memorandum made only the following observation: “Given the . . . increase in fraud, early
payment defaults, first payment defaults, subprime delinquencies, etc., management should reassess
the adequacy of staffing.”680 WaMu management agreed with the finding, but provided
no corrective action plan, stating only that “[s]taffing needs are evaluated continually and
adjusted as necessary.”681
In the September 2007 annual ROE, OTS wrote:
“Risk management practices in the HLG (Home Loans Group) during most of the review
period were inadequate …. We believe that there were sufficient negative credit trends
that should have elicited more aggressive action by management with respect to limiting
credit exposure. In particular, as previously noted, the risk misrepresentation in stated
income loans has been generally reported for some time. This information should have
led management to better assess the prudence of stated income lending and curtail riskier
products well before we indicated during this examination that we would limit the Bank’s
ability to continue such lending.” 682
The ROE also faulted management and Board inaction:
“Board oversight and management’s performance was less than satisfactory. …
Contributing factors should have been more proactively managed by the Board and
management. The most significant of these factors include Matters Requiring Board
678 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing
Exhibit 4/16-10.
679 Prepared statement of Treasury IG Thorson, April 16, 2010 Subcommittee Hearing, at 5.
680 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing
Exhibit 4/16-10.
681 Id. at 011.
682 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046681, Hearing Exhibit 4/16-94 [Sealed Exhibit].
186
Attention that were noted in prior examinations but were not adequately addressed,
including … an ERM function that was not fully effective.”683
The ROE concluded: “The ERM function has been less than effective for some time. … ERM
has not matured in a timely manner and other ERM functions have been generally
ineffective.”684
A separate OTS examination of WaMu’s compliance function observed that WaMu had
hired nine different compliance officers in the past seven years, and that “[t]his amount of
turnover is very unusual for an institution of this size and is a cause for concern.”685
Despite these harsh assessments in 2007, OTS again refrained from taking any
enforcement action against the bank such as developing a nonpublic Memorandum of
Understanding or a public Cease and Desist Order with concrete plans for strengthening WaMu’s
risk management efforts.
2008 Risk Management Deficiencies. In 2008, as WaMu continued to post billions of
dollars in losses, OTS continued to express concerns about its risk management practices. In
February 2008, OTS downgraded WaMu to a 3 CAMELS rating and required the bank to issue a
Board Resolution committing to certain strategic initiatives including “a more disciplined
framework for the identification and management of compliance risks.”686
In June 2008, OTS issued a Findings Memorandum reacting to a WaMu internal review
that found significant levels of loan fraud at a particular loan office, and expressed concern “as to
whether similar conditions are systemic throughout the organization.”687
As referenced above, in July 2008, two months before the bank’s failure, OTS made a
presentation to the WaMu Board which, among other problems, criticized its risk management
efforts:
The memorandum
noted that “a formalized process did not exist to identify, monitor, resolve, and escalate third
party complaints” about loan fraud, expressed concern about “an origination culture focused
more heavily on production volume rather than quality”; noted that the WaMu review had found
the “loan origination process did not mitigate misrepresentation/fraud”; and described the “need
to implement incentive compensation programs to place greater emphasis on loan quality.”
“An adequate [Enterprise Risk Management] function still does not exist although this
has been an MRBA [Matter Requiring Board Attention] for some time. Critical as a
check and balance for profit oriented units[.] Necessary to ensure that critical risks are
683 Id. at OTSWMEF-0000046690.
684 Id. at OTSWMEF-0000046691.
685 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin-
00020408_001, Hearing Exhibit 4/16-9.
686 3/11/2008 WaMu presentation, “Summary of Management’s Action to Address OTS Concerns,”
JPM_WM01022322; 3/17/2008 letter from Kerry Killinger to Darrel Dochow with enclosed Board Resolution,
OTSWMS08-015 0001216 (committing to initiatives outlined by management).
687 6/19/2008 OTS Asset Quality Memo 22, Bisset_John-00046124_002, Hearing Exhibit 4/16-12a.
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identified, measured, monitored and communicated[.] Even more critical given increased
credit, market, and operational risk.”688
Failure to Correct Poor Risk Management. By neglecting to exercise its enforcement
authority, OTS chronicled WaMu’s inadequate risk management practices over a period of years,
but ultimately failed to change its course of action. During a hearing of the Subcommittee, the
Department of the Treasury Inspector General, Eric Thorson, whose office conducted an in-depth
review of WaMu’s regulatory oversight, testified:
“Issues related to poor underwriting and weak risk controls were noted as far back
as 2003, but the problem was OTS did not ensure that WaMu ever corrected those
weaknesses. We had a hard time understanding why OTS would allow these
satisfactory ratings to continue given that, over the years, they found the same
things over and over.”689
(c) Deficiencies in Home Appraisals
Still another area in which OTS failed to take appropriate enforcement action involves
WaMu’s appraisal practices. OTS failed to act even after other government entities accused
WaMu of systematically inflating property values to justify larger and more risky home loans.
Appraisals provide estimated dollar valuations of property by independent experts. They
play a key role in the mortgage lending process, because a property’s appraised value is used to
determine whether the property provides sufficient collateral to support a loan. Lending
standards at most banks require loans to meet, for example, certain loan-to-value (LTV) ratios to
ensure that, in the event of a default, the property can be sold and the proceeds used to pay off
any outstanding debt.
From 2004 to mid-2006, WaMu conducted its own property appraisals as part of the loan
approval process. During that period, OTS repeatedly expressed concerns about WaMu’s
appraisal efforts.690 In May 2005, OTS criticized WaMu – the most severe type of finding –
regarding its practice of allowing sellers to estimate the value of their property. OTS directed
WaMu to stop including an Owner’s Estimate of Value in documents sent to appraisers since it
biased the review; this criticism had been repeatedly noted in prior examinations, yet WaMu did
not satisfactorily address it until the end of 2005.691 A second finding criticized WaMu’s use of
automated appraisal software, noting “significant technical document weaknesses.”692 OTS
ultimately determined that none of WaMu’s automated appraisals complied with standard
appraisal practices and some even had “highly questionable value conclusions.”693
688 7/15/2008 OTS presentation to WaMu Board of Directors based on Comprehensive Examinations,
Polakoff_Scott-00061303-028, Hearing Exhibit 4/16-12b.
Despite this
689 See April 16, 2010 Subcommittee Hearing at 25.
690 See, e.g., 10/3/2005 OTS Report of Examination, at OTSWMEF-0000047601, Hearing Exhibit 4/16-94 [Sealed
Exhibit].
691 5/20/2005 OTS Memo 4, “Safety and Soundness Examination,” at OTSWME06-039 0000214.
692 Id.
693 3/14/2005 OTS Report of Examination, at OTSWMEN-000001794, Hearing Exhibit 4/16-94 [Sealed Exhibit].
188
dramatic criticism, OTS found in the next year’s examination that WaMu had continued to use
noncompliant automated appraisals.694
To address the issue, WaMu decided in mid-2006 to outsource its appraisal function to
two vendors: eAppraiseIT and Lender Service Incorporated (LSI).
Before any enforcement action was taken, WaMu
management agreed to cease using automated appraisals by October 2006.
695 Calling the move “Project
Cornerstone,” WaMu fired all of its residential staff appraisers, reducing a staff of about 400 to
30,696 and eAppraiseIT and LSI were tasked with conducting appraisals of homes purchased with
WaMu loans.697
The Decision to Outsource. WaMu’s decision to outsource the appraisal function
received minimal attention from OTS. Documentation obtained by the Subcommittee indicates
only a few meetings took place between OTS examiners and the WaMu staff tasked with the
outsourcing. During a Subcommittee interview, the key OTS appraisal expert, Bruce Thorvig,
explained that it was his first time supervising a large institution that decided to outsource the
appraisal function.
WaMu assigned oversight of the outside appraisals to a new Appraisal Business
Oversight (ABO) group, a unit within the WaMu Home Loans Risk Management division.
698 Though the bank had repeatedly delayed taking action or failed to respond
to OTS recommendations and criticisms in the appraisal area in the past, the OTS appraisal
expert told the Subcommittee that he saw nothing to indicate that WaMu management could not
competently handle a large appraisal outsourcing project of this scale.699 In one of the few
meetings that did occur between WaMu and OTS staff on appraisal issues, the bank’s
management came away with what they thought was full OTS approval for the outsourcing
project,700 though OTS’ appraisal expert disputed that he was even in a position to grant approval
and was instead simply receiving notification of WaMu’s plans.701
Appraisal Problems. Problems began almost immediately after WaMu outsourced the
appraisal function. Whether appraisals are conducted internally by the bank or through a vendor,
the bank must take responsibility for establishing a standard process to ensure accurate, unbiased
home appraisal values. One, for example, was a repeat problem from when WaMu did its own
appraisals: “WaMu allowed a homeowner’s estimate of the value of the home to be included on
the form sent from WaMu to third party appraisers, thereby biasing the appraiser’s evaluation”
toward a higher home value, in violation of standard residential appraisal methods.702
694 5/23/2006 OTS Memo 2, “Safety and Soundness Examination,” at OTSWME06-039 0000205.
A
seasoned appraisal compliance manager, who oversaw WaMu as an FDIC examiner prior to
coming to work for the bank, drafted a February 2007 Residential Appraisal Department Review
which included a long list of issues. Problems included: “undefined” appraisal standards and
processes; “loosely defined” vendor management; “unreasonable and imprudent sales force
695 Undated OTS internal memo, OTSWMSP-00000001936-51 at 39 [Sealed Exhibit].
696 Undated OTS internal memo, OTSWMEN-0000015926-31 at 28 [Sealed Exhibit].
697 Undated OTS internal memo, OTSWMSP-00000001936-51 at 39 [Sealed Exhibit].
698 Subcommittee Interview of Bruce Thorvig (2/24/2010).
699 Id.
700 5/22/2006 WaMu internal email, OTSWMEN-0000020983.
701 Subcommittee Interview of Bruce Thorvig (2/24/2010).
702 IG Report, at 11, Hearing Exhibit 4/16-82.
189
influence over the appraisal function;” and a “broken” third party appraisal risk control process
that “may be contributing to the increasing incidence of mortgage fraud.”703
These problems continued without resolution or enforcement action from OTS
throughout 2007. In an April 2007 memorandum, OTS detailed its concerns, both old and new,
with WaMu’s appraisal operations. OTS found that WaMu had failed to update and revise its
appraisal manual after outsourcing, which put the bank at risk of regulatory violations. In
addition, an OTS review of 54 WaMu appraisals identified a number of concerns:
“Primary appraisal issues (red flags requiring attention by the underwriter or review
appraiser) included seller paid closing costs and concession, misstatements/
contradictions, inadequate/incomplete explanations and support for the value conclusion,
reconciliation of the sales comparison approach, and weakness in the appraisal review
process.”704
Despite the extent of these concerns, OTS issued a “recommendation” to the bank that it address
the identified problems, rather than the stronger “criticism” which would have elevated the issue
to the bank’s senior management or Board of Directors.705
Attorney General Complaint. On November 1, 2007, the New York Attorney General
issued a complaint against WaMu’s appraisal vendors, LSI and eAppraiseIT, alleging fraud and
collusion with WaMu to systematically inflate real estate values.706
“[F]irst American and eAppraiseIT have abdicated their role in providing ‘third-party,
unbiased valuations’ for eAppraiseIT’s largest client, WaMu. Instead, eAppraiseIT
improperly allows WaMu’s loan production staff to hand-pick appraisers who bring in
appraisal values high enough to permit WaMu’s loans to close, and improperly permits
WaMu to pressure eAppraiseIT appraisers to change appraisal values that are too low to
permit loans to close.”
The complaint stated in part:
707
Though OTS had been aware of the Attorney General’s investigation in May 2007, it
took no action until after the Attorney General issued the complaint. Even then, OTS did not
initiate its own investigation until after an internal WaMu investigation was already underway.
The OTS Western Region Director advised: “I believe OTS needs to open up its own special
investigation. WaMu started their own special investigation a few days ago when this broke.”708
703 2/21/2007 draft internal WaMu report, “Residential Appraisal Department Review,” OTSWMEN-0000000274
(drafted by Mark Swift).
704 4/5/2007 OTS Asset Quality Memo 2, OTSWME07-067 0001082.
705 Id.
706 11/1/2007 New York Attorney General press release,
http://www.ag.ny.gov/media_center/2007/nov/nov1a_07.html. Both companies appraised property in New York,
which provided jurisdiction for the complaint.
707 New York v. First American Corporation, et al., (N.Y. Sup.), Complaint (November 1, 2007), at 3.
708 11/7/2007 email from Darrel Dochow to Benjamin Franklin, Randy Thomas, others, OTSWMS07-011 0001294.
190
It took nearly a month for OTS to launch its own investigation into the allegations set out
in the New York Attorney General’s complaint.709
“This appears to be a comprehensive (and impressive) review schedule. It doesn’t
appear, on the surface anyway, to leverage off of WaMu’s own review. Do you
think we might be totally reinventing the wheel and possibly taking too long to
complete our review?”
In November 2007, when the director of
OTS, John Reich, was presented with his agency’s investigation plan, he responded:
710
Despite his concerns about how long the planned investigation might take, the OTS investigation
proceeded as proposed. It took over 10 months, until September 2008, for OTS to gather,
analyze, and reach conclusions about WaMu’s appraisal practices.
The OTS investigation uncovered many instances of improper appraisals. After
reviewing 225 loan files, the OTS appraisal expert found that “[n]umerous instances were
identified where, because of undue influence on the appraiser, values were increased without
supporting documentation.”711 OTS also found that WaMu had violated the agency’s appraisal
regulations by failing to comply with appraisal independence procedures after they outsourced
the function.712 The OTS investigation concluded that WaMu’s appraisal practices constituted
“unsafe or unsound banking practices.”713 The OTS investigation also concluded that WaMu
was not in compliance with the Uniform Standards of Professional Appraisal Practice and other
minimum appraisal standards.714
Failure to Correct Appraisal Deficiencies. Shortly before WaMu was sold, OTS’ staff
prepared a draft recommendation that the agency issue a cease and desist order to bar the bank
from engaging in any activity that would lead to further violation of the appraisal regulations.715
A cease and desist order would have been the first public enforcement action against WaMu
regarding its lending practices. Ultimately, the legal staff submitted the memorandum to OTS’
Deputy Director and Chief Counsel on October 3, 2008, more than a week after the bank
collapsed and was sold.716 By this point, the recommendation was too late and the issue was
moot.
709 See undated OTS internal memo to John Bowman, OTSWMSP-0000001936 [Sealed Exhibit].
71011/16/2007 email from OTS Director John Reich to OTS Operations Director Scott Polakoff, Reich_John-
00040045_001.
711 7/28/2008 Draft Memo to Hugo Zia from Bruce Thorvig, OTSWMEN-0000015851 [Sealed Exhibit].
712 See 12 CFR Part 564.
713 Undated OTS internal memo, OTSWMSP-00000001936-51 at 47 [Sealed Exhibit].
714 Id. at 37 [Sealed Exhibit]. The Subcommittee found no evidence that anyone in OTS senior management
disputed the conclusions of the investigation.
715 Id.
716 OTS internal document, OTS Enforcement Status of Formal Investigations, Quigley_Lori-00231631_001.
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(d) Deficiencies Related to Long Beach
In 1999, WaMu’s parent holding company, Washington Mutual Inc., purchased Long
Beach Mortgage Company (Long Beach). Long Beach’s business model was to issue subprime
loans initiated by third party mortgage lenders and brokers and then sell or package those loans
into mortgage backed securities for sale to Wall Street firms. Beginning in 1999, Washington
Mutual Bank worked closely with Long Beach to sell or securitize its subprime loans and
exercised oversight over its lending and securitization operations. Because Long Beach was a
subsidiary of Washington Mutual Inc., the holding company, however, and not a subsidiary of
Washington Mutual Bank, OTS did not have direct regulatory authority over the company, but
could review its operations to the extent they affected the holding company or the bank itself.
OTS was aware of ongoing problems with Long Beach’s management, lending and risk
standards, and issuance of poor quality loans and mortgage backed securities. OTS reported, for
example, that Long Beach’s “early operations as a subsidiary of [Washington Mutual Inc.] were
characterized by a number of weaknesses” including “loan servicing weaknesses, documentation
exceptions, high delinquencies, and concerns regarding compliance with securitization-related
representations and warranties.”717 OTS also reported that, in 2003, “adverse internal reviews of
[Long Beach] operations led to a decision to temporarily cease securitization activity” until a
“special review” by the WaMu legal department ensured that file documentation “adequately
supported securitization representations and warranties” made by Long Beach.718
“An internal residential quality assurance (RQA) report for [Long Beach]’s first quarter
2003 … concluded that 40% (109 of 271) of loans reviewed were considered
unacceptable due to one or more critical errors. This raised concerns over [Long
Beach]’s ability to meet the representations and warranty’s made to facilitate sales of
loan securitizations, and management halted securitization activity. A separate credit
review report … disclosed that [Long Beach]’s credit management and portfolio
oversight practices were unsatisfactory. … Approximately 4,000 of the 13,000 loans in
the warehouse had been reviewed … of these, approximately 950 were deemed saleable,
800 were deemed unsaleable, and the remainder contained deficiencies requiring
remediation prior to sale. … [O]f 4,500 securitized loans eligible for foreclosure, 10%
could not be foreclosed due to documentation issues.”
OTS was
aware of an examination report issued by a state regulator and the FDIC after a review of 2003
Long Beach loans, which provides a sense of the extent of problems with those loans at the time:
719
Despite these severe underwriting and operational problems, Long Beach resumed
securitization of its subprime loans in 2004. In April 2005, OTS examiners circulated an internal
email commenting on the poor quality of Long Beach loans and mortgage backed securities
compared to its peers:
717 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, OTSWMS06-007
0001010, Hearing Exhibit 4/16-31.
718 Id.
719 1/13/2004 FDIC-Washington State joint visitation report, FDIC-EM_00102515-20, Hearing Exhibit 4/13-8b.
OTS held a copy of this report in its files, OTSWME04-0000029592.
192
“Performance data for 2003 and 2004 vintages appear to approximate industry average
while issues prior to 2003 have horrible performance. . . . [Long Beach] finished in the
top 12 worst annualized [Net Credit Losses] in 1997 and 1999 thru 2003. [Long Beach
nailed down the number 1 spot as top loser with an [Net Credit Loss] of 14.1% in 2000
and placed 3rd in 2001 with 10.5%. … For ARM [adjustable rate mortgage] losses, [Long
Beach] really outdid themselves with finishes as one of the top 4 worst performers from
1999 through 2003. For specific ARM deals, [Long Beach] made the top 10 worst deal
list from 2000 thru 2002. … Although underwriting changes were made from 2002 thru
2004, the older issues are still dragging down overall performance. … At 2/05, [Long
Beach] was #1 with a 12% delinquency rate. Industry was around 8.25%.”720
Six months later, after conducting a field visit, an OTS examiner wrote: “Older securitizations
of [Long Beach] continue to have some issues due to previously known underwriting issues in
some vintages. The deterioration in these older securitizations is not unexpected.”721
Purchase of Long Beach. In 2005, Washington Mutual Bank proposed purchasing Long
Beach from its holding company so that Long Beach would become a wholly owned subsidiary
of the bank. In making the case for the purchase, which required OTS approval, WaMu
contended that making Long Beach a subsidiary would give the bank greater control over Long
Beach’s operations and allow it to strengthen Long Beach’s lending practices and risk
management, as well as reduce funding costs and administrative expenses. In addition, WaMu
proposed that it could replace its current “Specialty Mortgage Finance” program, which involved
purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan
portfolio provided by Long Beach.722
In June 2005, an OTS examiner expressed concerns about the purchase in an internal
memorandum to OTS regional management and recommended that the purchase be conditioned
on operational improvements:
“At the start of this examination, it was our intent to perform a review of the operation of
[Long Beach] with the expectation that [Washington Mutual Inc.] or the bank would be
requesting approval to move [Long Beach] as an operating subsidiary of the bank. Such
a move would obviously place the heightened risks of a subprime lending operation
directly within the regulated institution structure. Because of the high profile nature of
the business of [Long Beach] and its problematic history, we believe that any and all
concerns regarding the subprime operation need to be fully addressed prior to any
move.”723
720 4/14/2005 OTS internal email, OTSWME05-012 0000806, Hearing Exhibit 4/16-19.
721 10/3/2005 OTS Holding Company Field Visit Report of Examination, at OTSWMS06-010 00002532, Hearing
Exhibit 4/16-94 [Sealed Exhibit].
722 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, at
OTSWMS06-007 0001011, Hearing Exhibit 4/16-31.
723 6/3/2005 OTS memorandum from Rich Kuczek to Darrel Dochow, “Long Beach Mortgage Corporation (LBMC)
Review,” OTSWMS06-007 0002683, Hearing Exhibit 4/16-28.
193
The memorandum identified several matters that required resolution prior to a WaMu purchase
of Long Beach, including the establishment of pre- and post-funding loan quality reviews that
were already in place at the bank. The memorandum also stated that Long Beach management
had “worked diligently to improve its operation and correct significant deficiencies … reported
in prior years,” and observed, “there is definitely a new attitude and culture.”724
OTS continued to review Long Beach’s lending practices and found additional
deficiencies throughout the year. Those deficiencies included errors in loan calculations of debtto-
income ratios, lack of documentation to support the reasonableness of borrower income on
stated income loans, and lack of explanation of a borrower’s ability to handle payment shock on
loans with rising interest rates.725 OTS also determined that Long Beach’s newly created
portfolio of subprime loans “had attributes that could result in higher risk” than WaMu’s existing
subprime loan portfolio.726
Nevertheless, in December 2005, OTS examiners wrote that, even though Long Beach
was “engaged in a high-risk lending activity and we are not yet fully satisfied with its practices,”
they recommended approving WaMu’s purchase of the company with certain conditions.727
Those conditions included WaMu’s reconsidering its high risk lending concentration limits,
including “stated income loans with low FICOs and high LTV ratios”; WaMu’s assurance that
Long Beach would comply with certain loan guidance; a WaMu commitment to continue to
bring down its loan exception and error rates; and a WaMu commitment to ensure its Enterprise
Risk Management division would provide a “countervailing balance” to “imprudent” desires to
expand Long Beach’s subprime lending.728
About the same time as this memorandum was completed, OTS learned that, during the
fourth quarter of 2005, Long Beach had been required to repurchase tens of millions of dollars of
loans it had sold to third parties due to early payment defaults.729
724 Id. See also 5/19/2005 OTS email, “LBMC Fair Lending,” OTSWMS05-005 0002002, Hearing Exhibit 4/16-20
(“I would not … feel comfortable with their moving [Long Beach] under the thrift without some conditions”).
By December, this unexpected
wave of repurchases had overwhelmed Long Beach’s repurchase reserves, leading to a reserve
shortfall of nearly $75 million. Altogether in the second half of 2005, Long Beach had to
repurchase loans with about $837 million in unpaid principal, and incurred a net loss of about
725 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel
Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31.
726 Id. at OTSWMS06-007 0001011.
727 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel
Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31.
728 Id. at OTSWMS06-007 0001015-16.
729 See 10/3/2005 OTS Report of Examination, OTSWMS06-010 0002530, Hearing Exhibit 4/16-94 [Sealed
Exhibit] (noting that, after a field visit to Long Beach that concluded in December 2005, OTS learned that loan
repurchases had surged: “Subsequent to our on-site field visit, management informed us that loan repurchases had
increased considerably. … Management indicated that approximately $0.6 billion in loans were repurchased during
the fourth quarter of 2005 out of approximately $13.2 billion in total whole loan sales. The gross financial impact at
December 31, 2005, was $72.3 million.”); 1/20/2006 email from Darrel Dochow to Michael Finn and others, with
chart, OTSWMS06-007 0001020 to 1021 (describing Long Beach repurchases).
194
$107 million.730 In response, its auditor, Deloitte and Touche, cited Long Beach for a
Significant Deficiency in its financial reporting. Despite the sudden evidence of Long Beach’s
poor quality loans, inadequate repurchase reserves, and negative earnings impact on its parent
company, Washington Mutual Inc., OTS approved the bank’s application to purchase Long
Beach. OTS explained its decision to the Subcommittee by contending that the change in status
gave WaMu more control over Long Beach to ensure its improvement.731
WaMu ultimately purchased Long Beach on March 1, 2006.732 After the purchase, Long
Beach’s practices did not improve, but continued to exhibit numerous problems, as described in
the prior chapter. A May 2006 OTS examination of Long Beach loans concluded, for example,
“that the number and severity of underwriting errors noted remain at higher than acceptable
levels.”733
“We gave them the benefit of doubt based on commitments and some progress when we
allowed them to bring [Long Beach] into the bank, but … we have the same type of
concerns remaining 6 months later.”
In a June 2006 internal email to his colleagues, the OTS Regional Deputy Director
wrote:
734
In the annual 2006 ROE and again in the annual 2007 ROE, OTS found that Long
Beach’s lending practices “remain[ed] less than satisfactory.”735 At a hearing of the
Subcommittee on April 13, 2010, WaMu’s chief credit risk officers from 2004 to 2008 uniformly
condemned Long Beach’s poor performance and testified that it had never developed an
effective risk management system.736
730 See 4/17/2006 memorandum by WaMu General Auditor to Board of Directors’ Audit Committees of Washington
Mutual Inc. and Washington Mutual Bank, “Long Beach Repurchase Reserve Root Cause Analysis,”
JPM_WM02533760, Hearing Exhibit 4/13-10 (Long Beach “experienced a dramatic increase in EPD’s [early
payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases.
The unpaid principal balance repurchased as a result of the EPD provision for the year ended December 31, 2005
was $837.3 million. The net loss from these repurchases was approximately $107 million.”).
731 Subcommittee interview of Benjamin Franklin (2/18/2010).
732 See “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j.
733 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06-
008 0001243, Hearing Exhibit 4/16-35. See also 1/20/2006 email from Darrel Dochow to Michael Finn, et al.,
“LBMC EDP Impact,” OTSWMS06-007 0001020 (emphasis added).
734 6/9/2006 email from Darrel Dochow to Richard Kuczek, Lawrence Carter, and Benjamin Franklin, “Findings
Memos,” OTSWMS06-008 0001253, Hearing Exhibit 4/16-36.
735 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit];
9/18/2007 OTS Report of Examination, OTSWMEF-0000047146, Hearing Exhibit 4/16-94 (“Based on our review
of 75 subprime loans originated by LBMC, we concluded that subprime underwriting practices remain less than
satisfactory . . . . Given that this is a repeat concern and MRBA, we informed management that underwriting must
be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to
continue SFR subprime underwriting.”) [Sealed Exhibit].
736 April 13, 2010 Subcommittee Hearing at 22.
195
(e) Over 500 Deficiencies in 5 Years
As part of their review of Washington Mutual, the Treasury and the FDIC Inspectors
General determined that, over a five-year period, 2004-2008, OTS examiners identified a total of
over 540 criticisms, observations, and recommendations related to WaMu operations.737 At the
Subcommittee hearing, when asked whether those 540 findings constituted “serious criticisms”
of the bank, Treasury IG Eric Thorson responded: “Absolutely.”738
“[T]he examiners, from what I have seen here, were pointing out the problems,
underwriting problems, riskier products, concentrations, distributions, and markets that
may display more risk – they were all significant problems and they were identified. At
the end of the day, though, I don’t think forceful enough action was taken.”
The FDIC Inspector
General, Jon Rymer, agreed:
739
As WaMu accumulated hundreds of infractions from OTS, longstanding problems with
asset quality in the bank’s portfolio continued. While some observers have blamed WaMu’s
failure on its liquidity troubles in late 2008, years of unresolved problems festered below the
surface.
The consequences of WaMu’s failure to address its underwriting problems, risk
concentrations, risk layering, and other problems were exponential increases in its loss rates.
The FDIC later calculated the loss rates for several WaMu products. In WaMu’s held-forinvestment
Option ARM portfolio, delinquency rates nearly doubled every year, rising from
0.48% at the end of 2005 to 0.90% a year later, to 2.63% at year end 2007, and up to 4.63% by
June 30, 2008.740 In its subprime portfolio, its delinquency rate increased from 7.39% in 2005 to
25.20% in June 2008.741 The delinquency rate in its HELOC portfolio rose from 0.58% in 2005
to 4.00% in June 2008.742 As a result, net charge-offs for WaMu’s Option ARM portfolio rose
from $15 million at year end 2005 to $37 million in 2006, to $147 million in 2007, and to $777
million by June 2008.743 HELOC net charge-offs likewise increased, rising from $21 million in
2005, to $23 million in 2006, to $424 million in 2007, and to $1.19 billion by June 2008.744
Subprime net charge-offs expanded even more rapidly, rising from $47 million in 2005, to $134
million in 2006, to $550 million in 2007, and $956 million by June 2008.745 To account for
these losses, WaMu’s loss provisions jumped from $218 million in 2006 to over $2 billion in
2007, and an additional $6 billion by June 2008.746
737 Id. at 20. See also IG Report at 28.
738 April 16, 2010 Subcommittee Hearing at 17.
739 Id. at 18.
740 See FDIC Complaint Against WaMu Executives at ¶ 79.
741 Id.
742 Id.
743 Id. at ¶ 81.
744 Id.
745 Id.
746 Id. at ¶ 82.
196
The joint report of the Treasury and the FDIC Inspectors General specifically identified
WaMu’s poor quality loans and poor risk management practices as the real cause of its failure,
rather than the liquidity crisis that hit the bank in 2008.747 During the Subcommittee’s hearing,
when asked why WaMu failed, a senior FDIC official put it this way: “Asset quality. Weak
asset quality. It brought on the liquidity problems.”748
“If you have strong asset quality, you will not have liquidity issues because your assets –
you can borrow either against them or you can sell them. If you have weak asset quality,
then you are going to have liquidity issues at some point.”
He explained:
749
(4) OTS Turf War Against the FDIC
As WaMu approached the end, tensions between OTS and the FDIC that had built up
over two years evolved into a turf war. OTS examination and regional officials began to express
distrust of their FDIC counterparts. The conflict was elevated to the top leaders of both agencies,
who came to take different views of what to do with WaMu – the FDIC becoming more
aggressive and OTS becoming more protective. When the bank’s imminent collapse was no
longer a question, the result was a hasty seizure and sale. Had the two government agencies
acted in concert, rather than as adversaries, it is likely that WaMu’s problems would have been
resolved earlier and with less collateral damage. During an interview, the chairman of the FDIC,
Sheila Bair, stated pointedly that WaMu “could have sold themselves in July if they had
tried.”750
As mentioned earlier, OTS was the primary, but not the only, federal bank regulator that
oversaw Washington Mutual. Since WaMu was also an insured institution, the FDIC served as a
backup examiner responsible for evaluating the risk that the bank posed to the Deposit Insurance
Fund. Because WaMu was one of the eight largest insured institutions in the country, the FDIC
had assigned a Dedicated Examiner whose full time responsibility was to determine whether the
bank was operating in a safe and sound manner. The FDIC Examiner reviewed all OTS ROEs
and examination findings, participated on many occasions in OTS examinations, and reviewed
bank documents. The FDIC reviewed the CAMELS ratings for the bank, as well as LIDI ratings
under its Large Insured Depository Institutions Program.
The same outcome was not accomplished until two months later in September when no
other options remained, and OTS worked with the FDIC to make it happen.
For many years, FDIC examiners worked cooperatively with OTS examiners to conduct
oversight of WaMu. But beginning in 2006, OTS management expressed increasing reluctance
to allow FDIC examiners to participate in WaMu examinations and review bank documents.
Claiming that joint efforts created confusion about which agency was WaMu’s primary
747 IG Report at 8.
748 April 16, 2010 Subcommittee Hearing at 76. John Corston was the Acting Deputy Director of the FDIC’s
Division of Supervision and Consumer Protection, Complex Financial Institution Branch.
749 Id.
750 Subcommittee interview of Sheila Bair (4/5/2010).
197
regulator,751
Resisting FDIC Advice. During the period 2004-2008, internal FDIC evaluations of
Washington Mutual were consistently more negative than those of OTS, at times creating friction
between the two agencies. OTS also resisted the FDIC’s advice to subject WaMu to stronger
enforcement actions, downgrade its CAMELS rating, and solicit buyers for the bank.
OTS officials employed a variety of tactics to limit the FDIC oversight of the bank,
including restricting its physical access to office space at the bank, its participation in bank
examinations, and its access to loan files. In addition, as the FDIC began to express greater
concern about the bank’s viability, recommend ratings downgrades, and urge enforcement
action, OTS officials displayed increasing resistance to its advice. In the end, OTS not only
undermined years of cooperative oversight efforts, but at times actively impeded FDIC oversight
of one of the largest insured banks in the country.
As early as 2005, the FDIC examination team expressed concerns about WaMu’s high
risk lending strategy, even though the bank’s management expressed confidence that the risks
were manageable. In an internal memorandum, for example, the FDIC team identified multiple
negative impacts on WaMu’s loan portfolio if housing prices were to stop climbing. The
memorandum stated in part:
“Washington Mutual Bank’s (WMB) single-family residential (SRF) loan portfolio has
embedded risk factors that increase exposure to a widespread decline in housing prices.
The overall level of risk is moderate, but increasing. … A general decline in housing
prices would adversely impact: a) The SRF loan portfolio; b) The home equity loan
portfolio; and c) Mortgage banking revenue. … In January 2005, management developed
a higher-risk lending (HRL) strategy and defined company-wide higher-risk loans as …
sub prime loans … SFR loans with FICO scores below 620, … consumer loans with
FICO scores below 660, and … [the] Long Beach … portfolio. Management intends to
expand the HRL definition and layer additional risk characteristics in the future. …
Management acknowledges the risks posed by current market conditions and recognizes
that a potential decline in housing prices is a distinct possibility. Management believes,
however that the impact on WMB would be manageable, since the riskiest segments of
production are sold to investors, and that these investors will bear the brunt of a bursting
housing bubble.”752
751 See, e.g., April 16, 2010 Subcommittee Hearing at 61 (testimony of OTS Director Reich: “[F]irst of all, the
primary regulator is the primary Federal regulator, and when another regulator enters the premises, when the FDIC
enters the premises, confusion develops about who is the primary regulator, who really is calling the shots, and who
do we report to, which agency.”)
752 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large
Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). In an interview, when shown the
draft memorandum, FDIC Assistant Regional Director George Doerr, who was a member of the WaMu examination
team, told the Subcommittee that this type of analysis was prepared for a select group of mortgage lenders, including
WaMu, to understand where the mortgage market was headed and how it would affect those insured thrifts. He did
not have a copy of the final version of the memorandum, but said the FDIC’s analysis was discussed with OTS.
Subcommittee interview of George Doerr (3/30/2010).
198
In mid-2005, an internal FDIC memorandum discussed the increased risk associated with
the new types of higher risk mortgage loans being issued in the U.S. housing market:
“Despite the favorable history, we believe recent lending practices and buyer
behavior have elevated the risk of residential lending. Concerns are compounded
by significantly increased investor activity and new loan products that allow less
creditworthy borrowers to obtain mortgages. The new loan products of most
concern include Option Adjustment Rate Mortgage (ARM) Loans, Interest Only
(IO) Loans, and Piggyback Home Equity Loans.”753
WaMu offered all three types of loans, in addition to subprime loans through Long
Beach.
In 2007, an FDIC memorandum again identified WaMu’s high risk home loans as
its “primary risk,” singling out both its subprime and Option ARM loans:
“SFR [Single Family Residential loan] credit risk remains the primary risk. The
bank has geographic concentrations, moderate exposure to subprime assets, and
significant exposure to mortgage products with potential for payment shock. …
The bank’s credit culture emphasized home price appreciation and the ability to
perpetually refinance. … In the past, the bank relied on quarterly sales of
delinquent residential loans to manage its non performing assets. The bank’s
underwriting standards were lax as management originated loans under an
originate to sell model. When the originate to sell model collapsed in July 2007
for private and subprime loans, management was no longer able to sell non
performing assets. Consequently, non performing assets are now mounting, and
the bank’s credit risk mitigation strategy is no longer effective.”754
From 2004 to 2008, the FDIC assigned LIDI ratings to WaMu that indicated a higher
degree of risk at the bank than portrayed by the bank’s CAMELS ratings. LIDI ratings are
intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund,
with A being the best rating and E the worst.755 The FDIC IG explained the difference between
LIDI and CAMELS ratings as follows: “LIDI ratings consider future risks at an institution,
where CAMELS rating, in practice, are more point-in-time measures of performance.”756
753 7/5/2005 memorandum from FDIC Associate Director John H. Corston to FDIC Associate Director Michael
Zamorski, “Insured Institutions’ Exposures to a Housing Slowdown,” FDIC_WAMU_000015114, Hearing Exhibit
4/16-51b.
As
754 FDIC Washington Mutual Bank LIDI Report, Q307, FDIC_WAMU_000014851, Hearing Exhibit 4/16-94
[Sealed Exhibit].
755 An A rating indicates a “low risk” of concern that an institution will cause a loss to the Deposit Insurance Fund, a
B rating indicates an “ordinary level of concern,” a C rating indicates a “more than an ordinary level of concern,” a
D rating conveys a “high level of concern,” and an E rating conveys “serious concerns.” See prepared statement of
FDIC IG Rymer at 5 (chart showing FDIC LIDI ratings descriptions), April 16, 2010 Subcommittee Hearing, at 124
(showing FDIC LIDI ratings description).
756 Id.
199
early as 2004, the FDIC viewed WaMu as having higher levels of risk than indicated by its
CAMELS ratings. This chart shows the comparable ratings over time:
WaMu CAMELS and LIDI Ratings, 2004-2008757
Assessment
Period
CAMELS
Composite Rating
LIDI
Rating
January 2004 2 B
July 2004 2 B/C
January 2005 2 B/C
July 2005 2 B/C
January 2006 2 B/C
July 2006 2 B/C
March 2007 2 B/C
June 2007 2 C
September 2007 2 C
December 2007 2 C
March 2008 3 D
June 2008 3 E
September 2008 4 E
FDIC IG Rymer explained that the B/C rating meant that the FDIC viewed WaMu as posing a
“somewhat more than ordinary risk” to the Deposit Insurance Fund, the C rating meant it “posed
more than an ordinary risk,” D meant the FDIC had “a high level of concern,” and E meant that
the FDIC had “serious concerns” that WaMu would cause a loss to the Fund.758
Despite assigning lower LIDI ratings to the bank, indicating the increasing risk it posed
to the Deposit Insurance Fund, the FDIC – like OTS – continued to support a 2 CAMELS rating
throughout 2007. The result of both regulators delaying a downgrade in WaMu’s rating had a
direct impact on FDIC operations. According to the FDIC Inspector General, WaMu’s
CAMELS rating of 2 prevented the FDIC from charging higher premiums for the Deposit
Insurance Fund until February 2008, when its rating was dropped to a 3.759
OTS downgraded the bank to a 3 CAMELS rating in February 2008, after WaMu
incurred substantial losses. OTS also required WaMu to issue a nonpublic Board Resolution
making general commitments to strengthen its operations. The FDIC undertook a special
insurance examination of the bank, analyzed its capital, and concluded that the bank should raise
Higher premiums are
one of the tools used by the FDIC to signal to financial institutions that they should better control
their risk. Unfortunately, in this case, that tool was not available in 2005, 2006, or 2007.
757 See prepared statement of FDIC IG Rymer at 6 (chart showing WaMu ratings and insurance assessments), April
16, 2010 Subcommittee Hearing at 125.
758 Id.
759 Prepared statement of FDIC IG Rymer at 6-7, April 16, 2010 Subcommittee Hearing, at 125-26. See also IG
Report at 40-42.
200
additional capital.760 The FDIC staff attempted to engage OTS staff in discussions about
increasing the bank’s capital and downgrading its CAMELS ratings, but OTS was not
persuaded.761
In July 2008, tensions between the FDIC and OTS flared after the FDIC sent a letter to
OTS urging it to take additional enforcement action: “As we discussed, we believe that
[WaMu’s] financial condition will continue to deteriorate unless prompt and effective
supervisory action is taken.”762 The letter urged OTS to impose a “corrective program” that
included requiring the bank to raise $5 billion in additional capital and provide quarterly reports
on its financial condition. OTS not only rejected that advice, but also expressed the hope that the
FDIC would refrain from future “unexpected letter exchanges.”763
“I have read the attached letter from the FDIC regarding supervision of Wamu and am
once again disappointed that the FDIC has confused its role as insurer with the role of the
Primary Federal Regulator. Its letter is both inappropriate and disingenuous. I would
like to see our response to the FDIC, which I assume will remind it that we, as the PFR,
will continue to effectively supervise the entity and will continue to consider the FDIC’s
views.”
In a separate email, Scott
Polakoff, a senior OTS official called the FDIC letter “inappropriate and disingenuous”:
764
Two weeks later, on July 31, both OTS and the FDIC met with the WaMu Board of
Directors to discuss the bank’s problems. At that meeting, the FDIC Dedicated Examiner
suggested that the bank look for a “strategic partner” who could buy or invest in the bank. The
OTS director, John Reich, later expressed anger at the FDIC for failing to clear that suggestion
first with OTS as the bank’s primary regulator. An FDIC examiner wrote to his colleagues:
“Major ill will at WAMU meeting yesterday caused by FDIC suggestion in front of
WAMU management that they find a strategic partner. [OTS Director] Reich reportedly
indicated that was totally inappropriate and that type of conversation should have
occurred amongst regulatory agencies before it was openly discussed with
management.”765
The next day, on August 1, 2008, due to WaMu’s increasing financial and deposit losses,
the FDIC Chairman, Sheila Bair, suggested that the bank’s condition merited a downgrade in its
CAMELS rating to a 4, signaling a troubled bank.766
“In my view rating WaMu a 4 would be a big error in judging the facts in this situation.
It would appear to be a rating resulting from fear and not a rating based on the condition
The head of OTS sent an email to the head
of the FDIC responding that “rating WaMu a 4 would be a big error”:
760 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.
761 Subcommittee interview of Steve Funaro (3/18/2010).
762 7/21/2008 letter from the FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.
763 7/22/2008 letter from OTS to the FDIC, OTSWMS08-015 0001312, Hearing Exhibit 4/16-60.
764 7/22/2008 email from OTS Deputy Director Scott Polakoff to OTS colleagues, Hearing Exhibit 4/16-59.
765 8/1/2008 email from David Promani to FDIC colleagues, FDIC-EM_00246958, Hearing Exhibit 4/16-64.
766 See 8/1/2008, email from Darrell Dochow to OTS senior officials, Hearing Exhibit 4/16-62.
201
of the institution. WaMu has both the capital and the liquidity to justify a 3 rating. It
seems based on email exchanges which have taken place that FDIC supervisory staff in
San Francisco is under pressure by the fear in Washington to downgrade this institution.
… [P]rior to such action I would request a[n FDIC] Board meeting to consider the proper
rating on this institution.”767
The FDIC Chairman responded: “We will follow the appropriate procedures if the staff cannot
agree.”768
A few days later, Ms. Bair sent an email to Mr. Reich requesting a discussion of
“contingency planning” for WaMu, including making “discrete inquiries” to determine whether
any institution would be willing to buy the bank. The OTS Director responded with a lengthy
email criticizing the request and stating in part:
“I do not under any circumstances want to discuss this on Friday’s conference call …. I
should not have to remind you the FDIC has no role until the PFR [Primary Federal
Regulator] (i.e. the OTS) rules on solvency …. You personally, and the FDIC as an
agency, would likely create added instability if you pursue what I strongly believe would
be a precipitous and unprecedented action. … It seems as though the FDIC is behaving as
some sort of super-regulator – which you and it are not.”769
In September 2008, Ms. Bair informed WaMu that there was a likely ratings
disagreement between the FDIC and OTS, and that the FDIC intended to lower the bank’s rating
to a 4. After the FDIC Chairman informed the OTS Director by email of her conversation with
WaMu, Mr. Reich forwarded the exchange to his OTS Deputy Director, upset that she had not
come to him first with that information: “I cannot believe the continuing audacity of this
woman.”770
Restricting Office Space and Information. Throughout the period examined by the
Subcommittee, OTS not only rebuffed the FDIC’s analysis and advice, it began to actively
impede FDIC oversight efforts at WaMu. OTS even went so far as to limit the FDIC’s physical
access to office space, as well as to needed information, at WaMu’s new headquarters. Prior to
2006, OTS had always provided the FDIC examiners with space in its on-site offices at the bank,
making it easy for FDIC examiners to participate in OTS examinations. In the summer of 2006,
however, following WaMu’s move to a new headquarters in Seattle, OTS did not provide any of
its desks for the FDIC examiners. OTS also restricted the FDIC’s access to an important
database that all examiners used to review WaMu documents, referred to as the “examiner’s
library.” From July until November 2006, a period of about four months, the FDIC examiners
were denied access to both office space on the bank’s premises and the examiner’s library. The
Two weeks later, the bank failed.
767 8/1/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, Hearing Exhibit 416-63.
768 Id.
769 8/6/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, “Re: W,” FDIC-EM_00110089,
Hearing Exhibit 4/16-66.
770 9/10/2008 email from OTS Director John Reich to OTS Deputy Director Scott Polakoff, Polakoff_Scott-
00065461_001, Hearing Exhibit 4/16-68.
202
FDIC had to make multiple requests, taking the issue up through the OTS hierarchy in
Washington, D.C. headquarters, to regain the access it had enjoyed for years at WaMu.
In an October 2006 email to the FDIC Assistant Regional Director, George Doerr, the
FDIC Dedicated Examiner at WaMu, described in exasperation how he had been promised
permanent space at the bank, but still did not have it. Demonstrating how poisoned the
relationship was at that point, the FDIC examiner blamed the lack of cooperation on “stalling
tactics and misrepresentations:”
“Our issue is with OTS management (Finn and Dochow) and how they have apparently
mislead RD [Regional Director] Carter, DRD [Deputy Regional Director] Villalba, you,
and me. This regards space for the dedicated examiner and access to information …. I
met with OTS examiners yesterday and they have not made arrangements for permanent
space for me at the new location and protocols for information sharing have not been
developed …. In July RD Carter [from FDIC] talked with Finn [from OTS] and he
agreed to space and access. On 8/17 you and DRD Villalba had a telephone conversation
with Dochow and he agreed it was not necessary to fix what was not broken and he
promised access to space and information. On 9/15 I met with Dochow and he agreed to
space and information sharing …. I am prepared for more of Dochow’s stalling tactics
and misrepresentations.”771
Mr. Doerr forwarded the “info about OTS denying us space and access to information” to other
FDIC officials stating: “The situation has gone from bad to worse.”772
At the Subcommittee hearing, when asked why OTS took four months to restore FDIC
access to office space and WaMu documents, Mr. Doerr of the FDIC responded:
Mr. Doerr: I can’t explain what the reason was. I personally think they didn’t want us
there. I mean, we were denied physical access and the access to this examiner library …
of electronic materials that WaMu puts together for the regulators …. [Y]ou shouldn’t
have to go 4 months without having to have that. …
Senator Levin: And it was essential that Mr. Funaro [the FDIC Dedicated Examiner]
have access to that library in order to get information about the Washington Mutual?
Mr. Doerr: Absolutely.773
By November 2006, when OTS relented and provided desk space and database access to
the FDIC Dedicated Examiner, it did little to ameliorate the situation. Its actions contributed to a
771 10/13/2006 email chain from Vanessa Villalba to J. George Doerr, John F. Carter, and John H. Corston, “Re:
wamu quarterly,” FDIC_WAMU_000014449, Hearing Exhibit 4/16-53. See also 9/6/2006 FDIC internal email
chain, “OTS re: WAMU,” FDIC-EM_00252239, Hearing Exhibit 4/16-51c (“He absolutely agreed you’d have
access to the Examiner Library. And he hasn’t arranged that.”).
772 Id.
773 April 16, 2010 Subcommittee Hearing at 72-73.
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worsening relationship between the two agencies, impeded FDIC oversight efforts, and
weakened oversight of WaMu’s activities.774
Restricting FDIC Examinations. At the same time OTS was withholding office space
and database access from the FDIC examination team, it also, for the first time, refused an FDIC
request to participate in an OTS examination of WaMu.
Although the FDIC has a broad statutory right to participate in examinations of insured
depository institutions,775 it had agreed to spell out how it would exercise that statutory authority
in a 2002 Interagency Agreement with the Federal Reserve, OCC, and OTS.776 The Interagency
Agreement authorized the FDIC to conduct “special examinations” of insured institutions that
“represent a heightened risk” to the Deposit Insurance Fund, defined as institutions with a 3, 4,
or 5 rating on the CAMELS scale or which were “undercapitalized as defined under Prompt
Corrective Action” standards.777
“The message was crystal clear today. Absolutely no FDIC participation on any OTS 1
and 2 rated exams. . . . We should also deny FDIC requests to participate on HC [holding
company] or affiliate exams.
Other FDIC bank examinations had to be authorized by the
primary regulator. Prior to 2006, OTS had routinely authorized joint OTS-FDIC examinations
without regard to the CAMELS ratings, but in January 2006, OTS suddenly changed its policy.
The change was signaled in an email sent by a senior OTS official to his colleagues:
Permission for FDIC to join us on WaMu … will stand for now, but they should not be
[in] direct contact with thrift management or be requesting info directly from the
thrift.”778
This email signaled the beginning of a much more restrictive policy toward the FDIC
participation in OTS examinations, even though in January 2006, OTS indicated it would allow
an exception for the FDIC examiners to continue participating in its scheduled examination of
WaMu. The reasons for this change in policy were never made clear, but in several interviews,
OTS and FDIC officials attributed it to certain senior OTS officials who were reluctant to share
thrift oversight responsibilities with the FDIC.
In August 2006, the FDIC made what it viewed as a routine request to join in the next
OTS examination of WaMu, which was designed to focus, in part, on WaMu’s subprime lending.
To the surprise and consternation of the FDIC, the OTS Regional Director Michael Finn sent a
letter denying the request and stating that OTS would instead “share our exam findings with the
774 See also IG Report at 42-45 (“It appears that 2006 was a turning point in the relationship between FDIC and OTS
in terms of information sharing that carried through to 2008.”).
775 See 12 U.S.C. § 1820(b)(3).
776 See “Coordination of Expanded Supervisory Information Sharing and Special Examinations,” PSI-FDIC-10-
0001.
777Id.
778 1/24/2006 email from OTS senior official Michael Finn to Edwin Chow and Darrel Dochow, OTSWM06-006
0000129, Hearing Exhibit 4/16-49.
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FDIC, as we have in the past.”779
After discussing the Finn letter in an internal email, the FDIC Assistant Regional
Director, George Doerr, wrote to his colleagues:
Mr. Finn wrote that because WaMu’s CAMELS rating was a 2
and FDIC had not shown “any concerns regarding our past or planned examination activities,
and our continued commitment to share all appropriate information, the FDIC has not shown the
regulatory need to participate in the upcoming Washington Mutual examination.”
“Obviously, we have a major problem here. OTS is taking the approach we need to
establish a ‘regulatory need to participate’ on an exam, and that the basis would have to
be disagreement on exam findings. Mr. Finn is totally missing the point on our need for
timely accurate information to properly categorize WAMU for deposit insurance
premium purposes, more so now than ever in the past.”780
In October 2006, John Carter with the FDIC sent Michael Finn of OTS a letter repeating
the FDIC’s request to participate in the WaMu examination:
“I have received your response to our August 14 2006 letter in which we request
permission to participate in aspects of the upcoming examination of Washington Mutual
Bank. Regarding your reasoning for rejecting our participation in these target reviews,
you are correct that our request is not predicated on any current disagreement related to
examination findings or concerns regarding supervisory activities at Washington Mutual.
Such criteria are not prerequisite for requesting – or for the OTS granting – FDIC staff
participation in target examination activities.
As you are aware, the FDIC and the OTS have a long, cooperative, and productive
working relationship with respect to the examination of Washington Mutual Bank, which
we hope to continue. Past experience has proven that our participation in targeted
reviews is beneficial to our respective Agencies, as well as to the Bank. … The 2002
Agreement clearly allows for FDIC staff participation in examination activities to
evaluate the risk of a particular banking activity to the deposit insurance fund.
Washington Mutual Bank is very large insured financial institution, and in our view
participation on the upcoming targeted reviews is necessary to fulfill our responsibilities
to protect the deposit insurance fund.”781
On November 10, 2006, Mr. Finn responded with a letter that, again, refused to allow the
FDIC to participate in the WaMu examination:
“OTS does not seek to have FDIC staff actively participate in our examination activities
and conclusions at Washington Mutual. We do understand your need for access to
779 9/6/2006 FDIC internal email chain, “OTS re: WAMU,” FDIC-EM_00252239-40, Hearing Exhibit 4/16-51c.
780 Id. at FDIC-EM_00252240.
781 10/6/2006 letter from FDIC senior official John Carter to OTS senior official Michael Finn,
FDIC_WAMU_000014445-46, Hearing Exhibit 4/16-52a.
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examination information and your need to meet with OTS staff to discuss our supervisory
activities at Washington Mutual. To facilitate this information sharing and discussions,
we have agreed to allow your Dedicated Examiner … to conduct his FDIC risk
assessment activities on site at Washington Mutual when our examination team is on site.
All FDIC requests for information should continue to be funneled through our examinerin-
charge.”782
The OTS letter also restricted the ability of the FDIC to place more than one examiner on site at
WaMu, even though the bank, with $300 billion in assets, was one of the largest insured
institutions in the country and was engaged in a high risk lending strategy:
“We also understand that the FDIC may occasionally request OTS permission to have
FDIC examination staff assist [its Dedicated Examiner] on site at Washington Mutual in
his risk assessment activities. We will consider these limited requests to send additional
FDIC staff to Washington Mutual on a case-by-case basis.”783
Despite the negative tone of the OTS letter, the FDIC persisted in its request, and OTS
eventually allowed the FDIC examiners to participate in some WaMu examinations in 2006 and
2007, though it continued to press the FDIC to limit its requests and personnel.784
During the Subcommittee hearing, the FDIC staff described their surprise at the new OTS
policy and frustration at its seemingly circular reasoning – that the FDIC needed to specify a
“basis” and “disagreement” with OTS to justify joining an OTS examination, but the FDIC was
also barred from participating in the very examinations that could develop that basis and
disagreement.785
Restricting Access to Loan Files. Even after OTS reluctantly allowed the FDIC to
participate in some OTS examinations, it held firm in its refusal to allow the FDIC to directly
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