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United States Senate

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

Committee on Homeland Security and Governmental Affairs

Carl Levin, Chairman

Tom Coburn, Ranking Minority Member

WALL STREET AND

THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

MAJORITY AND MINORITY

STAFF REPORT

PERMANENT SUBCOMMITTEE

ON INVESTIGATIONS

UNITED STATES SENATE

April 13, 2011

SENATOR CARL LEVIN

Chairman

SENATOR TOM COBURN, M.D.

Ranking Minority Member

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

ELISE J. BEAN

Staff Director and Chief Counsel

ROBERT L. ROACH

Counsel and Chief Investigator

LAURA E. STUBER

Counsel

ZACHARY I. SCHRAM

Counsel

DANIEL J. GOSHORN

Counsel

DAVID H. KATZ

Counsel

ALLISON F. MURPHY

Counsel

ADAM C. HENDERSON

Professional Staff Member

PAULINE E. CALANDE

Detailee

MICHAEL J. MARTINEAU

Detailee

CHRISTOPHER J. BARKLEY

Staff Director to the Minority

ANTHONY G. COTTO

Counsel to the Minority

KEITH B. ASHDOWN

Chief Investigator to the Minority

JUSTIN J. ROOD

Senior Investigator to the Minority

VANESSA CAREIRO

Law Clerk

BRITTANY CLEMENT

Law Clerk

DAVID DeBARROS

Law Clerk

ERIN HELLING

Law Clerk

HELENA MAN

Law Clerk

JOSHUA NIMMO

Intern

ROBERT PECKERMAN

Intern

TANVI ZAVERI

Law Clerk

MARY D. ROBERTSON

Chief Clerk

5/10/11

Permanent Subcommittee on Investigations

199 Russell Senate Office Building – Washington, D.C. 20510

Main Number: 202/224-9505

Web Address: www.hsgac.senate.gov [Follow Link to “Subcommittees,” to “Investigations”]

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WALL STREET AND THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

TABLE OF CONTENTS

I. EXECUTIVE SUMMARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A. Subcommittee Investigation . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

B. Overview . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

(1) High Risk Lending: Case Study of Washington Mutual Bank. . . . . . . . . . . . . . . . . . 2

(2) Regulatory Failure: Case Study of the Office of Thrift Supervision.. . . . . . . . . . . . . 4

(3) Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s. . . . . . . . . . 5

(4) Investment Bank Abuses: Case Study of Goldman Sachs and Deutsche Bank.. . . . . 7

C. Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

A. Rise of Too-Big-To-Fail U.S. Financial Institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . 15

B. High Risk Mortgage Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

C. Credit Ratings and Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

D. Investment Banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

E. Market Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

F. Government Sponsored Enterprises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

G. Administrative and Legislative Actions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

H. Financial Crisis Timeline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK. . . . . . . . . . . . . . . . . . . . . . . . . . . 48

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

B. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

(1) Major Business Lines and Key Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

(2) Loan Origination Channels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

(3) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

(4) Securitization.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

(5) Overview of WaMu’s Rise and Fall. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

C. High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

(1) Strategic Direction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(2) Approval of Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(3) Definition of High Risk Lending.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

(4) Gain on Sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

(5) Acknowledging Unsustainable Housing Price Increases.. . . . . . . . . . . . . . . . . . . . . . 65

(6) Execution of the High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

D. Shoddy Lending Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

(1) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

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(2) WaMu Retail Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(a) Inadequate Systems and Weak Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(b) Risk Layering.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

(c) Loan Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

(d) Steering Borrowers to High Risk Option ARMs. . . . . . . . . . . . . . . . . . . . . . . . . 104

(e) Marginalization of WaMu Risk Managers.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

E. Polluting the Financial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

(1) WaMu and Long Beach Securitizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

(2) Deficient Securitization Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

(3) Securitizing Delinquency-Prone Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

(4) WaMu Loan Sales to Fannie Mae and Freddie Mac. . . . . . . . . . . . . . . . . . . . . . . . . . 136

F. Destructive Compensation Practices.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

(1) Sales Culture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

(2) Paying for Speed and Volume. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

(a) Long Beach Account Executives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

(b) WaMu Loan Consultants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

(c) Loan Processors and Quality Assurance Controllers. . . . . . . . . . . . . . . . . . . . . . 151

(3) WaMu Executive Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

G. Preventing High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

1. Ensure “Qualified Mortgages” Are Low Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 160

2. Require Meaningful Risk Retention. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

3. Safeguard Against High Risk Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

4. Require Greater Reserves for Negative Amortization Loans.. . . . . . . . . . . . . . . 160

5. Safeguard Bank Investment Portfolios.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

IV. REGULATORY FAILURE:

CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION. . . . . . . . . . . . . . . . . . . 161

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

(1) Office of Thrift Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

(2) Federal Deposit Insurance Corporation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

(3) Examination Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

C. Washington Mutual Examination History. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

(1) Regulatory Challenges Related to Washington Mutual.. . . . . . . . . . . . . . . . . . . . . . . 169

(2) Overview of Washington Mutual’s Ratings History and Closure.. . . . . . . . . . . . . . . 173

(3) OTS Identification of WaMu Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(a) Deficiencies in Lending Standards.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(b) Deficiencies in Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

(c) Deficiencies in Home Appraisals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

(d) Deficiencies Related to Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

(e) Over 500 Deficiencies in 5 Years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

(4) OTS Turf War Against the FDIC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

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D. Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

(1) OTS’ Failed Oversight of WaMu. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(a) Deference to Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(b) Demoralized Examiners.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

(c) Narrow Regulatory Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224

(d) Inflated CAMELS Ratings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

(e) Fee Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

(2) Other Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(a) Countrywide.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(b) IndyMac. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

(c) New Century . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

(d) Fremont. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

E. Preventing Regulatory Failures.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

1. Complete OTS Dismantling.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

2. Strengthen Enforcement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

3. Strengthen CAMELS Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

4. Evaluate Impacts of High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

V. INFLATED CREDIT RATINGS:

CASE STUDY OF MOODY’S AND STANDARD & POOR’S. . . . . . . . . . . . . . . . . . . . . 243

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

(1) Credit Ratings Generally. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

(2) The Rating Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

(3) Record Revenues.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256

C. Mass Credit Rating Downgrades.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259

(1) Increasing High Risk Loans and Unaffordable Housing. . . . . . . . . . . . . . . . . . . . . . . 259

(2) Mass Downgrades. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

D. Ratings Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

(1) Awareness of Increasing Credit Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268

(2) CRA Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

(a) Drive for Market Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

(b) Investment Bank Pressure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

(3) Inaccurate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(a) Inadequate Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(b) Unclear and Subjective Ratings Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

(4) Failure to Retest After Model Changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

(5) Inadequate Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

(6) Mortgage Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310

E. Preventing Inflated Credit Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

(1) Past Credit Rating Agency Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

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(2) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

(3) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

1. Rank Credit Rating Agencies by Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

2. Help Investors Hold CRAs Accountable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

3. Strengthen CRA Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

4. Ensure CRAs Recognize Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

5. Strengthen Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

6. Reduce Ratings Reliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

VI. INVESTMENT BANK ABUSES:

CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK.. . . . . . . . . . . . . . . . 318

A. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(1) Investment Banks In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(2) Roles and Duties of an Investment Bank: Market Maker, Underwriter,

Placement Agent, Broker-Dealer.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

(3) Structured Finance Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

B. Running the CDO Machine: Case Study of Deutsche Bank. . . . . . . . . . . . . . . . . . . . 330

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 333

(2) Deutsche Bank Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334

(3) Deutsche Bank’s $5 Billion Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

(a) Lippmann’s Negative Views of Mortgage Related Assets. . . . . . . . . . . . . . . . . 337

(b) Building and Cashing in the $5 Billion Short. . . . . . . . . . . . . . . . . . . . . . . . . . . 341

(4) The “CDO Machine” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

(5) Gemstone.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(a) Background on Gemstone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(b) Gemstone Asset Selection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

(c) Gemstone Risks and Poor Quality Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357

(d) Gemstone Sales Effort. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

(e) Gemstone Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

(6) Other Deutsche Bank CDOs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

(7) Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

C. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs. . . . . . . . . . 376

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 376

(2) Goldman Sachs Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

(3) Overview of Goldman Sachs Case Study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

(a) Overview of How Goldman Shorted the Subprime Mortgage Market. . . . . . . . 382

(b) Overview of Goldman’s CDO Activities.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

(4) How Goldman Shorted the Subprime Mortgage Market.. . . . . . . . . . . . . . . . . . . . . . 398

(a) Starting $6 Billion Net Long. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398

(b) Going Past Home: Goldman’s First Net Short. . . . . . . . . . . . . . . . . . . . . . . . . . 404

(c) Attempted Short Squeeze.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

(d) Building the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430

(e) “Get Down Now”.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

v

(f) Profiting from the Big Short: Making “Serious Money”. . . . . . . . . . . . . . . . . . . 444

(g) Goldman’s Records Confirm Large Short Position. . . . . . . . . . . . . . . . . . . . . . . 445

(i) Top Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

(ii) Risk Reports.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

(h) Profiting From the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466

(5) How Goldman Created and Failed to Manage Conflicts of Interest in its

Securitization Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474

(a) Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(i) Goldman’s Securitization Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(ii) Goldman’s Negative Market View. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

(iii) Goldman’s Securitization Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

AA. RMBS Sell Off.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

BB. CDO Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492

CC. CDO Marks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

DD. Customer Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

(b) Goldman’s Conflicts of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

(i) Conflicts of Interest Involving RMBS Securities. . . . . . . . . . . . . . . . . . . . 513

(ii) Conflicts of Interest Involving Sales of CDO Securities. . . . . . . . . . . . . . 516

AA. Hudson Mezzanine Funding 2006-1. . . . . . . . . . . . . . . . . . . . . . . . . 517

BB. Anderson Mezzanine Funding 2007-1.. . . . . . . . . . . . . . . . . . . . . . . 532

CC. Timberwolf I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

DD. Abacus 2007-AC1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560

(iii) Additional CDO Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

AA. Liquidation Agent in Hudson 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

BB. Collateral Put Provider in Timberwolf. . . . . . . . . . . . . . . . . . . . . . . 588

(6) Analysis of Goldman’s Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602

(a) Securities Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603

(b) Analysis .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(i) Claiming Market Maker Status.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(ii) Soliciting Clients and Recommending Investments. . . . . . . . . . . . . . . . . . 613

(iii) Failing to Disclose Material Adverse Information. . . . . . . . . . . . . . . . . . . 615

(iv) Making Unsuitable Investment Recommendations. . . . . . . . . . . . . . . . . . 619

(7) Goldman’s Proprietary Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624

D. Preventing Investment Bank Abuses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

1. Review Structured Finance Transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

2. Narrow Proprietary Trading Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

3. Design Strong Conflict of Interest Prohibitions.. . . . . . . . . . . . . . . . . . . . . . . . . 639

4. Study Bank Use of Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

# # #

Wall Street and The Financial Crisis:

Anatomy of a Financial Collapse

April 13, 2011

In the fall of 2008, America suffered a devastating economic collapse. Once valuable

securities lost most or all of their value, debt markets froze, stock markets plunged, and storied

financial firms went under. Millions of Americans lost their jobs; millions of families lost their

homes; and good businesses shut down. These events cast the United States into an economic

recession so deep that the country has yet to fully recover.

This Report is the product of a two-year bipartisan investigation by the U.S. Senate

Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The

goals of this investigation were to construct a public record of the facts in order to deepen the

understanding of what happened; identify some of the root causes of the crisis; and provide a

factual foundation for the ongoing effort to fortify the country against the recurrence of a similar

crisis in the future.

Using internal documents, communications, and interviews, the Report attempts to

provide the clearest picture yet of what took place inside the walls of some of the financial

institutions and regulatory agencies that contributed to the crisis. The investigation found that

the crisis was not a natural disaster, but the result of high risk, complex financial products;

undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the

market itself to rein in the excesses of Wall Street.

While this Report does not attempt to examine every key moment, or analyze every

important cause of the crisis, it provides new, detailed, and compelling evidence of what

happened. In so doing, we hope the Report leads to solutions that prevent it from happening

again.

I. EXECUTIVE SUMMARY

A. Subcommittee Investigation

In November 2008, the Permanent Subcommittee on Investigations initiated its

investigation into some of the key causes of the financial crisis. Since then, the Subcommittee

has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and

depositions, and consulting with dozens of government, academic, and private sector experts.

The Subcommittee has accumulated and reviewed tens of millions of pages of documents,

including court pleadings, filings with the Securities and Exchange Commission, trustee reports,

prospectuses for public and private offerings, corporate board and committee minutes, mortgage

transactions and analyses, memoranda, marketing materials, correspondence, and emails. The

Subcommittee has also reviewed documents prepared by or sent to or from banking and

2

securities regulators, including bank examination reports, reviews of securities firms,

enforcement actions, analyses, memoranda, correspondence, and emails.

In April 2010, the Subcommittee held four hearings examining four root causes of the

financial crisis. Using case studies detailed in thousands of pages of documents released at the

hearings, the Subcommittee presented and examined evidence showing how high risk lending by

U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality

financial products designed and sold by some investment banks, contributed to the financial

crisis. This Report expands on those hearings and the case studies they featured. The case

studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office

of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard &

Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank,

two leaders in the design, marketing, and sale of mortgage related securities. This Report

devotes a chapter to how each of the four causative factors, as illustrated by the case studies,

fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and

recommendations for next steps.

B. Overview

(1) High Risk Lending:

Case Study of Washington Mutual Bank

The first chapter focuses on how high risk mortgage lending contributed to the financial

crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu

was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in

deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it

embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By

2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in

2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in

2007, the bank itself began incurring losses due to a portfolio that contained poor quality and

fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and

depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On

September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed

in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan

Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the

entire $45 billion Deposit Insurance Fund.

This case study focuses on how one bank’s search for increased growth and profit led to

the origination and securitization of hundreds of billions of dollars in high risk, poor quality

mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial

system. WaMu had held itself out as a prudent lender, but in reality, the bank turned

increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from

19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans

fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of

3

subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage

Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006.

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

loans.

WaMu also originated an increasing number of its flagship product, Option Adjustable

Rate Mortgages (Option ARMs), which created high risk, negatively amortizing mortgages and,

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

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

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

Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In

addition, WaMu greatly increased its origination and securitization of high risk home equity loan

products. By 2007, home equity loans made up $63.5 billion or 27% of its home loan portfolio,

a 130% increase from 2003.

At the same time that WaMu was implementing its high risk lending strategy, WaMu and

Long Beach engaged in a host of shoddy lending practices that produced billions of dollars in

high risk, poor quality mortgages and mortgage backed securities. Those practices included

qualifying high risk borrowers for larger loans than they could afford; steering borrowers from

conventional mortgages to higher risk loan products; accepting loan applications without

verifying the borrower’s income; using loans with low, short term “teaser” rates that could lead

to payment shock when higher interest rates took effect later on; promoting negatively

amortizing loans in which many borrowers increased rather than paid down their debt; and

authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to

enforce compliance with their own lending standards; allowed excessive loan error and exception

rates; exercised weak oversight over the third party mortgage brokers who supplied half or more

of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower

information. They also designed compensation incentives that rewarded loan personnel for

issuing a large volume of higher risk loans, valuing speed and volume over loan quality.

As a result, WaMu, and particularly its Long Beach subsidiary, became known by

industry insiders for its failed mortgages and poorly performing residential mortgage backed

securities (RMBS). Among sophisticated investors, its securitizations were understood to be

some of the worst performing in the marketplace. Inside the bank, WaMu’s President Steve

Rotella described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.”

WaMu’s high risk lending operation was also problem-plagued. WaMu management was

provided with compelling evidence of deficient lending practices in internal emails, audit reports,

and reviews. Internal reviews of two high volume WaMu loan centers, for example, described

“extensive fraud” by employees who “willfully” circumvented bank policies. A WaMu review

of internal controls to stop fraudulent loans from being sold to investors described them as

“ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone

loans to investors. Aside from Long Beach, WaMu’s President described WaMu’s prime home

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

4

Documents obtained by the Subcommittee reveal that WaMu launched its high risk

lending strategy primarily because higher risk loans and mortgage backed securities could be

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

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

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

books and appeared to insulate the bank from risk.

The Subcommittee investigation indicates that unacceptable lending and securitization

practices were not restricted to Washington Mutual, but were present at a host of financial

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

home loans that inundated U.S. financial markets. Many of the resulting securities ultimately

plummeted in value, leaving banks and investors with huge losses that helped send the economy

into a downward spiral. These lenders were not the victims of the financial crisis; the high risk

loans they issued were the fuel that ignited the financial crisis.

(2) Regulatory Failure:

Case Study of the Office of Thrift Supervision

The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop

the unsafe and unsound practices that led to the demise of Washington Mutual, one of the

nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500

serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending

operations and even impeded oversight by the bank’s backup regulator, the FDIC.

Washington Mutual Bank was the largest thrift under the supervision of OTS and was

among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a

profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates

of delinquency, default, and loss. After the market for subprime mortgage backed securities

collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans

and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against

the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s

depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity

crisis, followed by the bank’s closure.

OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners

repeatedly identified significant problems with Washington Mutual’s lending practices, risk

management, asset quality, and appraisal practices, and requested corrective action. Year after

year, WaMu promised to correct the identified problems, but never did. OTS failed to respond

with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and

soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines

for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually

rated WaMu as financially sound.

The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from

an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to

5

correct identified problems with minimal regulatory intervention, and expressed reluctance to

interfere with even unsound lending and securitization practices. OTS displayed an unusual

amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its

use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply

identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems

would be corrected, with little need for tough enforcement actions. It was a regulatory approach

with disastrous results.

Despite identifying over 500 serious deficiencies in five years, OTS did not once, from

2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending

practices, nor did it lower the bank’s rating for safety and soundness. Only in 2008, as the bank

incurred mounting losses, did OTS finally take two informal, nonpublic enforcement actions,

requiring WaMu to agree to a “Board Resolution” in March and a “Memorandum of

Understanding” in September, neither of which imposed sufficient changes to prevent the bank’s

failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator, for stronger

measures and even impeded FDIC oversight efforts by at times denying FDIC examiners office

space and access to bank records. Tensions between the two agencies remained high until the

end. Two weeks before the bank was seized, the FDIC Chairman contacted WaMu directly to

inform it that the FDIC was likely to have a ratings disagreement with OTS and downgrade the

bank’s safety and soundness rating, and informed the OTS Director about that communication,

prompting him to complain about the FDIC Chairman’s “audacity.”

Hindered by a culture of deference to management, demoralized examiners, and agency

infighting, OTS officials allowed the bank’s short term profits to excuse its risky practices and

failed to evaluate the bank’s actions in the context of the U.S. financial system as a whole. Its

narrow regulatory focus prevented OTS from analyzing or acknowledging until it was too late

that WaMu’s practices could harm the broader economy.

OTS’ failure to restrain Washington Mutual’s unsafe lending practices allowed high risk

loans at the bank to proliferate, negatively impacting investors across the United States and

around the world. Similar regulatory failings by other agencies involving other lenders repeated

the problem on a broad scale. The result was a mortgage market saturated with risky loans, and

financial institutions that were supposed to hold predominantly safe investments but instead held

portfolios rife with high risk, poor quality mortgages. When those loans began defaulting in

record numbers and mortgage related securities plummeted in value, financial institutions around

the globe suffered hundreds of billions of dollars in losses, triggering an economic disaster. The

regulatory failures that set the stage for those losses were a proximate cause of the financial

crisis.

(3) Inflated Credit Ratings:

Case Study of Moody’s and Standard & Poor’s

The next chapter examines how inflated credit ratings contributed to the financial crisis

by masking the true risk of many mortgage related securities. Using case studies involving

Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC

6

(S&P), the nation’s two largest credit rating agencies, the Subcommittee identified multiple

problems responsible for the inaccurate ratings, including conflicts of interest that placed

achieving market share and increased revenues ahead of ensuring accurate ratings.

Between 2004 and 2007, Moody’s and S&P issued credit ratings for tens of thousands of

U.S. residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).

Taking in increasing revenue from Wall Street firms, Moody’s and S&P issued AAA and other

investment grade credit ratings for the vast majority of those RMBS and CDO securities,

deeming them safe investments even though many relied on high risk home loans.1 In late

2006, high risk mortgages began incurring delinquencies and defaults at an alarming rate.

Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to

issue investment grade ratings for numerous RMBS and CDO securities.

Then, in July 2007, as mortgage delinquencies intensified and RMBS and CDO securities

began incurring losses, both companies abruptly reversed course and began downgrading at

record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a

year old. Investors like banks, pension funds, and insurance companies, who are by rule barred

from owning low rated securities, were forced to sell off their downgraded RMBS and CDO

holdings, because they had lost their investment grade status. RMBS and CDO securities held

by financial firms lost much of their value, and new securitizations were unable to find investors.

The subprime RMBS market initially froze and then collapsed, leaving investors and financial

firms around the world holding unmarketable subprime RMBS securities that were plummeting

in value. A few months later, the CDO market collapsed as well.

Traditionally, investments holding AAA ratings have had a less than 1% probability of

incurring defaults. But in 2007, the vast majority of RMBS and CDO securities with AAA

ratings incurred substantial losses; some failed outright. Analysts have determined that over

90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were

later downgraded by the credit rating agencies to junk status. In the case of Long Beach, 75 out

of 75 AAA rated Long Beach securities issued in 2006, were later downgraded to junk status,

defaulted, or withdrawn. Investors and financial institutions holding the AAA rated securities

lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in

the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the

viability of U.S. financial markets.

Inaccurate AAA credit ratings introduced risk into the U.S. financial system and

constituted a key cause of the financial crisis. In addition, the July mass downgrades, which

were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO

secondary markets, and perhaps more than any other single event triggered the beginning of the

financial crisis.

1 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this

Report will refer to both ratings as “AAA.”

7

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent

conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies

were paid by the Wall Street firms that sought their ratings and profited from the financial

products being rated. Under this “issuer pays” model, the rating agencies were dependent upon

those Wall Street firms to bring them business, and were vulnerable to threats that the firms

would take their business elsewhere if they did not get the ratings they wanted. The rating

agencies weakened their standards as each competed to provide the most favorable rating to win

business and greater market share. The result was a race to the bottom.

Additional factors responsible for the inaccurate ratings include rating models that failed

to include relevant mortgage performance data; unclear and subjective criteria used to produce

ratings; a failure to apply updated rating models to existing rated transactions; and a failure to

provide adequate staffing to perform rating and surveillance services, despite record revenues.

Compounding these problems were federal regulations that required the purchase of investment

grade securities by banks and others, which created pressure on the credit rating agencies to issue

investment grade ratings. While these federal regulations were intended to help investors stay

away from unsafe securities, they had the opposite effect when the AAA ratings proved

inaccurate.

Evidence gathered by the Subcommittee shows that the credit rating agencies were aware

of problems in the mortgage market, including an unsustainable rise in housing prices, the high

risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead

of using this information to temper their ratings, the firms continued to issue a high volume of

investment grade ratings for mortgage backed securities. If the credit rating agencies had issued

ratings that accurately reflected the increasing risk in the RMBS and CDO markets and

appropriately adjusted existing ratings in those markets, they might have discouraged investors

from purchasing high risk RMBS and CDO securities, and slowed the pace of securitizations.

It was not in the short term economic interest of either Moody’s or S&P, however, to

provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would

have hurt their own revenues. Instead, the credit rating agencies’ profits became increasingly

reliant on the fees generated by issuing a large volume of structured finance ratings. In the end,

Moody’s and S&P provided AAA ratings to tens of thousands of high risk RMBS and CDO

securities and then, when those products began to incur losses, issued mass downgrades that

shocked the financial markets, hammered the value of the mortgage related securities, and helped

trigger the financial crisis.

(4) Investment Bank Abuses:

Case Study of Goldman Sachs and Deutsche Bank

The final chapter examines how investment banks contributed to the financial crisis,

using as case studies Goldman Sachs and Deutsche Bank, two leading participants in the U.S.

mortgage market.

8

Investment banks can play an important role in the U.S. economy, helping to channel the

nation’s wealth into productive activities that create jobs and increase economic growth. But in

the years leading up to the financial crisis, large investment banks designed and promoted

complex financial instruments, often referred to as structured finance products, that were at the

heart of the crisis. They included RMBS and CDO securities, credit default swaps (CDS), and

CDS contracts linked to the ABX Index. These complex, high risk financial products were

engineered, sold, and traded by the major U.S. investment banks.

From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS and

over $1.4 trillion in CDO securities, backed primarily by mortgage related products. Investment

banks typically charged fees of $1 to $8 million to act as the underwriter of an RMBS

securitization, and $5 to $10 million to act as the placement agent for a CDO securitization.

Those fees contributed substantial revenues to the investment banks, which established internal

structured finance groups, as well as a variety of RMBS and CDO origination and trading desks

within those groups, to handle mortgage related securitizations. Investment banks sold RMBS

and CDO securities to investors around the world, and helped develop a secondary market where

RMBS and CDO securities could be traded. The investment banks’ trading desks participated in

those secondary markets, buying and selling RMBS and CDO securities either on behalf of their

clients or in connection with their own proprietary transactions.

The financial products developed by investment banks allowed investors to profit, not

only from the success of an RMBS or CDO securitization, but also from its failure. CDS

contracts, for example, allowed counterparties to wager on the rise or fall in the value of a

specific RMBS security or on a collection of RMBS and other assets contained or referenced in a

CDO. Major investment banks developed standardized CDS contracts that could also be traded

on a secondary market. In addition, they established the ABX Index which allowed

counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities,

which could be used to reflect the status of the subprime mortgage market as a whole. The

investment banks sometimes matched up parties who wanted to take opposite sides in a

transaction and other times took one or the other side of the transaction to accommodate a client.

At still other times, investment banks used these financial instruments to make their own

proprietary wagers. In extreme cases, some investment banks set up structured finance

transactions which enabled them to profit at the expense of their clients.

Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of

troubling practices that raise conflicts of interest and other concerns involving RMBS, CDO,

CDS, and ABX related financial instruments that contributed to the financial crisis.

The Goldman Sachs case study focuses on how it used net short positions to benefit from

the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that

created conflicts of interest with the firm’s clients and at times led to the bank=s profiting from

the same products that caused substantial losses for its clients.

From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006

and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO

9

securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf

of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In

December 2006, however, when it saw evidence that the high risk mortgages underlying many

RMBS and CDO securities were incurring accelerated rates of delinquency and default,

Goldman quietly and abruptly reversed course.

Over the next two months, it rapidly sold off or wrote down the bulk of its existing

subprime RMBS and CDO inventory, and began building a short position that would allow it to

profit from the decline of the mortgage market. Throughout 2007, Goldman twice built up and

cashed in sizeable mortgage related short positions. At its peak, Goldman’s net short position

totaled $13.9 billion. Overall in 2007, its net short position produced record profits totaling $3.7

billion for Goldman’s Structured Products Group, which when combined with other mortgage

losses, produced record net revenues of $1.1 billion for the Mortgage Department as a whole.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without

disclosing its own net short position against the subprime market or its purchase of CDS

contracts to gain from the loss in value of some of the very securities it was selling to its clients.

The case study examines in detail four CDOs that Goldman constructed and sold called

Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1. In some cases, Goldman transferred

risky assets from its own inventory into these CDOs; in others, it included poor quality assets

that were likely to lose value or not perform. In three of the CDOs, Hudson, Anderson and

Timberwolf, Goldman took a substantial portion of the short side of the CDO, essentially betting

that the assets within the CDO would fall in value or not perform. Goldman’s short position was

in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to

disclose the size and nature of its short position while marketing the securities. While Goldman

sometimes included obscure language in its marketing materials about the possibility of its

taking a short position on the CDO securities it was selling, Goldman did not disclose to

potential investors when it had already determined to take or had already taken short investments

that would pay off if the particular security it was selling, or RMBS and CDO securities in

general, performed poorly. In the case of Hudson 1, for example, Goldman took 100% of the

short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the

Hudson securities to investors without disclosing its short position. When the securities lost

value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold

the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets

for the CDO, took 40% of the short position, and then marketed Anderson securities to its

clients. When a client asked how Goldman “got comfortable” with the New Century loans in the

CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s

own negative view of them or its short position in the CDO.

In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the

securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities

to clients at prices above its own book values and, within days or weeks of the sale, marked

10

down the value of the sold securities, causing its clients to incur quick losses and requiring some

to post higher margin or cash collateral. Timberwolf securities lost 80% of their value within

five months of being issued and today are worthless. Goldman took 36% of the short position in

the CDO and made money from that investment, but ultimately lost money when it could not sell

all of the Timberwolf securities.

In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund,

Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in

selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was

designed to lose value and without disclosing the hedge fund’s asset selection role or investment

objective to potential investors. Three long investors together lost about $1 billion from their

Abacus investments, while the Paulson hedge fund profited by about the same amount. Today,

the Abacus securities are worthless.

In the Hudson and Timberwolf CDOs, Goldman also used its role as the collateral put

provider or liquidation agent to advance its financial interest to the detriment of the clients to

whom it sold the CDO securities.

The Deutsche Bank case study describes how the bank’s top global CDO trader, Greg

Lippmann, repeatedly warned and advised his Deutsche Bank colleagues and some of his clients

seeking to buy short positions about the poor quality of the RMBS securities underlying many

CDOs. He described some of those securities as “crap” and “pigs,” and predicted the assets and

the CDO securities would lose value. At one point, Mr. Lippmann was asked to buy a specific

CDO security and responded that it “rarely trades,” but he “would take it and try to dupe

someone” into buying it. He also at times referred to the industry’s ongoing CDO marketing

efforts as a “CDO machine” or “ponzi scheme.” Deutsche Bank’s senior management disagreed

with his negative views, and used the bank’s own funds to make large proprietary investments in

mortgage related securities that, in 2007, had a notional or face value of $128 billion and a

market value of more than $25 billion. Despite its positive view of the housing market, the bank

allowed Mr. Lippmann to develop a large proprietary short position for the bank in the RMBS

market, which from 2005 to 2007, totaled $5 billion. The bank cashed in the short position from

2007 to 2008, generating a profit of $1.5 billion, which Mr. Lippmann claims is more money on

a single position than any other trade had ever made for Deutsche Bank in its history. Despite

that gain, due to its large long holdings, Deutsche Bank lost nearly $4.5 billion from its mortgage

related proprietary investments.

The Subcommittee also examined a $1.1 billion CDO underwritten by Deutsche Bank

known as Gemstone CDO VII Ltd. (Gemstone 7), which issued securities in March 2007. It was

one of 47 CDOs totaling $32 billion that Deutsche Bank underwrote from 2004 to 2008.

Deutsche Bank made $4.7 million in fees from Gemstone 7, while the collateral manager, a

hedge fund called HBK Capital Management, was slated to receive $3.3 million. Gemstone 7

concentrated risk by including within a single financial instrument 115 RMBS securities whose

financial success depended upon thousands of high risk, poor quality subprime loans. Many of

those RMBS securities carried BBB, BBB-, or even BB credit ratings, making them among the

highest risk RMBS securities sold to the public. Nearly a third of the RMBS securities contained

11

subprime loans originated by Fremont, Long Beach, and New Century, lenders well known

within the industry for issuing poor quality loans. Deutsche Bank also sold securities directly

from its own inventory to the CDO. Deutsche Bank’s CDO trading desk knew that many of

these RMBS securities were likely to lose value, but did not object to their inclusion in

Gemstone 7, even securities which Mr. Lippmann was calling “crap” or “pigs.” Despite the poor

quality of the underlying assets, Gemstone’s top three tranches received AAA ratings. Deutsche

Bank ultimately sold about $700 million in Gemstone securities, without disclosing to potential

investors that its global head trader of CDOs had extremely negative views of a third of the

assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19

million in value since their purchase. Within months of being issued, the Gemstone 7 securities

lost value; by November 2007, they began undergoing credit rating downgrades; and by July

2008, they became nearly worthless.

Both Goldman Sachs and Deutsche Bank underwrote securities using loans from

subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities

to investors across the United States and around the world. They also enabled the lenders to

acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities

without full disclosure of the negative views of some of their employees regarding the

underlying assets and, in the case of Goldman, without full disclosure that it was shorting the

very CDO securities it was marketing, raising questions about whether Goldman complied with

its obligations to issue suitable investment recommendations and disclose material adverse

interests.

The case studies also illustrate how these two investment banks continued to market new

CDOs in 2007, even as U.S. mortgage delinquencies intensified, RMBS securities lost value, the

U.S. mortgage market as a whole deteriorated, and investors lost confidence. Both kept

producing and selling high risk, poor quality structured finance products in a negative market, in

part because stopping the “CDO machine” would have meant less income for structured finance

units, smaller executive bonuses, and even the disappearance of CDO desks and personnel,

which is what finally happened. The two case studies also illustrate how certain complex

structured finance products, such as synthetic CDOs and naked credit default swaps, amplified

market risk by allowing investors with no ownership interest in the reference obligations to place

unlimited side bets on their performance. Finally, the two case studies demonstrate how

proprietary trading led to dramatic losses in the case of Deutsche Bank and undisclosed conflicts

of interest in the case of Goldman Sachs.

Investment banks were the driving force behind the structured finance products that

provided a steady stream of funding for lenders originating high risk, poor quality loans and that

magnified risk throughout the U.S. financial system. The investment banks that engineered,

sold, traded, and profited from mortgage related structured finance products were a major cause

of the financial crisis.

12

C. Recommendations

The four causative factors examined in this Report are interconnected. Lenders

introduced new levels of risk into the U.S. financial system by selling and securitizing complex

home loans with high risk features and poor underwriting. The credit rating agencies labeled the

resulting securities as safe investments, facilitating their purchase by institutional investors

around the world. Federal banking regulators failed to ensure safe and sound lending practices

and risk management, and stood on the sidelines as large financial institutions active in U.S.

financial markets purchased billions of dollars in mortgage related securities containing high

risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering

and promoting risky mortgage related structured finance products, and enabling investors to use

naked credit default swaps and synthetic instruments to bet on the failure rather than the success

of U.S. financial instruments. Some investment banks also ignored the conflicts of interest

created by their products, placed their financial interests before those of their clients, and even

bet against the very securities they were recommending and marketing to their clients. Together

these factors produced a mortgage market saturated with high risk, poor quality mortgages and

securities that, when they began incurring losses, caused financial institutions around the world

to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith

in U.S. capital markets.

Nearly three years later, the U.S. economy has yet to recover from the damage caused by

the 2008 financial crisis. This Report is intended to help analysts, market participants,

policymakers, and the public gain a deeper understanding of the origins of the crisis and take the

steps needed to prevent excessive risk taking and conflicts of interest from causing similar

damage in the future. Each of the four chapters in this Report examining a key aspect of the

financial crisis begins with specific findings of fact, details the evidence gathered by the

Subcommittee, and ends with recommendations. For ease of reference, all of the

recommendations are reprinted here. For more information about each recommendation, please

see the relevant chapter.

Recommendations on High Risk Lending

1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their

regulatory authority to ensure that all mortgages deemed to be “qualified residential

mortgages” have a low risk of delinquency or default.

2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk

retention requirement under Section 941 by requiring the retention of not less than a

5% credit risk in each, or a representative sample of, an asset backed securitization’s

tranches, and by barring a hedging offset for a reasonable but limited period of time.

3. Safeguard Against High Risk Products. Federal banking regulators should

safeguard taxpayer dollars by requiring banks with high risk structured finance

products, including complex products with little or no reliable performance data, to

meet conservative loss reserve, liquidity, and capital requirements.

13

4. Require Greater Reserves for Negative Amortization Loans. Federal banking

regulators should use their regulatory authority to require banks issuing negatively

amortizing loans that allow borrowers to defer payments of interest and principal, to

maintain more conservative loss, liquidity, and capital reserves.

5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the

Section 620 banking activities study to identify high risk structured finance products

and impose a reasonable limit on the amount of such high risk products that can be

included in a bank’s investment portfolio.

Recommendations on Regulatory Failures

1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)

should complete the dismantling of the Office of Thrift Supervision (OTS), despite

attempts by some OTS officials to preserve the agency’s identity and influence within

the OCC.

2. Strengthen Enforcement. Federal banking regulators should conduct a review of

their major financial institutions to identify those with ongoing, serious deficiencies,

and review their enforcement approach to those institutions to eliminate any policy of

deference to bank management, inflated CAMELS ratings, or use of short term profits

to excuse high risk activities.

3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a

comprehensive review of the CAMELS ratings system to produce ratings that signal

whether an institution is expected to operate in a safe and sound manner over a

specified period of time, asset quality ratings that reflect embedded risks rather than

short term profits, management ratings that reflect any ongoing failure to correct

identified deficiencies, and composite ratings that discourage systemic risks.

4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

should undertake a study to identify high risk lending practices at financial

institutions, and evaluate the nature and significance of the impacts that these

practices may have on U.S. financial systems as a whole.

Recommendations on Inflated Credit Ratings

1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory

authority to rank the Nationally Recognized Statistical Rating Organizations in terms

of performance, in particular the accuracy of their ratings.

2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory

authority to facilitate the ability of investors to hold credit rating agencies accountable

in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or

recklessly fails to conduct a reasonable investigation of the rated security.

14

3. Strengthen CRA Operations. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies institute internal controls, credit

rating methodologies, and employee conflict of interest safeguards that advance

rating accuracy.

4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies assign higher risk to financial

instruments whose performance cannot be reliably predicted due to their novelty or

complexity, or that rely on assets from parties with a record for issuing poor quality

assets.

5. Strengthen Disclosure. The SEC should exercise its authority under the new Section

78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required

new ratings forms by the end of the year and that the new forms provide

comprehensible, consistent, and useful ratings information to investors, including by

testing the proposed forms with actual investors.

6. Reduce Ratings Reliance. Federal regulators should reduce the federal government’s

reliance on privately issued credit ratings.

Recommendations on Investment Bank Abuses

1. Review Structured Finance Transactions. Federal regulators should review the

RMBS, CDO, CDS, and ABX activities described in this Report to identify any

violations of law and to examine ways to strengthen existing regulatory prohibitions

against abusive practices involving structured finance products.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on

proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking

or risk-mitigating hedging activities, should be strictly limited in the

implementing regulations to activities that serve clients or reduce risk.

3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the

conflict of interest prohibitions in Sections 619 and 621 should consider the types of

conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6)

of this Report.

4. Study Bank Use of Structured Finance. Regulators conducting the banking

activities study under Section 620 should consider the role of federally insured banks

in designing, marketing, and investing in structured finance products with risks that

cannot be reliably measured and naked credit default swaps or synthetic financial

instruments.

15

II. BACKGROUND

Understanding the recent financial crisis requires examining how U.S. financial markets

have changed in fundamental ways over the past 15 years. The following provides a brief

historical overview of some of those changes; explains some of the new financial products and

trading strategies in the mortgage area; and provides background on credit ratings, investment

banks, government sponsored enterprises, and financial regulators. It also provides a brief

timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of

risk and conflicts of interest in U.S. financial markets.

A. Rise of Too-Big-To-Fail U.S. Financial Institutions

Until relatively recently, federal and state laws limited federally-chartered banks from

branching across state lines.2 Instead, as late as the 1990s, U.S. banking consisted primarily of

thousands of modest-sized banks tied to local communities. Since 1990, the United States has

witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to

approximately 8,000 by 2009,3 while at the same time nearly 13,000 regional and local credit

unions have been reduced to 7,500.4 This broad-based approach meant that when a bank

suffered losses, the United States could quickly close its doors, protect its depositors, and avoid

significant damage to the U.S. banking system or economy. Decentralized banking also

promoted competition, diffused credit in the marketplace, and prevented undue concentrations of

financial power.

In the mid 1990s, the United States initiated substantial changes to the banking industry,

some of which relaxed the rules under which banks operated, while others imposed new

regulations, and still others encouraged increased risk-taking. In 1994, for the first time,

Congress explicitly authorized interstate banking, which allowed federally-chartered banks to

open branches nationwide more easily than before.5 In 1999, Congress repealed the Glass-

Steagall Act of 1933, which had generally required banks, investment banks, securities firms,

and insurance companies to operate separately,6 and instead allowed them to openly merge

operations.7 The same law also eliminated the Glass-Steagall prohibition on banks engaging in

proprietary trading8

2 See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states);

Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches

in multiple states). See also “Going Interstate: A New Dawn for U.S. Banking,” The Regional Economist, a

publication of the Federal Reserve Bank of St. Louis (7/1994).

and exempted investment bank holding companies from direct federal

3 See U.S. Census Bureau, “Statistical Abstract of the United States 2011,” at 735,

http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf.

4 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration

(showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions).

5 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, P.L. 103-328 (repealing statutory

prohibitions on interstate banking).

6 Glass-Steagall Act of 1933, also known as the Banking Act, P.L. 73-66.

7 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. Some

banks had already begun to engage in securities and insurance activities, with the most prominent example at the

time being Citicorp’s 1998 merger with the Travelers insurance group.

8 Glass-Steagall Act, Section 16.

16

regulation.9 In 2000, Congress enacted the Commodity Futures Modernization Act which barred

federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks,

broker-dealers, and other financial institutions to develop, market, and trade these unregulated

financial products, including credit default swaps, foreign currency swaps, interest rate swaps,

energy swaps, total return swaps, and more.10

In 2002, the Treasury Department, along with other federal bank regulatory agencies,

altered the way capital reserves were calculated for banks, and encouraged the retention of

securitized mortgages with investment grade credit ratings by allowing banks to hold less capital

in reserve for them than if the individual mortgages were held directly on the banks’ books.11 In

2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow

even larger, often with borrowed funds.12 In 2005, when the SEC attempted to assert more

control over the growing hedge fund industry, by requiring certain hedge funds to register with

the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC

regulation.13

These and other steps paved the way, over the course of little more than the last decade,

for a relatively small number of U.S. banks and broker-dealers to become giant financial

conglomerates involved in collecting deposits; financing loans; trading equities, swaps and

commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt

instruments, insurance policies, and derivatives. As these financial institutions grew in size and

complexity, and began playing an increasingly important role in the U.S. economy, policymakers

began to ask whether the failure of one of these financial institutions could damage not only the

U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of

too-big-to-fail financial institutions had become a reality in the United States.14

9 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See

also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit

Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform

Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given

the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”).

10 The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated

Appropriations Act of 2001, P.L. 106-554.

11 See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-basedcapital-

guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of.

12 See “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised

Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the

Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain

broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of

investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC

in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for brokerdealers

were terminated at the same time.

13 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

14 The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had

purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had

purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each

controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger:

Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post

17

Over the last ten years, some U.S. financial institutions have not only grown larger and

more complex, but have also engaged in higher risk activities. The last decade has witnessed an

explosion of so-called “innovative” financial products with embedded risks that are difficult to

analyze and predict, including collateralized debt obligations, credit default swaps, exchange

traded funds, commodity and swap indices, and more. Financial engineering produced these

financial instruments which typically had little or no performance record to use for risk

management purposes. Some U.S. financial institutions became major participants in the

development of these financial products, designing, selling, and trading them in U.S. and global

markets.

In addition, most major U.S. financial institutions began devoting increasing resources to

so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain

investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, brokerdealers,

and investment banks had offered investment advice and services to their clients, and did

well when their clients did well. Over the last ten years, however, some firms began referring to

their clients, not as customers, but as counterparties. In addition, some firms at times developed

and used financial products in transactions in which the firm did well only when its clients, or

counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided

them with billions of dollars in client and bank funds, and allowed the hedge funds to make high

risk investments on the bank’s behalf, seeking greater returns.

By 2005, as U.S. financial institutions reached unprecedented size and made increasing

use of complex, high risk financial products, government oversight and regulation was

increasingly incoherent and misguided.

B. High Risk Mortgage Lending

The U.S. mortgage market reflected many of the trends affecting the U.S. financial

system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a

local bank or mortgage company, applied for a loan and, after providing detailed financial

information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or

mortgage company then typically kept that mortgage until the homeowner paid it off, earning its

profit from the interest rates and fees paid by the borrower.

Lenders were required to keep a certain amount of capital for each loan they issued,

which effectively limited the number of loans one bank could have on its books. To increase

their capital, some lenders began selling the loans on their books to other financial institutions

that wanted to service the loans over time, and then used the profits to make new loans to

prospective borrowers. Lenders began to make money, not from holding onto the loans they

originated and collecting mortgage payments over the years, but from the relatively short term

fees associated with originating and selling the loans.

(8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three

credit cards. Id.

18

By 2003, many lenders began using higher risk lending strategies involving the

origination and sale of complex mortgages that differed substantially from the traditional 30-year

fixed rate home loan. The following describes some of the securitization practices and higher

risk mortgage products that came to dominate the mortgage market in the years leading up to the

financial crisis.

Securitization. To make home loans sales more efficient and profitable, banks began

making increasing use of a mechanism now called “securitization.” In a securitization, a

financial institution bundles a large number of home loans into a loan pool, and calculates the

amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer

then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage

revenue stream to support the creation of bonds that make payments to investors over time.

Those bonds, which are registered with the SEC, are called residential mortgage backed

securities (RMBS) and are typically sold in a public offering to investors. Investors typically

make a payment up front, and then hold onto the RMBS securities which repay the principal plus

interest over time. The amount of money paid periodically to the RMBS holders is often referred

to as the RMBS “coupon rate.”

For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages

with few defaults, and mortgage backed securities built up a reputation as a safe investment.

Lenders earned fees for bundling the home loans into pools and either selling the pools or

securitizing them into mortgage backed securities. Investment banks also earned fees from

working with the lenders to assemble the pools, design the mortgage backed securities, obtain

credit ratings for them, and sell the resulting securities to investors. Investors like pension funds,

insurance companies, municipalities, university endowments, and hedge funds earned a

reasonable rate of return on the RMBS securities they purchased.

Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages,

RMBS holdings also became increasingly attractive to banks, which could determine how much

capital they needed to hold based on the credit ratings their RMBS securities received from the

credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002

rule “created opportunities for banks to lower their ratio of capital to assets through structured

financing” and “created the incentive for rating agencies to provide overly optimistic assessment

of the risk in mortgage pools.”15

High Risk Mortgages. The resulting increased demand for mortgage backed securities,

joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue

mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk

borrowers were often referred to as “subprime” borrowers to distinguish them from the more

creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began

15 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September

2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

19

to specialize in issuing loans to subprime borrowers and became known as subprime lenders.16

Federal law does not define subprime loans or subprime borrowers, but in 2001, guidance

issued by federal banking regulators defined subprime borrowers as those with certain credit risk

characteristics, including one or more of the following: (1) two or more 30-day delinquencies in

the last 12 months, or one or more 60-day delinquencies in the last 24 months; (2) a judgment or

foreclosure in the prior 24 months; (3) a bankruptcy in the last five years; (4) a relatively high

default probability as evidenced by, for example, a credit score below 660 on the FICO scale; or

(5) a debt service-to-income ratio of 50% or more.

Subprime loans provided new fuel for the securitization engines on Wall Street.

17 Some financial institutions reduced that

definition to any borrower with a credit score below 660 or even 620 on the FICO scale;18 while

still others failed to institute any explicit definition of a subprime borrower or loan.19 Credit

scores are an underwriting tool used by lenders to evaluate the likelihood that a particular

individual will repay his or her debts. FICO credit scores, developed by the Fair Issacs

Corporation, are the most widely used credit scores in U.S. financial markets and provide scores

ranging from 300 to 850, with the higher scores indicating greater creditworthiness.20

High risk loans were not confined, however, to those issued to subprime borrowers.

Some lenders engaged in a host of risky lending practices that allowed them to quickly generate

a large volume of high risk loans to both subprime and prime borrowers. Those practices, for

example, required little or no verification of borrower income, required borrowers to provide

little or no down payments, and used loans in which the borrower was not required to pay down

the loan amount, and instead incurred added debt over time, known as “negative amortization”

loans. Some lenders offered a low initial “teaser rate,” followed by a higher interest rate that

16 A Federal Reserve Bank of New York research paper identifies the top ten subprime loan originators in 2006 as

HSBC, New Century, Countrywide, Citigroup, WMC Mortgage, Fremont, Ameriquest Mortgage, Option One,

Wells Fargo, and First Franklin. It identifies the top ten originators of subprime mortgage backed securities as

Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding Corp.,

Lehman Brothers, WMC Mortgage, and Ameriquest. “Understanding the Securitization of Subprime Mortgage

Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008)

at 4.

17 Interagency “Expanded Guidance for Subprime Lending Programs, (1/31/2001) at 3. See also “Understanding the

Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of

New York Staff Report No. 318, (3/2008) at 14.

18 See, e.g., 1/2005 “Definition of Higher Risk Lending,” chart from Washington Mutual Board of Directors Finance

Committee Discussion, JPM_WM00302979, Hearing Exhibit 4/13-2a; 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, at 8, Hearing Exhibit 4/16-82.

19 See, e.g., Countrywide Financial Corporation, as described in SEC v. Mozilo, Case No. CV09-03994 (USDC CD

Calif.), Complaint (June 4, 2009), at ¶¶ 20-21.

20 To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual

credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding

debt. Key factors in the FICO score include an individual’s overall level of debt, payment history, types of credit

extensions, and use of available credit lines. See “What’s in Your FICO Score,” Fair Isaac Corporation,

http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been

developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian

Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial

markets.

20

took effect after a specified event or period of time, to enable borrowers with less income to

make the initial, smaller loan payments. Some qualified borrowers according to whether they

could afford to pay the lower initial rate, rather than the higher rate that took effect later,

expanding the number of borrowers who could qualify for the loans. Some lenders deliberately

issued loans that made economic sense for borrowers only if the borrowers could refinance the

loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some

lenders also issued loans that depended upon the mortgaged home to increase in value over time,

and cover the loan costs if the borrower defaulted. Still another risky practice engaged in by

some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of

containing fraudulent borrower information.

These practices were used to qualify borrowers for larger loans than they could have

otherwise obtained. When borrowers took out larger loans, the mortgage broker typically

profited from higher fees and commissions; the lender profited from higher fees and a better

price for the loan on the secondary market; and Wall Street firms profited from a larger revenue

stream to support bigger pools of mortgage backed securities.

The securitization of higher risk loans led to increased profits, but also injected greater

risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide,

made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate

mortgages and increasing their sale of higher risk loans.21

After 2000, the number of high risk loans increased rapidly, from about $125 billion in

dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or

34% of all loan originations in 2006.

Because higher risk loans required

borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for

lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the

higher risk loans, because once securitized, the AAA securities relying on those loans typically

paid investors a higher rate of return than other AAA investments, due to the higher risk

involved. As a result, investors were willing to pay more, and mortgaged backed securities

relying on higher risk loans typically fetched a better price than those relying on lower risk loans.

Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the

loans and kept the risk off their books.

22 Altogether from 2000 to 2007, U.S. lenders originated

about 14.5 million high risk loans.23

21 See, e.g., “Shift to Higher Margin Products,” chart from Washington Mutual Board of Directors meeting, at

JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher

risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the

Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of

WaMu’s loan originations); SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at

¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its

loan originations).

The majority of those loans, 59%, were used to refinance

22 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data

Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime

loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are

understated.

23 Id. at 5.

21

an existing loan, rather than buy a new home.24

“refinanced their mortgages at a higher amount than the loan balance to convert their

home equity into money for personal use (known as ‘cash-out refinancing’). Of the

subprime mortgages originated from 2000 through 2007, 55 percent were for cash-out

refinancing, 9 percent were for no-cash-out refinancing, and 36 percent were for a home

purchase.”

In addition, according to research performed by

GAO, many of these borrowers:

25

Some lenders became known inside the industry for issuing high risk, poor quality loans,

yet during the years leading up to the financial crisis were able to securitize and sell their home

loans with few problems. Subprime lenders like Long Beach Mortgage Corporation, New

Century Financial Corporation, and Fremont Loan & Investment, for example, were known for

issuing poor quality subprime loans.26

These three lenders and others issued a variety of nontraditional, high risk loans whose

subsequent delinquencies and defaults later contributed to the financial crisis. They included

hybrid adjustable rate mortgages, pick-a-payment or option ARM loans, interest-only loans,

home equity loans, and Alt A and stated income loans. Although some of these loans had been

in existence for years, they had previously been restricted to a relatively small group of

borrowers who were generally able to repay their debts. In the years leading up to the financial

crisis, however, lenders issued these higher risk loans to a wide variety of borrowers, including

subprime borrowers, who often used them to purchase more expensive homes than they would

have been able to buy using traditional fixed rate, 30-year loans.

Despite their reputations for poor quality loans, leading

investment banks continued to do business with them and helped them sell or securitize hundreds

of billions of dollars in home mortgages.

Hybrid ARMs. One common high risk loan used by lenders in the years leading up to

the financial crisis was the short term hybrid adjustable rate mortgage (Hybrid ARM), which was

offered primarily to subprime borrowers. From 2000 to 2007, about 70% of subprime loans

were Hybrid ARMs.27

24 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 24,

Table 3.

Hybrid ARMs were often referred to “2/28,” “3/27,” or “5/25” loans.

These 30-year mortgages typically had a low fixed teaser rate, which then reset to a higher

floating interest rate, after two years for the 2/28, three years for the 3/27, or five years for the

5/25. The initial loan payment was typically calculated by assuming the initial low, fixed

interest rate would be used to pay down the loan. In some cases, the loan used payments that

initially covered only the interest due on the loan and not any principal; these loans were called

“interest only” loans. After the fixed period for the teaser rate expired, the monthly payment was

typically recalculated using the higher floating rate to pay off the remaining principal and interest

owing over the course of the remaining loan period. The resulting monthly payment was much

25 Id. at 7.

26 For more information about Long Beach, see Chapter III of this Report. For more information about New

Century and Fremont, see section (D)(2)(c)-(d) of Chapter IV.

27 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data

Sources,” GAO, Report No. GAO-10-805 at 5, 11.

22

larger and sometimes caused borrowers to experience “payment shock” and default on their

loans. To avoid the higher interest rate and the larger loan payment, many of the borrowers

routinely refinanced their loans; when those borrowers were unable to refinance, many were

unable to afford the higher mortgage payment and defaulted.

Pick-A-Payment or Option ARMs. Another common high risk loan, offered to both

prime and subprime borrowers during the years leading up to the financial crisis, was known as

the “pick-a-payment” or “option adjustable rate mortgage” (Option ARM). According to a 2009

GAO report:

“[P]ayment-option ARMs were once specialized products for financially sophisticated

borrowers but ultimately became more widespread. According to federal banking

regulators and a range of industry participants, as home prices increased rapidly in some

areas of the country, lenders began marketing payment-option ARMs as affordability

products and made them available to less-creditworthy and lower-income borrowers.”28

Option ARMs typically allowed the borrower to pay an initial low teaser rate, sometimes

as low as a 1% annual rate for the first month, and then imposed a much higher interest rate

linked to an index, while also giving the borrower a choice each month of how much to pay

down the outstanding loan balance. These loans were called “pick-a-payment” or “option”

ARMs, because borrowers were typically allowed to choose among four alternatives: (1) paying

the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher

amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no

principal; or (4) making a “minimum” payment that covered only a portion of the interest owed

and none of the principal. If the minimum payment option were selected, the unpaid interest

would be added to the loan principal. If, each month, the borrower made only the minimum

payment, the loan principal would increase rather than decrease over time, creating a negatively

amortizing loan.

Typically, after five years or when the loan principal reached a designated threshold, such

as 110%, 115%, or 125% of the original loan amount, the loan would “recast.” The borrower

would then be required to make the fully amortizing payment needed to pay off the remaining

loan amount within the remaining loan period. The new monthly payment amount was typically

much greater, causing payment shock and increasing loan defaults. For example, a borrower

taking out a $400,000 loan, with a teaser rate of 1.5% and subsequent interest rate of 6%, might

have a minimum payment of $1,333. If the borrower then made only the minimum payments

until the loan recast, the new payment using the 6% rate would be $2,786, an increase of more

than 100%. What began as a 30-year loan for $400,000 became a 25-year loan for $432,000. To

avoid having the loan recast, option ARM borrowers typically sought to refinance their loans. At

some lenders, a significant portion of their option ARM business consisted of refinancing

existing loans.

Home Equity Loans. A third type of high risk loan that became popular during the

years leading up to the financial crisis was the home equity loan (HEL). HELs provided loans

287/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 12-13.

23

secured by the borrower’s equity in his or her home, which served as the loan collateral. HELs

typically provided a lump sum loan amount that had to be repaid over a fixed period of time,

such as 5, 10, or 30 years, using a fixed interest rate, although adjustable rates could also be

used. A related loan, the Home Equity Line of Credit (HELOC), created a revolving line of

credit, secured by the borrower’s home, that the borrower could use at will, to take out and repay

various levels of debt over time, typically using an adjustable rate of interest. Both HELs and

HELOCs created liens against the borrower’s house which, in the event of a default, could be

sold to repay any outstanding loan amounts.

During the years leading up to the financial crisis, lenders provided HELs and HELOCs

to both prime and subprime borrowers. They were typically high risk loans, because most were

issued to borrowers who already had a mortgage on their homes and held only a limited amount

of equity. The HEL or HELOC was typically able to establish only a “second lien” or “second

mortgage” on the property. If the borrower later defaulted and the home sold, the sale proceeds

would be used to pay off the primary mortgage first, and only then the HEL or HELOC. Often,

the sale proceeds were insufficient to repay the HEL or HELOC loan. In addition, some lenders

created home loan programs in which a HEL was issued as a “piggyback loan” to the primary

home mortgage to finance all or part of the borrower’s down payment.29 Taken together, the

HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even

100% of the property’s value.30

Alt A Loans. Another type of common loan during the years leading up to the financial

crisis was the “Alt A” loan. Alt A loans were issued to borrowers with relatively good credit

histories, but with aggressive underwriting that increased the risk of the loan.

The resulting high loan-to-value ratio, and the lack of borrower

equity in the home, meant that, if the borrower defaulted and the home had to be sold, the sale

proceeds were unlikely to be sufficient to repay both loans.

31 For example, Alt

A loans often allowed borrowers to obtain 100% financing of their homes, to have an unusually

high debt-to-income ratio, or submit limited or even no documentation to establish their income

levels. Alt A loans were sometimes referred to as “low doc” or “no doc” loans. They were

originally developed for self employed individuals who could not easily establish their income

by producing traditional W-2 tax return forms or pay stubs, and so were allowed to submit

“alternative” documentation to establish their income or assets, such as bank statements.32 The

reasoning was that other underwriting criteria could be used to ensure that Alt A loans would be

repaid, such as selecting only borrowers with a high credit score or with a property appraisal

showing the home had substantial value in excess of the loan amount. According to GAO, from

2000 to 2006, the percentage of Alt A loans with less than full documentation of the borrower’s

income or assets rose from about 60% to 80%.33

29 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 9.

30 Id. GAO determined that, in 2000, only about 2.4% of subprime loans had a combined loan-to-value ratio,

including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%.

31 Id. at 1. GAO treated both low documentation loans and Option ARMs as Alt A loans. This Report considers

Option ARMs as a separate loan category.

32 See id. at 14.

33 Id.

24

Stated Income Loans. Stated income loans were a more extreme form of low doc Alt A

loans, in that they imposed no documentation requirements and required little effort by the lender

to verify the borrower’s income. These loans allowed borrowers simply to “state” their income,

with no verification by the lender of the borrower’s income or assets other than to consider the

income’s “reasonableness.” They were sometimes called “NINA” loans, because “No Income”

and “No Assets” of the borrower were verified by the lender. They were also referred to as “liar

loans,” since borrowers could lie about their incomes, and the lender would make little effort to

substantiate the claimed income. Many lenders believed they could simply rely on the other

underwriting tools, such as the borrower’s credit score and the property appraisal, to ensure the

loans would be repaid. Once rare and reserved only for wealthier borrowers, stated income loans

became commonplace in the years leading up to the financial crisis. For example, at Washington

Mutual Bank, one of the case studies in this Report, by the end of 2007, stated income loans

made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity

loans.34

Nationwide, the percentage of high risk loans issued with low or no documentation of

borrower income or assets was less dramatic. According to GAO, for example, from 2000 to

2006, the nationwide percentage of subprime loans with low or no documentation of borrower

income or assets grew from about 20% to 38%.35

Volume and Speed. When lenders kept on their books the loans they issued, the

creditworthiness of those loans determined whether the lender would turn a profit. Once lenders

began to sell or securitize most of their loans, volume and speed, as opposed to creditworthiness,

became the keys to a profitable securitization business.

In addition, in the years leading up to the financial crisis, investors that might normally

insist on purchasing only high quality securities, purchased billions of dollars in RMBS

securities containing poor quality, high risk loans, in part because those securities bore AAA

ratings from the credit rating agencies, and in part because the securities offered higher returns

compared to other AAA rated investments. Banks also bought investment grade RMBS

securities to take advantage of their lower capital requirements. Increasingly, the buyers of

RMBS securities began to forego detailed due diligence of the RMBS securities they purchased.

Instead, they, like the lenders issuing the mortgages, operated in a mortgage market that came to

be dominated by volume and speed, as opposed to credit risk.

Lenders that produced a high volume of loans could sell pools of the loans to Wall Street

or to government sponsored entities like Fannie Mae and Freddie Mac. Likewise, they could

securitize the loans and work with Wall Street investment banks to sell the securities to investors.

These lenders passed on the risk of nonpayment to third parties, and so lost interest in whether

the sold loans would, in fact, be repaid. Investment banks that securitized the loans garnered

fees for their services and also typically passed on the risk of nonpayment to the investors who

34 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” prepared by the Offices of

Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing

Exhibit 4/16-82.

35 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 14.

25

bought the mortgage backed securities. The investment banks were typically interested in loan

repayment rates only to the extent needed to ensure defaulting loans did not cause losses to the

mortgage backed securities they sold. Even some of the investors who purchased the mortgage

backed securities lost interest in their creditworthiness, so long as they could buy “insurance” in

the form of credit default swaps that paid off if a mortgage backed security defaulted.

To ensure an ongoing supply of loans for sale, lenders created compensation incentives

that encouraged their personnel to quickly produce a high volume of loans. They also

encouraged their staffs to issue or purchase higher risk loans, because those loans produced

higher sale prices on Wall Street. Loan officers, for example, received more money per loan for

originating higher risk loans and for exceeding established loan targets. Loan processing

personnel were compensated according to the speed and number of the loans they processed.

Loan officers and their sales associates received still more compensation, often called yield

spread premiums, if they charged borrowers higher interest rates or points than required in the

lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan

agreements. The Subcommittee’s investigation found that lenders employed few compensation

incentives to encourage loan officers or loan processors to produce high quality, creditworthy

loans in line with the lender’s credit requirements.

As long as home prices kept rising, the high risk loans fueling the securitization markets

produced few problems. Borrowers who could not make their loan payments could refinance

their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart

shows, over the ten years before the crisis hit, housing prices shot up faster than they had in

decades, allowing price increases to mask problems with the high risk loans being issued.36

36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by

Paulson & Co. Inc., Hearing Exhibit 4/13-1j.

26

Borrowers were able to pay for the increasingly expensive homes, in part, because of the

exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house

than they could really afford.

C. Credit Ratings and Structured Finance

Despite the increasing use of high risk loans to support mortgage related securities,

mortgage related securities continued to receive AAA and other investment grade ratings from

the credit rating agencies, indicating they were judged to be safe investments. Those credit

ratings gave a sense of security to investors and enabled investors like pension funds, insurance

companies, university endowments, and municipalities, which were often required to hold safe

investments, to continue to purchase mortgage related securities.

Credit Ratings Generally. A credit rating is an assessment of the likelihood that a

particular financial instrument, such as a corporate bond or mortgage backed security, may

27

default or incur losses.37

Credit ratings are issued by private firms that have been officially designated by the SEC

as Nationally Recognized Statistical Rating Organizations (NRSROs). NRSROs are usually

referred to as “credit rating agencies.” While there are ten registered credit rating agencies in the

United States, the market is dominated by just three: Moody’s Investors Service, Inc.

(Moody’s); Standard & Poor’s Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch).

A high credit rating indicates that a debt instrument is expected to be

repaid and so qualifies as a safe investment.

38

By some accounts, these firms issue about 98% of the total credit ratings and collect 90% of total

credit rating revenue in the United States.39

Credit ratings use a scale of letter grades to indicate credit risk, ranging from AAA to D,

with AAA ratings designating the safest investments. Investments with AAA ratings have

historically had low default rates. For example, S&P reported that its cumulative RMBS default

rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and

1.09% for BBB.40

Investors often rely on credit ratings to gauge the safety of a particular investment. Some

institutional investors design an investment strategy that calls for acquiring assets with specified

credit ratings. State and federal law also restricts the amount of below investment grade bonds

that certain investors can hold, such as pension funds and insurance companies.

Financial instruments bearing AAA through BBB- ratings are generally

referred to as “investment grade,” while those with ratings below BBB- (or Baa3) are referred to

as “below investment grade” or sometimes as having “junk” status. Financial instruments that

default receive a D rating from Standard & Poor’s, but no rating at all from Moody’s.

41

Although the SEC has generally overseen the credit rating industry for many years, it had

no statutory basis to exercise regulatory authority until enactment of the Credit Rating Agency

Reform Act in September 2006. Concerned by the inflated credit ratings that had been issued for

Banks are also

limited by law in the amount of noninvestment grade bonds they can hold, and are typically

required to post additional capital for investments carrying riskier ratings. Because so many

federal and state statutes and regulations required financial institutions to hold securities with

investment grade ratings, the credit rating agencies were not only guaranteed a steady business,

but were encouraged to issue AAA and other investment grade ratings. Issuers of securities and

other financial instruments also worked hard to obtain favorable credit ratings to ensure more

investors could buy their products.

37 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service

Report No. R40613 (revised report issued 4/9/2010). For more information about the credit rating process and the

credit rating agencies, see Chapter V, below.

38 See 9/25/2008 “Credit Rating Agencies—NRSROs,” SEC, http://www.sec.gov/answers/nrsro.htm.

39 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service

Report No. R40613 (revised report issued 4/9/2010).

40 Prepared Statement of Vickie A. Tillman, Executive Vice President, Standard & Poor’s Credit Market Services,

“The Role of Credit Rating Agencies in the Structured Finance Market,” before the U.S. House of Representatives

Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial

Services, Serial No. 110-62 (9/27/2007), S&P SEC-PSI 0001945-71, at 51. (See Chapter V below.) See also 1/2007

“Annual 2006 Global Corporate Default Study and Ratings Transitions,” S&P.

41 For more detail on these matters, see Chapter V, below.

28

bonds from Enron Corporation and other troubled corporations, Congress strengthened the

SEC’s authority over the credit rating industry. Among other provisions, the law established

criteria for the NRSRO designation and authorized the SEC to conduct examinations of credit

rating agencies. The law also, however, prohibited the SEC from regulating credit rating criteria

or methodologies used in credit rating models. In June 2007, the SEC issued implementing

regulations, which were essentially too late to affect the ratings already provided for mortgage

related securities. One month later, in July 2007, the credit rating agencies issued the first of

several mass downgrades of the ratings earlier issued for mortgage related securities.

Structured Finance. In recent years, Wall Street firms have devised increasingly

complex financial instruments for sale to investors. These instruments are often referred to as

structured finance. Because structured finance products are so complicated and opaque,

investors often place particular reliance on credit ratings to determine whether they should buy

them.

Among the oldest types of structured finance products are RMBS securities. To create

these securities, issuers – often working with investment banks – bundle large numbers of home

loans into a loan pool, and calculate the revenue stream coming into the loan pool from the

individual mortgages. They then design a “waterfall” that delivers a stream of revenues in

sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is

typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed

to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a

bond, linked to that first tranche. That security typically receives a AAA credit rating since its

revenue stream is the most secure.

The security created from the next tranche receives the same or a lower credit rating and

so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically

receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages

in the loan pool default. Since virtually every mortgage pool has at least some mortgages that

default, equity tranches are intended to provide loss protection for the tranches above it. Because

equity tranches are riskier, however, they are often assigned and receive a higher rate of interest

and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or

more tranches, each of which is used to create a residential mortgage backed security that is rated

and then sold to investors.

Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured

finance product whose securities receive credit ratings and are sold to investors. CDOs are a

more complex financial product that involves the re-securitization of existing income-producing

assets. From 2004 through 2007, many CDOs included RMBS securities from multiple

mortgage pools. For example, a CDO might contain BBB rated securities from 100 different

RMBS securitizations. CDOs can also contain other types of assets, such as commercial

mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often

called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and

other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it

is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often

29

referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the

revenue stream coming into the pool of assets, designs a waterfall to divide those incoming

revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be

marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all

of its underlying assets have BBB ratings.

Synthetic CDOs. Some investment banks also created “synthetic CDOs” which

mimicked cash CDOs, but did not contain actual mortgages or other assets that produced income.

Instead, they simply “referenced” existing assets and then allowed investors to use credit default

swaps to place bets on the performance of those referenced assets. Investors who bet that the

referenced assets would maintain or increase in value bought the CDO’s securities and, in

exchange, received periodic coupon payments to recoup their principal investment plus interest.

Investors who bet that the referenced assets would lose value or incur a specified negative credit

event purchased one or more credit default swap contracts referencing the CDO’s assets, and

paid monthly premiums to the CDO in exchange for obtaining a large lump sum payment if the

loss or other negative credit event actually occurred. Investors in synthetic CDOs who bet the

referenced assets would maintain or increase in value were said to be on the “long” side, while

investors who bet the assets would lose value or fail were said to be on the “short” side. Some

investment banks also created “hybrid CDOs” which contained some cash assets as well as credit

default swaps referencing other assets. Others created financial instruments called CDO squared

or cubed, which contained or referenced tranches from other CDOs.

Like RMBS mortgage pools and cash CDOs, synthetic and hybrid CDOs pooled the

payments they received, designed a waterfall assigning portions of the revenues to tranches set

up in a certain order, created securities linked to the various tranches, and then sold the CDO

securities to investors. Some CDOs employed a “portfolio selection agent” to select the initial

assets for the CDO. In addition, some CDOs employed a “collateral manager” to select both the

initial and subsequent assets that went into the CDO.

Ratings Used to Market RMBS and CDOs. Wall Street firms helped design RMBS

and CDO securities, worked with the credit rating agencies to obtain ratings for the securities,

and sold the securities to investors like pension funds, insurance companies, university

endowments, municipalities, and hedge funds. Without investment grade ratings, Wall Street

firms would have had a more difficult time selling structured finance products to investors,

because each investor would have had to perform its own due diligence review of the product. In

addition, their sales would have been restricted by federal and state regulations limiting certain

institutional investors to the purchase of instruments carrying investment grade credit ratings.

Still other regulations conditioned capital reserve requirements on the credit ratings assigned to a

bank’s investments. Investment grade credit ratings, thus, purported to simplify the investors’

due diligence review, ensured some investors could make a purchase, reduced banks’ capital

calls, and otherwise enhanced the sales of the structured finance products. Here’s how one

federal bank regulator’s handbook put it:

“The rating agencies perform a critical role in structured finance evaluating the credit

quality of the transactions. Such agencies are considered credible because they possess

30

the expertise to evaluate various underlying asset types, and because they do not have a

financial interest in a security’s cost or yield. Ratings are important because investors

generally accept ratings by the major public rating agencies in lieu of conducting a due

diligence investigation of the underlying assets and the servicer.”42

The more complex and opaque the structured finance instruments became, the more reliant

investors were on high credit ratings for the instruments to be marketable.

In addition to making structured finance products easier to sell to investors, Wall Street

firms used financial engineering to combine AAA ratings – normally reserved for ultra-safe

investments with low rates of return – with high risk assets, such as the AAA tranche from a

subprime RMBS paying a relatively high rate of return. Higher rates of return, combined with

AAA ratings, made subprime RMBS and related CDOs especially attractive investments.

Record Ratings and Revenues. From 2004 to 2007, Moody’s and S&P produced a record

number of ratings and a record amount of revenues for rating structured finance products. A

2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued

more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings.43 According

to a 2008 Moody’s submission to the SEC, from 2004 to 2007, Moody’s issued over 4,000

RMBS ratings and over 870 CDO ratings.44

Revenues increased dramatically over the same time period. The credit rating agencies

charged substantial fees to rate a product. To obtain a rating during the height of the market, for

example, S&P generally charged from $40,000 to $135,000 to rate tranches of an RMBS and

from $30,000 to $750,000 to rate the tranches of a CDO.45 Surveillance fees generally ranged

from $5,000 to $50,000 per year for mortgage backed securities.46 Over a five-year period,

Moody’s gross revenues from RMBS and CDO ratings more than tripled, going from over $61

million in 2002, to over $260 million in 2006.47

42 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset

Securitization,” at 11.

S&P’s revenue also increased. S&P’s gross

revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in

43 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent the

RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or

CDO pool. (See Chapter V below.)

44 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.

These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for

multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS

CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on

mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director

of Moody’s RMBS Group (10/29/2009). (See Chapter V below.)

45 “U.S. Structured Ratings Fee Schedule Residential Mortgage-backed Financings and Residential Servicer

Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized

Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. (See Chapter V below.)

46 Id.

47 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.

The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the

transition of Moody’s accounting systems. (See Chapter V below.)

31

2002, to over $265 million in 2006.48 Altogether, revenues from the three leading credit rating

agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007.49

Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for

the products they sell. Issuers and the investment banks want high ratings, whether to help

market their products or ensure they comply with federal regulations. Because credit rating

agencies issue ratings to issuers and investment banks who bring them business, they are subject

to an inherent conflict of interest that can create pressure on the credit rating agencies to issue

favorable ratings to attract business. The issuers and investment banks engage in “ratings

shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping

weakens rating standards as the rating agencies who provide the most favorable ratings win more

business. In September 2007, Moody’s CEO described the problem this way: “What happened

in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went

nuts. Everything was investment grade.”50 In 2003, the SEC reported that “the potential

conflicts of interest faced by credit rating agencies have increased in recent years, particularly

given the expansion of large credit rating agencies into ancillary advisory and other businesses,

and the continued rise in importance of rating agencies in the U.S. securities markets.”51

Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are

designed to last the lifetime of the securities. Because circumstances can change, however,

credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate

the rating and determine whether it should be upgraded or downgraded. Prior to the financial

crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially

lower.52

From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a

majority of the RMBS and CDO securities issued in the United States, sometimes providing

AAA ratings to as much as 95% of a securitization.

Beginning in July 2007, however, Moody’s and S&P issued hundreds and then

thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history.

53 By 2010, analysts had determined that

over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been

downgraded to junk status.54

48 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19. (See Chapter V below.)

49 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by the Subcommittee using data from

http://thismatter.com/money, Hearing Exhibit 4/23-1g.

50 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, Hearing Exhibit 4/23-98.

51 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,”

prepared by the SEC, at 40. The report continued: “[C]oncerns had been expressed that a rating agency might be

tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to

submit future large issues to the rating agency.” Id. at 40 n.109.

52 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by

Fitch.

53 See “MBS Ratings and the Mortgage Credit Boom,” Federal Reserve Bank of New York Staff Report no. 449,

May 2010, at 1.

54 See, e.g., “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by

BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime

Mortgage Credit,” Federal Reserve Bank of New York Staff Report no. 318, at 58 and chart 31 (“92 percent of 1st32

Moody’s and S&P began downgrading RMBS and CDO products in late 2006, when

residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both

S&P and Moody’s initiated the first of several mass downgrades that shocked the financial

markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an

original value of $7.35 billion. Later that day, Moody’s downgraded 399 subprime RMBS with

an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had

placed on credit watch.

In October 2007, Moody’s began downgrading CDOs on a daily basis, downgrading

more than 270 CDO securities with an original value of $10 billion. In December 2007,

Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit

watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were

downgraded and 1954 ratings from 732 deals were upgraded,”55 which means that it downgraded

over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or

placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing

issuance amounts of approximately $270.1 billion and $263.9 billion, respectively.56

These downgrades created significant turmoil in the securitization markets, as investors

were required by regulations to sell off assets that had lost their investment grade status, holdings

at financial firms plummeted in value, and new securitizations were unable to find investors. As

a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and

financial firms around the world were left holding billions of dollars in suddenly unmarketable

RMBS and CDO securities.

D. Investment Banks

Historically, investment banks helped raise capital for business and other endeavors by

helping to design, finance, and sell financial products like stocks or bonds. When a corporation

needed capital to fund a large construction project, for example, it often hired an investment

bank either to help it arrange a bank loan or raise capital by helping to market a new issue of

shares or corporate bonds to investors. Investment banks also helped with corporate mergers and

acquisitions. Today, investment banks also participate in a wide range of other financial

activities, including offering broker-dealer and investment advisory services, and trading

derivatives and commodities. Many have also been active in the mortgage market and have

worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage

backed securities. Investment banks have traditionally performed these services in exchange for

fees.

lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been

downgraded.”).

55 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by

Moody’s, at 4.

56 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108

(1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s

RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and

additional information is needed to evaluate the rating.

33

If an investment bank agreed to act as an “underwriter” for the issuance of a new security

to the public, it typically bore the risk of those securities on its books until the securities were

sold. By law, securities sold to the public generally must be registered with the SEC.57

Registration statements explain the purpose of a proposed public offering, an issuer’s operations

and management, key financial data, and other important facts to potential investors. Any

offering document or prospectus provided to the investing public must also be filed with the

SEC. If an issuer decides not to offer a new security to the general public, it can still offer it to

investors through a “private placement.”58 Investment banks often act as the “placement agent”

in these private offerings, helping to design, market, and sell the security to selected investors.

Solicitation documents in connection with private placements are not required to be filed with

the SEC. Under the federal securities laws, however, investment banks that act as an underwriter

or placement agent may be liable for any material misrepresentations or omissions of material

facts made in connection with a solicitation or sale of a security to an investor.59

In the years leading up to the financial crisis, RMBS securities were generally registered

with the SEC and sold in public offerings, while CDO securities were generally sold to investors

through private placements. Investment banks frequently served as the underwriter or placement

agent in those transactions, and typically sold both types of securities to large institutional

investors.

In addition to arranging for a public or private offering, some investment banks take on

the role of a “market maker,” standing willing and able to buy or sell financial products to their

clients or other market participants. To facilitate client orders to buy or sell those products, the

investment bank may acquire an inventory of them and make them available for client

transactions.60 By filling both buy and sell orders, market makers help create a liquid market for

the financial products and make it easier and more attractive for clients to buy and sell them.

Market makers typically rely on fees in the form of markups in the price of the financial products

for their profits.

At the same time, investment banks may decide to buy and sell the financial products for

their own account, which is called “proprietary trading.” Investment banks often use the same

inventory of financial products to carry out both their market making and proprietary trading

activities. Investment banks that trade for their own account typically rely on changes in the

values of the financial products to turn a profit.

Inventories that are used for market making and short term proprietary trading purposes

are typically designated as a portfolio of assets “held for sale.” Investment banks also typically

maintain an inventory or portfolio of assets that they intend to keep as long term investments.

57 Securities Act of 1933, 15 U.S.C. § 77a (1933).

58 See, e.g., Securities Act of 1933 §§ 3(b) and 4(2); 17 CFR § 230.501 et seq. (Regulation D).

59 Securities Act of 1933, § 11, 15 U.S.C. § 77k; and Securities Exchange Act of 1934, § 10(b), 15 U.S.C. § 78j(b),

and Rule 10b-5 thereunder.

60 For a detailed discussion of market making, see “Study & Recommendations on Prohibitions on Proprietary

Trading & Certain Relationships with Hedge Funds & Private Equity Funds,” prepared by the Financial Stability

Oversight Council, at 28-29 (Jan. 18, 2011) (citing SEC Exchange Act Rel. No. 34-58775 (Oct. 14, 2008)).

34

This inventory or portfolio of long-term assets is typically designated as “held for investment,”

and is not used in day-to-day transactions.

Investment banks that carry out market-making and proprietary trading activities are

required – by their banking regulator in the case of banks and bank holding companies61 and by

the SEC in the case of broker-dealers62 – to track their investments and maintain sufficient

capital to meet their regulatory requirements and financial obligations. These capital

requirements typically vary based on how the positions are held and how they are classified. For

example, assets that are “held for sale” or are in the “trading account” typically have lower

capital requirements than those that are “held for investment,” because of the expected lower

risks associated with what are expected to be shorter term holdings.

Many investment banks use complex automated systems to analyze the “Value at Risk”

(VaR) associated with their holdings. To reduce the VaR attached to their holdings, investment

banks employ a variety of methods to offset or “hedge” their risk. These methods can include

diversifying their assets, taking a short position on related financial products, purchasing loss

protection through insurance or credit default swaps, or taking positions in derivatives whose

values move inversely to the value of the assets being hedged.

Shorting the Mortgage Market. Prior to the financial crisis, investors commonly

purchased RMBS or CDO securities as long-term investments that produced a steady income. In

2006, however, the high risk mortgages underlying these securities began to incur record levels

of delinquencies. Some investors, worried about the value of their holdings, sought to sell their

RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market.

Some managed to sell their high risk RMBS securities to investment banks assembling cash

CDOs.

Some investors, instead of selling their RMBS or CDO securities, purchased “insurance”

against a loss by buying a credit default swap (CDS) that would pay off if the specified securities

incurred losses or other negative credit events. By 2005, investment banks had standardized

CDS contracts for RMBS and CDO securities, making this a practical alternative.

Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS

seller, who guaranteed the referenced security against loss. CDS contracts referencing a single

security or corporate bond became known as “single name” CDS contracts. If the referenced

security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer

to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge

to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular

RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on

securities that were not owned by the CDS buyer were known as “naked credit default swaps.”

61 See, e.g., 12 CFR part 3, Appendix A (for the Office of the Comptroller of the Currency), 12 CFR part 208,

Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325,

Appendix A (for the Federal Deposit Insurance Corporation).

62 Securities Exchange Act of 1934, Rule 15c3-1.

35

Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit

from mortgage backed securities they believed would fail.

Some investment banks took the CDS approach a step further. In 2006, a consortium of

investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which

created five indices that tracked the aggregate performance of a basket of 20 designated

subprime RMBS securitizations.63 Borrowing from longstanding practice in commodities

markets, investors could buy and sell contracts linked to the value of one of the ABX indices.

Each contract consisted of a credit default swap agreement in which the parties could essentially

wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX

Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset

class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short

position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS

securities would lose value.

Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this

approach, an investment bank created a synthetic CDO that referenced a variety of RMBS

securities. One or more investors could take the “short” position by paying premiums to the

CDO in exchange for a promise that the CDO would pay a specified amount if the referenced

assets incurred a negative credit event, such as a default or credit rating downgrade. If that event

took place, the CDO would have to pay an agreed-upon amount to the short investors to cover

the loss, removing income from the CDO and causing losses for the long investors. Synthetic

CDOs became a way for investors to short multiple specific RMBS securities that they expected

would incur losses.

Proprietary Trading. Financial institutions also built increasingly large proprietary

holdings of mortgage related assets. Numerous financial firms, including investment banks,

bought RMBS and CDO securities, and retained these securities in their investment portfolios.

Others retained these securities in their trading accounts to be used as inventory for short term

trading activity, market making on behalf of clients, hedging, providing collateral for short term

loans, or maintaining lower capital requirements. Deutsche Bank’s RMBS Group in New York,

for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio

at an affiliated hedge fund, Winchester Capital, exceeded $8 billion.64

63 Each of the five indices tracked a different tranche of securities from the designated 20 subprime RMBS

securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked

AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and

BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX

index. See 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” prepared by Federal Reserve

Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in

2006 and 2007, but has not issued any new indices since then.

Other financial firms,

including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan

Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products.

When the value of these holdings dropped, some of these financial institutions lost tens of

64 For more information, see Chapter VI, section discussing Deutsche Bank.

36

billions of dollars,65 and either declared bankruptcy, were sold off,66 or were bailed out by U.S.

taxpayers seeking to avoid damage to the U.S. economy as a whole.67

One investment bank, Goldman Sachs, built a large number of proprietary positions to

short the mortgage market.68 Goldman Sachs had helped to build an active mortgage market in

the United States and had accumulated a huge portfolio of mortgage related products. In late

2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the

mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only

when some of its clients lost money on the very securities that Goldman Sachs had sold to them

and then shorted. Altogether in 2007, Goldman’s mortgage department made $1.1 billion in net

revenues from shorting the mortgage market.69 Despite those gains, Goldman Sachs was given a

$10 billion taxpayer bailout under the Troubled Asset Relief Program,70 tens of billions of

dollars in support through accessing the Federal Reserve’s Primary Dealer Credit Facility,71 and

billions more in indirect government support72

E. Market Oversight

to ensure its continued existence.

U.S. financial regulators failed to stop financial firms from engaging in high risk,

conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of

U.S. financial oversight as well as statutory barriers to regulating high risk financial products.

65 See, e.g., Goldman Sachs Group, Inc., 2008 Annual Report 27 (2009) (stating that the firm had “long proprietary

positions in a number of [its] businesses. These positions are accounted for at fair value, and the declines in the

values of assets have had a direct and large negative impact on [its] earnings in fiscal 2008.”); see also, Viral V.

Acharya and Matthew Richardson, “Causes of the Financial Crisis,” 21 Critical Review 195, 199-204 (2009) (citing

proprietary holdings of asset backed securities as one of the primary drivers of accumulated risks causing the

financial crisis); “Prop Trading Losses Ain’t Peanuts,” The Street (1/27/2010),

http://www.thestreet.com/story/10668047/prop-trading-losses-aint-peanuts.html.

66 See, e.g., “Lehman Files for Bankruptcy; Merrill is Sold,” New York Times (9/14/2008); and discussion in

Chapter III of Washington Mutual Bank which was sold to JPMorgan Chase.

67 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of

the Treasury, at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/

cpp/Pages/capitalpurchaseprogram.aspx.

68 For more information, see Chapter VI, section describing Goldman Sachs.

69 Id. Goldman’s Structured Product Group Trading Desk earned $3.7 billion in net revenues, which was offset by

losses on other desks within the mortgage department, resulting in the $1.1 billion in total net revenues.

70 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of

the Treasury, available at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/

cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at

http://www.treasury.gov/initiatives/financial-stability/briefing-room/reports/tarptransactions/

DocumentsTARPTransactions/transactions-report-062309.pdf.

71 See data available at http://www.federalreserve.gov/newsevents/reform_pdcf.htm showing Goldman Sachs’ use of

the Primary Dealer Credit Facility 85 times in 2008.

72 See, e.g., prepared statement of Neil Barofsky, Special Inspector General of the Troubled Asset Relief Program,

“The Federal Bailout of AIG,” before the House Committee on Oversight and Government Reform (1/27/2010),

http://oversight.house.gov/images/stories/Hearings/pdfs/20100127barofsky.pdf (noting that some firms, including

Goldman Sachs, disproportionately benefited from the federal government’s bailout of AIG).

37

Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally

insured banks and thrifts,73 plus about 8,700 federally insured credit unions, many of which were

in the business of issuing home loans.74 On the federal level, these financial institutions were

overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were

part of the Federal Reserve System as well as foreign banks and others; the Office of the

Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of

Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union

Administration which oversaw federal credit unions; and the Federal Deposit Insurance

Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance

(hereinafter referred to as “federal bank regulators”).75 In addition, state banking regulators

oversaw the state-chartered institutions and at times took action to require federally-chartered

financial institutions to comply with certain state laws.

The primary responsibility of the federal bank regulators was to ensure the safety and

soundness of the financial institutions they oversaw. One key mechanism they used to carry out

that responsibility was to conduct examinations on a periodic basis of the financial institutions

within their jurisdiction and provide the results in an annual Report of Examination (ROE) given

to the Board of Directors at each entity. The largest U.S. financial institutions typically operated

under a “continuous exam” program, which required federal bank examiners to conduct a series

of specialized examinations during the year with the results from all of those examinations

included in the annual ROE.

Federal examination activities were typically led by an Examiner in Charge and were

organized around a rating system called CAMELS that was used by all federal bank regulators.

The CAMELS rating system evaluated a financial institution’s: (C) capital adequacy, (A) asset

quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.

CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no

cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more

areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the

annual ROE, regulators typically provided a financial institution with a rating for each CAMELS

component, as well as an overall composite rating on its safety and soundness.

In addition, the FDIC conducted its own examinations of financial institutions with

federal deposit insurance. The FDIC reviews relied heavily on the examination findings and

ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its

own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion

or more, the FDIC established a Large Insured Depository Institutions (LIDI) Program to assess

and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund.

Under this program, the FDIC performed an ongoing analysis of emerging risks within each

73 See FDIC Quarterly Banking Profile, 1 (Fourth Quarter 2005) (showing that, as of 12/31/2005, the United States

had 8,832 federal and state chartered insured banks and thrifts).

74 See 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration

(showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions).

75 The Dodd-Frank Act has since abolished one of these agencies, the Office of Thrift Supervision, and assigned its

duties to the OCC. See Chapter IV.

38

insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the

best rating and E the worst.

If a regulator became concerned about the safety or soundness of a financial institution, it

had a wide range of informal and formal enforcement actions that could be used to require

operational changes. Informal actions included requiring the financial institution to issue a

safety and soundness plan, memorandum of understanding, Board resolution, or commitment

letter pledging to take specific corrective actions by a certain date, or issuing a supervisory letter

to the financial institution listing specific “matters requiring attention.” These informal

enforcement actions are generally not made public and are not enforceable in court. Formal

enforcement actions included a regulator issuing a public memorandum of understanding,

consent order, or cease and desist order requiring the financial institution to stop an unsafe

practice or take an affirmative action to correct identified problems; imposing a civil monetary

penalty; suspending or removing personnel from the financial institution; or referring misconduct

for criminal prosecution.

A wide range of large and small banks and thrifts were active in the mortgage market.

Banks like Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo originated,

purchased, and securitized billions of dollars in home loans each year. Thrifts, whose charters

typically required them to hold 65% of their assets in mortgage related assets, also originated,

purchased, sold, and securitized billions of dollars in home loans, including such major lenders

as Countrywide Financial Corporation, IndyMac Bank, and Washington Mutual Bank. Some of

these banks and thrifts also had affiliates, such as Long Beach Mortgage Corporation, which

specialized in issuing subprime mortgages. Still more lenders operated outside of the regulated

banking system, including New Century Financial Corporation and Fremont Loan & Investment,

which used such corporate vehicles as industrial loan companies, real estate investment trusts, or

publicly traded corporations to carry out their businesses. In addition, the mortgage market was

populated with tens of thousands of mortgage brokers that were paid fees for their loans or for

bringing qualified borrowers to a lender to execute a home loan.76

Oversight of Securities Firms. Another group of financial institutions active in the

mortgage market were securities firms, including investment banks, broker-dealers, and

investment advisors. These security firms did not originate home loans, but typically helped

design, underwrite, market, or trade securities linked to residential mortgages, including the

RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear

Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset

management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase.

Some of these firms also had affiliates which specialized in securitizing subprime mortgages.

Securities firms were overseen on the federal level by the Securities and Exchange

Commission (SEC) whose mission is to “protect investors, maintain fair, orderly, and efficient

76 1/2009 “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated

U.S. Financial Regulatory System,” prepared by the Government Accountability Office, Report No. GAO-09-216, at

26-27.

39

markets, and facilitate capital formation.”77 The SEC oversees the “key participants in the

securities world, including securities exchanges, securities brokers and dealers, investment

advisors, and mutual funds,” primarily for the purpose of “promoting the disclosure of important

market related information, maintaining fair dealing, and protecting against fraud.”78

The securities firms central to the financial crisis were subject to a variety of SEC

regulations in their roles as broker-dealers, investment advisors, market makers, underwriters,

and placement agents. Most were also subject to oversight by state securities regulators.79 The

securities firms were required to submit a variety of public filings with the SEC about their

operations and in connection with the issuance of new securities. The SEC’s Office of

Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers,

among others, to understand industry practices, encourage compliance, evaluate risk

management, and detect violations of the securities laws. In addition, under the voluntary

Consolidated Supervised Entities program, the SEC’s Division of Trading and Markets

monitored the investment activities of the largest broker-dealers, including Bear Stearns,

Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JPMorgan

Chase, evaluating their capital levels, use of leverage, and risk management.80

Like bank regulators, if the SEC became concerned about a particular securities firm, it

could choose from a range of informal and formal enforcement actions. Informal actions could

include issuing a “deficiency letter” identifying problems and requiring the securities firm to take

corrective action by a certain date. Formal enforcement actions, undertaken by the SEC’s

Division of Enforcement, could include civil proceedings before an administrative law judge; a

civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel

from a firm or bar them from the brokerage industry; or a referral for criminal prosecution.

Common securities violations included selling unregistered securities, misrepresenting

information about a security, unfair dealing, price manipulation, and insider trading.81

Statutory and Regulatory Barriers. Federal and state financial regulators responsible

for oversight of banks, securities firms, and other financial institutions in the years leading to the

financial crisis operated under a number of statutory and regulatory constraints.

One key constraint was the sweeping statutory prohibition on the federal regulation of

any type of swap, including credit default swaps. This prohibition took effect in 2000, with

enactment of the Commodity Futures Modernization Act (CFMA).82

77 See SEC website, “About the SEC: What We Do,”

The key statutory section

explicitly prohibited federal regulators from requiring the registration of swaps as securities;

issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping

www.sec.gov.

78 Id.

79 Some firms active in the U.S. securities and mortgage markets, such as hedge funds, operated without meaningful

federal oversight by taking advantage of exemptions in the Investment Company Act of 1940.

80 See 9/2008 “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program,” report

prepared by Office of the SEC Inspector General, Report No. 446-A.Report No. 446-A, (9/2008).

81 See SEC website, “About the SEC: What We Do,” www.sec.gov.

82 CFMA was included as a title of H.R. 4577, the Consolidated Appropriations Act of 2001, P.L.106-554.

40

requirements for swaps.83 In addition, the law explicitly prohibited regulation of any “‘interest

rate swap,’ including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap,

currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit

default swap, credit swap, weather swap, or commodity swap.”84 These prohibitions meant that

federal regulators could not even ask U.S. financial institutions to report on their swaps trades or

holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage

market or other U.S. financial markets.

As a result, the multi-trillion-dollar U.S. swaps markets operated with virtually no

disclosure requirements, no restrictions, and no oversight by any federal agency, including the

market for credit default swaps which played a prominent role in the financial crisis. On

September 23, 2008, in a hearing before the Senate Committee on Banking, Housing, and Urban

Affairs, then SEC Chairman Christopher Cox testified that, as a result of the statutory

prohibition, the credit default swap market “is completely lacking in transparency,” “is regulated

by no one,” and “is ripe for fraud and manipulation.”85 In a September 26, 2008 press release, he

discussed regulatory gaps impeding his agency and again raised the issue of swaps:

“Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately

$60 trillion credit default swap market, which is regulated by no agency of government. Neither

the SEC nor any regulator has authority even to require minimum disclosure.”86 In 2010, the

Dodd-Frank Act removed the CFMA prohibition on regulating swaps.87

A second significant obstacle for financial regulators was the patchwork of federal and

state laws and regulations applicable to high risk mortgages and mortgage brokers. Federal bank

regulators took until October 2006, to provide guidance to federal banks on acceptable lending

practices related to high risk home loans.88 Even then, the regulators issued voluntary guidance

whose standards were not enforceable in court and failed to address such key issues as the

acceptability of stated income loans.89 In addition, while Congress had authorized the Federal

Reserve, in 1994, to issue regulations to prohibit deceptive or abusive mortgage practices –

regulations that could have applied across the board to all types of lenders and mortgage brokers

– the Federal Reserve failed to issue any until July 2008, after the financial crisis had already

hit.90

83 CFMA, § 302, creating a new section 2A of the Securities Act of 1933.

84 CFMA, § 301, creating a new section 206A of the Gramm-Leach-Bliley Act.

85 Statement of SEC Chairman Christopher Cox, “Turmoil in U.S. Credit Markets: Recent Actions Regarding

Government Sponsored Entities, Investment Banks and Other Financial Institutions,” before the U.S. Senate

Committee on Banking, Housing and Urban Affairs, S.Hrg. 110-1012 (9/23/2008).

86 9/26/2008 SEC press release, “Chairman Cox Announces End of Consolidated Supervised Entities Program,”

http://www.sec.gov/news/press/2008/2008-230.htm.

87 Title VII of the Dodd-Frank Act.

88 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg.

192 at 58609.

89 For more information, see Chapter IV.

90 Congress authorized the Federal Reserve to issue the regulations in Section 151 of the Home Ownership and

Equity Protection Act of 1994 (HOEPA), P.L. 103-325. The Federal Reserve did not issue any regulations under

HOEPA, however, until July 2008, when it amended Regulation Z. The new rules primarily strengthened consumer

protections for “higher priced loans,” which included many types of subprime loans. See “New Regulation Z Rules

Enhance Protections for Mortgage Borrowers,” Consumer Compliance Outlook (Fourth Quarter 2008) (Among

41

A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC

to prohibit states from enforcing state consumer protection laws against national banks.91 After

the New York State Attorney General issued subpoenas to several national banks to enforce New

York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC

regulation, and held that states were allowed to enforce state consumer protection laws against

national banks.92 During the intervening four years, however, state regulators had been

effectively unable to enforce state laws prohibiting abusive mortgage practices against federallychartered

banks and thrifts.

Systemic Risk. While bank and securities regulators focused on the safety and

soundness of individual financial institutions, no regulator was charged with identifying,

preventing, or managing risks that threatened the safety and soundness of the overall U.S.

financial system. In the area of high risk mortgage lending, for example, bank regulators

allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly

sold the high risk loans to get them off their books. Securities regulators allowed investment

banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as

long as the securities received high ratings from the credit rating agencies and so were deemed

“safe” investments. No regulatory agency focused on what would happen when poor quality

mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO

securities with high risk loans. In addition, none of the regulators focused on the impact

derivatives like credit default swaps might have in exacerbating risk exposures, since they were

barred by federal law from regulating or even gathering data about these financial instruments.

F. Government Sponsored Enterprises

Between 1990 and 2004, homeownership rates in the United States increased rapidly

from 64% to 69%, the highest level in 50 years.93 While many highly regarded economists and

officials argued at the time that this housing boom was the result of healthy economic activity, in

retrospect, some federal housing policies encouraged people to purchase homes they were

ultimately unable to afford, which helped to inflate the housing bubble.

Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal

National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation

(Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing

a secondary market for home mortgages. They created that secondary market by purchasing

loans from lenders, securitizing them, providing a guarantee that they would make up the cost of

other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the

borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent

restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and

mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d]

inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”).

91 12 CFR § 7.4000.

92 Cuomo v. Clearing House Association, Case No. 08-453, 129 S.Ct. 2710 (2009).

93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,”

http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls.

42

any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to

investors. Many believed that the securities had the implicit backing of the federal government

and viewed them as very safe investments, leading investors around the world to purchase them.

The existence of this secondary market encouraged lenders to originate more loans, since they

could easily sell them to the GSEs and use the profits to increase their lending.

Over time, however, Fannie Mae and Freddie Mac began to purchase larger quantities of

higher risk loans, providing a secondary market for those loans and encouraging their

proliferation. Between 2005 and 2007, Fannie Mae alone purchased billions of dollars in high

risk home loans, including Option ARM, Alt A, and loans with subprime characteristics. For

example, data from Fannie Mae shows that, in mid 2008, 62% of the Option ARM loans on its

books had been purchased between 2005 and 2007.94 Likewise, 84% of its interest-only loans

were purchased in that time frame, as were 57% of those with FICO scores less than 620; 62% of

its loans with loan-to-value ratios greater than 90; and 73% of its Alt A loans.95 While these

loans constituted only a small percentage of Fannie Mae’s purchases at the time, they came to

account for some its most significant losses. By the middle of 2009, Fannie Mae reported an

unpaid principal balance of $878 billion for its loans with subprime characteristics, nearly a third

of its total portfolio of $2.7 trillion.96

According to economist Arnold Kling, Fannie Mae and Freddie Mac purchased these

loans after “lowering their own credit standards in order to maintain a presence in the market and

to meet their affordable housing goals.”97

Throughout their history, Fannie Mae and Freddie Mac were able to bundle the

mortgages they purchased into securities that were popular with investors, because many

believed the securities carried the implicit support of the federal government. The Congressional

Budget Office found the following:

“Because of their [Fannie Mae and Freddie Mac] size and interconnectedness with other

financial institutions, they posed substantial systemic risk—the risk that their failure

could impose very high costs on the financial system and the economy. The GSEs’

market power also allowed them to use their profits partly to benefit their other stakeholders

rather than exclusively to benefit mortgage borrowers. The implicit guarantee

created an incentive for the GSEs to take excessive risks: Stakeholders would benefit

when gambles paid off, but taxpayers would absorb the losses when they did not. …

One way that Fannie Mae and Freddie Mac increased risk was by expanding the volume

of mortgages and MBSs held in their portfolios, which exposed them to the risk of losses

94 Fannie Mae, 2008 Q2 10-Q Investor Summary, August 8, 2008,

http://www.fanniemae.com/media/pdf/newsreleases/2008_Q2_10Q_Investor_Summary.pdf.

95 Id.

96 Fannie Mae, 2009 Second Quarter Credit Supplement, August 6, 2009,

http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf.

97 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September

2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

43

from changes in interest or prepayment rates. Over the past decade, the two GSEs also

increased their exposure to default losses by investing in lower-quality mortgages, such

as subprime and Alt-A loans.”98

The risks embedded in their mortgage portfolios finally overwhelmed the GSEs in

September 2008, and both Fannie Mae and Freddie Mac were taken into conservatorship by the

federal government. Since that time, the Treasury Department has spent nearly $150 billion to

support the two GSEs, a total which projections show could rise to as high as $363 billion.99

Ginnie Mae. Additional housing policies that allowed borrowers with less than adequate

credit to obtain traditional mortgages included programs at the Federal Housing Administration

(FHA) and the Department of Veterans Affairs (VA). Both agencies provided loan guarantees to

lenders that originated loans for borrowers that qualified under the agencies’ rules. Many of the

loans guaranteed by the FHA and VA, some of which required down payments as low as 3%,

were bundled and sold as mortgage backed securities guaranteed by the Government National

Mortgage Association (Ginnie Mae), a government corporation. Ginnie Mae guaranteed

investors the timely payment of principal and interest on mortgage backed securities backed by

federally insured or guaranteed loans.

In the years leading up to the financial crisis, FHA guaranteed millions of home loans

worth hundreds of billions of dollars.100 According to FHA data, as of 2011, nearly 20% of all

FHA loans originated in 2008 were seriously delinquent, meaning borrowers had missed three or

more payments, while loans originated in 2007 had a serious delinquency rate of over 22%. The

2007 and 2008 loans, which currently make up about 15% of FHA’s active loan portfolio,

remain the worst performing in that portfolio. In 2009 and 2010, FHA tightened its underwriting

guidelines, and the loans it guaranteed performed substantially better. By early 2011, the serious

delinquency rate for all FHA borrowers was about 8.8%, down from over 9.4% the prior year.

G. Administrative and Legislative Actions

In response to the financial crisis, Congress and the Executive Branch have taken a

number of actions. Three that have brought significant changes are the Troubled Asset Relief

Program, Federal Reserve assistance programs, and the Dodd-Frank Wall Street and Consumer

Protection Act.

Troubled Asset Relief Program (TARP). On October 3, 2008, Congress passed and

President Bush signed into law the Emergency Economic Stabilization Act of 2008, P.L. 110-

343. This law, which passed both Houses with bipartisan majorities, established the Troubled

98 Congressional Budget Office, “Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage

Market,” December 2010, at x, http://www.cbo.gov/ftpdocs/120xx/doc12032/12-23-FannieFreddie.pdf.

99 Federal Housing Finance Agency, News Release, “FHFA Releases Projections Showing Range of Potential

Draws for Fannie Mae and Freddie Mac,” October 21, 2010, http://fhfa.gov/webfiles/19409/Projections_102110.pdf.

100 The statistics cited in this paragraph are taken from the U.S. Department of Housing and Urban Development,

“FHA Single-Family Mutual Mortgage Insurance Fund Programs, Quarterly Report to Congress, FY 2011 Q1,”

March 17, 2011, at 4 and 19, http://www.hud.gov/offices/hsg/rmra/oe/rpts/rtc/fhartc_q1_2011.pdf.

44

Asset Relief Program (TARP) and authorized the expenditure of up to $700 billion to stop

financial institutions from collapsing and further damaging the U.S. economy. Administered by

the Department of the Treasury, with support from the Federal Reserve, TARP funds have been

used to inject capital into or purchase or insure assets at hundreds of large and small banks.

The largest recipients of TARP funds were AIG, Ally Financial (formerly GMAC

Financial Services), Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan

Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo, as well as Chrysler, and

General Motors. Most have repaid all or a substantial portion of the TARP funds they received.

Although initially expected to cost U.S. taxpayers more than $350 billion, the

Congressional Budget Office estimated in November 2010, that the final cost of the TARP

program will be approximately $25 billion.101

Federal Reserve Emergency Support Programs. In addition, as the financial crisis

began to unfold, the Federal Reserve aggressively expanded its balance sheet from about $900

billion at the beginning of 2008, to more than $2.4 trillion in December 2010, to provide support

to the U.S. financial system and economy. Using more than a dozen programs, through more

than 21,000 individual transactions, the Federal Reserve provided trillions of dollars in assistance

to U.S. and foreign financial institutions in an effort to promote liquidity and prevent a financial

collapse.102 In some instances, the Federal Reserve created new programs, such as its Agency

Mortgage Backed Securities Purchase Program which purchased more than $1.25 trillion in

mortgage backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae.103

Dodd-Frank Act. On July 21, 2010, Congress passed and President Obama signed into

law the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. This law,

which passed both Houses with bipartisan majorities, expanded the authority of regulatory

agencies to try to prevent future financial crises. Among other provisions, the law:

In other

instances, it modified and significantly expanded existing programs, such as by lowering the

quality of collateral it accepted and increasing lending by the discount window.

– established a Financial Stability Oversight Council, made up of federal financial

regulators and others, to identify and respond to emerging financial risks;

– established a Consumer Financial Protection Bureau to strengthen protection of

American consumers from abusive financial products and practices;

– restricted proprietary trading and investments in hedge funds by banks and other large

financial institutions;

101 11/2010 “Report on the Troubled Asset Relief Program,” prepared by the Congressional Budget Office,

http://www.cbo.gov/ftpdocs/119xx/doc11980/11-29-TARP.pdf.

102 “Usage of Federal Reserve Credit and Liquidity Facilities,” Federal Reserve Board, available at

http://www.federalreserve.gov/newsevents/reform_transaction.htm.

103 “Agency Mortgage-Backed Securities Purchase Program,” Federal Reserve Board, available at

http://www.federalreserve.gov/newsevents/reform_mbs.htm.

45

– prohibited sponsors of asset backed securities from engaging in transactions that would

involve or result in a material conflict of interest with investors in those securities;

– established procedures to require nonbank firms whose failure would threaten U.S.

financial stability to divest some holdings or undergo an orderly liquidation;

– strengthened regulation of credit rating agencies;

– strengthened mortgage regulation, including by clamping down on high cost mortgages,

requiring securitizers to retain limited liability for securities reliant on high risk

mortgages, banning stated income loans, and restricting negative amortization loans;

– required better federal regulation of mortgage brokers;

– directed regulators to require greater capital and liquidity reserves;

– required regulation of derivatives and derivative dealers;

– required registration of certain hedge funds and private equity funds;

– authorized regulators to impose standards of conduct that are the same as those

applicable to investment advisers on broker-dealers who provide personalized

investment advice to retail customers; and

– abolished the Office of Thrift Supervision.

H. Financial Crisis Timeline

This Report reviews events from the period 2004 to 2008, in an effort to identify and

explain four significant causes of the financial crisis. A variety of events could be identified as

the start of the crisis. Candidates include the record number of home loan defaults that began in

December 2006; the FDIC’s March 2007 cease and desist order against Fremont Investment &

Loan which exposed the existence of unsafe and unsound subprime lending practices; or the

collapse of the Bear Stearns hedge funds in June 2007. Still another candidate is the two-week

period in September 2008, when half a dozen major U.S. financial institutions failed, were

forcibly sold, or were bailed out by U.S. taxpayers seeking to prevent a collapse of the U.S.

economy.

This Report concludes, however, that the most immediate trigger to the financial crisis

was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDO

securities. The firms took this action because, in the words of one S&P senior analyst, the

investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities

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

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

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

46

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

was on.

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

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

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

and investment banks in causing the financial crisis.

47

Financial Crisis Timeline104

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

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

December 2006:

Ownit Mortgage Solutions bankruptcy

February 27, 2007:

Freddie Mac announces it will no longer buy the

most risky subprime mortgages

March 7, 2007:

FDIC issues cease and desist order against Fremont

for unsafe and unsound banking

April 2, 2007:

New Century bankruptcy

June 17, 2007:

Two Bear Stearns subprime hedge funds collapse

July 10 and 12, 2007:

Credit rating agencies issue first mass ratings

downgrades of hundreds of RMBS and CDO

securities

August 6, 2007:

American Home Mortgage bankruptcy

August 17, 2007:

Federal Reserve: “[M]arket conditions have

deteriorated… downside risks to growth have

increased appreciably.”

August 31, 2007:

Ameriquest Mortgage ceases operations

December 12, 2007:

Federal Reserve establishes Term Auction Facility

to provide bank funding

January 2008:

ABX Index stops issuing new subprime indices

January 11, 2008:

Countrywide announces sale to Bank of America

January 30, 2008:

S&P downgrades or places on credit watch over

8,000 RMBS and CDO securities

March 24, 2008:

Federal Reserve Bank of New York forms Maiden

Lane I to help JPMorgan Chase acquire Bear Stearns

May 29, 2008:

Bear Stearns shareholders approve sale

July 11, 2008:

IndyMac Bank fails and is seized by FDIC

July 15, 2008:

SEC restricts naked short selling of some financial

stocks

September 7, 2008:

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

September 15, 2008:

Lehman Brothers bankruptcy

September 15, 2008

Merrill Lynch announces its sale to Bank of America

September 16, 2008:

Federal Reserve offers $85 billion credit line to AIG;

Reserve Primary Money Fund NAV falls below $1

September 21, 2008:

Goldman Sachs and Morgan Stanley convert to bank

holding companies

September 25, 2008:

WaMu fails, is seized by FDIC, and is sold to

JPMorgan Chase

October 3, 2008:

Congress and President Bush establish TARP

October 12, 2008:

Wachovia is sold to Wells Fargo

October 28, 2008:

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

stock at nine banks

November 25, 2008:

Federal Reserve buys Fannie and Freddie assets

48

III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK

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

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

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

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

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

crisis of 2008.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

49

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

from 2003.

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

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

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

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

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

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

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

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

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

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

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

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

loans, valuing speed and volume over loan quality.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

appeared to insulate the bank from risk.

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

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

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

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

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

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

50

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

becoming a major Wall Street player.

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

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

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

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

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

became the fuel that ignited the financial crisis.

A. Subcommittee Investigation and Findings of Fact

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

home loans.

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

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

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

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

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

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

Hearing”).

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

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

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

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

loans or sell their homes before the payments shot up.

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

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

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

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

delinquency and loss.

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

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

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

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

was discovered.

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

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

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

gave executives millions of dollars even when their High Risk Lending Strategy

placed the bank in financial jeopardy.

B. Background

Washington Mutual Bank was a federally chartered thrift whose primary federal regulator

was the Office of Thrift Supervision (OTS). As an insured depository institution, it was also

overseen by the Federal Deposit Insurance Corporation (FDIC). Washington Mutual was a full

service consumer and business bank. This Report focuses only on WaMu’s home lending and

securitization business. As part of that business, WaMu originated home loans, acquired home

loans for investment and securitization, sold pools of loans, and also securitized pools of home

loans that it had originated or acquired. It was also a leading servicer of residential mortgages.

(1) Major Business Lines and Key Personnel

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

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

The Home Loans Group

handled WaMu’s home mortgage originations, securitizations, and servicing operations. The

Commercial Group handled apartment buildings and other commercial properties. The Retail

Banking Group provided retail banking services to consumers and businesses across the country.

The Card Services Group handled a credit card business purchased from Providian Financial

Corporation.

52

For most of the five-year period reviewed by the Subcommittee, WaMu was led by its

longtime Chairman of the Board and Chief Executive Officer (CEO) Kerry Killinger who joined

the bank in 1982, became bank president in 1988, and was appointed CEO in 1990. Mr.

Killinger was the moving force behind WaMu’s acquisitions and growth strategy during the

1990s, and made the fateful decision to embark upon its High Risk Lending Strategy in 2005.

Mr. Killinger stepped down as Chairman of the Board in June 2008, after shareholders opposed

having the same person occupy the bank’s two top positions. He was dismissed from the bank

on September 8, 2008, the same day WaMu was required by its regulator, OTS, to sign a public

Memorandum of Understanding to address its lending and securitization deficiencies. Two

weeks later the bank failed.

Other key members of the bank’s senior management included President Steve Rotella

who joined the bank in January 2005; Chief Financial Officer Tom Casey; President of the Home

Loans Division David Schneider who joined the bank in July 2005; and General Counsel Faye

Chapman. David Beck served as Executive Vice President in charge of the bank’s Capital

Markets Division, oversaw its securitization efforts, and reported to the head of Home Loans.

Anthony Meola headed up the Home Loans Sales effort. Jim Vanasek was WaMu’s Chief Credit

Officer from 1999 until 2004, and was then appointed its Chief Risk Officer, a new position,

from 2004-2005. After Mr. Vanasek’s retirement, Ronald Cathcart took his place as Chief Risk

Officer, and headed the bank’s newly organized Enterprise Risk Management Division, serving

in that post from 2005 to 2007.

(2) Loan Origination Channels

WaMu was one of the largest mortgage originators in the United States.108 It originated

and acquired residential mortgages through several methods, which it referred to as loan

origination channels. WaMu referred to them as its retail, wholesale, subprime, correspondent,

and conduit channels.

Retail Channel. In WaMu’s parlance, “retail channel” loans were loans originated by

WaMu employees, typically loan officers or sales associates operating out of WaMu branded

loan centers. The prospective borrower typically communicated directly with the WaMu loan

officer, who was often called a “loan consultant.” WaMu considered all retail channel loans to

be “prime” loans, regardless of the characteristics of the loan or the creditworthiness of the

borrower, and sometimes referred to the retail channel as the “prime” channel. The retail

channel originated significant numbers of Option ARM loans, which WaMu treated as prime

loans, despite their inherent risks. According to the Inspectors General of the U.S. Treasury

Department and the FDIC, who prepared a report on WaMu’s failure (hereinafter “IG Report”),

“Option ARMs represented as much as half of all loan originations from 2003 to 2007 and

approximately $59 billion, or 47 percent, of the home loans on WaMu’s balance sheet at the end

108 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com

(indicating WaMu was one of the top three issuers of U.S. residential mortgages from 2003 to 2005); “Washington

Mutual to Acquire PNC’s Residential Mortgage Business,” Business Wire (10/2/2000),

http://findarticles.com/p/articles/mi_m0EIN/is_2000_Oct_2/ai_65635032.

53

of 2007.”109 The retail channel was also used to originate substantial numbers of home equity

loans and home equity lines of credit.

Wholesale Channel. According to WaMu, its “wholesale channel” loans were loans that

the bank acquired from third party mortgage brokers. These brokers, who were not WaMu

employees, located borrowers interested in purchasing a home or refinancing an existing

mortgage, and explained available loans that could be underwritten by WaMu. The borrower’s

primary, and sometimes sole, contact was with the mortgage broker. The mortgage broker

would then provide the borrower’s information to a WaMu loan officer who would determine

whether the bank would finance the loan. If the bank decided to finance the loan, the broker

would receive a commission for its efforts. Third party mortgage brokers typically received little

guidance or training from WaMu, aside from receiving daily “rate sheets” explaining the terms

of the loans that WaMu was willing to accept and the available commissions. WaMu treated

wholesale loans issued under the WaMu brand as prime loans.

Subprime Channel. WaMu also originated wholesale loans through its subprime

affiliate and later subsidiary, Long Beach Mortgage Company (Long Beach). Long Beach was a

purely wholesale lender, and employed no loan officers that worked directly with borrowers.

Instead, its account executives developed relationships with third party mortgage brokers who

brought prospective loans to the company, and if Long Beach accepted those loans, received a

commission for their efforts. WaMu typically referred to Long Beach as its “subprime channel.”

Later, in 2007, when the bank decided to eliminate Long Beach as a separate entity, it rebranded

Long Beach as its “Wholesale Specialty Lending” channel.

At times, WaMu also acquired subprime loans through “correspondent” or “conduit”

channels, which it used to purchase closed loans loans that had already been financed from

other lenders for investment or securitization. For example, WaMu at times operated a

correspondent channel that it referred to as “Specialty Mortgage Finance” and used to purchase

subprime loans from other lenders, especially Ameriquest, for inclusion in its investment

portfolio. In addition, in 2005, its New York securitization arm, Washington Mutual Capital

Corporation, established a “subprime conduit” to purchase closed subprime loans in bulk from

other lenders for use in securitizations. At the end of 2006, WaMu reported that its investment

portfolio included $4 billion in subprime loans from Long Beach and about $16 billion in

subprime loans from other parties.110

Other Channels. At times, WaMu also originated or acquired loans in other ways. Its

“Consumer Direct” channel, for example, originated loans over the phone or internet; borrowers

did not need to meet in person with a WaMu loan officer. In addition, in 2004, Washington

Mutual Capital Corporation (WCC) set up a conduit to purchase closed Alt A loans in bulk from

109 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” report prepared by the

Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, Hearing

Exhibit 4/16-82 (hereinafter “IG Report”).

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

54

other lenders and use them in securitizations. WCC shut down both the Alt A and subprime

conduits in April 2008, after it became too difficult to find buyers for new securitizations.111

The Treasury and the FDIC IG report examining the failure of WaMu found that, from

2003 to 2007, the bulk of its residential loans – from 48% to 70% came from third party

lenders and brokers.112 That report also determined that, in 2007, WaMu had 14 full-time

employees overseeing 34,000 third party brokers doing business with the bank nationwide, and

criticized the Bank’s oversight and staffing effort.113

(3) Long Beach

WaMu had traditionally originated mortgages to well qualified prime borrowers. But in

1999, WaMu bought Long Beach Mortgage Company,114 which was exclusively a subprime

lender to borrowers whose credit histories did not support their getting a traditional mortgage.115

Long Beach was located in Anaheim, California, had a network of loan centers across the

country, and at its height had as many as 1,000 employees.

Long Beach made loans for the express purpose of securitizing them and profiting from

the gain on sale; it did not hold loans for its own investment. It had no loan officers of its own,

but relied entirely on third party mortgage brokers bringing proposed subprime loans to its

doors. In 2000, the year after it was purchased by WaMu, Long Beach made and securitized

approximately $2.5 billion in home loans. By 2006, its loan operations had increased more than

tenfold, and Long Beach securitized nearly $30 billion in subprime home loans and sold the

securities to investors.116

Long Beach’s most common subprime loans were short term, hybrid adjustable rate

mortgages, known as “2/28,” “3/27,” or “5/25” loans. These 30-year mortgages typically had a

low fixed “teaser” rate, which then reset to a higher floating rate after two years for the 2/28,

three years for the 3/27, or five years for the 5/25.117

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

47c.

Long Beach typically qualified borrowers

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

112 See prepared statement of Treasury IG Eric Thorson, “Wall Street and the Financial Crisis: Role of the

Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010)

(hereinafter “April 16, 2010 Subcommittee Hearing”), at 5.

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

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

Mortgage Corporation, for about $350 million.

115 12/21/2005 OTS internal memorandum from OTS examiners to Darrel Dochow, OTSWMS06-007 0001009,

Hearing Exhibit 4/16-31 (“LBMC was acquired … as a vehicle for WMI to access the subprime loan market.

LBMC’s core business is the origination of subprime mortgage loans through a nationwide network of mortgage

brokers.”).

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

Exhibit 4/13-1c.

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

55

higher interest rate.118 For “interest-only” loans, monthly loan payments were calculated to

cover only the interest due on the loan and not any principal. After the fixed interest rate period

expired, the monthly payment was typically recalculated to pay off the entire remaining loan

within the remaining loan period at the higher floating rate. Unless borrowers could refinance,

the suddenly increased monthly payments caused some borrowers to experience “payment

shock” and default on their loans.

From 1999 to 2006, Long Beach operated as a subsidiary of Washington Mutual Inc., the

parent of Washington Mutual Bank. Long Beach’s loans repeatedly experienced early payment

defaults, high delinquency rates, and losses, and its securitizations were among the worst

performing in the market.119 In 2006, in a bid to strengthen Long Beach’s performance, WaMu

received permission from its regulator, OTS, to purchase the company from its parent and make

it a wholly owned subsidiary of the bank. WaMu installed new management, required the head

of Long Beach to report to its Home Loans Division President, and promised OTS that it would

improve Long Beach. When Long Beach’s loans continued to perform poorly, in June 2007,

WaMu shut down Long Beach as a separate entity, and took over its subprime lending

operations, rebranding Long Beach as its “Wholesale Specialty Lending” channel. WaMu

continued to issue and securitize subprime loans. After the subprime market essentially shut

down a few months later in September 2007, WaMu ended all of its subprime lending.

From 2000 to 2007, Long Beach and WaMu together securitized tens of billions of

dollars in subprime loans, creating mortgage backed securities that frequently received AAA or

other investment grade credit ratings.120 Although AAA securities are supposed to be very safe

investments with low default rates of one to two percent, of the 75 Long Beach mortgage backed

security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to

junk status, defaulted, or been withdrawn.121 In most of the 2006 Long Beach securitizations,

the underlying loans have delinquency rates of 50% or more.122

(4) Securitization

Washington Mutual depended on the securitization process to generate profit, manage

risk, and obtain capital to originate new loans. Washington Mutual and Long Beach sold or

securitized most of the subprime home loans they acquired. Initially, Washington Mutual kept

most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or

securitizing those loans as well. From 2000 to 2007, Washington Mutual and Long Beach

118 See April 13, 2010 Subcommittee Hearing at 50.

119 See 4/14/2005 email exchange between OTS examiners, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a

(discussing findings by Fitch, a credit rating agency, highlighting poor performance of Long Beach securities).

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

Exhibit 4/13-1c.

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

122 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach

and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage

backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 –

54.32%).

56

securitized at least $77 billion in subprime home loans. Washington Mutual sold or securitized

at least $115 billion of Option ARM loans, as well as billions more of other types of high risk

loans, including hybrid adjustable rate mortgages, Alt A, and home equity loans.

When Washington Mutual began securitizing its loans, it was dependent upon investment

banks to help underwrite and sell its securitizations. In order to have greater control of the

securitization process and to keep securitization underwriting fees in house, rather than paying

them to investment banks, WaMu acquired a company able to handle securitizations and

renamed it Washington Mutual Capital Corporation (WCC), which became a wholly owned

subsidiary of the bank.123 WCC was a registered broker-dealer and began to act as an

underwriter of WaMu and Long Beach securitizations.124 WCC worked with two other bank

subsidiaries, Washington Mutual Mortgage Securities Corp. and Washington Mutual Asset

Acceptance Corp., that provided warehousing for WaMu loans before they were securitized.

WCC helped to assemble RMBS pools and sell the resulting RMBS securities to investors. At

first it worked with other investment banks; later it became the sole underwriter of some WaMu

securitizations.

WCC was initially based in Seattle with 30 to 40 employees.125 In 2004, it moved its

headquarters to Manhattan.126 At the height of WCC operations, right before the collapse of the

securitization market, WCC had over 200 employees and offices in Seattle, New York, Los

Angeles, and Chicago, with the majority of its personnel in New York.127 WCC closed its doors

in December 2007, after the securitization markets collapsed.

(5) Overview of WaMu’s Rise and Fall

Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding

company, Washington Mutual Inc.128 From 1996 to 2002, WaMu acquired over a dozen other

financial institutions, including American Savings Bank, Great Western Bank, Fleet Mortgage

Corporation, Dime Bancorp, PNC Mortgage, and Long Beach, expanding to become the nation’s

largest thrift and sixth largest bank. WaMu also became one of the largest issuers of home loans

in the country. Washington Mutual kept a portion of those loans for its own investment

portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to

Fannie Mae or Freddie Mac. From 2000 to 2008, Washington Mutual sold over $500 billion in

loans to Fannie Mae and Freddie Mac, representing more than a quarter of its loan production

during those years.

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

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

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

126 Id.

127 Id.

128 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001, at 002. Washington

Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id.

57

In 2006, WaMu took several major actions that reduced the size of its Home Loans

Group. It sold $140 billion in mortgage servicing rights to Wells Fargo; sold a $22 billion

portfolio of home loans and other securities; and reduced its workforce significantly.129

In July 2007, after the Bear Stearns hedge funds collapsed and the credit rating agencies

downgraded the ratings of hundreds of mortgaged backed securities, including over 40 Long

Beach securities, the secondary market for subprime loans dried up. In September 2007, due to

the difficulty of finding investors willing to purchase subprime loans or mortgage backed

securities, Washington Mutual discontinued its subprime lending. It also became increasingly

difficult for Washington Mutual to sell other types of high risk loans and related mortgage

backed securities, including its Option ARMs and home equity products. Instead, WaMu

retained these loans in its portfolios. By the end of the year, as the value of its loans and

mortgage backed securities continued to drop, Washington Mutual began to incur significant

losses, reporting a $1 billion loss in the fourth quarter of 2007, and another $1 billion loss in the

first quarter of 2008.

In February 2008, based upon increasing deterioration in the bank’s asset quality,

earnings, and liquidity, OTS and the FDIC lowered the bank’s safety and soundness rating to a 3

on a scale of 1 to 5, signaling it was a troubled institution.130 In March 2008, at the request of

OTS and the FDIC, Washington Mutual allowed several potential buyers of the bank to review

its financial information.131 JPMorgan Chase followed with a purchase offer that WaMu

declined.132 Instead, in April 2008, Washington Mutual’s parent holding company raised $7

billion in new capital and provided $3 billion of those funds to the bank.133 By June, the bank

had shut down its wholesale lending channel.134 It also closed over 180 loan centers and

terminated 3,000 employees.135 In addition, WaMu reduced its dividend to shareholders.136

In July 2008, a $30 billion subprime mortgage lender, IndyMac, failed and was placed

into receivership by the government. In response, depositors became concerned about

Washington Mutual and withdrew over $10 billion in deposits, putting pressure on the bank’s

liquidity. After the bank disclosed a $3.2 billion loss for the second quarter, its stock price

continued to drop, and more deposits left.

129 Subcommittee interview of Steve Rotella (2/24/2010). See also 3/1/2007 Washington Mutual Inc. 10-K filing

with the SEC, at 1 (Washington Mutual reduced its workforce from 60,789 to 49,824 from December 31, 2005 to

December 31, 2006.); “Washington Mutual to cut 2,500 jobs,” MarketWatch (2/15/2006), available at

http://www.marketwatch.com/story/washington-mutual-cutting-2500-mortgage-jobs.

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

131 Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); and OTS West Region

Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington Mutual Regulators Timeline,” prepared by the

Subcommittee, Hearing Exhibit 4/16-1j.

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

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

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

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

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

136 Id.

58

On September 8, 2008, Washington Mutual signed a public Memorandum of

Understanding that it had negotiated with OTS and the FDIC to address the problems affecting

the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million

severance payment.137 Allen Fishman was appointed his replacement.

On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on

September 18, OTS and the FDIC lowered Washington Mutual’s rating to a “4,” indicating that a

bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of

the bank and its parent holding company. Over the span of eight days starting on September 15,

nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained

about $45 billion, an amount which could have been exhausted by the failure of a $300 billion

institution like Washington Mutual. As the financial crisis worsened each day, regulatory

concerns about the bank’s liquidity and viability intensified.

Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to

close the bank. Unable to wait for a Friday, the day on which most banks are closed, the

agencies acted on a Thursday, September 25, 2008, which was also the 119th anniversary of

WaMu’s founding. That day, OTS seized Washington Mutual Bank, placed it into receivership,

and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan

Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund.

WaMu’s parent, Washington Mutual, Inc., declared bankruptcy soon after.

C. High Risk Lending Strategy

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

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

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

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

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

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

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

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

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

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

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

Subcommittee, Hearing Exhibit 4/13-1h.

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

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

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

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

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

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

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

59

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

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

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

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

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

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

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

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

beginning of 2005.139

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

suffering above-average home value depreciation.147

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

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

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

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

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

Exhibit 4/13-1c.

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

142 Id. at 9-10.

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

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

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

rates or payment adjustments.” Id. at 2.

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

145 Id. at 10.

146 Id.

147 Id. at 11.

60

(1) Strategic Direction

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

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

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

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

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

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

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

predicted continuing growth opportunities for the bank:

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

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

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

independent company is appropriate at this time because of substantial growth

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

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

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

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

value, diligently protecting our shareholders from inadequate unsolicited takeover

proposals and maintaining our long held position of remaining an independent

company.”149

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

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

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

margin products.”151

(2) Approval of Strategy

After 2002, Washington Mutual stopped acquiring lenders specializing in residential

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

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

WaMu’s 2004 Report on Examination:

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

Direction,” JPM_WM05385579 at 581.

149 Id. at 582.

150 Id.

151 Id. at 585.

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

61

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

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

increasing to near $500 billion by 2009.”153

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

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

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

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

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

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

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

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

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

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

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

government backed loans.156

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

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

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

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

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

Exhibit].

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

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

problems.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

risk, implementing lending technology and enacting organizational changes).

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

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

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

showing peak loss rates in 2007).

62

(3) Definition of High Risk Lending

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

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

contained a slide defining “Higher Risk Lending”:

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

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

expanded definition of Higher Risk Lending encapsulating multiple risk

layering and expanded underwriting criteria and its corresponding

concentration limit will be presented for Board approval.

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

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

comprised of:

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

or purchased through our Specialty Mortgage Finance program

-SFR [Single Family Residential] and Consumer Loans to

Borrowers with low credit scores at origination.”160

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

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

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

equity lines of credit (HELOC), and other consumer loans.161

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

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

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

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

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

a definition of higher risk loans.

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

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

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

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

Borrowers’”), OTSWME04-0000005357 at 61.

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

JPM_WM00302979, Hearing Exhibit 4/13-2a.

161 Id. at JPM_WM00302979.

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

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

63

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

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

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

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

expanded underwriting criteria and multiple risk layering:

“Expanded Criteria

-‘No Income’ loan documentation type

-All Manufactured Housing loans …

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

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

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

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

documentation type

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

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

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

loan.

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

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

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

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

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

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

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

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

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

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

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

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

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

D(2)(b), below.

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

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

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

following.”

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

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

$16.05 billion in subprime mortgage loans”).

64

(4) Gain on Sale

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2005 WaMu Gain on Sale

Margin by Product

in bps171

Government 13

Fixed 19

Hybrid/ARM 25

Alt A 40

Option ARM 109

Home Equity 113

Subprime 150

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

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

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

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

Hearing Exhibit 4/13-3.

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

170 Id.

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

65

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

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

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

loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and

Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin

loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most

profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005,

subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at

19 basis points and more than 10 times as profitable as government backed loans.

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

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

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

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

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

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

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

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

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

and servicing of home loans.”173

(5) Acknowledging Unsustainable Housing Price Increases

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

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

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

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

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

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

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

heading, “Perspective,” Mr. Vanasek wrote:

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

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

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

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

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

continues to be difficult.

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

173 April 13, 2010 Subcommittee Hearing at 53.

66

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

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

all of this in perspective.

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

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

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

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

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

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

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

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

expressed renewed concern over this issue.

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

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

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

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

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

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

heeded.

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

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

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

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

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

demonstrates.176

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

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

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

67

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

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

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

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

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

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

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

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

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

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

Mr. Killinger replied:

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

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

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

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

177 April 13, 2010 Subcommittee Hearing at 85.

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

68

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

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

signifies a bubble.”

Mr. Vanasek agreed:

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

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

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

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

much risk we can afford to take ….”

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

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

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

(6) Execution of the High Risk Lending Strategy

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

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

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

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

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

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

Lending Strategy was only contemplated, but not really executed:

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

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

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

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

those strategies for expansion on hold.”180

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

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

executives.

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

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

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

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

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

Exhibit].

180 April 13, 2010 Subcommittee Hearing at 88.

69

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

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

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

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

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

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

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

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

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

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

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

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

Subcommittee, Hearing Exhibit 4/13-1i.

182 Id.

183 Id.

70

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

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

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

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

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

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

accelerate it:

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

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

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

wholesale and correspondent channels.”185

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

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

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

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

share in 2006.”186

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

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

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

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

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

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

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

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

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

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

categories to over 10%.”188

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

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

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

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

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

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

185 Id. at 644.

186 Id. at 646.

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

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

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

71

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

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

business under common management, merging correspondent activities into our

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

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

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

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

and lower volatility over time.”189

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

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

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

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

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

2008:

WaMu Volume By Product

$ In Billions191

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

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

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

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

189 Id. at 319.

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

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

191 Id. [formatted for clarity].

Fixed

$69B

33%

Hyb/ARM

$28B

13%

Option ARM

$63B

31%

Subprime

$34B

16%

Home Equity

$4B

2%

Govt

$8B

4%

Alt-A

$1B

0%

2005 Fixed

$4B

2%

Hyb/ARM

$38B

17%

Option ARM

$63B

23%

Subprime

$70B

30%

Home Equity

$30B

13%

New Product

$13B

5%

Alt A

$24B

10%

2008

$206 Billion $232 Billion

72

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

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

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

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

2005 to $4 billion in 2008.

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

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

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

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

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

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

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

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

their initial low-rate loans.”192

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

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

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

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

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

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

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

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

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

mortgages and proprietary products such as Mortgage Plus.”193

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

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

company’s Chief Risk Officer, testified:

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

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

away from traditional mortgage lending into alternative lending programs involving

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

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

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

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

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

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

73

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

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

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

bank in January 2005, testified before the Subcommittee:

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

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

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

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

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

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

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

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

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

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

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

acquisition costs and greater efficiency.”197

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

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

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

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

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

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

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

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

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

as a mortgage banker at JPMorgan Chase:

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

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

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

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

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

195 Id. at 83.

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

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

198 Id. at JPM_WM00665374.

199 Id.

200 Id.

74

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

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

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

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

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

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

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

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

“2001 to 2005

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

products ….

2006

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

in specific product segments ….

2007 & Beyond

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

secondary market disappears[.]”

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

unambiguous: by 2006, WaMu had “[t]argeted production franchise toward higher margin

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

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

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

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

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

“New business model, high margin products.”205

Despite warnings by some within its management about unsustainable housing prices,

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

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

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

upon borrowers being able to refinance or sell their homes to pay off their loans in the event of a

default. Stagnant or declining house prices made refinancing and home sales more difficult.

201 Id. at JPM_WM00665373.

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

Exhibit 4/13-80.

203 Id. at 1.

204 Id.

205 Id. at 4.

75

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

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

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

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

effective risk management and oversight.

D. Shoddy Lending Practices

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

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

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

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

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

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

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

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

of loans with fraudulent or erroneous borrower information.

(1) Long Beach

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

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

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

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

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

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

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

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

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

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

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

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

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

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

correct them.

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

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

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

returned and lingered for several years.

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

showing Long Beach Annual Origination Volume).

76

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

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

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

respect to Long Beach’s mortgage backed securities:

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

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

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

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

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

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

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

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

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

State: “This raised concerns over LBMC’s ability to meet the representations and warrant[ies]

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

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

portfolio oversight practices were unsatisfactory.”211

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

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

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

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

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

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

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

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

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

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

place.215

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

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

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

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

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

Beach quality assurance report).

210 Id.

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

212 Id.

213 Id.

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

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

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

77

After a short hiatus, WaMu allowed Long Beach to resume securitizing subprime loans in

2004.216 An internal WaMu memorandum, later prepared by a WaMu risk officer who had been

asked to review Long Beach in 2004, recalled significant problems:

“You’ve asked for a chronological recap of ERM [Enterprise Risk Management] market

risk involvement with Longbeach and the sub prime conduit. … [In] 2004: I conducted

an informal but fairly intensive market risk audit of Longbeach …. The climate was very

adversarial. … We found a total mess.”217

A November 2004 email exchange between two WaMu risk officers provides a sense that

poor quality loans were still a problem. The first WaMu risk officer wrote:

“Just a heads-up that you may be getting some outreach from Carroll Moseley (or

perhaps someone higher up in the chain) at Long Beach regarding their interest in

exploring the transfer of … a small amount (maybe $10-20mm in UPB [unpaid principal

balance]) of Piggieback ‘seconds’ (our favorite toxic combo of low FICO borrower and

HLTV loan) from HFS [hold for sale portfolio] to HFI [hold for investment portfolio].

“As Carroll described the situation, these are of such dubious credit quality that they

can’t possibly be sold for anything close to their ‘value’ if we held on to them. … I urged

him to reach out to you directly on these questions. (E.g., it’s entirely possible we might

want to make a business decision to keep a small amount of this crap on our books if it

was already written down to near zero, but we would want all parties to be clear that no

precedent was being set for the product as a whole, etc., etc.).”218

The second risk officer sent the email to the head of Long Beach, with the comment, “I think it

would be prudent for us to just sell all of these loans.”

2005 Early Payment Defaults. Early in 2005, a number of Long Beach loans

experienced “early payment defaults,” meaning that the borrower failed to make a payment on

the loan within three months of the loan being sold to investors. That a loan would default so

soon after origination typically indicates that there was a problem in the underwriting process.

Investors who bought EPD loans often demanded that Long Beach repurchase them, invoking

the representations and warranties clause in the loan sales agreements.

216 Subcommittee interview of Fay Chapman (2/9/2010). See also 12/21/2005 OTS memorandum, “Long Beach

Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31 (“In 2003, adverse internal

reviews of LBMC operations led to a decision to temporarily cease securitization activity. WMU’s Legal

Department then led a special review of all loans in LBMC’s pipeline and held-for-sale warehouse in order to ensure

file documentation adequately supported securitization representations and warranties and that WMI was not

exposed to a potentially significant contingent liability. Securitization activity was reinstated in early 2004 after the

Legal Department concluded there was not a significant liability issue.”).

217 Undated memorandum from Dave Griffith to Michelle McCarthy, “Sub Prime Chronology,” likely prepared in

early 2007, JPM_WM02095572.

218 11/24/2004 email from Michael Smith to Mark Hillis and others, “LBMC Transfer of Piggiebacks from HFS to

HFI,” JPM_WM01407692.

78

To analyze what happened, WaMu conducted a “post mortem” review of 213 Long

Beach loans that experienced first payment defaults in March, April, and May of 2005.219 The

review found that many early defaults were not only preventable, but that in some instances

fraud should have been easily detected from the presence of “White Out” on an application or a

borrower having two different signatures:

“First Payment Defaults (FPD’s) are preventable and / or detectable in nearly all cases

(~99%)[.] Most FPD cases (60%) are failure of current control effectiveness[.] … High

incident rate of potential fraud among FPD cases[.] … All roles in the origination process

need to sharpen watch for misrepresentation and fraud[.] … Underwriting guidelines are

not consistently followed and conditions are not consistently or effectively met[.] …

Underwriters are not consistently recognizing non-arm’s length transactions and/or

underwriting associated risk effectively[.] … Credit Policy does not adequately address

certain key risk elements in layered high risk transactions[.] …

“66% of reviewed FPD cases had significant variances in the file[.] … Stated Income

should be reviewed more closely ([fraud] incidence rate of 35%) …. Signatures should

be checked – 14% Borrowers signature vary[.] Altered documents are usually detectable

–5% White-out on documentation[.] … 92% of the Purchases reviewed are 100% CLTV

[combined loan-to-value][.] … 52% are Stated Income.”220

A subsequent review conducted by WaMu’s General Auditor of the “root causes” of the

Long Beach loans with early payment defaults pointed not only to lax lending standards and a

lack of fraud controls, but also to “a push to increase loan volume”:

“In 2004, LBMC [Long Beach] relaxed underwriting guidelines and executed loan sales

with provisions fundamentally different from previous securitizations. These changes,

coupled with breakdowns in manual underwriting processes, were the primary drivers for

the increase in repurchase volume. The shift to whole loan sales, including the EPD

provision, brought to the surface the impact of relaxed credit guidelines, breakdowns in

manual underwriting processes, and inexperienced subprime personnel. These factors,

coupled with a push to increase loan volume and the lack of an automated fraud

monitoring tool, exacerbated the deterioration in loan quality.”221

Due to the early payment defaults, Long Beach was forced to repurchase loans totaling

nearly $837 million in unpaid principal, and incurred a net loss of about $107 million.222

219 11/1/2005 “LBMC Post Mortem – Early Findings Read Out,” prepared by WaMu, JPM_WM03737297, Hearing

Exhibit 4/13-9.

This

220 Id.

221 4/17/2006 WaMu memorandum to the Washington Mutual Inc. and WaMu Board of Directors’ Audit

Committee, “Long Beach Mortgage Company - Repurchase Reserve Root Cause Analysis,” prepared by WaMu

General Auditor, JPM_WM02533760-61, Hearing Exhibit 4/13-10.

222 Id. (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

79

loss overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75

million.223 Due to its insufficient loss reserves, its outside auditor, Deloitte and Touche, cited

Long Beach for a serious deficiency in its financial reporting.224 These unexpected repurchases

were significant enough that Washington Mutual Inc., Long Beach’s parent company, made

special mention of them in its 2005 10-K filing:

“In 2004 and 2005, the Company’s Long Beach Mortgage Company subsidiary engaged

in whole loan sale transactions of originated subprime loans in which it agreed to

repurchase from the investor each ‘early payment default’ loan at a price equal to the

loan’s face value plus the amount of any premium paid by the investor. An early

payment default occurs when the borrower fails to make the first post-sale payment due

on the loan by a contractually specified date. Usually when such an event occurs, the fair

value of the loan at the time of its repurchase is lower than the face value. In the fourth

quarter of 2005, the Company experienced increased incidents of repurchases of early

payment default loans sold by Long Beach Mortgage Company and this trend is expected

to continue in the first part of 2006.225

In addition to the early payment default problem, a September 2005 WaMu audit

observed that at Long Beach, policies designed to mitigate the risk of predatory lending practices

were not always followed. The audit report stated: “In 24 of 27 (88%) of the refinance

transactions reviewed, policies established to preclude origination of loans providing no net

tangible benefit to the borrower were not followed.”226 In addition, in 8 out of 10 of the newly

issued refinance loans that WaMu reviewed, Long Beach had not followed procedures designed

to detect “loan flipping,” an industry term used to describe the practice of unscrupulous brokers

or lenders quickly or repeatedly refinancing a borrower’s loan to reap fees and profits but

provide no benefit to the borrower.227

2006 Purchase of Long Beach. In response to all the problems at Long Beach, at the

end of 2005, WaMu fired Long Beach’s senior management and moved the company under the

direct supervision of the President of WaMu’s Home Loans Division, David Schneider.228

Washington Mutual promised its regulator, OTS, that Long Beach would improve.229 The bank

also filed a formal application, requiring OTS approval, to purchase Long Beach from its parent

company, so that it would become a wholly owned subsidiary of the bank.230

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.”).

WaMu told OTS

that making Long Beach a subsidiary would give the bank greater control over Long Beach’s

223 Id.

224 Id.

225 Washington Mutual Inc. 2005 10-K filing with the SEC.

226 9/21/2005 WaMu audit of Long Beach, JPM_WM04656627.

227 Id.

228 Subcommittee interview of David Schneider (2/17/2010).

229 See, e.g., 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007

0001009, Hearing Exhibit 4/16-31.

230 Id. at OTSWMS06-007 0001009 (stating WaMu filed a 12/12/2005 application to acquire Long Beach).

80

operations and allow it to strengthen Long Beach’s lending practices and risk management, as

well as reduce funding costs and administrative expenses.231 In addition, WaMu proposed that it

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.232 OTS had expressed a number of concerns about Long Beach in connection with the

purchase request,233 but in December 2005, after obtaining commitments from WaMu to

strengthen Long Beach’s lending and risk management practices, OTS agreed to the purchase.234

The actual purchase date was March 1, 2006.235

Immediately after the purchase, in April 2006, after reviewing Long Beach’s

operations, WaMu President Rotella sent an email to WaMu CEO Killinger warning

about the extent of the problems: “[D]elinquencies are up 140% and foreclosures close to

70%. … First payment defaults are way up and the 2005 vintage is way up relative to

previous years. It is ugly.”236 Mr. Rotella, however, expressed hope that operations

would improve:

“Early changes by the new team from HL [Home Loans], who have deep

subprime experience, indicate a solid opportunity to mitigate some of this. I

would expect to see this emerge in 3 to 6 months. That said, much of the paper

we originated in the 05 growth spurt was low quality. … I have the utmost

confidence in the team overseeing this now and no doubt this unit will be more

productive and better controlled, but I figured you should know this is not a pretty

picture right now. We are all over it, but as we saw with repurchases, there was a

lot of junk coming in.”

Despite the new management and direct oversight by WaMu’s Home Loans Division,

Long Beach continued to perform poorly. Five months later, expected improvements had not

materialized. In September 2006, Mr. Rotella sent another email to Mr. Killinger stating that

Long Beach was still “terrible”:

“[Long Beach] is terrible, in fact negative right now. … We are being killed by the

lingering movement of EPDs [early payment defaults] and other credit related issues ….

[W]e are cleaning up a mess. Repurchases, EPDs, manual underwriting, very weak

servicing/collections practices and a weak staff. Other than that, well you get the

picture.”237

231 Id. at OTSWMS06-007 0001010.

232 Id. at OTSWMS06-007 0001011.

233 See, e.g., 6/3/2005 OTS internal memorandum by OTS examiner to OTS Deputy Regional Director, at

OTSWMS06-007 0002683, Hearing Exhibit 4/16-28.

234 See 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009,

Hearing Exhibit 4/16-31.

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

236 4/27/2006 email from Steve Rotella to Kerry Killinger, JPM_WM05380911, Hearing Exhibit 4/13-11.

237 9/14/2006 WaMu internal email, Hearing Exhibit 4/13-12.

81

Again, he expressed hope that the situation would improve: “The good news is David and his

team are pros and are all over it.”238 Two months later, in November 2006, however, the head of

WaMu Capital Markets in New York, David Beck, relayed even more bad news to Mr.

Schneider, the Home Loans President: “LBMC [Long Beach] paper is among the worst

performing in the mkt [market] in 2006.”239

Despite the additional focus on improving its lending operations throughout 2006, Long

Beach was once again flooded with repurchase requests. According to a memorandum later

written by an FDIC examination specialist, “[d]uring 2006, more than 5,200 LBMC loans were

repurchased, totaling $875.3 million.”240 Even though, in January 2006, the bank had ceased

executing whole loan sales which allowed an automatic repurchase in the event of an EPD, 46%

of the repurchase volume was as a result of EPDs. Further, 43% of the repurchase volume

resulted from first payment defaults (FPDs) in which the borrower missed making the first

payment on the loan after it was sold.241 Another 10% of the repurchases resulted from

violations related to representation and warranties (R&W) not included in the EPD or FPD

numbers, meaning the violations were identified only later in the life of the loan.

R&W repurchases generally pose a challenge for a bank’s loss reserves, because the

potential liability the repurchase request continues for the life of the loan. The FDIC

memorandum observed:

“Management claims that R&W provisions are industry standard and indeed they may be.

However, I still found that the Mortgage Loan Purchase Agreement contains some

representations and warranties worth noting. For example, not only must the loans be

‘underwritten in accordance with the seller’s underwriting guideline,’ but the

‘origination, underwriting, and collection practices used by the seller with respect to each

mortgage loan have been in all material respects legal, proper, prudent, and customary in

the subprime mortgage business.’ This provision elevates the potential that investors can

put back a problem loan years after origination and not only must the loan have been

underwritten in line with bank guidelines but must also have been underwritten in

accordance with what is customary with other subprime lenders.”242

R&W repurchase requests and loss reserves continued to be an issue at Long Beach. The

fourth quarter of 2006 saw another spike in R&W repurchase requests, and in December the

required amount of R&W loss reserves jumped from $18 million to $76 million.243

238 Id.

239 11/7/2006 WaMu internal email, Hearing Exhibit 4/13-50.

240 See 6/5/2007 memorandum by Christopher Hovik, Examination Specialist, sent to FDIC Dedicated Examiner

Steve Funaro, “WaMu – Long Beach Mortgage Company (LMC) Repurchases,” at 1, FDIC_WAMU_000012348,

Hearing Exhibit 4/13-13b.

241 Id.

242 Id.

243 Id. at 3.

82

On December 22, 2006, the FDIC Dedicated Examiner at WaMu, Steve Funaro, sent an

email to Mr. Schneider, the Home Loans President, raising questions about the unexpected loan

defaults and repurchase demands. He wrote that Long Beach had the “[s]ame issues as FPD last

quarter … Current forecast of 35 to 50m [million] risk.” His email also noted potentially

insufficient loss reserves related to WaMu’s own subprime conduit that purchased subprime

loans from other lenders and mortgage brokers, some of which were going out of business and

would be unable to shoulder any liability for defaulting loans. His email noted forecasts of early

payment defaults totaling $15.6 million and loan delinquencies totaling $10.7 million, in addition

to other problems, and asked: “Why the miss? … Who is accountable?”244

Mr. Schneider forwarded the email to his team and expressed frustration at Long Beach’s

continuing problems:

“Short story is this is not good. … There is [a] growing potential issue around Long

Beach repurchases …. [W]e have a large potential risk from what appears to be a recent

increase in repurchase requests. … We are all rapidly losing credibility as a management

team.”245

Performance in 2007 Worsens. The following year, 2007, was no better as the

performance of WaMu’s loan portfolio continued to deteriorate. WaMu’s chief risk officer, Ron

Cathcart, asked WaMu’s Corporate Credit Review team to assess the quality of Long Beach

loans and RMBS securities in light of the slowdown and decline in home prices in some areas.246

In January 2007, he forwarded an email with the results of the review, which identified “key risk

issues” related to recent loans and described deteriorating loan performance at Long Beach. The

“top five priority issues” were:

“Appraisal deficiencies that could impact value and were not addressed[;]

Material misrepresentations relating to credit evaluation were confirmed[;]

Legal documents were missing or contained errors or discrepancies[;]

Credit evaluation or loan decision errors[; and]

Required credit documentation was insufficient or missing from the file.”247

The review also found: “[D]eterioration was accelerating in recent vintages with each vintage

since 2002 having performed worse than the prior vintage.” Mr. Cathcart also expressed concern

that problems were not being reported to senior management. He wrote: “Long Beach

represents a real problem for WaMu. … I am concerned that Credit Review may seem to have

been standing on the sidelines while problems continue. For instance, why have Cathcart,

Schneider, Rotella and Killinger received NO report on any of this?”248

244 12/22/2006 email from Steve Funaro to David Schneider, Hearing Exhibit 4/13-13a.

245 12/2006 WaMu internal email, Hearing Exhibit 4/13-13a.

246 12/7/2006 email from Ron Cathcart to his colleagues, Hearing Exhibit 4/13-15.

247 1/2/2007 email from Ron Cathcart to Cory Gunderson, Hearing Exhibit 4/13-16.

248 Id.

83

In February 2007, WaMu senior managers discussed “how best to dispose” of $433

million in Long Beach performing second lien loans, due to “disarray” in the securitization

market.249 David Beck, head of WaMu’s Wall Street operation, wrote that securitizing the loans

was “not a viable exit strategy” and noted:

“Investors are suffering greater than expected losses from subprime in general as well as

subprime 2nd lien transactions. As you know, they are challenging our underwriting

representations and warrants. Long Beach was able to securitize 2nd liens once in 2006

in May. We sold the BBB- bonds to investors at Libor +260. To date, that transaction

has already experienced 7% foreclosures.”250

WaMu CEO Killinger complained privately to President Steve Rotella:

“Is this basically saying that we are going to lose 15 [percent] on over $400 million of

this product or 60 million. That is a pretty bad hit that reflects poorly on credit and others

responsibility for buying this stuff. Is this showing up in hits to compensation or

personnel changes.”251

WaMu President Rotella responded:

“This is second lien product originated 7-10 months ago from Long Beach. … In 2006

Beck’s team started sprinkling seconds in deals as they could. And, we now have the %

down to the low single digits, so that we can sell all into our deals (assuming the market

doesn’t get even worse).”

He continued: “In terms of folks losing their jobs, the people largely responsible for bringing us

this stuff are gone, the senior management of LB.”252

Also in February 2007, early payment defaults again ticked up. A review of the first

quarter of 2007 found: “First payment defaults (FPDs) rose to 1.96% in March but are projected

to fall back to 1.87% in April based on payments received through May 5th.”253 It also reported

that the findings from a “deep dive into February FPDs revealed” that many of the problems

could have been eliminated had existing guidelines been followed:

“The root cause of over 70% of FPDs involved operational issues such as missed fraud

flags, underwriting errors, and condition clearing errors. This finding indicates there may

be opportunities to improve performance without further restricting underwriting

guidelines.”254

249 2/2007 email chain among WaMu personnel, JPM_WM00673101-03, Hearing Exhibit 4/13-17.

250 Id. at JPM_WM00673103.

251 Id. at JPM_WM00673101.

252 Id.

253 “Quarterly Credit Risk Review SubPrime,” prepared by WaMu Home Loans Risk Management (1st Quarter,

2007), Hearing Exhibit 4/13-18.

254 Id.

84

In June 2007, WaMu decided to discontinue Long Beach as a separate entity, and instead

placed its subprime lending operations in a new WaMu division called “Wholesale Specialty

Lending.” That division continued to purchase subprime loans and issue subprime

securitizations.

Some months later, an internal WaMu review assessed “the effectiveness of the action

plans developed and implemented by Home Loans to address” the first payment default problem

in the Wholesale Specialty Lending division.255 After reviewing 187 FPD loans from November

2006 through March 2007, the review found:

“The overall system of credit risk management activities and process has major

weaknesses resulting in unacceptable level of credit risk. Exposure is considerable and

immediate corrective action is essential in order to limit or avoid considerable losses,

reputation damage, or financial statement errors.”256

In particular, the review found:

“Ineffectiveness of fraud detection tools – 132 of the 187 (71%) files were reviewed …

for fraud. [The review] confirmed fraud on 115 [and 17 were] … ‘highly suspect’. ...

Credit weakness and underwriting deficiencies is a repeat finding …. 80 of the 112

(71%) stated income loans were identified for lack of reasonableness of income[.] 133

(71%) had credit evaluation or loan decision errors …. 58 (31%) had appraisal

discrepancies or issues that raised concerns that the value was not supported.”257

July 2007 was a critical moment not only for WaMu, but also for the broader market for

mortgage securities. In that month, Moody’s and S&P downgraded the ratings of hundreds of

RMBS and CDO securities, including 40 Long Beach subprime securities.258 The mass

downgrades caused many investors to immediately stop buying subprime RMBS securities, and

the securities plummeted in value. Wall Street firms were increasingly unable to find investors

for new subprime RMBS securitizations.

In August 2007, WaMu’s internal audit department released a lengthy audit report

criticizing Long Beach’s poor loan origination and underwriting practices.259 By that

time, Long Beach had been rebranded as WaMu’s Wholesale Specialty Lending division,

the subprime market had collapsed, and subprime loans were no longer marketable. The

audit report nevertheless provided a detailed and negative review of its operations:

255 9/28/2007 “Wholesale Specialty Lending-FPD,” WaMu Corporate Credit Review, JPM_WM04013925, Hearing

Exhibit 4/13-21.

256 Id. at 2.

257 Id. at 3.

258 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99.

259 8/20/2007 “Long Beach Mortgage Loan Origination & Underwriting,” WaMu audit report, JPM_WM02548939,

Hearing Exhibit 4/13-19.

85

“[T]he overall system of risk management and internal controls has deficiencies related to

multiple, critical origination and underwriting processes .… These deficiencies require

immediate effective corrective action to limit continued exposure to losses. … Repeat

Issue – Underwriting guidelines established to mitigate the risk of unsound underwriting

decisions are not always followed …. Improvements in controls designed to ensure

adherence to Exception Oversight Policy and Procedures is required …. [A]ccurate

reporting and tracking of exceptions to policy does not exist.”260

In response, Mr. Rotella wrote to WaMu’s General Auditor: “This seems to me to be the

ultimate in bayonetting the wounded, if not the dead.”261

Subprime Lending Ends. In September 2007, with investors no longer interested in

buying subprime loans or securitizations, WaMu shut down all of its subprime operations.262

During the prior year, which was their peak, Long Beach and WaMu had securitized $29 billion

in subprime loans; by 2007, due to the collapse of the subprime secondary market, WaMu’s

volume for the year dropped to $5.5 billion. Altogether, from 2000 to 2007, Long Beach and

WaMu had securitized at least $77 billion in subprime loans.263

When asked about Long Beach at the Subcommittee’s hearing, all of the WaMu former

managers who testified remembered its operations as being problematic, and could not explain

why WaMu failed to strengthen its operations. Mr. Vanasek, former Chief Risk Officer, testified

that Long Beach did not have an effective risk management regime when he arrived at WaMu in

1999, and that it had not developed an effective risk management regime by the time he retired at

the end of 2005.264 Likewise, Mr. Cathcart, who replaced Mr. Vanasek as Chief Risk Officer,

testified that Long Beach never developed effective risk management during the course of his

tenure.265

At the April 13 Subcommittee hearing, Senator Levin asked Mr. Vanasek: “Is it fair to

say that WaMu is not particularly worried about the risk associated with Long Beach subprime

mortgages because it sold those loans and passed the risk on to investors?” Mr. Vanasek replied:

“Yes, I would say that was a fair characterization.”266

Home Loans President David Schneider, who had direct responsibility for addressing the

problems at Long Beach, testified that he tried to improve Long Beach, but “ultimately decided

… Long Beach was an operation that we should shut down.”267

260 Id. at JPM_WM02548940-41.

WaMu President Steve Rotella

also acknowledged the inability of WaMu management to resolve the problems at Long Beach:

261 8/21/2007 email from Steve Rotella to Randy Melby, JPM_WM04859837, Hearing Exhibit 4/13-20.

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

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

Exhibit 4/13-1c.

264 April 13, 2010 Subcommittee Hearing at 22.

265 Id.

266 Id. at 23.

267 Id. at 55.

86

“We did bring the volume in Long Beach down substantially every quarter starting in the

first quarter of 2006. As we went through that process, it became increasingly clear, as I

have indicated in here, that the problems in Long Beach were deep and the only way we

could address those were to continue to cut back volume and ultimately shut it down.”268

Community Impact. Long Beach’s poor quality loans not only proved unprofitable for

many investors, they were often devastating for the borrowers and their communities. Mr.

Killinger testified at the Subcommittee hearing that WaMu, “entered the subprime business with

our purchase of Long Beach Mortgage in 1999 to better serve an underserved market.”269 But

the unfortunate result of many Long Beach loans was that they left communities reeling from

widespread foreclosures and lost homes.

In November 2008, the Office of the Comptroller of the Currency (OCC) which oversees

all nationally chartered banks, identified the ten metropolitan areas across the United States with

the highest rates of foreclosure for subprime and Alt A mortgages originated from 2005 through

2007.270 Those ten areas were, in order: Detroit, Cleveland, Stockton, Sacramento,

Riverside/San Bernardino, Memphis, Miami/Fort Lauderdale, Bakersfield, Denver, and Las

Vegas. The OCC then identified the lenders with the highest foreclosure rates in each of those

devastated cities. Long Beach had the worst foreclosure rate in four of those areas, and was near

the worst in five more, with the lone exception being Las Vegas. The OCC data also showed

that, overall in the ten metropolitan areas, Long Beach mortgages had the second worst

foreclosure rate of all the lenders reviewed, with over 11,700 foreclosures at the time of the

report. Only New Century was worse.

(2) WaMu Retail Lending

Washington Mutual’s problems were not confined to its subprime operations; they also

affected its retail operations. WaMu loosened underwriting standards as part of its High Risk

Lending Strategy, and received repeated criticisms from its regulators, as outlined in the next

chapter, for weak underwriting standards, risk layering, excessive loan error and exception rates,

appraisal problems, and loan fraud. In August 2007, more than a year before the collapse of the

bank, WaMu’s President Steve Rotella emailed CEO Kerry Killinger saying that, aside from

Long Beach, WaMu’s prime home loan business “was the worst managed business I had seen in

my career.”271

(a) Inadequate Systems and Weak Oversight

One reason for WaMu’s poor lending practices was its failure to adequately monitor the

hundreds of billions of dollars of residential loans being issued each year by its own loan

268 Id. at 90.

269 Id. at 86.

270 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the Office of the Comptroller of the Currency,

http://www.occ.treas.gov/news-issuances/news-releases/2009/nr-occ-2009-112b.pdf, Hearing Exhibit 4/13-58.

271 8/23/2007 email from Mr. Rotella to Mr. Killinger, JPM_WM00675851, Hearing Exhibit 4/13-79.

87

personnel. From 1990 until 2002, WaMu acquired more than 20 new banks and mortgage

companies, including American Savings Bank, Great Western Bank, Fleet Mortgage

Corporation, Dime Bancorp, PNC Mortgage, and Long Beach. WaMu struggled to integrate

dozens of lending platforms, information technology systems, staffs, and policies, whose

inconsistencies and gaps exposed the bank to loan errors and fraud.

To address the problem, WaMu invested millions of dollars in a technology program

called Optis, which WaMu President Rotella described in the end as “a complete failure” that the

bank “had to write off” and abandon.272 In 2004, an OTS Report of Examination (ROE), which

was given to the bank’s Board of Directors, included this observation:

“Our review disclosed that past rapid growth through acquisition and unprecedented

mortgage refinance activity placed significant operational strain on [Washington Mutual]

during the early part of the review period. Beginning in the second half of 2003, market

conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past

mortgage banking acquisitions, address operational issues, and realize expectations from

certain major IT initiatives exposed the institution’s infrastructure weaknesses and began

to negatively impact operating results.”273

The records reviewed by the Subcommittee showed that, from 2004 until its shuttering in 2008,

WaMu constantly struggled with information technology issues that limited its ability to monitor

loan errors, exception rates, and indicators of loan fraud.

From 2004 to 2008, WaMu’s regulators also repeatedly criticized WaMu’s failure to

exercise sufficient oversight of its loan personnel to reduce excessive loan error and exception

rates that allowed the issuance of loans in violation of WaMu’s credit standards.274 In 2004,

Craig Chapman, then the President of WaMu Home Loans, visited a number of the bank’s loan

centers around the country. Lawrence Carter, then OTS Examiner-in-Charge at WaMu, spoke

with Mr. Chapman about what he found. Recalling that conversation in a later email, Mr. Carter

wrote:

“Craig has been going around the country visiting home lending and fulfillment offices.

His view is that band-aids have been used to address past issues and that there is a

fundamental absence of process.”275

The regulators’ examination reports on WaMu indicate that its oversight efforts remained

weak. In February 2005, OTS stated that WaMu’s loan underwriting “has been an area of

272 Subcommittee interview of Steve Rotella (2/24/2010).

273 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed

Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share

to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity

issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been

exceedingly patient.”).

274 See, e.g., OTS examination reports cited in Chapter IV, below.

275 8/13/2004 email from Lawrence Carter to Michal Finn, Finn_Michael-00005331.

88

concern for several exams.”276 In June 2005, OTS expressed concern about the bank’s

underwriting exceptions and policy compliance.277 In August of the same year, the OTS Report

of Examination stated that, “the level of deficiencies, if left unchecked, could erode the credit

quality of the portfolio,” and specifically drew attention to WaMu concentrations in higher risk

loans that were a direct result of its High Risk Lending Strategy.278 2006 was no better. OTS

repeatedly criticized the level of underwriting exceptions and errors.279

Another problem was the weak role played by WaMu’s compliance department. In

March 2007, an OTS examiner noted that WaMu had just hired its “ninth compliance leader

since 2000,” and that its “compliance management program has suffered from a lack of steady,

consistent leadership.” The examiner added: “The Board of Directors should commission an

evaluation of why smart, successful, effective managers can’t succeed in this position. …

(HINT: It has to do with top management not buying into the importance of compliance and turf

warfare and Kerry [Killinger] not liking bad news.)”280

Still another problem was that WaMu failed to devote sufficient resources to overseeing

the many loans it acquired from third party lenders and mortgage brokers. The 2010 Treasury

and FDIC IG report found that, from 2003 to 2007, a substantial portion of WaMu’s residential

loans from 48% to 70% came from third party lenders and brokers.281 The IG report also

found:

“The financial incentive to use wholesale loan channels for production was significant.

According to an April 2006 internal presentation to the WaMu Board, it cost WaMu

about 66 percent less to close a wholesale loan ($1,809 per loan) than it did to close a

retail loan ($5,273). Thus, WaMu was able to reduce its cost of operations through the

use of third-party originators but had far less oversight over the quality of

originations.”282

During its last five years, WaMu accepted loans from tens of thousands of third party

brokers and lenders across the country, not only through its wholesale and correspondent

channels, but also through its securitization conduits that bought Alt A and subprime loans in

bulk. Evidence gathered by the Subcommittee from OTS examination reports, WaMu internal

276 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention,

OTSWMEF-0000047591, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See the Regulator Chapter of this Report for

more information.

277 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan review,” OTSWME05-004

0000392, Hearing Exhibit 4/16-26. For more information, see Chapter IV, below.

278 3/14/2005 OTS Report of Examination, OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit].

(Examination findings were issued to WaMu on August 28, 2005.)

279 See, for example, 5/23/2006 OTS Exam Finding Memo, “Home Loan Underwriting, “ OTSWMS06-008

0001299, Hearing Exhibit 4/16-33; and 8/29/2006 OTS Report of Examination, OTSWMS06-008 0001690, Hearing

Exhibit 4/16-94 [Sealed Exhibit].

280 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin-

00020408_001, Hearing Exhibit 4/16-9.

281 4/2010 IG Report, at 23, Hearing Exhibit 4/16-82.

282 Id. at 23.

89

documents, and oral testimony shows that WaMu exercised weak oversight over the thousands of

brokers submitting loans. For example, a 2003 OTS report concluded that WaMu’s “annual

review and monitoring process for wholesale mortgage brokers was inadequate, as management

did not consider key performance indicators such as delinquency rates and fraud incidents.”283 A

2003 WaMu quality assurance review found an “error rate of 29 percent for wholesale mortgage

loans, more than triple the acceptable error rate of 8 percent established by WaMu.”284 A 2004

OTS examination noted that 20,000 brokers and lenders had submitted loans to WaMu for

approval during the year, a volume that was “challenging to manage.”285 A 2005 internal WaMu

investigation of two high volume loan centers in Southern California that accepted loans from

brokers found that “78% of the funded retail broker loans reviewed were found to contain

fraud.”286 A 2006 internal WaMu inquiry into why loans purchased through its subprime

conduit were experiencing high delinquency rates found the bank had securitized broker loans

that were delinquent, not underwritten to standards, and suffering from “lower credit quality.”287

OTS examinations in 2006 and 2007 also identified deficiencies in WaMu’s oversight

efforts.288 For example, a 2007 OTS memorandum found that, in 2007, Washington Mutual had

only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to

the bank for approval,289 which meant that each WaMu employee oversaw more than 2,400

brokers. The OTS examination not only questioned the staffing level, but also criticized the

scorecard WaMu used to rate the mortgage brokers, which did not include the rates at which

significant lending or documentation deficiencies were attributed to the broker, the rate at which

the broker’s loans were denied or produced unsaleable loans, or any indication of whether the

broker was included on industry watch lists for prior or suspected misconduct.

In 2006, federal regulators issued Interagency Guidance on Nontraditional Mortgage

Product Risks (NTM Guidance) providing standards on how banks “can offer nontraditional

mortgage products in a safe and sound manner.”290 It focused, in part, on the need for banks to

“have strong systems and controls in place for establishing and maintaining relationships” with

third party lenders and brokers submitting high risk loans for approval. It instructed banks to

monitor the quality of the submitted loans to detect problems such as “early payment defaults,

incomplete documentation, and fraud.” If problems arose, the NTM Guidance directed banks to

“take immediate action”:

283 Id.

284 Id. at 24.

285 Id.

286 11/16/2005 “Retail Fraud Risk Overview,” prepared by WaMu Credit Risk Management, at JPM_WM02481938,

Hearing Exhibit 4/13-22b.

287 12/12/2006 WaMu Market Risk Committee Minutes, JPM_WM02095545, Hearing Exhibit 4/13-28.

288 4/2010 IG Report, at 24-25, Hearing Exhibit 4/16-82.

289 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing

Exhibit 4/16-10.

290 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg.

192 at 58609.

90

“Oversight of third party brokers and correspondents who originate nontraditional

mortgage loans should involve monitoring the quality of originations so that they reflect

the institution’s lending standards and compliance with applicable laws and regulations.

… If appraisal, loan documentation, credit problems or consumer complaints are

discovered, the institution should take immediate action.”291

WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of

its subprime loans, for example, showed that Long Beach which by then reported to the WaMu

Home Loans Division had terminated relationships with ten brokers in 2006, primarily because

their loans had experienced high rates of first payment defaults requiring Long Beach to

repurchase them at significant expense.292 But terminating those ten brokers was not enough to

cure the many problems with the third party loans WaMu acquired. The report also noted that, in

2006, apparently for the first time, Long Beach had introduced “collateral and broker risk” into

its underwriting process.293

WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and

subprime securitization conduits in 2008.

(b) Risk Layering

During the five-year period reviewed by the Subcommittee, from 2004 to 2008, WaMu

issued many loans with multiple higher risk features, a practice known as “risk layering.” At the

April 13 Subcommittee hearing, Mr. Vanasek, its Chief Risk Officer from 2004 to 2005, testified

about the dangers of this practice:

“It was the layering of risk brought about by these incremental changes that so altered the

underlying credit quality of mortgage lending which became painfully evident once

housing prices peaked and began to decline. Some may characterize the events that took

place as a ‘perfect storm,’ but I would describe it as an inevitable consequence of

consistently adding risk to the portfolio in a period of inflated housing price

appreciation.”294

Stated Income Loans. One common risk layering practice at WaMu was to allow

borrowers to “state” the amount of their annual income in their loan applications without any

direct documentation or verification by the bank. Data compiled by the Treasury and the FDIC

IG report showed that, by the end of 2007, 50% of WaMu’s subprime loans, 73% of its Option

ARMs, and 90% of its home equity loans were stated income loans.295

291 Id. at 58615.

The bank’s acceptance of

unverified income information came on top of its use of loans with other high risk features, such

292 12/2006 “Home Loans – SubPrime Quarterly Credit Risk Review,” JPM_WM04107374, Hearing Exhibit 4/13-

14.

293 Id. at JPM_WM04107375.

294 April 13, 2010 Subcommittee Hearing at 16.

295 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82.

91

as borrowers with low credit scores or the use of low initial teaser interest rates followed by

much higher rates.

Stated income loans were originally developed to assist self employed individuals that

had good credit and high net worth to obtain loans they could afford. But from 2004 to 2008,

stated income loans became much more widespread, including with respect to a wide variety of

high risk loans.296 Mr. Cathcart testified at the Subcommittee hearing:

“[Stated income loans] originated as a product for self-employed individuals who didn’t

have pay stubs and whose financial statements didn’t necessarily reflect what they made.

It was intended to be available for only the most creditworthy borrowers and it was

supposed to be tested for reasonableness so that a person who said that they were a waiter

or a lower-paid individual couldn’t say that they had an income of $100,000.

“I think that the standards eroded over time. At least I have become aware, reading all

that has happened … standards eroded over time and that it became a competitive tool

that was used by banks to gather business, so that if a loan consultant could send his loan

to Bank A or Bank B, the consultant would say, well, why don’t you go to Bank B? You

don’t have to state your income.

“I do think, thinking it through, that there was a certain amount of coaxing that was

possible between the loan consultant and the individual, which would be something

which would be invisible to a bank that received the application and the only test for that

would be reasonableness, which as you have heard there were some issues within the

portfolio.”297

WaMu required its loan personnel to determine whether a loan applicant’s stated income

was reasonable, but evidence obtained by the Subcommittee indicates that requirement was not

effectively implemented. A 2008 press report about a WaMu stated income loan is illustrative:

“As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons

was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and

schoolteachers with incomes rivaling stockbrokers. He rarely questioned them. A real

estate frenzy was under way and WaMu, as his bank was known, was all about saying

yes.

“Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows.

The borrower was claiming a six-figure income and an unusual profession: mariachi

singer.

296 See, e.g., NTM Guidance at 58614 (“Institutions increasingly rely on reduced documentation, particularly

unverified income, to qualify borrowers for nontraditional mortgage loans.”). The NTM Guidance directed banks to

use stated income loans “with caution,” but did not prohibit them or even issue guidance limiting their use. Id. at

58611.

297 April 13, 2010 Subcommittee Hearing at 41.

92

“Mr. Parsons could not verify the singer’s income, so he had him photographed in front

of his home dressed in his mariachi outfit. The photo went into a WaMu file.

Approved.”298

Instead of verifying borrower income, WaMu loan personnel apparently focused instead

on borrower credit scores, as a proxy measure of a borrower’s creditworthiness. The problem

with this approach, however, was that a person could have a high credit score reflecting the

fact that they paid their bills on time and still have an income that was insufficient to support

the mortgage amount being requested.

High LTV Ratios. A second risk-layering practice at WaMu involved loan-to-value

(LTV) ratios. LTV ratios are a critical risk management tool, because they compare the loan

amount to the estimated dollar value of the property. If an LTV ratio is too high and the

borrower defaults, the sale of the property may not produce sufficient proceeds to pay off the

loan. In interagency guidance, federal banking regulators noted that banks should generally

avoid issuing loans with LTV ratios over 80%, and directed banks to ensure that loans with LTV

ratios of 90% or more have additional credit support such as mortgage insurance or added

collateral.299 The Treasury and the FDIC IG report found that WaMu held a “significant

percentage” of home loans in which the LTV ratios exceeded 80%.300

These loans were the result of explicit WaMu policies allowing high LTV ratios to be

used in loans that already had other high risk features. In February 2005, for example, WaMu set

up automated loan approval parameters to approve loans with a 90% LTV in Option ARM and

interest-only loans providing financing of up to $1 million.301 Still another layer of risk was

added to these loans by permitting the borrowers to have credit scores as low as 620.

The Treasury and the FDIC IG report determined that 44% of WaMu’s subprime loans

and 35% of its home equity loans had LTV ratios in excess of 80%.302 These loans resulted in

part from a 2006 WaMu decision to combine home equity loans bearing high LTV ratios with

borrowers bearing low credit scores. That initiative was discussed in a June 2006 email sent to

Mr. Rotella, after he inquired about the project. He was informed:

298 “Saying Yes, WaMu Built Empire on Shaky Loans,” New York Times (12/27/08). When asked about this press

report, WaMu told the Subcommittee that it had no record of this loan, but could not deny that the incident took

place as reported. See also, in the following subsection, a WaMu loan issued to a “Sign Designer” who claimed

earnings of $34,000 per month.

299 See 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,”

http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm.

300 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82.

301 2/2005 email chain between Timothy Bates, Tony Meola, Mr. Rotella and others, JPM_WM00616783-84.

302 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. See also 3/1/2007 Washington Mutual Inc. 10-K filing with

the SEC, at 52 (showing that, as of 12/31/2006, WaMu held $7.4 billion in home mortgages without private

mortgage insurance or government guarantees with LTV ratios in excess of 80%, and $15 billion in home equity

loans and lines of credit with LTV ratios in excess of 80%).

93

“$4 billion home equity investment program [was] approved … last Friday. High CLTVs

[Combined Loan-to-Value ratios] (up to 100%) and lower FICOs (down to 600)

permitted with some concentration limits.”303

In order to issue these loans as soon as possible in 2006, WaMu set up an underwriting team to

provide “manual” approvals outside of its automated systems:

“Our team is currently focused on several HE [Home Equity] modeling initiatives to

include higher risk lending …. [W]e are adjusting our decision engine rules for a July

roll out to allow for 580-620 [FICO scores] and LT 80% CLTV [combined loan-to-value]

loans to be referred to a manual ‘sub-prime’ underwriting team that we are putting in

place. … [W]e see this 580-620 segment as the biggest opportunity where we aren’t

lending today.”304

Also in 2006, WaMu began issuing so-called “80/20 loans,” in which a package of two

loans are issued together, imposing an 80% LTV first lien and a 20% LTV second lien on the

property, for a total combined LTV (CLTV) of 100%.305 Loans that provide financing for 100%

of a property’s value are extremely high risk, because the borrower has no equity in the property,

the borrower can stop payments on the loan without losing a personal investment, and a

subsequent home sale may not produce sufficient funds to pay off the debt.306 Yet in 2006,

Home Loans Division President David Schneider approved issuing 80/20 loans despite the risk

and despite the fact that WaMu’s automatic underwriting system was not equipped to accept

them, and loan officers initially had to use a manual system to issue the loans.307

Using Low Interest Rates to Qualify Borrowers. A third risk layering practice at

WaMu was allowing loan officers to qualify prospective borrowers for short term hybrid ARMs

or Option ARMs based upon only the initial low rate and not the higher interest rate that would

take effect later on. In a filing with the SEC, for example, Washington Mutual Inc. wrote that its

“underwriting guidelines” allowed “borrowers with hybrid adjustable-rate home loans … where

the initial interest rate is fixed for 2 to 5 years” to be “qualified at the payment associated with

the fixed interest rate charged in the initial contractual period.”308

303 6/13/2006 email from Cheryl Feltgen to David Schneider who forwarded it to Steve Rotella,

JPM_WM01311922-23.

In addition, in 2005, WaMu

personnel informed OTS that, since 2004, the bank had not been qualifying its Option ARM

304 6/14/2006 email from Mark Hillis to Cheryl Feltgen, included in a longer email chain involving Mr. Rotella and

Mr. Schneider, among others, JPM_WM01311922.

305 See, e.g., 6/2006 email chain between Mr. Rotella, Mr. Schneider, Mr. Hillis, and Ms. Feltgen,

JPM_WM01311922-23.

306 See NTM Guidance at 58614. See also SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint

(June 4, 2009), at ¶ 50 (quoting an email by Countrywide CEO Angelo Mozilo who, when discussing the 80/20

loans being issued by his bank, wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.”).

307 Id.; Subcommittee interview of Cheryl Feltgen (2/6/2010). 2/2006 WaMu internal email chain, “FW: 80/20,”

JPM_WM03960778. See also 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598,

Hearing Exhibit 4/16-75 (indicating WaMu issued loans with CLTVs in excess of 95% until ending the practice in

March 2007).

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

94

borrowers using the “fully indexed rate.”309 Instead, WaMu was using a lower “administrative”

rate that was “significantly less than the fully indexed rate.”310

Borrowers, loan officers, and WaMu executives often assumed that hybrid and Option

ARMs could be refinanced before the payments reset to higher levels an expectation that

eventually proved to be unfounded. In a November 30, 2007 email discussing loan

modifications from Mr. Schneider to Mr. Killinger, Mr. Rotella and other senior executives, Mr.

Schneider described WaMu’s faulty assumptions about the “start rate” and life span of these

loans:

“I also think it is clear that the economic benefit of providing modifications for these

borrowers is compelling for the following reasons:

- None of these borrowers ever expected that they would have to pay at a rate

greater than the start rate. In fact, for the most part they were qualified at the start

rate

- We need to provide incentive to these borrowers to maintain the home –

especially if the home value has declined

- When we booked these loans, we anticipated an average life of 2 years and

never really anticipated the rate adjustments ….”311

Qualifying borrowers using the lower initial interest rate enabled banks to qualify more

borrowers for those loans and enabled them to issue loans for larger amounts. Concerned that

more banks were beginning to use this risky practice, federal banking regulators addressed it in

the October 2006 NTM Guidance, which cautioned banks to use the fully indexed rate when

qualifying borrowers for a loan, including loans with lower initial teaser rates.312 In addition, the

Guidance provided that for negatively amortizing loans, banks should consider not only the

“initial loan amount” but also “any balance increase that may accrue from the negative

amortization provision.”313 After the NTM Guidance was issued, a WaMu analyst calculated

that applying the new requirement to all of its loans would cause a 33% drop in its loan volume

due to borrowers who would no longer qualify for its loans:

“Implementing the NTM change for Purchase only drops additional 2.5% of volume …

If we implement the NTM changes to all loans, then we’ll see additional drop of 33% of

volume.”314

309 9/15/2005 email from Darrel Dochow to OTS Examiner-In-Charge at WaMu, OTSWMS05-002 0000537,

Hearing Exhibit 4/16-6. The “fully indexed rate” is the prevailing interest rate in the published index to which an

adjustable rate mortgage is tied, plus the additional percentage points that the lender adds to the index value to

calculate the loan’s interest rate. See NTM Guidance at 58614, n.5.

310 Id.

311 11/30/2007 email from David Schneider to John McMurray, Kerry Killinger and others, JPM_WM05382127-28.

312 NTM Guidance at 58614.

313 Id.

314 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598, Hearing Exhibit 4/16-75.

95

In response to this information, WaMu’s chief risk officer wrote that the impact on the bank

“argues in favor of holding off on implementation until required to act for public relations … or

regulatory reasons.”

Because OTS gave the bank more than six months to come into compliance with the

NTM Guidance, WaMu continued qualifying high risk borrowers using the lower interest rate,

originating billions of dollars in new loans that would later suffer significant losses.

WaMu’s risk-layering practices went beyond its use of stated income loans, high LTV

ratios, and the qualification of borrowers using low initial interest rates. The bank also allowed

its loan officers to issue large volumes of high risk loans to borrowers who did not occupy the

homes they were purchasing or had large debt-to-income ratios.315 On top of those risks, WaMu

concentrated its loans in a small number of states, especially California and Florida, increasing

the risk that a downturn in those states would have a disproportionate impact upon the

delinquency rates of its already high risk loans.

At one point in 2004, Mr. Vanasek made a direct appeal to WaMu CEO Killinger, urging

him to scale back the high risk lending practices that were beginning to dominate not only

WaMu, but the U.S. mortgage market as a whole. Despite his efforts, he received no response:

“As the market deteriorated, in 2004, I went to the Chairman and CEO with a proposal

and a very strong personal appeal to publish a full-page ad in the Wall Street Journal

disavowing many of the then-current industry underwriting practices, such as 100 percent

loan-to-value subprime loans, and thereby adopt what I termed responsible lending

practices. I acknowledged that in so doing the company would give up a degree of

market share and lose some of the originators to the competition, but I believed that

Washington Mutual needed to take an industry-leading position against deteriorating

underwriting standards and products that were not in the best interests of the industry, the

bank, or the consumers. There was, unfortunately, never any further discussion or

response to the recommendation.”316

(c) Loan Fraud

Perhaps the clearest evidence of WaMu’s shoddy lending practices came when senior

management was informed of loans containing fraudulent information, but then did little to stop

the fraud.

315 See, e.g., OTS document, “Hybrid ARM Lending Survey” (regarding WaMu), undated but the OTS Examiner-in-

Charge estimated it was prepared in March or mid-2007, JPM_WM03190673 (“For Subprime currently up to 100%

LTV/CLTV with 50% DTI is allowed for full Doc depending on FICO score. Up to 95% LTV/CLTV is allowed

with 50% DTI for Stated Doc depending on FICO score. … For No Income Verification, No Income No Ratio, and

No Income No Asset only up to 95% LTV/CLTV is allowed.”).

316 April 13, 2010 Subcommittee Hearing at 17.

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Downey and Montebello Fraud Investigations. The most significant example involves

an internal WaMu investigation that, in 2005, uncovered substantial evidence of loan fraud

involving two top producing loan offices in Southern California. WaMu management was

presented with the findings, but failed to respond, leading to the same fraud allegations erupting

again in 2007. According to the WaMu Home Loans Credit Risk Mitigation Team that

conducted the 2005 internal investigation, it was initiated in response to “a sustained history of

confirmed fraud findings over the past three years” involving the two offices, known as Downey

and Montebello.317 Each office was located in a low-income area of Los Angeles and headed by

a loan officer who had won repeated WaMu awards for high volume loan production.

To conduct its inquiry, the WaMu Risk Mitigation Team reviewed all of the loans

produced by the two offices over a two-month period from August to September 2005, which

totaled 751 loans. Analysts scored the loans using a standard electronic fraud detection program,

and then reviewed all of the loans flagged for possible fraud, as well as ten percent of the

remaining loans.318 A November 2005 memorandum summarizing the review stated that it

found an “extensive level of loan fraud” caused primarily by employees “circumventing” bank

policies:

“[A]n extensive level of loan fraud exists in the Emerging Markets [loan processing

centers], virtually all of it stemming from employees in these areas circumventing bank

policy surrounding loan verification and review. Of the 129 detailed loan review[s] …

conducted to date, 42% of the loans reviewed contained suspect activity or fraud,

virtually all of it attributable to some sort of employee malfeasance or failure to execute

company policy. In terms of employee activity enabling this perpetration of fraud, the

following categories of activity appeared most frequently: inconsistent application of

credit policy, errors or negligence, process design flaws, intentional circumvention of

established processes, and overriding automated decisioning recommendations. …

Based on the consistent and pervasive pattern of activity among these employees, we are

recommending firm action be taken to address these particular willful behaviors on the

part of the employees named.”319

A presentation prepared for WaMu management provided additional detail.320 It stated

that, out of the 751 loans produced, the Risk Mitigation Team had selected 180 loans for detailed

review, of which 129 had been completed.321 It stated that 42% of the reviewed loans had

“contained excessive levels of fraud related to loan qualifying data.”322

317 11/17/2005 WaMu internal memorandum, “So. CA Emerging Markets Targeted Loan Review Results,”

JPM_WM01083051, Hearing Exhibit 4/13-22a.

It also stated that the

fraud findings did not differ between loans originated by WaMu’s own loan officers and loans

318 Id.

319 Id.

320 11/16/2005 “Retail Fraud Risk Overview,” prepared by Credit Risk Management, JPM_WM02481934, Hearing

Exhibit 4/13-22b.

321 Id. at JPM_WM02481940.

322 Id. at JPM_WM02481936.

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originated by third party brokers and brought to the loan centers.323 The presentation also stated

that the fraud uncovered by the review was found to be “preventable with improved processes

and controls.”

The presentation indicated that the loan fraud involved primarily “misrepresentation of

loan qualifying data,” including misrepresentations of income and employment, false credit

letters and appraisal issues.324 The presentation included a few examples of misrepresentations,

including:

“Loan #0694256827[:] Misrepresentation [of] the borrower’s identification and

qualifying information were confirmed in every aspect of this file, including: – Income –

SSN – Assets – Alternative credit reference letters – Possible Strawbuyer or Fictitious

borrower[.] The credit package was found to be completely fabricated. Throughout the

process, red flags were over-looked, process requirements were waived, and exceptions

to policy were granted.”325

The presentation noted that the loan delinquency rate for Luis Fragoso, the loan officer

heading the Montebello loan office, was “289% worse than the delinquency performance for the

entire open/active retail channel book of business,” while the delinquency rate for Thomas

Ramirez, the loan officer heading the Downey loan office was 157% worse.326 The message

from the Risk Mitigation Team was clear that the two head loan officers were willfully flouting

bank policy, issuing poor quality loans, and needed to be the subject of “firm action” by the

bank.

Three months prior to its formal presentation on the fraud, the Risk Mitigation Team

supplied a lengthy email with its fraud findings to colleagues in the credit risk department. The

August 2005 email provided spreadsheets containing data collected on the loans from the two

offices as well as figures about the types of loans reviewed and fraud found.327 Among other

information, it indicated that at the Downey office, 83 loans had been reviewed, including 28

originated by the WaMu loan officer Thomas Ramirez, and 54 submitted to him by third party

brokers; while at the Montebello office, 48 loans had been reviewed, including 19 originated by

the WaMu loan officer Luis Fragoso and 29 submitted to him by third party brokers. The email

was forwarded by a credit risk officer to WaMu’s Chief Risk Officer Jim Vanasek, with the

following comment:

“As you requested in our Enterprise Fraud Committee meeting last Friday, the attached

email contains a high-level summary of the investigations the Home Loans Risk Mit team

has conducted on [the two offices] over the past year and a half, based on loans that were

referred to them. … As you can see, among the referred cases there is an extremely high

323 Id. at JPM_WM02481936.

324 Id. at JPM_WM02481938.

325 Id. at JPM_WM02481943.

326 Id. at JPM_WM02481948.

327 8/29/2005 email from Jill Simons to Tim Bates, JPM_WM04026076-77, Hearing Exhibit 4/13-23b.

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incidence of confirmed fraud (58% for Ramirez, 83% for Fragoso) …. [Additional

analysis] will allow us to substantially validate what we suspect, which is that the

incidence of fraud in this area is greater than with other producers.”328

At the Subcommittee hearing, Mr. Vanasek agreed these were “eye popping” rates of fraud.329

On November 18, 2005, Cheryl Feltgen, the Home Loans Chief Credit Officer, “had a

very quick meeting” with Home Loans President David Schneider, the head of Home Loans

sales, Tony Meola, and others in which she reviewed the memorandum and presentation on the

fraud investigation.330 After the meeting, she sent an email to the Risk Mitigation Team stating:

“The good news is that people are taking this very seriously. They requested some additional

information that will aid in making some decisions on the right course of action.”331 She asked

the Risk Mitigation Team to prepare a new spreadsheet with the loan information, which the

team did over the weekend in anticipation of a Monday meeting.

The trail of documentation in 2005 about the fraud investigation ends there. Despite the

year-long effort put into the investigation, the written materials prepared, the meetings held, and

fraud rates in excess of 58% and 83% at the Downey and Montebello offices, no discernable

actions were taken by WaMu management to address the fraud problem in those two offices. No

one was fired or disciplined for routinely violating bank policy, no anti-fraud program was

installed, no notice of the problem was sent to the bank’s regulators, and no investors who

purchased RMBS securities containing loans from those offices were alerted to the fraud

problem underlying their high delinquency rates. Mr. Vanasek retired from the bank in

December 2005, and the new Chief Risk Officer Ron Cathcart was never told about the fraud

investigation. Senior personnel, including Mr. Schneider, Mr. Meola, and Ms. Feltgen, failed to

follow up on the matter.

Over the next two years, the Downey and Montebello head loan officers, Messrs.

Ramirez and Fragoso, continued to issue high volumes of loans332 and continued to win awards

for their loan productivity, including winning trips to Hawaii as members of WaMu’s

“President’s Club.” One of the loan officers even suggested to bank President Steve Rotella

ways to further relax bank lending standards.333

In June 2007, however, the fraud problem erupted again. That month, AIG, which

provided mortgage insurance for some of WaMu’s residential mortgages, contacted the bank

with concerns about material misrepresentations and fraudulent documents included in

328 8/30/2005 email from Tim Bates to Jim Vanasek and others, JPM_WM04026075, Hearing Exhibit 4/13-23b.

329 April 13, 2010 Subcommittee Hearing at 28.

330 11/18/2005 email from Cheryl Feltgen to Nancy Gonseth on the Risk Mitigation Team and Tim Bates,

JPM_WM03535695, Hearing Exhibit 4/13-23a.

331 Id.

332 At the Subcommittee’s hearing, Mr. Vanasek testified that as much as $1 billion in loans originated out of these

two offices per year. April 13, 2010 Subcommittee Hearing at 27.

333 See, e.g., 3/2006 WaMu email chain, JPM_WM03985880-83.

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mortgages being issued by Mr. Fragoso, the loan officer heading the Montebello office.334 When

no one responded to its concerns, in September 2007, AIG filed a Suspected Fraud Claim with

the California Department of Insurance which, in turn, notified OTS of the problem.335 The OTS

Examiner-in-Charge at WaMu at the time, Benjamin Franklin, asked the bank to conduct an

investigation into the matter.336 WaMu’s legal department asked the WaMu Corporate Fraud

Investigation (CFI) group and the Audit department to conduct a joint inquiry.

Seven months later, in April 2008, CFI and the Audit department issued a 12-page

memorandum with their findings.337 The memorandum not only confirmed the presence of fraud

in the Montebello office, citing a loan file review that found a fraud rate of 62%, it also

uncovered the 2005 investigation that had identified the problem two years earlier, but was

ignored by management. The 2008 memorandum stated:

“In 2005, HL [Home Loans] Risk Mitigation provided Senior HL Management with an

assessment of fraud and loan performance in the Retail Broker Program and two

Southern California Emerging Markets [loan centers] for the period of September 2003

through August 2005. This assessment identified excessive levels of fraud related to loan

qualifying data …. It also highlighted the Downey and Montebello [loan centers] as the

primary contributors of these fraudulent loan documents based upon volume and

articulated strategies to mitigate fraud. The report also stated that delinquency

performance on these [loan centers] … were significantly worse that the delinquency

performance for the entire open/active retail channel book of business. In 2007, HL Risk

Mitigation mirrored their 2005 review with a smaller sample of loans and found that, for

the September and October 2007 sampled time period, the volume of misrepresentation

and suspected loan fraud continued to be high for this [loan center] (62% of the sampled

loans).”338

Examples of fraudulent loan information uncovered in the 2007 review included falsified income

documents, unreasonable income for the stated profession, false residency claims, inflated

appraisal values, failure of the loan to meet bank guidelines, suspect social security numbers,

misrepresented assets, and falsified credit information.339

The memorandum found that, in 2005, the WaMu Risk Mitigation Team had reported its

findings to several WaMu managers whom it “felt were very aware of high volumes of fraud” in

the loans issued by the two loan officers.340

334 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name

redacted],” at 1, Hearing Exhibit 4/13-24.

The memorandum reported that one individual

believed that David Schneider “was made aware of these findings” and wanted Risk Mitigation

335 Id.

336 Subcommittee interview of Benjamin Franklin (2/18/2010).

337 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name

redacted],” at 1, Hearing Exhibit 4/13-24.

338 Id. at 2.

339 Id. at 3.

340 Id. at 7.

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to “monitor the situation.”341 But no one knew “of additional monitoring that was done, or

efforts to bring additional attention to” the fraudulent loans from the Downey and Montebello

offices. The memorandum also noted that no personnel action had been taken against either of

the loan officers heading the two offices.342 David Schneider was interviewed and “recalled

little about the 2005 fraud findings or actions taken to address them.”343 He “thought the matter

was handled or resolved.” The WaMu memorandum concluded:

“Outside of training sessions … in late 2005, there was little evidence that any of the

recommended strategies were followed or that recommendations were operationalized.

There were no targeted reviews conducted … on the Downey or Montebello loan

portfolios between 2005 and the actions taken in December 2007.”344

After the memorandum was issued, WaMu initially resisted providing a copy to OTS,

claiming it was protected by attorney-client privilege.345 The OTS Examiner-in-Charge

Benjamin Franklin told the Subcommittee that he insisted on seeing the memorandum. After

finally receiving it and reading about the substantial loan fraud occurring at the two loan offices

since 2005, he told the Subcommittee that it was “the last straw” that ended his confidence that

he could rely on WaMu to combat fraudulent practices within its own ranks.

The 2008 WaMu memorandum and a subsequent OTS examination memorandum346

included a number of recommendations to address the fraud problem at the Downey and

Montebello offices. The recommendations in the WaMu memorandum included actions to

“[d]etermine appropriate disciplinary actions for employees”; “[e]nhance Code of Conduct

training to stress each employee’s role as a corporate steward and the consequences for passively

facilitating the placement of loans into the origination process that could be suspect”; enhance

WaMu compensation incentives “to support loan quality”; and determine if further analysis was

required of the loans originated by the Montebello office or “the broader loan population (bank

owned and securitized)” including “if actions are needed to address put backs or sales to

investors of loans that contain misrepresentation[s] or other fraud findings.”347

By the time WaMu issued the April 2008 memorandum on the Downey and Montebello

fraud problem, however, the bank was already experiencing serious liquidity problems and was

cutting back on its loan operations and personnel. On April 30, 2008, WaMu put an end to its

wholesale loan channel which had accepted loans from third party mortgage brokers, closed 186

341 Id.

342 Id.

343 Id. at 8.

344 Id. at 9.

345 Subcommittee interview of Benjamin Franklin (2/18/2010).

346 1/7/2008 OTS Asset Quality Memo 22, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13-

25.

347 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name

redacted],” at 4, Hearing Exhibit 4/13-24.

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stand-alone loan centers, and reduced its workforce by 3,000.348 The Downey and Montebello

offices were closed as part of that larger effort. The two loan officers heading those offices left

the bank and found other jobs in the mortgage industry that involve making loans to borrowers.

Other Fraud Problems. The loan fraud problems at the Downey and Montebello offices

were not the only fraud problems plaguing WaMu. The Subcommittee uncovered three

additional examples that demonstrate the problem was not isolated.

The first example involves the Westlake Village loan office outside of Los Angeles. On

April 1, 2008, WaMu’s Risk Mitigation Team sent 13 home loans with early payment defaults to

the WaMu Corporate Fraud Investigations (CFI) group for further examination.349 All 13, whose

unpaid loan balances totaled about $14.3 million, had been issued in 2007, by the Westlake

Village loan office which was one of WaMu’s top loan producers. Two loan officers, Chris

O’Brien and Brian Minkow, who worked in tandem, had won multiple awards for their loan

production and had a team of 14 sales associates assisting them.350 CFI reviewed the referred

loans which contained a variety of fraud indicators, including “fabricated asset statements,

altered statements, income misrepresentation and one altered statement that is believed to have

been used in two separate loans.”351 CFI then interviewed the loan officers, sales associates, and

personnel at the WaMu “loan fulfillment center” (LFC) that processed Westlake Village loan

applications.

In one egregious example of document “manufacturing,” a sales associate confessed that

if “it was too late to call the borrower,” the “sales associates would take [bank] statements from

other [loan] files and cut and paste the current borrower’s name and address” onto the old bank

statements.352 The same sales associate “admitted that during that crunch time some of the

Associates would ‘manufacture’ asset statements from previous loan docs,” because end-ofmonth

loans would often get funded without full documentation. The pressure to get the

necessary documentation was “tremendous” and they had been told to get the loans funded “with

whatever it took.”353

The LFC loan processor in charge of handling Westlake Village’s loan applications was

fired, as was the sales associate who confessed to manufacturing false documents. The rest of

the employees were also let go, when the office itself was closed on April 30, 2008, in

348 Subcommittee interview of Brian Minkow (2/16/2010); 5/27/2008 “Internal Investigative Report” on Westlake

Home Loan Center, JPM_WM03171384, Hearing Exhibit 4/13-31. See also “Washington Mutual Exits Wholesale

Lending Business, Will Close Home-Loan Centers,” Mercury News, 4/7/2008,

http://blogs.mercurynews.com/realestate/2008/04/07/washington-mutual-exits-wholesale-lending-business-willclose-

home-loan-centers.

349 5/12/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452386, Hearing Exhibit 4/13-30.

350 Subcommittee interview of Brian Minkow (2/16/2010). See also 2005 “President’s Club 2005 - Maui, Awards

Night Show Script,” Washington Mutual, Home Loans Group, Hearing Exhibit 4/13-63a (stating Mr. O’Brien and

Mr. Minkow had produced $1.2 billion in loans in 2005).

351 Id.

352 5/27/2008 “Internal Investigative Report” on Westlake Home Loan Center, JPM_WM03171384, Hearing Exhibit

4/13-31.

353 5/12/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452386, Hearing Exhibit 4/13-30.

102

connection with WaMu’s reorganization and downsizing. One of the loan officers who headed

the office told the Subcommittee, however, that he had been offered another job within the bank,

but declined it due to lower compensation.354 He went on to work in the mortgage industry

arranging residential loans.

The second example involves 25 Home Equity Lines of Credit (HELOCs) totaling $8.5

million that were originated in 2008 by a WaMu loan officer at the Sunnyvale loan office in

California. Before all of the loans were funded, they were referred to the Risk Mitigation Team

because of fraud indicators. On May 1, 2008, the loan files were sent on to the CFI group for

further inquiry. An internal document summarizing the CFI investigation stated:

“The review found that the borrowers indicated they owned the property free and clear

when in fact existing liens were noted on the properties. The properties are located in

California, Arizona and Washington. … WaMu used … Abbreviated Title reports [that]

… do not provide existing lien information on the subject property.”355

Of the 25 loan applications, 22 were ultimately terminated or declined. The employee involved

in originating the loans was terminated as part of the April 30, 2008 reorganization.

The third example involves a review of 2006 and 2007 WaMu loans conducted by Radian

Guaranty Inc., a company which provided mortgage insurance for those loans.356 Radian’s

objectives were to test WaMu’s “compliance with Radian’s underwriting guidelines and eligible

loan criteria,” assess the quality of WaMu’s underwriting decisions, “rate the risk of the

individual loans insured,” and identify any errors in the loan data transmitted to Radian.357 The

review looked at a random selection of 133 loans and found enough problems to give WaMu an

overall rating of “unacceptable.”358

The Radian review identified a number of problems in the loan files it deemed ineligible

for insurance. In one, WaMu issued a $484,500 loan to a “Sign Designer” who claimed to be

making $34,000 in income every month.359

354 Subcommittee interview of Brian Minkow (2/16/2010).

The Radian review observed: “Borrower’s stated

monthly income of $34,000 does not appear reasonable for a ‘Sign Designer.’” The review also

noted several high risk elements in the loan, which was an 85% LTV loan given to a borrower

with a 689 credit score who used the loan to refinance an existing loan and “cash-out” the equity

in the house. The review noted that the borrower received $203,000 at the loan closing. In

addition, the review stated that WaMu had appraised the house at $575,000, but an automated

appraisal verification program assigned the house a probable value of only $321,000, less than

the amount of the loan.

355 5/15/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452389, Hearing Exhibit 4/13-32b.

356 2/7/2008 Radian Guaranty Inc. review of Washington Mutual Bank loans, JPM_WM02057526, Hearing Exhibit

4/13-33.

357 Id. at 1.

358 Id.

359 Id. at 5.

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Extent of Fraud. At the Subcommittee hearing, when asked about these matters, Mr.

Vanasek, WaMu’s Chief Risk Officer from 2004 to 2005, attributed the loan fraud to

compensation incentives that rewarded loan personnel and mortgage brokers according to the

volume of loans they processed rather than the quality of the loans they produced:

“Because of the compensation systems rewarding volume versus quality and the

independent structure of the originators, I am confident at times borrowers were coached

to fill out applications with overstated incomes or net worth to meet the minimum

underwriting requirements. Catching this kind of fraud was difficult at best and required

the support of line management. Not surprisingly, loan originators constantly threatened

to quit and to go to Countrywide or elsewhere if the loan applications were not

approved.”360

When asked by Senator Coburn if he thought the type of fraud at the Downey and Montebello

loan offices extended beyond those two offices, Mr. Vanasek replied: “Yes, Senator.”361

Another sobering internal WaMu report, issued in September 2008, a few weeks before

the bank’s failure, found that loans marked as containing fraudulent information had nevertheless

been securitized and sold to investors. The report blamed ineffective controls that had “existed

for some time”:

“The controls that are intended to prevent the sale of loans that have been confirmed by

Risk Mitigation to contain misrepresentations or fraud are not currently effective. There

is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or

confirmed to contain suspicious activity from being sold to an investor. ... Of the 25

loans tested, 11 reflected a sale date after the completion of the investigation which

confirmed fraud. There is evidence that this control weakness has existed for some

time.”362

Loans not meeting the bank’s credit standards, deliberate risk layering, sales associates

manufacturing documents, offices issuing loans in which 58%, 62%, or 83% contained evidence

of loan fraud, and selling fraudulent loans to investors are evidence of deep seated problems that

existed within WaMu’s lending practices. Equally disturbing is evidence that when WaMu

senior managers were confronted with evidence of substantial loan fraud, they failed to take

corrective action. WaMu’s failure to strengthen its lending practices, even when problems were

identified, is emblematic of how lenders and mortgage brokers produced billions of dollars in

high risk, poor quality home loans that contributed to the financial crisis.

360 April 13, 2010 Subcommittee Hearing at 17.

361 Id. at 30.

362 9/8/2008 “WaMu Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” JPM_WM00312502, Hearing

Exhibit 4/13-34.

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(d) Steering Borrowers to High Risk Option ARMs

In addition to subprime loans, Washington Mutual made a variety of high risk loans to

“prime” borrowers, including its flagship product, the Option Adjustable Rate Mortgage (Option

ARM). Washington Mutual’s Option ARMs typically offered borrowers an initial teaser rate,

sometimes as low as 1% for the first month, which later adjusted to a much higher floating

interest rate linked to an index, but gave borrowers the choice each month of paying a higher or

lower amount. These loans were called “Option” ARMs, because borrowers were typically

given four options: (1) paying the fully amortizing amount needed to pay off the loan in 30

years; (2) paying an even higher amount to pay off the loan in 15 years; (3) paying only the

interest owed that month and no principal; or (4) making a “minimum payment” that covered

only a portion of the interest owed and none of the principal.363 If the borrower selected the

minimum payment option, unpaid interest would be added to the loan principal. If the borrower

repeatedly selected the minimum payment, the loan principal would increase rather than decrease

over time, creating a negatively amortizing loan.

Negative amortization created additional credit risk for WaMu and posed a challenge to

risk managers. At the April 13 Subcommittee hearing, Mr. Vanasek testified:

“We had concerns from the standpoint of negative amortization that was accumulating

and we had been reassured that in the past, borrowers would negatively amortize during

difficult times and then make up for the lost payments in good times. But the percentage

and the potential percentage for negative amortization was very large, and, of course the

attendant payment shock was also very large, which was a concern to credit.”364

Few executives at WaMu shared Mr. Vansek’s concern about the Option ARM. To the extent

that risk managers expressed concern, it was outweighed by the product’s favorable gain-onsale

margin.

As part of its High Risk Lending Strategy, WaMu determined to increase its issuance of

its Option ARM loans. To do that, WaMu had to convince customers to forego a simple, low

risk conventional loan in favor of the complex and higher risk Option ARM. In late 2003,

WaMu conducted two focus group studies to “explore ways to increase sales of Option ARMs,

Washington Mutual’s most profitable mortgage loan products.”365 The first focus group

examined the views of WaMu loan consultants and third party mortgage brokers. The second

focus group examined the views of WaMu Option ARM customers.

The report following the first focus group with WaMu loan consultants and mortgage

brokers identified a number of impediments to selling Option ARMs. It noted that Option ARM

363 See 8/2006 “Option ARM Credit Risk,” WaMu presentation, at 3, Hearing Exhibit 4/13-37; 10/17/2006 “Option

ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing Exhibit 4/13-38.

364 April 13, 2010 Subcommittee Hearing at 49.

365 9/17/2003 “Option ARM Focus Groups – Phase II, WaMu Option ARM Customers,” WaMu research report, at

3, Hearing Exhibit 4/13-35.

105

loans had to be “sold” to customers asking for a 30-year fixed loan, and training was needed to

overcome the feeling of “many” WaMu loan consultants that Option ARMs were “bad” for their

customers. The report also recommended increasing commissions so salespersons would take

the “hour” needed to sell an Option ARM, and increasing loan processing times so salespersons

and brokers were not inconvenienced. The report stated in part:

“Option ARMs are sold to customers and few walk through the door and ask for them. ...

If salespeople don’t understand Option ARMs, they won’t sell them. Many felt that more

training would be needed to better educate salespeople about this type of loan, and to

change the mindset of current Loan Consultants. Some felt there were many within

Washington Mutual who simply felt these loans were ‘bad’ for customers, probably from

a lack of understanding the product and how it could benefit customers. ...

It is critical that salespeople fully understand a customer’s financial situation and

motivation for the loan. By taking into account these factors, they can recommend the

loan that will best fit their customers’ needs. Given today’s low interest rate

environment, it can be challenging to get salespeople to take the time to do this.

Currently it is easier to give customers what they ask for (a 30 year fixed loan) than to

sell them an Option ARM. They can take 20 minutes and sell a 30 fixed-rate loan, or

spend an hour trying to sell an Option ARM.

Commission caps make it unappealing for Mortgage Brokers to sell Washington Mutual

Option ARMs. Most would not sell loans to customers with prepayment penalties, and

given the low commission rate for selling them without the prepayment penalty, many

simply go to another company or product where they can make more money.

Slow ARM processing times (up to 90 days) can cause Mortgage Brokers to take

business elsewhere. …

Improving collateral would help salespeople better explain Option ARMs to customers

and take away some of the mystery. … They also would like improved brochures which

talk to the customer in simple, easy to understand terms about features and benefits.

They liked the current sample statements they are provided.”366

The second focus group with existing Option ARM customers showed they were also

unenthusiastic about the product. The focus group report stated:

“In general, people do not seem to have a good understanding of their mortgage and its

terms. What understanding they do have is framed by the concept of a 30-year fixed

mortgage. Option ARMs are very complicated and need to be explained in simple, easy

366 8/14/2003 “Option ARM Focus Groups – Phase I, WaMu Loan Consultants and Mortgage Brokers,” WaMu

research report, at 2, Hearing Exhibit 4/13-36 [emphasis in original].

106

to understand terms, prospective borrowers need to be educated about the loan – this is

not a product that sells itself.”367

The focus group identified several reasons that borrowers were leery of Option ARMs

and suggested ways to address the unease: “Helping prospective borrowers understand payment

and interest rate caps may mitigate fears of wild monthly payment swings .… Similarly, fears

about negative amortization, a concept also not very well understood by the participants, could

be reduced or eliminated by showing how much residential properties in the local market have

appreciated over time.”368

The main findings of the focus group included:

“Few participants fully understood the Option ARM and its key benefits. A number of

them were not familiar with the payment options or how they could be used. …

Additionally, most did not understand how their interest rate was derived, how often their

payments would change, and what, if any, were the interest and/or payment caps.

Perhaps the best selling point for the Option ARM loan was being shown how much

lower their monthly payment would be by choosing an Option ARM versus a fixed-rate

loan.

Many participants did not know what happened to their loan at the end of the fixed

interest rate period. Most of them assumed they would have to sell or refinance because

of a potential balloon payment or a steep jump in their payments. Because of these

misperceptions, most participants expect to refinance their loans within the next three to

five years.”369

To increase Option ARM sales, WaMu increased the compensation paid to its loan

personnel and outside mortgage brokers for the loans.370 The bank also qualified borrowers for

Option ARMs by using a monthly payment amount that was less than what the borrower would

likely pay once the loan recast.371

The Option ARM was also frequently featured in sales promotion efforts communicated

to loan officers through WaMu’s internal alert email system known as, “e-Flash.” For example,

a June 5, 2006 e-Flash from Steve Stein, the Director of Retail Lending in the Home Loans

division, to the entire retail sales team announced:

367 9/17/2003 “Option ARM Focus Groups – Phase II, WaMu Option ARM Customers,” WaMu research report, at

4, Hearing Exhibit 4/13-35.

368 Id.

369 Id. at 5 [emphasis in original].

370 Subcommittee interview of David Schneider (2/17/2010).

371 See April 13, 2010 Subcommittee Hearing at 50.

107

“We are beginning to focus on higher-margin products like our flagship product, the

Option ARM. This is a fantastic product for almost any borrower. To help our sales

force feel more comfortable with selling the Option ARM to a wide variety of borrowers,

we are rolling out a comprehensive skills assessment and training initiative. ... This

initiative is not about selling the Option ARM to everyone. We will always stay true to

our values and provide the right loan for every customer. … Through the skills

assessment, training, role playing and a best-practices selling tips video, I think this retail

sales team will be unstoppable with the Option ARM. … The Option ARM is our

product and we can sell it better than anyone. I have great confidence that we’ll improve

our Option ARM market share quickly, like the experts that we are.”372

One month later, Mr. Stein announced increased compensation incentives for selling

Option ARMs. In another e-Flash to the entire retail sales team, Mr. Stein wrote:

“You’ve seen and heard a lot recently about our refined business model and focus on

higher margin products, especially Option ARMs. To further drive this focus, I’m

pleased to announce the 2006 Option ARM Blitz – Quarterly Incentive Campaign. This

will allow eligible Loan Consultants to earn 5 additional basis points on all Option ARM

volume funded during the 3rd quarter 2006.”373

Under the rules of the Option ARM Blitz, loan consultants who increased the percentage of

Option ARMs they sold by at least 10% would receive an additional bonus. In August 2006, an

e-Flash announced that the underwriting guidelines for Option ARMs had been loosened,

allowing higher loan amounts for “condos and co-ops” and greater loan-to-value ratios for “lowdoc”

second home mortgages.374 Also in August, an e-Flash announced that the “Option ARM

Sales Mastery Program” that was launched in June, would now become part of the mandatory

loan originator training curricula.375

In September 2006, WaMu introduced pricing incentives for Option ARMs in the

consumer direct channel which waived all closing costs for Option ARMs except for an appraisal

deposit.376 In the fourth quarter of 2006, the consumer direct channel also held a contest called

the “Fall Kickoff Contest.” For each of the 13 weeks in the quarter, the loan consultant who

scored the most points would receive a $100 gift card. An Option ARM sale was a “touchdown”

and worth seven points; jumbo-fixed, equity, and nonprime mortgages were only “field goals”

worth three points. At the end of the quarter the top five point winners were awarded with a

$1,000 gift card.377

372 6/5/2006 “e-Flash” from Steve Stein to Retail Production Sales, JPM_WM03246053.

In addition, from November 2006 through January 2007, e-Flashes sent to

373 7/3/2006 “e-Flash” from Steve Stein to Retail Production Sales, JPM_WM04471136-37.

374 8/17/2006 “e-Flash” from Steve Stein, Arlene Hyde, and John Schleck to Production and Operations,

JPM_WM03277786-87.

375 8/18/2006 “e-Flash” from Allen Myers to Retail Production Sales Managers, JPM_WM03277758.

376 8/31/2006 “e-Flash” from Mary Ann Kovach to Consumer Direct, JPM_WM03077747.

377 10/12/2006 “e-Flash” from Mary Ann Kovach to Consumer Direct, JPM_WM03627448-49.

108

consumer direct originators promoted Option ARM sales specials offering $1,000 off closing

costs for loans under $300,000 and a waiver of all fees for loans greater than $300,000.378

Judging by sales of Option ARMs in 2004, after the completion of the focus groups,

WaMu’s strategy to push sales of Option ARM loans was successful. In 2003, WaMu originated

$30.1 billion in Option ARMs; in 2004 WaMu more than doubled its Option ARM originations

to $67.5 billion. Although sales of Option ARMs declined thereafter because of challenges in

the market, in 2006, WaMu still originated $42.6 billion in Option ARMs. According to its

internal documents, by 2006, Washington Mutual was the second largest Option ARM originator

in the country.379

As WaMu’s Option ARM portfolio grew, and as the wider economy worsened, the

prevalence of negative amortization in the Option ARMs increased. While WaMu risk managers

viewed negative amortization as a liability, WaMu accountants, following generally accepted

accounting practices, treated negative amortization as an asset. In 2003, WaMu recognized $7

million in earnings from deferred interest due to negative amortization.380 By 2006, capitalized

interest recognized in earnings that resulted from negative amortization surpassed $1 billion; by

2007 it exceeded $1.4 billion.381 In other words, as WaMu customers stopped paying down their

mortgages, WaMu booked billions of dollars in earnings from the increasing unpaid balances.

By another measure, in 2003, $959 million in Option ARM loans that WaMu held in its

investment portfolio experienced negative amortization; in 2007, the figure was more than $48

billion.382

According to data compiled by the Treasury and the FDIC Inspectors General, in 2005,

WaMu borrowers selected the minimum monthly payment option for 56% of the value of the

Option ARM loans in its investment portfolio. By the end of 2007, 84% of the total value of the

Option ARMs in WaMu’s investment portfolio was negatively amortizing.383 To avoid having

their loans recast at a higher interest rate, Option ARM borrowers typically refinanced the

outstanding loan balance. Some borrowers chose to refinance every year or two.384 The

Treasury and the FDIC IG report determined that a significant portion of Washington Mutual’s

Option ARM business consisted of refinancing existing loans.385

One WaMu loan officer, Brian Minkow, told the Subcommittee that he expected the vast

majority of Option ARMs borrowers to sell or refinance their homes before their payments

increased.386

378 See, e.g., 11/13/2006 “e-Flash” from Mary Ann Kovack to Consumer Direct, JPM_WM03077089-90.

As long as home prices were appreciating, most borrowers were able to refinance if

379 2007 “Home Loans Product Strategy,” WaMu presentation at JPM_WM03097203, Hearing Exhibit 4/13-60a

(only Countrywide ranked higher).

380 2005 Washington Mutual Inc. 10-K filing with the SEC at 27.

381 Id.

382 Id. at 55; 3/2007 Washington Mutual Inc. 10-K filing with the SEC at 57.

383 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82.

384 Subcommittee interview of Brian Minkow (2/16/2010).

385 4/2010 IG Report, Hearing Exhibit 4/16-82.

386 Subcommittee interview of Brian Minkow (2/16/2010).

109

they chose to. According to Mr. Minkow, who was one of WaMu’s top loan consultants and in

some years originated more than $1 billion in loans, 80% of his business was in Option ARMs,

and 70% of his business consisted of refinances.387 Once housing prices stopped rising,

however, refinancing became difficult. At recast, many people found themselves in homes they

could not afford, and began defaulting in record numbers.

WaMu was one of the largest originators of Option ARMs in the country. In 2006 alone,

WaMu securitized or sold $115 billion in Option ARMs.388 Like Long Beach securitizations,

WaMu Option ARM securitizations performed badly starting in 2006, with loan delinquency

rates between 30 and 50%, and rising.389

(e) Marginalization of WaMu Risk Managers

WaMu knowingly implemented a High Risk Lending Strategy, but failed to establish a

corresponding system for risk management. Instead, it marginalized risk managers who warned

about and attempted to limit the risk associated with the high risk strategy.

At the time it formally adopted its High Risk Lending Strategy, WaMu executives

acknowledged the importance of managing the risks it created. For example, the January 2005

“Higher Risk Lending Strategy ‘Asset Allocation Initiative’” presentation to the Board of

Directors Finance Committee stated in its overview:

“In order to generate more sustainable, consistent, higher margins within Washington

Mutual, the 2005 Strategic Plan calls for a shift in our mix of business, increasing our

Credit Risk tolerance while continuing to mitigate our Market and Operational Risk

positions.

“The Corporate Credit Risk Management Department has been tasked, in conjunction

with the Business Units, to develop a framework for the execution of this strategy. Our

numerous activities include:

-Selecting best available credit loss models

-Developing analytical framework foundation

-Identifying key strategy components per Regulatory Guidance documents

“A strong governance process will be important as peak loss rates associated with this

higher risk lending strategy will occur with a several year lag and the correlation between

high risk loan products is important. For these reasons, the Credit Department will pro-

387 Id.

388 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing

Exhibit 4/13-38, chart at 2.

389 See wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and

WaMu mortgage backed securities showing, as of January 2011, delinquency rates for particular mortgage backed

securities, including WMALT 2006 OA-3 – 57.87% and WAMU 2007-OA4 – 48.43%).

110

actively review and manage the implementation of the Strategic Plan and provide

quarterly feedback and recommendations to the Executive Committee and timely

reporting to the Board.”390

The robust risk management system contemplated by in the January 2005 memorandum,

which was critical to the success of the High Risk Lending Strategy, was never meaningfully

implemented. To the contrary, risk managers were marginalized, undermined, and often ignored.

As former Chief Risk Manager Jim Vanasek testified at the April 13 Subcommittee hearing:

“I made repeated efforts to cap the percentage of high-risk and subprime loans in the

portfolio. Similarly, I put a moratorium on non-owner-occupied loans when the

percentage of these assets grew excessively due to speculation in the housing market. I

attempted to limit the number of stated income loans, loans made without verification of

income. But without solid executive management support, it was questionable how

effective any of these efforts proved to be.”391

Later in the hearing, Mr. Vanasek had the following exchange with Senator Coburn:

Senator Coburn: Did you ever step in and try to get people to take a more conservative

approach at WaMu?

Mr. Vanasek: Constantly.

Senator Coburn: Were you listened to?

Mr. Vanasek: Very seldom.

Senator Coburn: [Had] you ever felt that your opinions were unwelcomed, and could you

be specific?

Mr. Vanasek: Yes. I used to use a phrase. It was a bit of humor or attempted humor. I

used to say the world was a very dark and ugly place in reference to subprime loans. I

cautioned about subprime loans consistently.392

Mr. Vanasek’s description of his efforts is supported by contemporaneous internal

documents. In a February 24, 2005 memorandum to the Executive Committee with the subject

heading, “Critical Pending Decisions,” for example, Mr. Vanasek cautioned against expanding

WaMu’s “risk appetite”:

390 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” Washington Mutual Board of Directors

Finance Committee Discussion, JPM_WM00302975, Hearing Exhibit 4/13-2a [emphasis in original].

391 April 13, 2010 Subcommittee Hearing at 17.

392 Id. at 32.

111

“My credit team and I fear that we are considering expanding our risk appetite at exactly

the wrong point and potentially walking straight into a regulatory challenge and criticism

from both the Street and the Board. Said another way I fear that the timing of further

expansion into higher risk lending beyond what was contemplated in the ’05 Plan and

most especially certain new products being considered is ill-timed given the overheated

market and the risk [of] higher interest rates ….

So we come down to the basic question, is this the time to expand beyond the ’05 Plan

and/or to expand into new categories of higher risk assets? For my part I think not. We

still need to complete EDE [Enterprise Decision Engine, an automated underwriting

system], reduce policy exception levels, improve the pricing models, build our sub-prime

collection capability, improve our modeling etc. We need to listen to our instincts about

the overheated housing market and the likely outcome in our primary markets. We need

to build further credibility with the regulators about the control exercised over our SFR

underwriting and sub-prime underwriting particularly in LBMC.”393

Mr. Vanasek retired in December 2005, in part, because the management support for his

risk policies and culture was lacking.394 When Mr. Vanasek left WaMu, the company lost one of

the few senior officers urging caution regarding the high risk lending that came to dominate the

bank. After his departure, many of his risk management policies were ignored or discarded. For

example, by the end of 2007, stated income loans represented 73% of WaMu’s Option ARMs,

50% of its subprime loans, and 90% of its home equity loans.395

Ronald Cathcart was hired in December 2005 to replace Mr. Vanasek, and became the

Chief Enterprise Risk Officer. He had most recently been the Chief Risk Officer for Canadian

Imperial Bank of Commerce’s retail bank.396 Although the High Risk Lending Strategy was

well underway, after Mr. Vanasek’s departure, risk management was in turmoil. Mr. Cathcart

testified at the Subcommittee hearing: “When I arrived at WaMu, I inherited a Risk Department

that was isolated from the rest of the bank and was struggling to be effective at a time when the

mortgage industry was experiencing unprecedented demand for residential mortgage assets.” In

early 2006, the bank reorganized WaMu’s risk management.397 Under the new system, much of

the risk management was subordinated to the WaMu business divisions, with each business

division’s Chief Risk Officer reporting to two bosses, Mr. Cathcart and the head of the business

unit to which the division’s Chief Risk Officer was assigned. WaMu referred to this system of

reporting as a “Double-Double.”398

393 2/24/2005 Washington Mutual memorandum from Jim Vanasek to the Executive Committee, “Critical Pending

Decisions,” JPM_WM01265462-64.

394 Subcommittee interview of Jim Vanasek (12/18/2009 and 1/19/2010).

395 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82.

396 Subcommittee interview of Ronald Cathcart (2/23/2010).

397 Id.

398 Id.; Subcommittee interviews of David Schneider (2/17/2010) and Cheryl Feltgen (2/6/2010).

112

Cheryl Feltgen, for example, was the Chief Risk Officer for the Home Loans division.

She reported both to Mr. Cathcart and to Mr. Schneider, the Home Loans President, setting up a

tension between the two.399 Mr. Schneider had hired Ms. Feltgen from Citi Mortgage, where she

had been the Chief Marketing Officer, not a risk manager. Mr. Cathcart told the Subcommittee

that he would not have hired her for the role, because of her lack of risk management

experience.400

Ms. Feltgen told the Subcommittee that, although she was the Home Loans Chief Risk

Officer, she also had responsibility to meet business goals. She indicated that she did not see her

role as one of risk minimization, but rather of risk optimization.401 Her 2007 performance

evaluation reflected her dual responsibilities, but clearly subordinated her risk management

duties to the achievement of business growth objectives. For example, the evaluation identified a

series of goals and assigned each a percentage weighting to determine their precedence. Instead

of assigning priority to her performance in the area of managing risk, Ms. Feltgen’s number one

performance goal for 2007 was “GROWTH” in home loans, given a weighting of 35%, followed

by “RISK MANAGEMENT,” given a weighting of only 25%.402 Her performance review even

listed specific sales targets:

“Employee Goals

GROWTH 35%

1. Achieve Net Income - $340 MM for 2007

2. HL [Home Loan] Product Sales (Incl. Conduit)

1. Home Equity - $18B

2. Subprime - $32B

3. Option ARM - $33B

4. Alt A - $10B

3. Customer Satisfaction (Total HL) – 55%”403

By conditioning her evaluation on whether her division hit pre-determined sales figures, the

performance evaluation made her compensation more dependent upon the Home Loans division

hitting revenue growth and product sales than upon her contributions to risk management.

Further complicating matters were Ms. Feltgen’s two supervisors. In an interview, Ms.

Feltgen stated that Ron Cathcart, her supervisor on risk matters, was “not well respected” and

did not have “a strong voice.” 404

399 See April 13, 2010 Subcommittee Hearing at 34; Subcommittee interviews of Mr. Cathcart (2/23/2010), Mr.

Schneider (2/17/2010), and Ms. Feltgen (2/6/2010).

On the other hand, she described David Schneider, her

400 Subcommittee interview of Ronald Cathcart (2/23/2010).

401 Subcommittee interview of Cheryl Feltgen (2/6/2010).

402 “Performance Review Form: Leadership,” Hearing Exhibit 4/13-64 (the form is not dated, but Ms. Feltgen

confirmed that it is the 2007 review).

403 Id.

404 Subcommittee interview of Cheryl Feltgen (2/6/2010).

113

supervisor on loan origination matters, as having a strong voice and acting more as her boss.

This arrangement again de-emphasized the importance of her risk duties.

Ms. Feltgen’s dedication to the growth of the Home Loans business is apparent in her

communications with her staff. For example, on December 26, 2006, she sent a year-end email

to her staff. Under the subject line, “Year-End 2006 Message for the Home Loans Risk

Management Team,” Ms. Feltgen wrote:

“As we approach the close of 2006, it is fitting to reflect on the challenges and

accomplishments of this past year and to look forward to 2007 and beyond. Earlier this

year David Schneider and the leadership team of Home Loans articulated a new business

strategy that included: (1) a shift to higher margin products (Alt-A, subprime and home

equity); (2) reducing market risk … and taking on more credit risk and (3) aggressively

attacking the cost structure. We have made great strides as a business on all of those

fronts and you have all been a part of those accomplishments. You have partnered

successfully with the business units of Home Loans in pursuit of our collective goal to

drive profitable growth with the right balance of risk and return.”405

The email continued with a list of “accomplishments of the Home Loans Risk

Management Team in support of business goals,” that included the following accomplishment:

“Our appetite for credit risk was invigorated with the expansion of credit guidelines for various

product segments including the 620 to 680 FICO, low docs and also for home equity.”406 The

email continued with Ms. Feltgen stating her commitment to the High Risk Lending Strategy and

emphasizing revenue and sales despite an acknowledgement of the worsening condition of the

mortgage market:

“The year 2007 will be another challenging year for the mortgage industry with mortgage

origination volumes down, the inverted yield curve putting pressure on profitability and

gain on sale margins at lower level than prior years. The focus on the three key elements

of our 2006 strategy remains important: shift to higher margin products, reduce market

risk and increase credit risk and attack the cost structure. … In 2007, we must find new

ways to grow our revenue. Home Loans Risk Management has an important role to play

in that effort.

David Schneider has encouraged us to ‘BE BOLD’…. Recognize that ‘we are all in

sales’ passionately focused on delivering great products and service to our customers.”407

Ms. Feltgen’s year-end bonus was based upon her performance review.408

405 1/3/2007 email from Cheryl Feltgen, “Year-End 2006 Message for the Home Loans Risk Management Team,”

Hearing Exhibit 4/13-73.

According to

Mr. Cathcart, in 2007, the bank made bonus distributions more dependent on the performance of

406 Id.

407 Id.

408 Subcommittee Interview of Ronald Cathcart (2/23/2010).

114

each business line, rather than the performance of the bank as a whole, which largely removed

his control over compensation of his risk managers. Mr. Cathcart told the Subcommittee that he

disagreed with this change because it made his risk managers, who reported to him and to the

heads of the business units, more beholden to the business heads. Mr. Cathcart said he

approached the head of Human Resources, and strongly objected to the change, but was told to

take it up with Mr. Killinger. Mr. Cathcart told the Subcommittee that he voiced his objection to

Mr. Killinger, but Mr. Killinger told him to talk to Mr. Rotella. He said that he took his

objection to Mr. Rotella, but was unsuccessful at preventing the policy change.

Mr. Cathcart told the Subcommittee that this change created further separation between

him and his risk managers, and compromised the independence of risk management.409 He

testified at the Subcommittee hearing:

Mr. Cathcart: The chairman adopted a policy of what he called double reporting, and in

the case of the Chief Risk Officers, although it was my preference to have them reporting

directly to me, I shared that reporting relationship with the heads of the businesses so that

clearly any of the Chief Risk Officers reporting to me had a direct line to management

apart from me.

Senator Coburn: And was that a negative or a positive in terms to the ultimate outcome

in your view?

Mr. Cathcart: It depended very much on the business unit and on the individual who was

put in that double situation. I would say that in the case of home loans, it was not

satisfactory because the Chief Risk Officer of that business favored the reporting

relationship to the business rather than to risk.410

The subordination of risk management to sales was apparent at WaMu in many other

ways as well. Tony Meola, the head of home loans sales, reported directly to David Schneider.

He had direct access to Mr. Schneider and often pushed for more lenient lending standards.

According to Ms. Feltgen, the sales people always wanted more lenient standards and more

mortgage products, and Mr. Meola advocated for them.411

One example was the 80/20 loan, which consisted of a package of two loans issued

together, an 80% LTV first lien and a 20% LTV second lien, for a total CLTV of 100%. Ms.

Feltgen said she was nervous about the product, as a 100% CLTV was obviously very risky.

WaMu’s automatic underwriting system was not set up to accept such loans, but Mr. Meola

wanted permission to “side step” the systems issue.412

409 Id.

Mr. Schneider approved the product, and

Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk

410 April 13, 2010 Subcommittee Hearing at 34.

411 Subcommittee Interview of Cheryl Feltgen (2/6/2010).

412 See 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778.

115

product, but was priced accordingly, and that it might have been successful if housing prices had

not declined.413

When the housing market began to collapse, a time in which prudent risk management

became even more critical, Mr. Cathcart, the Chief Enterprise Risk Manager, was accorded even

less deference and authority. Mr. Cathcart testified at the April 13 Subcommittee hearing:

“Financial conditions … deteriorated further in 2007 and 2008. As head of risk, I began

to be excluded from key management decisions. By February 2008, I had been so fully

isolated that I initiated a meeting with the Director, where I advised that I was being

marginalized by senior management to the point that I was no longer able to discharge

my responsibilities as Chief Enterprise Risk Officer of WaMu. Within several weeks, I

was terminated by the Chairman.”414

During his interview with the Subcommittee Mr. Cathcart provided additional details

about his marginalization by senior management.415 He said that he initially had extensive

interaction with the WaMu Board of Directors and presented to the full Board every six months.

According to Mr. Cathcart, he attended all of the Board meetings until the end of 2007 or the

beginning of 2008, at which time he was no longer invited. Mr. Cathcart felt he was excluded

from Board meetings and calls with investment bankers because he was forthright about

WaMu’s mortgage loss rates, whereas senior management used older, more favorable numbers.

According to Mr. Cathcart, during one of the last Board meetings he attended, after a

presentation on expected mortgage losses, he interjected that the loan loss data being presented

were already out of date, and the real figures would be much worse. He also recalled speaking

up in a 2007 conference call with investment bankers to correct an overly optimistic loss figure.

According to Mr. Cathcart, he was chastised for his corrections by WaMu management and told

to leave the credit discussions to another senior manager.

Mr. Cathcart told the Subcommittee that regulators were also given out-of-date loss

projections as the situation worsened, because Mr. Killinger and Mr. Rotella wanted to prevent a

negative reaction. Mr. Cathcart said that the loss rates were increasing every week, and the

regulators were being provided with three-week old information. Mr. Cathcart told the

Subcommittee that in February or March 2008, he discovered that Mr. Killinger had provided the

Director of OTS, John Reich, with out-of-date loss rates. Mr. Cathcart said that he called a

meeting with Mr. Dochow, head of the OTS West Regional Office, and provided him with the

current numbers. Mr. Cathcart said that Mr. Killinger found out about the meeting and was

upset. In April, Mr. Killinger fired Mr. Cathcart.

413 Subcommittee Interview of Cheryl Feltgen (2/6/2010). See also 2/2006 WaMu internal email chain, “FW:

80/20,” JPM_WM03960778.

414 April 13, 2010 Subcommittee Hearing at 19.

415 Subcommittee interview of Ronald Cathcart (2/23/2010).

116

E. Polluting the Financial System

Washington Mutual, as the nation’s largest thrift, was a leading issuer of home loans.

When many of those loans began to go bad, they caused significant damage to the financial

system.

Washington Mutual originated or acquired billions of dollars of home loans through

multiple channels, including loans originated by its own loan officers, loans brought to the bank

by third party mortgage brokers, and loans purchased in bulk from other lenders or firms. Its

subprime lender, Long Beach, originated billions of dollars in home loans brought to it by third

party mortgage brokers across the country. According to a 2007 WaMu presentation, by 2006,

Washington Mutual was the second largest nonagency issuer of mortgage backed securities in

the United States, behind Countrywide.416

Washington Mutual and Long Beach sold or securitized the vast majority of their

subprime home loans. Initially, Washington Mutual kept most of its Option ARMs in its

proprietary investment portfolio, but eventually began selling or securitizing those loans as well.

With respect to other loans, such as fixed rate 30-year, Alt A, home equity, and jumbo loans,

WaMu kept a portion for its own investment portfolio, and sold the rest either to Wall Street

investors, usually after securitizing them, or to Fannie Mae or Freddie Mac.

By securitizing billions of dollars in poor quality loans, WaMu and Long Beach were

able to decrease their risk exposure while passing along risk to others in the financial system.

They polluted the financial system with mortgage backed securities which later incurred high

rates of delinquency and loss. At times, WaMu securitized loans that it had identified as likely

to go delinquent, without disclosing its analysis to investors to whom it sold the securities, and

also securitized loans tainted by fraudulent information, without notifying purchasers of the

fraud that was discovered and known to the bank.

(1) WaMu and Long Beach Securitizations

From 2000 to 2007, Washington Mutual and Long Beach securitized at least $77 billion

in subprime and home equity loans.417 WaMu also sold or securitized at least $115 billion in

Option ARM loans.418 Between 2000 and 2008, Washington Mutual sold over $500 billion in

loans to Fannie Mae and Freddie Mac, accounting for more than a quarter of every dollar in

loans WaMu originated.419

416 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13-

47c.

417 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980,

Hearing Exhibit 4/13-45.

418 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing

Exhibit 4/13-38 (see chart at 2). See also 8/2006 “Option ARM Credit Risk,” WaMu presentation, at

JPM_WM00212644, Hearing Exhibit 4/13-37 (see chart at 5).

419 See chart in section E(4), below, using loan data from Inside Mortgage Finance.

117

According to a 2007 WaMu presentation at a securities investor meeting in New York, in

2004, WaMu issued $37.2 billion in RMBS securitizations and was the sixth largest RMBS

issuer in the United States.420 In 2005, it doubled its production, issuing $73.8 billion in

securitizations, and became the third largest issuer. In 2006, it issued $72.8 billion and was the

second largest issuer, behind Countrywide.421

WaMu and Long Beach’s securitizations produced only RMBS securities. Although

WaMu considered issuing CDO securities as well, it never did so.422 From 2004 to 2006, WaMu

and Long Beach securitized dozens of pools of prime, subprime, Alt A, second lien, home

equity, and Option ARM loans.423 WaMu and Long Beach also sold “scratch and dent” pools of

nonperforming loans, including nonperforming primary mortgages, second lien, and Option

ARMs.424

At first, Washington Mutual worked with Wall Street firms to securitize its home loans,

but later built up its own securitization arm, Washington Mutual Capital Corporation (WCC),

which gradually took over the securitization of both WaMu and Long Beach loans. WCC was a

private Washington State corporation that WaMu acquired from another bank in 2001, and

renamed.425 WCC became a wholly owned subsidiary of Washington Mutual Bank. In July

2002, WaMu announced that WCC would act as an institutional broker-dealer handling RMBS

securities and would work with Wall Street investment banks to market and sell WaMu and

Long Beach RMBS securities.426

WCC was initially based in Seattle, and by 2003, had between 30 and 40 employees.427

In 2004, due to increasing securitizations, WaMu decided to move the headquarters of WCC to

Manhattan.428 In 2004, for the first time, WCC acted as the lead manager of a WaMu

securitization. That same year, WCC initiated a “conduit program” to buy Alt A and subprime

loans in bulk for securitization.429 WCC issued its first Alt A securitization in 2005, and its first

subprime securitization in 2006.430

420 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13-

47c.

It also conducted whole loan sales and credit card

421 Id. WaMu attributed its rapid rise in the issuer rankings over the three-year period to its establishment of a

Conduit Program, which began buying loans in bulk in 2004. Id.

422 See 12/15/2006 Enterprise Risk Management Committee, JPM_WM02656967. See also 10/25/2006 Asset-

Liability Management Committee Meeting Agenda, JPM_WM02406624.

423 See 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980,

Hearing Exhibits 4/13-45 and 46; 6/11/2007 chart entitled, “WaMu Capital Corp Sole/Lead Underwriter,”

JPM_WM03409861, Hearing Exhibit 4/13-47c.

424 See, e.g., undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b; 2/2007

internal WaMu email chain, JPM_WM00652762.

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

47c.

426 Id.

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

428 Id.

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

47c.

430 Id.

118

securitizations.431 At its peak, right before the collapse of the subprime securitization market,

WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago. The

majority of WCC employees were based in New York.432 WCC was headed by Tim Maimone,

WCC President, who reported to David Beck, Executive Vice President in charge of WaMu’s

Capital Markets Division. Mr. Beck reported to the President of WaMu’s Home Loans Division,

David Schneider.433

At the Subcommittee hearing on April 13, 2010, Mr. Beck explained the role of WCC in

WaMu and Long Beach securitizations as follows:

“WaMu Capital Corp. acted as an underwriter of securitization transactions generally

involving Washington Mutual Mortgage Securities Corp. or WaMu Asset Acceptance

Corp. Generally, one of the two entities would sell loans into a securitization trust in

exchange for securities backed by the loans in question, and WaMu Capital Corp. would

then underwrite the securities consistent with industry standards. As an underwriter,

WaMu Capital Corp. sold mortgage-backed securities to a wide variety of institutional

investors.434

WCC sold WaMu and Long Beach loans and RMBS securities to insurance companies, pension

funds, hedge funds, other banks, and investment banks.435 It also sold WaMu loans to Fannie

Mae and Freddie Mac. WCC personnel marketed WaMu and Long Beach loans both in the

United States and abroad.

Before WCC was able to act as a sole underwriter, WaMu and Long Beach worked with

a variety of investment banks to arrange, underwrite, and sell its RMBS securitizations, including

Bank of America, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill

Lynch, Royal Bank of Scotland, and UBS. To securitize its loans, WaMu typically assembled

and sold a pool of loans to a qualifying special-purpose entity (QSPE) that it established for that

purpose, typically a trust.436

431 Id.

The QSPE then issued RMBS securities secured by future cash

flows from the loan pool. Next, the QSPE working with WCC and usually an investment bank

sold the RMBS securities to investors, and used the sale proceeds to repay WaMu for the cost

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

433 Id.

434 April 13, 2010 Subcommittee Hearing at 53. Washington Mutual Mortgage Securities Corp. (WMMSC) and

WaMu Asset Acceptance Corp. (WAAC) served as warehouse entities that held WaMu loans intended for later

securitization. Mr. Beck explained in his prepared statement: “WMMSC and WAAC purchased loans from WaMu,

and from other mortgage originators, and held the loans until they were sold into the secondary market. WCC was a

registered broker-dealer and acted as an underwriter of securitization deals for a period of time beginning in 2004

and ending in the middle of 2007. In addition to buying and selling mortgage loans, WMMSC acted as a ‘master

servicer’ of securitizations. The master servicer collects and aggregates the payments made on loans in a securitized

pool and forwards those payments to the Trustee who, in turn, distributes those payments to the holders of the

securities backed by that loan pool.” Id. at 163.

435 See 6/11/2007 chart entitled, “Origination Through Distribution,” JPM_WM03409859, Hearing Exhibit 4/13-

47c; Subcommittee interview of David Beck (3/2/2010).

436 See 3/2007 Washington Mutual Inc. 10-K filing with the SEC, at 45 (describing securitization process).

119

of the loan pool. Washington Mutual Inc. generally retained the right to service the loans.

WaMu or Long Beach might also retain a senior, subordinated, residual, or other interest in the

loan pool.

The following two diagrams created for a 2005 Long Beach securitization, LBMC 2005-

2, demonstrate the complex structures created to issue the RMBS securities, as well as the

“waterfall” constructed to determine how the mortgage payments being made into the

securitization pool would be used.437

437 See “LBMC 2005-2 Structure” and “LBMC 2005-2 Cash Flow Waterfall,” FDIC_WAMU_000012358-59,

Hearing Exhibit 47a.

120

__

121

122

In that particular securitization, Goldman Sachs served as the lead underwriter, WCC served as

the securities dealer, Deutsche Bank served as the trustee of the trust set up to hold the securities,

and Long Beach served as the mortgage servicer.

Another document, prepared by Goldman Sachs, shows the variety of relationships that

WaMu engaged in as part of its securitization efforts.438 That document, which consists of a list

of various loan pools and related matters, shows that WaMu worked with Goldman Sachs to

make whole loan sales; securitize loans insured by the Federal Home Administration or Veterans

Administration; and securitize prime, subprime, Alt A, second lien, and scratch and dent

nonperforming loans. It also shows that Goldman Sachs asked WaMu and Long Beach to

repurchase more than $19.7 million in loans it had purchased from the bank.439

Goldman Sachs handled a number of securitizations for Long Beach. At one point in

2006, Goldman Sachs made a pitch to also handle loans issued by WaMu. One Goldman Sachs

broker explained to a colleague in an email: “They have possibly the largest subprime portfolio

on the planet.”440

(2) Deficient Securitization Practices

Over the years, both Long Beach and Washington Mutual were repeatedly criticized by

the bank’s internal auditors and reviewers, as well as its regulators, OTS and the FDIC, for

deficient lending and securitization practices. Their mortgage backed securities were among the

worst performing in the marketplace due to poor quality loans that incurred early payment

defaults, fraud, and high delinquency rates.

Long Beach Securitizations. In April 2005, an internal email sent by an OTS regulator

recounted eight years of abysmal performance by Long Beach securities, noting that loan

delinquencies and losses occurred in pools containing both fixed rate and adjustable rate

mortgages:

“[Securitizations] prior to 2003 have horrible performance …. For FRM [fixed rate

mortgage] losses, LBMC finished in the top 12 worst annual NCLs [net credit losses] in

1997 and 1999 thru 2003. LBMC nailed down the number 1 spot as top loser with an

NCL of 14.1% in 2000 and placed 3rd in 2001 with 10.5% .... For ARM losses, LBMC

really outdid themselves with finishes as one of the top 4 worst performers for 1999 thru

2003. For specific ARM deals, LBMC made the top 10 worst deal list from 2000 thru

2002. LBMC had an extraordinary year in 2001 when their securitizations had 4 of the

top 6 worst NCLs (range: 11.2% to 13.2%).

438 Undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b.

439 Id.

440 3/24/2005 email from Kevin Gasvoda of Goldman Sachs to Christopher Gething, others, Hearing Exhibit 4/27-

167b.

123

“Although underwriting changes were made from 2002 thru 2004, the older issues are

still dragging down overall performance. Despite having only 8% of UPB [unpaid

balances] in 1st lien FRM pools prior to 2002 and only 14.3% in 2002 jr. lien pools,

LBMC still had third worst delinquencies and NCLs for most of [the] period graphed

from 11/02 thru 2/05 and was 2nd worst in NCLs in 2005 out of 10 issuers graphed. …

At 2/05, LBMC was #1 with a 12% delinquency rate. Industry was around 8.25%. At

3/05, LBMC had a historical NCL rate of 2% smoking their closest competitor by 70bp

and tripling the industry average.”441

This email, which is based upon a 2005 Fitch analysis of Long Beach, shows that,

from 1997 to March 2005, due to loan delinquencies and losses, Long Beach securities

were among the very worst performing in the entire subprime industry.442

Long Beach’s performance did not improve after 2005. In April 2006, for

example, Nomura Securities issued an analysis of the ABX Index that tracked a basket of

20 subprime RMBS securities and identified Long Beach as the worst performer:

“Long Beach Mortgage Loan Trust appears to be the poorest performing issuer, with its

three deals averaging 15.67% in 60+ day delinquency and 12.75% in 90+ day

delinquency. Unsurprisingly, all three deals issued by LBMLT have exceeded their

delinquency trigger limits.”443

In November 2006, while attending the Asset Backed Securities East Conference

for the securitization industry, the head of WaMu’s Capital Markets Division, David

Beck, emailed WaMu’s Home Loans President, David Schneider, that with respect to

RMBS securities carrying noninvestment grade ratings, “LBMC [Long Beach] paper is

among the worst performing paper in the mkt [market] in 2006. Subordinate buyers want

answers.”444

In March 2007, an analysis by JPMorgan Chase again singled out Long Beach securities

for having the worst delinquency rates among the subprime securities tracked by the ABX Index:

“Washington Mutual Inc.’s subprime bonds are suffering from some of the worst rates of

delinquency among securities in benchmark indexes, according to JPMorgan Chase &

Co. research. … Delinquencies of 60 days or more on loans supporting WaMu’s Long

Beach LBMLT 2006-1 issue jumped … to 19.44 percent … the highest among the 20

441 4/14/2005 email from Steve Blelik to David Henry, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a.

442 Id.

443 4/19/2006 “ABX Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc.,

http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown.

444 11/7/2006 email from David Beck to David Schneider, Hearing Exhibit 4/13-50. See also 4/19/2006 “ABX

Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc.,

http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown.

124

bonds in the widely watched ABX-HE 06-2 index of bonds backed by residential loans to

risky borrowers.”445

In July 2007, Moody’s and S&P downgraded the credit ratings of hundreds of subprime

RMBS and CDO securities, due to rising mortgage delinquencies and defaults. Included were

approximately 40 Long Beach securities.446 A July 12, 2007 presentation prepared by Moody’s

to explain its ratings action shows that Long Beach was responsible for only 6% of all the

subprime RMBS securities issued in 2006, but received 14% of the subprime RMBS ratings

downgrades that day.447 Only Fremont had a worse ratio.

Over time, even AAA rated Long Beach securities performed terribly. Of the 75 Long

Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75

have been downgraded to junk status, defaulted, or been withdrawn.448 In most of the 2006

Long Beach securitizations, the underlying loans have delinquency rates of 50% or more.449

The problems were not confined to Long Beach loans. In early 2008, for example, an

investment adviser posted information on his personal blog about a WaMu-sponsored RMBS

securitization known as WMALT 2007-OC1. Formed in May 2007, this pool contained about

1,700 Alt A loans with a total outstanding balance of about $515 million. WaMu was the sole

underwriter. The credit rating agencies gave AAA and other investment grade ratings to more

than 92% of the securitization, but within eight months, 15% of the pool was in foreclosure. The

posting suggested that the poor performance of WaMu securities was systemic.

When informed by David Schneider of the complaint about the negative publicity

surrounding the pool, David Beck responded:

“Yes (ughh!) we are doing some peer group performance and looking at the servicing

data … and putting together an analysis. … The collateral is full of limited doc layered

risk alt a paper and at least half is TPO [third party originated]. The performance is not

great but my opinion is not a WaMu specific issue.”450

445 “WaMu subprime ABS delinquencies top ABX components,” Reuters (3/27/2007), Hearing Exhibit 4/13-52.

446 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99.

447 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,”

MOODYS-PSI2010-0046902, Hearing Exhibit 4/23-106.

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

449 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach

and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage

backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 –

54.32%).

450 2/2/2008 email from David Beck to David Schneider and others, JPM_WM02445758, Hearing Exhibit 4/13-51.

125

Home Loans President David Schneider replied: “Ok – thanks .… Are we sure there isn’t a

reporting issue?” Today, those securities have all been downgraded to junk status and more than

half of the underlying loans are delinquent or in foreclosure.451

Despite their poor performance, it is unclear that any investment bank refused to do

business with either Long Beach or WaMu. As long as investors expressed interest in

purchasing the securities, banks continued selling them until the entire subprime market

collapsed. Before the market collapsed, WaMu earned hundreds of millions of dollars a year

from its home loans sales and securitizations.452

Securitizing Fraudulent Loans. WaMu and Long Beach securitized not just poor

quality loans, but also loans that its own personnel had flagged as containing fraudulent

information. That fraudulent information included, for example, misrepresentations of the

borrower’s income and of the appraised value of the mortgaged property. In September 2008,

WaMu’s Corporate Credit Review team released a report which found that internal controls

intended to prevent the sale of fraudulent loans to investors were ineffective:

“The controls that are intended to prevent the sale of loans that have been confirmed by

Risk Mitigation to contain misrepresentations or fraud are not currently effective. There

is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or

confirmed to contain suspicious activity from being sold to an investor. ... Of the 25

loans tested, 11 reflected a sale date after the completion of the investigation which

confirmed fraud. There is evidence that this control weakness has existed for some

time.”453

In other words, even loans marked with a red flag indicating fraud were being sold to investors.

The review identified several factors contributing to the problem, including insufficient resources

devoted to anti-fraud work, an absence of automated procedures to alert personnel to fraud

indicators, and inadequate training on fraud awareness and prevention. The 2008 review

warned: “Exposure is considerable and immediate corrective action is essential in order to limit

or avoid considerable losses, reputation damage, or financial statement errors.”454

(3) Securitizing Delinquency-Prone Loans

The Subcommittee uncovered an instance in 2007 in which WaMu securitized certain

types of loans that it had identified as most likely to go delinquent, but did not disclose its

analysis to investors who bought the securities. Investors who purchased these securities without

the benefit of that analysis quickly saw the value of their purchases fall.

451 As of December 2010, the total loan delinquency rate of the WMALT 2007-OC1 series was 57.37%. See

wamusecurities.com.

452 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 82, 87.

453 9/8/2008 “Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” WaMu Corporate Credit Review,

JPM_WM00312502, Hearing Exhibit 4/13-34.

454 Id.

126

WaMu securitization agreements prohibited the bank from using an “adverse selection”

process when including loans within a securitized pool. On March 22, 2007, WaMu filed a

prospectus for WMALT Series 2007-OA3, in which Washington Mutual Bank and Washington

Mutual Mortgage Securities Corp. co-sponsored a securitization of a $2.3 billion pool of Option

ARM loans. In the section entitled, “Representations and Warranties Regarding the Mortgage

Loans,” the prospectus stated:

“Washington Mutual Mortgage Securities Corp. and Washington Mutual Bank, as

applicable, used no adverse selection procedures in selecting the mortgage loans from

among the outstanding adjustable rate conventional mortgage loans owned by it which

were available for sale and as to which the representations and warranties in the mortgage

loan sale agreement could be made.”455

On the following page of the prospectus, under the section heading, “Criteria for

Selection of Mortgage Loans,” it stated:

“Each co-sponsor selected the mortgage loans it sold to the depositor from among its

portfolio of mortgage loans held for sale based on a variety of considerations, including

type of mortgage loan, geographic concentration, range of mortgage interest rates,

principle balance, credit scores and other characteristics described in Appendix B to this

prospectus supplement, and taking into account investor preferences and the depositor’s

objective of obtaining the most favorable combination of ratings on the certificates.”456

WaMu emails and memoranda obtained by the Subcommittee indicate that, prior to

assembling the loan pool used in the WMALT 2007-OA3 securitization, WaMu identified

delinquency-prone Option ARM mortgages in its “Held for Investment” loan portfolio and

transferred those loans to its portfolio of mortgages available for sale or securitization. WaMu

then used its “Held for Sale” loan portfolio to select the loans for the loan pool used in the

WMALT 2007-OA3 securitization. The prospectus provides a list of criteria used to select the

loans in the WMALT 2007-OA3 loan pool, but omits any mention of the fact that some of the

loans were selected using statistical analysis designed to identify Option ARM loans likely to go

delinquent quickly. The internal emails demonstrate that WaMu selected delinquency-prone

loans for sale in order to move risk from the bank’s books to the investors in WaMu securities,

and profit from its internal analysis, which was not available to the market.

On Thursday, September 14, 2006, John Drastal, then Senior Managing Director of

WCC, sent David Beck, head of WaMu’s Capital Markets Division, with copies to others, an

email regarding “Tom Casey visit,” with the importance marked “high.” Tom Casey was then

the Chief Financial Officer of Washington Mutual Bank. In the email Mr. Drastal relayed Mr.

Casey’s concern about WaMu’s exposure to Option ARM loans:

455 3/22/2007 WaMu Prospectus Supplement, “Washington Mutual Mortgage Pass-Through Certificates, WMALT

Series 2007-OA3,” at S-102, Hearing Exhibit 4/13-86b.

456 Id. at S-103.

127

“David,

“Tom just stopped by after the Lehman investor conference. He says equity investors are

totally freaking about housing now. He asked how we could prepare for this. A few

items ….

“2. On the portfolio side, he asked about exposure on option ARMs. We talked about

looking to potentially sell ’06 production Option ARMs in portfolio. He even said

looking at this quarter. I don’t think that this is possible but we should look at what the

credit composition of this product is and see if we can sell quickly if it’s the right thing to

do (see Nagle’s message). He doesn’t for[e]see a tainting issue if we are doing it for

credit issues. Youyi, can you get me a collateral strat from the portfolio?”457

Three months later, on Wednesday, February 14, 2007, a WaMu portfolio analyst and

trader, Michael Liu, sent an email to a senior official in WaMu’s portfolio management

department, Richard W. Ellson, with the subject line: “Option ARM MTA and Option ARM

MTA Delinquency.” The email included the abbreviations “MTA,” which stands for “Monthly

Treasury Average,” and “PPD,” which stands for “Payment Past Due.” The email provided a

description of Option ARM loans in WaMu’s investment portfolio that were delinquent in the

fourth quarter of 2006:

“Hi Rick,

“Attached is the spreadsheet with the total Option ARM MTA … and Option ARM MTA

>=1 PPD summary. Some points for the Option ARM MTA >=1PPD:

• $105mm in Nonaccrual is between FICO 501-540.

• $222mm in Nonaccrual between LTV 61-80.

• CA [California] represents the greatest amount of Delinquency (1PPD, 2PPD,

3PPD, nonaccrual)[.]

• Loans originated in 2004 and 2005 represent the highest amount of 3 PPD and

nonaccrual[.]”458

On the same day, Mr. Ellson forwarded the email to the Division Executive for Portfolio

Management and Research, Youyi Chen, with the following comments:

“Youyi – attached is a description of the Option ARMs that were delinquent in the

2006q4 [fourth quarter]. You can see that it is very much a function of FICOs and Low

Doc loans. We are in the process of updating the optimum pricing matrix. Mike did the

work. Your comments are appreciated.”459

457 9/14/2006 email from John Drastal to David Beck, with Youyi Chen and Doug Potolsky copied, “Tom Casey

visit,” Hearing Exhibit 4/13-40a.

458 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b.

459 Id.

128

Mr. Chen, in turn, forwarded the email to the head of WaMu’s Capital Markets Division,

David Beck. Mr. Chen’s introductory comments indicated that the research had been performed

in response to a question from WaMu Home Loans President David Schneider and was intended

to identify criteria for the loans driving delinquencies in the Option ARM portfolio:

“This answers partially [David] Schneider’s questions on break down of the option arm

delinquencies.

The details (1PPD tab) shows Low fico, low doc, and newer vintages are where most of

the delinquency comes from, not a surprise.”460

On the same day, February 14, Mr. Beck forwarded the entire email chain to David

Schneider and WaMu Home Loans Risk Officer Cheryl Feltgen, adding his own view:

“Please review. The performance of newly minted option arm loans is causing us

problems. Cheryl can validate but my view is our alt a (high margin) option arms [are]

not performing well.

We should address selling 1Q [first quarter] as soon as we can before we loose [sic] the

oppty. We should have a figure out how to get this feedback to underwriting and

fulfillment.”461

Mr. Beck’s message indicated that recently issued Option ARM loans were not

performing well, and suggested selling them before the bank lost the opportunity. WaMu would

lose the opportunity to sell those loans if, for example, they went delinquent, or if the market

realized what WaMu analysts had already determined about their likelihood of going delinquent.

Mr. Beck’s email proposed selling the loans during the first quarter of the year, already six

weeks underway, and “as soon as we can.”

Four days later, on Sunday, February 18, Mr. Schneider replied to the email chain by

requesting Ms. Feltgen’s thoughts. Later that day, Ms. Feltgen responded with additional

analysis and an offer to help further analyze the Option ARM delinquencies:

“The results described below are similar to what my team has been observing.

California, Option ARMs, large loan size ($1 to $2.5 million) have been the fastest

increasing delinquency rates in the SFR [Single Family Residence] portfolio. Although

the low FICO loans have … higher absolute delinquency rates, the higher FICOs have

been increasing at a faster pace than the low FICOs. Our California concentration is

getting close to 50% and many submarkets within California actually have declining

house prices according to the most recent OFHEO [Office of Federal Housing Enterprise

Oversight] data from third quarter of 2006. There is a meltdown in the subprime market

which is creating a ‘flight to quality’. I was talking to Robert Williams just after his

460 Id.

461 Id.

129

return from the Asia trip where he and Alan Magleby talked to potential investors for

upcoming covered bond deals backed by our mortgages. There is still strong interest

around the world in USA residential mortgages. Gain on sale margins for Option ARMs

are attractive. This seems to me to be a great time to sell as many Option ARMs as we

possibly can. Kerry Killinger was certainly encouraging us to think seriously about it at

the MBR [Monthly Business Review] last week. What can I do to help? David, would

your team like any help on determining the impact of selling certain groupings of Option

ARMs on overall delinquencies? Let me know where we can help. Thanks.”462

As Chief Risk Officer in WaMu’s Home Loans division, Ms. Feltgen pointed out some

counterintuitive features of the latest delinquencies, noting that the fastest increases in

delinquencies occurred in large loans and loans with high FICO scores. She also noted that the

subprime meltdown had led to a “flight to quality,” and that foreign investors still had a strong

interest in U.S. residential mortgages, suggesting that WaMu might be able to sell its likely-to-go

delinquent Option ARMs to those foreign investors. From her perspective as a risk manager, she

urged selling “as many Option ARMs as we can.”

Her email also indicated that the topic of selling more Option ARMs had come up during

the prior week at the monthly business review meeting, in which WaMu CEO Killinger

expressed interest in exploring the idea.463 Finally, Ms. Feltgen offered help in analyzing the

impact of selling “certain groupings of Options ARMs” on overall delinquencies. Removing

those problematic loans from the larger pool of Option ARM loans in the bank’s investment

portfolio would reduce loan delinquencies otherwise affecting the value of the portfolio as a

whole.

Mr. Schneider sent a second email at 11:00 at night that same Sunday providing

instructions for moving forward:

“Let[’]s do the following:

1. db [David Beck] - please select the potential sample portfolios - along the lines we

discussed at the mbr [Monthly Business Review]

2. cf [Cheryl Feltgen] - please run credit scenarios

3. db - coordinate with finance on buy/sell analysis

4. db/cf – recommendation[.]”464

On Tuesday morning, February 20, 2007, Mr. Beck replied with additional analysis:

“Here’s how I see this going.

462 Id.

463 At the end of 2006, WaMu held about $63.5 billion in Option ARM mortgages, then comprising about 28% of its

investment portfolio. See 3/2007 Washington Mutual Inc. 10-K filing with the SEC, at 52.

464 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b.

130

From the MBR [Monthly Business Review], my notes indicate two portfolios we

discussed for sale; the 2007 high margin production (Jan and Feb so far) and the seasoned

COFI book.465

I will supply to Cheryl the loan level detail on both pools and the pricing assumptions for

losses. Cheryl, you need to run scenario analysis and on losses versus pricing AND

reserving assumptions. I can supply pricing assumptions but would like you to pull the

ALLL [Allowance for Loan and Lease Losses] against these pools.”466

Later that day, Ms. Feltgen forwarded the email chain to her team, changing the subject

line to read: “URGENT NEED TO GET SOME WORK DONE IN THE NEXT COUPLE

DAYS: Option ARM MTA and Option ARM MTA Delinquency.” Clearly, time was of the

essence:

“See the attached string of emails. We are contemplating selling a larger portion of our

Option ARMs than we have in the recent past. Gain on sale is attractive and this could be

a way to address California concentration, rising delinquencies, falling house prices in

California with a favorable arbitrage given that the market seems not to be yet

discounting a lot for those factors. David Schneider has set a meeting for Friday morning

with David Beck and me to hear our conclusions and recommendations. See the

comments below about the information that we need to provide for this analysis. We will

get the pools by tomorrow at the latest. We will need to coordinate with Joe Mattey and

get input from him in order to make a judgment regarding the ALLL impact. ...

In addition to the specific information that David Beck asks for, I would like your input

on portions of the Option ARM portfolio that we should be considering selling. We may

have a different view than David Beck’s team as to the most desirable to sell and we

should provide that input. Our suggestion, for instance, might include loans in California

markets where housing prices are declining. There may be other factors.

I will need to get from you by Thursday, February 22 end of day a summary of our

conclusions and recommendations.”467

465 Option ARMs were considered a “high margin” product within WaMu, because they produced a relatively high

gain on sale when sold. See 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at

JPM_WM00690894, Hearing Exhibit 4/13-3 (chart showing gain on sale margin by product). “COFI” stands for

“Cost of Funds Index” which is an index used to set variable interest rates. “Seasoned” means the loans are older

production.

466 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b.

467 Id.

131

A WaMu risk analyst, Robert Shaw, replied the same day and identified specific factors

that were driving delinquencies in the Option ARM portfolio:

“Cheryl,

I reviewed the HFI [Hold for Investment] prime loan characteristics that contributed to

rising 60+ delinquency rates468 between 1/06 - 1/07 [January 6 and 7]. The results of this

analysis show that seven combined factors contain $8.3 billion HFI Option ARM

balances which experienced above-average increases in the 60+ delinquency rate during

the last 12 months (a 821% increase, or 10 times faster than the average increase of 79%).

I recommend that we select loans with some or all of these characteristics to develop a

HFS [Hold for Sale] pool.

Below, I have listed the factors (layered), their percentage change in 60+ delinquency

rate over the last 12 months, and HFI balances as of January 2007.469

1) HFI Option ARMs – 79% increase (.56% to 1.0%), $60.6 billion

2) Above + Vintages 2004-2007 – 179% increase (.33% to .92%), $47.8 billion

3) Above + CA – 312% increase (.16 to .66%), $23.7 billion

4) Above + NY/NJ/CT – 254% increase (.21 to .76%), $29.3 billion

5) Above + $351k-1mil – 460% increase (.12 to .70%), $17.2 billion

6) Above + FICO 700-739 – 1197% increase (.03% to .40%), $4.2 billion

7) Above + FICO 780+ – 1484% increase (.02% to .38%), $5.2 billion

8) Above + FICO 620-659 – 821% increase (.07 to .67%), $8.3 billion[.]”470

Essentially, the key factors identified Option ARMs that were in certain states, like California,

had certain FICO scores or certain loan amounts, or were issued during the period 2004-2007.

Later that same day, Ms. Feltgen forwarded Mr. Shaw’s email to Mr. Beck, Mr. Chen,

and Mr. Ellson. Her email carried the subject line: “Some thoughts on target population for

potential Option ARM MTA loan sale.” She wrote:

“David, Youyi and Rick:

My team and I look forward to receiving the loan level detail on the pools of Option

ARMs we are considering for sale. I thought it might be helpful insight to see the

information Bob Shaw provides below about the components of the portfolio that have

been the largest contributors to delinquency in recent times. I know this is mostly an

exercise about gain on sale, but we might also be able to accomplish the other purpose of

reducing risk and delinquency at the same time. Talk to you soon.”471

468 A “60+ delinquency rate” applies to loans in which a payment is late by 60 days or more.

469 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b.

470 2/20/2007 email from Robert Shaw to Cheryl Feltgen, Hearing Exhibit 4/13-41.

471 2/20/2007 email from Cheryl Feltgen to David Beck, Youyi Chen, and Richard Ellson, Hearing Exhibit 4/13-41.

132

A week later, on Sunday, February 25, 2007, Mr. Beck sent an email with the subject

heading, “HFI Option Arms redirect to HFS,” to much of WaMu’s top management, including

Mr. Schneider, Mr. Rotella, Mr. Casey, as well as the FDIC Examiner-In-Charge Steve Funaro,

and others. The email indicated that a decision had been made to sell $3 billion in recent Option

ARM loans, with as many as possible to be sold before the end of the quarter, which was four

weeks away:

“David [Schneider] and I spoke today. He’s instructed me to take actions to sell all

marketable Option Arms that we intend to transfer to portfolio in 1Q[first quarter], 2007.

That amounts to roughly 3B [$3 billion] option arms availab[l]e for sale. I would like to

get these loans into HFS [the Hold for Sale portfolio] immediately so that [I] can sell as

many as possible in Q1.

John [Drastal], we are only targeting to sell Option Arms destined for portfolio since year

end at this point. I’ll need direction from you on any special accounting concerns or

documentation you will need to get these loans in the warehouse without tainting the HFI

[Hold for Investment] book.472

Michelle, I believe this action requires MRC [Market Risk Committee] approval. Please

advise.

This week I’ll work to get the necessary governance sign offs in place. Cheryl, please

direct me on what form the approval request should take and what committees should

review and authorize the request. I can pull all of the data.

We continue to work with Cheryl and the credit risk team to analyze emerging credit

risks in our prime portfolio and recommend actions to mitigate them.

Thanks for your help,

DJB”473

Two days later, on Tuesday, February 27, 2007, Mr. Chen sent an email with the subject

line, “HFI selection criteria changes,” to Michelle McCarthy, who was head of WaMu’s Market

Risk Management department474 as well as chair of both its Market Risk Committee and Asset

Liability Committee.475 The email was copied to Mr. Beck, Ms. Feltgen and others, and showed

that the implementation of the plan was underway:

472 Loans in a bank’s Hold for Investment portfolio receive different accounting treatment than loans in the bank’s

Hold for Sale portfolio, and generally accepted accounting principles (GAAP) frown upon frequent transfers

between the two portfolios. The GAAP principles were a key reason for Mr. Beck’s instruction that the transfer of

the Option ARM loans from WaMu’s HFI to HFS portfolios proceed “without tainting the HFI book.”

473 2/25/2007 email from David Beck to himself, David Schneider, Steve Rotella, Ron Cathcart, Tom Casey, Cheryl

Feltgen, others, Hearing Exhibit 4/13-42b.

474 12/28/2007 WaMu internal report, “Disclosure Management,” JPM_WM02414318.

475 3/9/2007 WaMu Market Risk Committee Meeting Minutes, Hearing Exhibit 4/13-43.

133

“After careful review with David and the teams, David suggested me to make the

following recommendations to MRC [Market Risk Committee] on the existing prime

HFI/HFS selection criteria

1. Effective March 7th 2007, modify the portfolio option ARM and COFI ARM

retention criteria (see attached ‘existing HFI descriptions’, ‘section 1.01 to 1.11 and

section 2.01 to 2.08’) to include only following loans for the portfolio (HFI)

a. Super jumbo of size greater or equal to $ 3 MM (Risk based pricing applied,

but difficult to sale)

b. Advantage 90 (high LTV loans without MI, very little production as 80/10/10

gets popularity)

c. Foreign Nationals (Risk based pricing applied, but difficult to sale due to FICO

problems)

d. FICO less than 620, except employee loans in which case FICO can be restated

after closing.

e. 3-4 units (excessive S & P level hit calls for portfolio execution)

2. Further more, we would like to request, transferring from HFI to HFS, all the MTA

option ARMs and COFI ARMs, funded or locked between January 1st, 2007 to

Mach [sic] 7th, 2007, and DO NOT fit the criteria listed above, and DO NOT fit the

criteria section 3.02 to 4.07 in the attached ‘existing HFI descriptions’)

As a result of this change, we expected to securitize and settle about $ 2 billion more

option/COFI ARMs in Q1-07 (mostly margin greater than 295), and going forward $ 1

billion per month potential incremental volume into HFS. For your information, the

impact to gain on sale for the year is estimated to be about $180 MM pretax based on

current market, and the impacts to 2007 portfolio NII is estimated to be about - $ 80 MM

pretax.

Also included in the attachment, is a pool of $1.3 billion option/COFI ARMs funded to

portfolio between January 1st and February 22nd that will be re-classified as HFS based

on the above recommendations. We understand that this population of loans will be

growing from now to March 7th until the portfolio selection criteria are officially

modified.

We expected to start marketing the deal on March 12th, your prompt response will be

greatly appreciated as the TSG [Technology Solutions Group] and QRM [Quantitative

Risk Management] teams also need time to implement the coding changes.”476

476 2/27/2007 email from Youyi Chen to Michelle McCarthy, with copies to David Beck, Cheryl Feltgen, Steve

Fortunato, and others, “HFI selection criteria changes,” Hearing Exhibit 4/13-42a [emphasis in original].

134

This email proposed several significant changes to WaMu’s treatment of its Option

ARMs. First, WaMu decided to require most of its Option ARMs to go directly into its Hold for

Sale portfolio instead of going into its Held for Investment portfolio. In light of its analysis that

Option ARM loans were rapidly deteriorating, the bank no longer wanted to treat them as

investments it would keep, but immediately sell them. Second, the only Option ARMs that it

would automatically direct into its investment portfolio were those that the bank considered to be

so obviously of poor quality that they were “non-salable,” according to another internal email.477

Third, WaMu proposed transferring all Option ARM loans originated in 2007 from the

investment portfolio to the sale portfolio. Since these three changes in how WaMu would treat

its Option ARMs had compliance, accounting, and tax consequences, they had to be approved by

the Market Risk Committee. That Committee was composed of senior risk officers throughout

the bank as well as senior managers in the bank’s finance, treasury, and portfolio management

departments. The email indicated that the changes needed to be implemented within about a

week so that marketing of some of the Option ARMs could begin by March 12.

On March 9, 2007 the Market Risk Committee met and approved the Option ARM

proposal. The minutes of that meeting describe the changes that had been proposed:

“- Change the Held for Investment (HFI) ARM and COFI ARM retention criteria to

include only the following loans for HFI effective March 12, 2007; Super jumbo ≥ $3.0

million, Advantage 90, Foreign Nationals, FICO < 620 except employee loans in which

case FICO can be re-stated after closing, and 3 to 4 units.

- Increase Prime Option ARM’s (including Second Liens) from $26.0 billion to $37.0

billion.

- Transfer up to $3.0 billion of saleable Option ARM and COFI ARM loans originated

between January 1, 2007 and March 12, 2007 from HFI to HFS (excluding HFI loans

described above).”478

The minutes also recorded an exchange between Ms. McCarthy and another Committee

member, Mr. Woods, who was the Chief Financial Officer of WaMu’s Home Loans division:

“A second part of the proposal requests approval to transfer up to $3.0 billion of saleable

Option ARM and COFI ARM loans originated since January 1, 2007 from HFI to Held

for Sale (HFS). In response to a question from Mr. Woods, Ms. McCarthy explained that

there are other Option ARM loans not included in the criteria that we are retaining in

portfolio. Ms. McCarthy noted that Ms. Feltgen ha[d] reviewed and approved this

proposal. Mr. Woods noted that Deloitte has reviewed the proposal as well.”479

477 2/27/2007 email from Youyi Chen to David Griffith, “Option ARM,” JPM_WM03117796 (“David, we sell all

295+ margin and other OA and COFI, and KEEP the 4 categories going forward due mostly to non-salable

reasons.”).

478 3/9/2007 WaMu Market Risk Committee Meeting Minutes, Hearing Exhibit 4/13-43.

479 Id.

135

This exchange acknowledges that not all of the saleable Option ARM loans were diverted from

the HFI to the HFS portfolio. WaMu chose to keep some Option ARMs and make other Option

ARMs available for sale. The internal WaMu documents and communications reviewed by the

Subcommittee strongly suggest that the decision to transfer the most recently originated Option

ARMs from the Held-for-Investment portfolio to the Held-for-Sale portfolio was part of an effort

to sell loans thought to be prone to delinquency, before they became delinquent. None of the

hearing witnesses recalled how these loans were specifically selected for securitization, nor did

any deny that they may have been selected for their propensity toward delinquency.480

The Subcommittee investigation determined that WaMu carried out the plan as approved,

and transferred at least $1.5 billion Option ARMs originated in the first quarter of 2007, from the

HFI to HFS portfolio. Of these loans, about 1,900 with a total value of a little over $1 billion

were assembled into a pool and used in the WMALT 2007-OA3 securitization in March 2007.481

WMALT 2007-OA3 securities were issued with WaMu as the sole underwriter and sold to

investors.482

None of the materials associated with the sale of the WMALT 2007-OA3 securities

informed investors of the process used to select the delinquency-prone Option ARMs from

WaMu’s investment portfolio and include them in the securitization.483 Nor did WaMu inform

investors of the internal analysis it performed to identify the delinquency-prone loans. Senator

Levin questioned Mr. Beck about this point at the April 13 Subcommittee hearing:

Senator Levin. When you said that investors were told of the characteristics of loans,

they were told of all the characteristics of loans. Did they know, were they informed that

loans with those or some of those characteristics had a greater propensity towards

delinquency in WaMu’s analysis? Were they told that?

Mr. Beck. They were not told of the WaMu analysis.484

Predictably, the securitization performed badly. Approximately 87% of the securities

received AAA ratings.485 Within 9 months, by January 2008, those ratings began to be

downgraded.486

480 Mr. Schneider and Mr. Beck were asked about this matter at the hearing. See April 13, 2010 Subcommittee

Hearing at 75-82.

As of February 2010, more than half of the loans in WMALT Series 2007-OA3

481 4/10/2010 Subcommittee email from Brent McIntosh, Sullivan & Cromwell LLP, Counsel for JPMorgan Chase

[Sealed Exhibit].

482 3/22/2007 WaMu Prospectus Supplement, “Washington Mutual Mortgage Pass-Through Certificates, WMALT

Series 2007-OA3,” at S-102, Hearing Exhibit 4/13-86b.

483 See, e.g., id. See also April 13, 2010 Subcommittee Hearing at 80.

484 April 13, 2010 Subcommittee Hearing at 82.

485 4/11/2007 “New Issue: Washington Mutual Mortgage Pass-Through Certificates WMALT Series 2007-OA3

Trust,” S&P’s Global Credit Portal, www.globalcreditportal.com.

486 See 1/14/2008 “Moody’s takes negative rating actions on certain WaMu Option Arm deals issued in 2007,”

Moody’s, http://www.moodys.com/viewresearchdoc.aspx?lang=en&cy=global&docid=PR_147683.

136

were delinquent, and more than a quarter were in foreclosure.487 All of the investment grade

ratings have been downgraded to junk status, and the investors have incurred substantial losses.

(4) WaMu Loan Sales to Fannie Mae and Freddie Mac

Washington Mutual had longstanding relationships with a number of government

sponsored enterprises (GSEs), including the Federal National Mortgage Association (Fannie

Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).488 Between 2000 and

2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac,

accounting for more than a quarter of every dollar in loans WaMu originated.489 While the

majority of those loans involved lower risk, fixed rate mortgages, WaMu also sold Fannie and

Freddie billions of dollars in higher risk Option ARMs.

Relationships with Fannie and Freddie. Fannie Mae and Freddie Mac purchase

residential mortgages that meet specified underwriting standards and fall below a specified dollar

threshold, so-called “conforming loans.” They often enter into multi-year contracts with large

mortgage issuers to purchase an agreed-upon volume of conforming loans at agreed-upon rates.

Prior to 2005, Washington Mutual sold most of its conforming loans to Fannie Mae, with

relatively little business going to Freddie Mac.490 From at least 1999 through 2004, WaMu sold

those loans to Fannie Mae through a long term “Alliance Agreement,”491 that resulted in its

providing more than 85% of its conforming loans to Fannie Mae.492 In 2004, WaMu calculated

that it “contributed 15% of Fannie Mae’s 2003 mortgage business,”493 and was “Fannie Mae’s

2nd largest provider of business (behind Countrywide).”494

487 “Select Delinquency and Loss Data for Washington Mutual Securitizations,” chart prepared by the

Subcommittee, Hearing Exhibit 4/13-1g.

Among the advantages that WaMu

believed it gained from its relationship with Fannie Mae were help with balance sheet

488 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, Hearing Exhibit 4/16-91 at

JPM_WM02575608. As mentioned earlier, GSEs are Congressionally chartered, nongovernment owned financial

institutions created for public policy purposes. At the time of the financial crisis, the GSEs included Fannie Mae,

Freddie Mac, and the Federal Home Loan Bank System (FHLBS), all of which were created by Congress to

strengthen the availability of capital for home mortgage financing.

489 See chart, below, using loan data from Inside Mortgage Finance.

490 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405463,

Hearing Exhibit 4/16-86 (“At current level, alternative executions, e.g., Freddie Mac, FHLB, and private investors,

do not win a significant level of business.”).

491 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405462,

Hearing Exhibit 4/16-86 (chart entitled, “Timeline of the Alliance Agreement”).

492 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405461,

Hearing Exhibit 4/16-86 (“Under this Alliance Agreement with Fannie Mae, WaMu has agreed to deliver no less

than 75% of eligible, conforming loans to Fannie Mae.”); 2/23/2005 email exchange between David Beck and

WaMu executives, Hearing Exhibit 4/16-85 (“5 years of 85%+ share with Fannie”).

493 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405459,

Hearing Exhibit 4/16-86.

494 Id. at JPM_WM02405467, Subcommittee Hearing Exhibit 4/16-86.

137

management, underwriting guidance, and support for WaMu’s Community Reinvestment Act

initiatives.495

The following slide, created by Washington Mutual in March 2004, provides an overview

of the GSEs’ impact on the mortgage market at the time as well as the status of WaMu’s

relationship with Fannie Mae in early 2004.496

495 Id. at JPM_WM02405461, Subcommittee Hearing Exhibit 4/16-86. The Community Reinvestment Act (CRA)

was passed by Congress to encourage banks to make loans in low- and moderate-income neighborhoods. See

website of the Federal Financial Institutions Examination Council, “Community Reinvestment Act,”

http://www.ffiec.gov/cra/history.htm. Regulators, including the Office of Thrift Supervision, periodically reviewed

banks’ CRA activities and took them into account if a bank applied for deposit facilities or a merger or acquisition.

Id. A 2005 presentation prepared by WaMu stated that its relationship with Freddie Mac helped the bank meet its

CRA goals by purchasing more than $10 billion in qualifying loans. See 9/29/2005 “GSE Forum,” presentation

prepared by WaMu Capital Markets, at JPM_WM02575611, Hearing Exhibit 4/16-91. Between 1991 and 2006,

WaMu was evaluated 20 times by OTS and the FDIC, achieving the highest possible CRA rating of “Outstanding”

in each evaluation. See website of the Federal Financial Institutions Examination Council, ratings search for

“Washington Mutual,” http://www.ffiec.gov/craratings/default.aspx. Regulations state that an “outstanding”

institution is one that not only meets the needs of its surrounding community, but utilizes “innovative or flexible

lending practices.” See 12 C.F.R. 345, Appendix A, http://www.fdic.gov/regulations/laws/rules/2000-

6600.html#fdic2000appendixatopart345.

496 Id. at JPM_WM02405459, Subcommittee Hearing Exhibit 4/16-86.

138

Despite Fannie Mae’s long history with WaMu, in 2005, the bank made a major change

and shifted the majority of its conforming loan business to Freddie Mac. WaMu made the

change in part because its long term contract with Fannie Mae was up for renegotiation,497 and

Freddie Mac offered better terms. According to WaMu, Freddie Mac had purchased $6 billion

of its Option ARM loans in 2004, without a contract in place, and WaMu wanted to sell more of

those loans.498 WaMu conducted detailed negotiations with both firms that lasted more than six

months.499 Internally, it considered a number of issues related to switching the majority of its

conforming loans to Freddie Mac.500 The deciding factor was Freddie Mac’s offer to purchase

100% of WaMu’s conforming Option ARM mortgages which were among the bank’s most

profitable loans.501 In January 2005, in a document comparing the proposals from Fannie and

Freddie, WaMu wrote:

“The Freddie Mac Business Relationship [proposal] dated 12/21/2004 establishes another

execution opportunity that diversifies WaMu’s execution risk and confers material

financial benefits for the Option ARM product. The key to the Freddie proposal is that it

provides significant liquidity for our Option ARM originations, with more advantageous

credit parameters, competitive g-fees and preferred access to their balance sheet relative

to our current agreement with Fannie. Fannie has made it very clear to us that we should

not expect to retain the same pricing and credit parameters for Option ARMs in our 2005

pricing agreement that we have enjoyed during 2004. For fixed rate loans and hybrids, gfe[

e]s adjusted for MAP Pricing and credit parameters are roughly equivalent to the

Fannie Agreement.”502

497 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405468,

Hearing Exhibit 4/16-86.

498 See, e.g., 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85

(reporting that Freddie Mac was “very aggressive in 2004 buying 6B of option arm without a share agreement in

place.”).

499 See, e.g., 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, Hearing Exhibit

4/16-86; 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH [Freddie

Mac],” JPM_WM05501399, Hearing Exhibit 4/16-88; 1/5/2005 “Business Relationship Proposal Issues,” document

prepared by WaMu, Hearing Exhibit 4/16-90 (describing multiple issues negotiated with both firms);

2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (David Beck wrote:

“Fannie negotiated hard for our business especially in the 11th hour.” CEO Killinger responded: “Good work

David. It appears we got a good economic outcome and haven’t burnt any bridges for the future.”).

500 See 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH [Freddie

Mac],” at JPM_WM05501401, Hearing Exhibit 4/16-88 (listing multiple issues including whether Fannie Mae

would “be less supportative [sic] of using their balance sheet to support our quarter-end liquidity needs”).

501 Id. at JPM_WM05501399 (describing Fannie Mae’s offer to purchase two-thirds of WaMu’s Option ARM

production); 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (“I

reviewed the most recent proposals from Freddie and Fannie today with Steve. We agreed that the Freddie 65%

minimum share (100% of option arms) proposal offers us between 26MM and 37MM of benefit depending on

volume … 39% of our 2005 home loans gain on sale comes from conforming option arm sales. FH [Freddie Mac]

stepped up with 21B of committed balance sheet and aggressive forward pricing for OA [Option ARMs] that result

in the financial benefit over FN [Fannie Mae].”). WaMu originated both conforming and nonconforming Option

ARMs, depending upon whether the loan exceeded the GSEs’ dollar limit for the loans they would purchase.

502 1/5/2005 “Business Relationship Proposal Issues,” document prepared by WaMu, Hearing Exhibit 4/16-90.

139

In April 2004, at the conclusion of its negotiations with Fannie and Freddie, WaMu

entered into a one-year contract with Freddie Mac, switching the lion’s share of the bank’s

conforming loans to that company and away from Fannie Mae.503 According to WaMu, Freddie

Mac’s share of its conforming loans “went from 20% in Q1 [first quarter of 2005] to 81% in Q2

[second quarter of 2005].”504 WaMu reported internally that, as a result of the new contract, it

became the second largest seller of mortgages to Freddie Mac behind Wells Fargo, and that

“[f]orty percent of FRE’s [Freddie Mac’s] portfolio growth in ’05 can be attributed to WM’s $8

billion sale of option ARMS.”505

As the 2005 contract’s expiration date neared, WaMu developed a list of issues to be

negotiated with Freddie Mac for a new contract, noting that Freddie Mac “does not want to be a

‘one-year’ wonder.”506 WaMu also observed that “FRE is not likely to outbid FNM by such a

wide margin on option ARMS like in the current contract.”507 In a list of “asks … to cement our

relationship” with Freddie Mac, WaMu indicated, among other issues, that it would press

Freddie Mac to buy more subprime and “lower quality loans”:

Credit

WM [WaMu] wants FRE [Freddie Mac] to expand the eligibility of lower

quality loans to ensure WM is ‘market competitive’. …

Non-prime

Potential securitization of SMF [Specialty Mortgage Finance] assets ($1.5 -

$10 bil) that will create liquidity for WM and create a positive affordability

profile for FRE;

Expansion of credit profile into subprime; (Keith Johnson wants to keep this

point very general); …

Liquidity – we want to understand how we can best help the FRE portfolio

w/Product.

Longer term portfolio commitment on option ARMS;

Broader deliverability guidelines w/respect to option ARMs.”508

WaMu wrote that it also expected Freddie Mac to discuss trends related to accepting “lower

documentation standards.”509

In April 2006, WaMu signed a new, two-year contract with Freddie Mac, again agreeing

to sell the majority of its conforming loans to that company.510

503 See 7/5/2006 “Freddie Mac – WaMu Meeting,” document prepared by WaMu, JPM_WM03200453, Hearing

Exhibit 4/16-87 (“WM executed a majority share arrangement w/FRE [Freddie Mac], effective 4/1/05 thru 3/31/06;

included in that arrangement was a market-leading opportunity to sell up to $21 billion of option ARMs to the FRE

portfolio.”).

WaMu President Steve Rotella

504 Id.

505 Id.

506 Id.

507 Id.

508 Id. [italics in original omitted].

509 Id. at JPM_WM03200454.

140

wrote: “Congratulations to the team for getting this done and with terrific results for the

company.”511 In a document describing the “highlights” of the new agreement, a Wamu

employee wrote:

“Aligns WM with the stronger GSE over the next 12-18 months; we fully expect once

FNM [Fannie Mae] gets its financial house in order to become a very aggressive

competitor – just when this contract is coming up for renewal.”512

WaMu’s reference to the “stronger GSE” was in response to accounting scandals that,

over the prior year, had weakened both Freddie Mac and Fannie Mae. In 2003, Freddie Mac

announced that it had misstated its earnings by at least $4.5 billion, mostly by under-reporting its

earnings in order to smooth the volatility of its quarterly earnings reports, and would be restating

its earnings for the prior three years.513 Later that year, Freddie Mac paid a $125 million civil

fine to settle civil charges of accounting fraud brought by its regulator, the Office of Federal

Housing Enterprise Oversight (OFHEO).514 In September 2004, OFEHO issued a report finding

that Fannie Mae had also violated accounting rules to smooth its earnings reports.515 Fannie Mae

later filed a $6.3 billion restatement of earnings and paid a $400 million fine.516

When asked at the Subcommittee hearing to define Washington Mutual’s relationship

with Fannie Mae and Freddie Mac, Mr. Rotella provided the following response:

Both GSEs also

changed their senior management.

“Well, like all big mortgage lenders, Senator, Fannie Mae and Freddie Mac were

important .... [T]here was a substantial amount of production that was sold off to either

Fannie or Freddie. ... [A]ny mortgage lender that is in the mortgage business, given the

government advantages and the duopoly that Fannie and Freddie had, needed to do

business with them. It would be very difficult to be a mortgage player without them.”517

510 See 4/28/2006 email exchange between WaMu executives, JPM_WM02521921, Hearing Exhibit 4/16-89

(celebrating contract that “David Schneider signed today”).

511 Id.

512 Id.

513 See “Freddie Mac Raises its Estimate of Errors,” Associated Press (9/26/2003).

514 See “Freddie to Settle with Fat Civil Fine,” Associated Press (12/11/2003). In 2007, Freddie Mac paid an

additional $50 million civil fine to the SEC to settle civil charges of securities fraud, without admitting or denying

wrongdoing. “Freddie Mac to Pay $50 million,” Associated Press (9/28/2007).

515 9/17/2004 Office of Federal Housing Enterprise Oversight Report of Findings to Date, “Special Examination of

Fannie Mae,” available at http://www.fhfa.gov/Preview-

FHFAWWW/webfiles/748/FNMfindingstodate17sept04.pdf.

516 See 2004 10-K filing with the SEC. Fannie Mae paid the $400 million civil fine in May 2006, to settle

accounting fraud charges brought by OFHEO and SEC. See also “Fannie Settles Fraud Charges,” National

Mortgage News (5/29/2006).

517 April 13, 2010 Subcommittee Hearing at 105, Senator Coburn question to Mr. Rotella.

141

Loan Sales to Fannie and Freddie. During the years examined by the Subcommittee,

WaMu sold a variety of loans to both Fannie Mae and Freddie Mac, including 15, 20, and 30-

year fixed rate mortgages; Option ARMs; interest-only ARMs; and hybrid ARMs.518

A September 2005 chart prepared by WaMu, identifying the loans it sold to Fannie Mae

and Freddie Mac during the first part of that year, details the types and volumes of loans

involved.519 The chart showed, for example, that the largest category of loans that WaMu sold to

Fannie and Freddie at that point in 2005 was fixed rate loans, which together totaled nearly

140,000 loans with a collective, total loan amount of about $24.3 billion.520 The next largest

category of loans was Option ARMs, which WaMu sold only to Freddie Mac and which

consisted of 35,421 loans with a total loan amount of about $7.9 billion.521 The third largest

category was interest-only ARMs, totaling about 8,400 loans with a total loan amount of about

$2 billion.522 The fourth largest category was hybrid ARMs, totaling 6,500 loans with a total

loan amount of about $1.4 billion.523 WaMu also sold other loans to Fannie and Freddie which

included 6,020 loans of various types bearing a total loan amount of about $2 billion.524

The chart showed that, altogether by September 2005, WaMu had sold Fannie and

Freddie about 196,000 loans with a total loan amount of $36.5 billion.525 About 70% were fixed

rate loans;526 about 20% were Option ARMs;527 and other types of loans made up the final 10%.

In addition to those single family mortgages, WaMu had an active business with Fannie and

Freddie regarding loans related to multifamily apartment buildings.528 The 2005 loan data

indicates that WaMu sold twice as many loans to Fannie and Freddie as it did to all other buyers

combined.529

518 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit

4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). For more information on these types of

loans, see Chapter II, above. WaMu did not sell loans directly to Ginnie Mae which, instead, guaranteed certain

government backed mortgages when they were securitized by one of its approved securitizers. The WaMu chart

showed that, in 2005, WaMu originated 35,291 loans with a total loan amount of about $4.6 billion that were

securitized with Ginnie Mae guarantees. Id.

Most of those loans were fixed rate mortgages, but they also included the higher

519 Id.

520 Id. The WaMu chart showed that WaMu sold 31,460 fixed rate loans with a total loan amount of about $5.2

billion to Fannie Mae, and 108,246 loans with a total loan amount of about $19.1 billion to Freddie Mac.

521 Id.

522 Id. The WaMu chart showed that WaMu sold 5,350 interest-only ARMs with a total loan amount of about $1.3

billion to Fannie Mae, and 3,016 interest-only ARMs with a total loan amount of $724 million to Freddie Mac.

523 Id. The WaMu chart showed that WaMu sold 3,250 hybrid ARMs with with a total loan amount of nearly $700

million to Fannie Mae, and 3,303 hybrid ARMs with a total loan amount of nearly $700 million to Freddie Mac.

524 Id. See chart for more detail.

525 Id. The chart showed that, altogether, WaMu sold about 45,000 loans with a total loan amount of $7.9 billion to

Fannie Mae and 151,000 loans with a total loan amount of about $28.6 billion to Freddie Mac.

526 By loan number, the percentage is 71%; by loan amount, the percentage is 67%.

527 By loan number, the percentage is 18%; by loan amount, the percentage is 22%.

528 See, e.g., 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at

JPM_WM02405461, JPM_WM02405467, Hearing Exhibit 4/16-86 (chart entitled, “Overview of the Alliance,” and

“WaMu was responsible for 34.7% of Fannie Mae’s Multifamily business”).

529 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit

4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). During the same time period in 2005,

WaMu sold about 99,000 loans with a total loan amount of about $35 billion to buyers other than Fannie and

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risk Option ARMs. In 2005, for example, WaMu sold three times as many Option ARMs to

Freddie Mac than to all of its other buyers combined.530

The amount and variety of the loans that WaMu sold to the GSEs fluctuated over time.

For example, the following chart, which is taken from data compiled by Inside Mortgage

Finance, presents the total dollar volume of loans sold by WaMu to Fannie and Freddie from

2000 until 2008 when WaMu was sold, as well as the percentage those loans represented

compared to WaMu’s total loan originations.531

Year Sold to Freddie Mac

(in billions)

Sold to Fannie Mae

(in billions)

Percent of Total WaMu

Originations Sold to GSEs

2000 $ 0 $ 7.1 14%

2001 $ 1.4 $ 35.3 20%

2002 $ 0.2 $ 95.7 29%

2003 $ 2.2 $ 174.3 40%

2004 $ 1.1 $ 25.9 10%

2005 $ 34.6 $ 20.3 20%

2006 $ 32.3 $ 11.2 23%

2007 $ 31.8 $ 8.2 29%

2008 $ 20.8 $ 2.1 70%

TOTAL $ 124.4 $ 380.1 27.3%

Source: Inside Mortgage Finance

The data indicates that, in total, WaMu sold more than half a trillion dollars in loans to the two

GSEs in the nine years leading up to the bank’s collapse, accounting for more than a quarter of

all of the loans WaMu originated.

The documents obtained by the Subcommittee indicate that, from 2004 to 2008, Fannie

Mae and Freddie Mac competed to purchase billions of dollars in WaMu’s residential mortgage

loans, and WaMu used that competition to negotiate better terms for its loan sales. Twice during

that period, WaMu successfully played one GSE off the other to sell more high risk Option

ARM loans under better terms to Freddie Mac.

Freddie. The two largest categories of loans sold to buyers other than Fannie or Freddie were jumbo loans (43,758

loans with a total loan amount of $26.9 billion) and government backed loans in securities guaranteed by Ginnie

Mae (35,291 loans with a total loan amount of $4.6 billion). Id.

530 Id. The chart indicates that WaMu sold over 17,000 loans with a total loan amount of nearly $4 billion to Freddie

Mac, but only 5,841 Option ARMs with a total loan amount of $1.2 billion to all other buyers. It is possible,

however, that the data on Option ARMs sold to other buyers is understated if some portion of the loans categorized

on the chart as “jumbo” loans were, in fact, also Option ARMs. See, e.g., Id. at JPM_WM02575611, Hearing

Exhibit 4/16-91 (interpretive note below chart); 8/2006 WaMu chart entitled, “WaMu Originations Product Mix,” at

JPM_WM00212644, Hearing Exhibit 4/13-37 (showing that WaMu used Option ARMs in both conforming and

jumbo loans). In addition to selling Option ARMs to Freddie Mac and others, WaMu kept a portion of the Option

ARMs it originated in its investment portfolio and securitized still others.

531 “Historical Data from Inside Mortgage Finance, Inside Mortgage Finance, www.imfpubs.com/data.

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F. Destructive Compensation Practices

Washington Mutual and Long Beach’s compensation practices contributed to and

deepened its high risk lending practices. Loan officers and processors were paid primarily on

volume, not primarily on the quality of their loans, and were paid more for issuing higher risk

loans. Loan officers and mortgage brokers were also paid more when they got borrowers to pay

higher interest rates, even if the borrower qualified for a lower rate a practice that enriched

WaMu in the short term, but made defaults more likely down the road. Troubling compensation

practices went right to the top. In 2008, when he was asked to leave the bank that failed under

his management, CEO Kerry Killinger received a severance payment of $15 million.532

(1) Sales Culture

WaMu’s compensation policies were rooted in the bank culture that put loan sales ahead

of loan quality. As early as 2004, OTS expressed concern about WaMu’s sales culture: “The

overt causes for past underwriting concerns were many, but included: (1) A sales culture

focused heavily on market share via loan production, (2) extremely high lending volumes.”533 In

early 2005, WaMu’s Chief Credit Officer complained to Mr. Rotella that: “[a]ny attempts to

enforce [a] more disciplined underwriting approach were continuously thwarted by an

aggressive, and often times abusive group of Sales employees within the organization.”534 The

aggressiveness of the sales team toward underwriters was, in his words, “infectious and

dangerous.”535

In late 2006, as home mortgage delinquency rates began to accelerate and threaten the

viability of WaMu’s High Risk Lending Strategy, Home Loans President David Schneider

presided over a “town hall” meeting to rally thousands of Seattle based employees of the WaMu

Home Loans Group.536

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

the Subcommittee, Hearing Exhibit 4/13-1h.

At the meeting, Mr. Schneider made a presentation, not just to WaMu’s

sales force, but also to the thousands of risk management, finance, and technology staff in

533 5/12/2004 OTS Safety & Soundness Examination Memo 5, “SFR Loan Origination Quality,” at 1, Hearing

Exhibit 4/16-17.

534 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current

Conditions, and Future Opportunities,” JPM_WM00783315 (a legal pleading states this draft memorandum was

prepared for Mr. Rotella by WaMu’s Chief Credit Officer in or about February or March 2005; FDIC v. Killinger,

Case No. 2:2011cv00459 (W.D. Wash.), Complaint (March 16, 2011), at ¶ 35).

535 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current

Conditions, and Future Opportunities,” JPM_WM00783315, at JPM_WM00783322.

536 Mr. Schneider told the Subcommittee that this meeting was held in early 2007, but Ms. Feltgen’s end of 2006

email to her staff quotes Mr. Schneider’s language from this presentation. 1/3/2007 email from Ron Cathcart to

Cheryl Feltgen, Hearing Exhibit 4/13-73.

144

attendance.537 The title and theme of his presentation was: “Be Bold.”538 One slide

demonstrates the importance and pervasiveness of the sales culture at WaMu:539

When asked about this presentation, Mr. Schneider told the Subcommittee it was an appropriate

message, even for WaMu’s risk managers.540

The sales culture was also promoted through WaMu’s “President’s Club,” which

sponsored an annual all-expense-paid gala and retreat in an exotic locale, such as Hawaii or the

Bahamas, where the top producing loan officers were feted and lavished with gifts and

plaudits.541 Only a limited number of top producing loan officers were made members of the

club, and the President’s Club trips were used to incentivize sales volume. Loan officers were

encouraged to look up their sales rankings on the company’s intranet to see if they would qualify

for a trip.

In November 2006, as subprime mortgages began to incur delinquencies, Mr. Schneider

sent a letter about the President’s Club to WaMu loan consultants. Under a photo of the Grand

Hyatt Kauai in Hawaii and the banner headline, “President’s Club – Take the Lead!,” Mr.

Schneider wrote:

537 Subcommittee interview of David Schneider (2/17/2010).

538 “Way2Go, Be Bold!,” WaMu presentation prepared by David Schneider, Home Loans President, at 28, Hearing

Exhibit 4/13-4.

539 Id. at 30 [recreated by the Subcommittee staff from an image].

540 Subcommittee interview of David Schneider (2/17/2010).

541 Subcommittee interviews of Brian Minkow (2/16/2010), David Schneider (2/17/2010), and Kerry Killinger

(2/5/2010).

145

“I attended WaMu’s President’s Club last year for the first time and had an awesome

time getting to know the stars of our sales force. You work hard, but you know how to

have a good time too ….

“At the first-class awards dinner, I looked around the room and felt honored to be with so

many talented people. Congratulations to those of you who were repeat President’s Club

honorees. Of those of you who have not yet reached the President’s Club, I want each

and every one of you to believe you have the potential to achieve this great reward.

“Now is the time to really kick it into high gear and drive for attending this awesome

event! Rankings are updated and posted monthly on the DashBoards (under reports) and

on WaMu.net: President’s Club Rankings. Where do you rank? What can you do to take

your business [to] the next level? Your management team is here to help.”542

At the April 13 Subcommittee hearing, Mr. Schneider testified:

“As housing prices peaked, the economy softened, and credit markets tightened, WaMu

adopted increasingly conservative credit policies and moved away from loan products

with greater credit risk. ... During my time at WaMu, we reduced and then entirely

stopped making Alt A loans and Option ARM loans.”543

However, his November 2006 letter to WaMu loan consultants showed no reticence about the

High Risk Lending Strategy. The letter went on to say:

“As you know, growth is a key area of focus for WaMu and Home Loans. I am

extremely proud of the achievements in Production so far this year and I know it’s been

tough. I’m especially pleased with your ability to change with the market and

responsibly sell more higher-margin products Option ARM, Home Equity, Non-prime,

and Alt A. I also know that you truly the best sales team in the industry are up to the

challenge of doing even more by year end. ...

“I hope to see you in Kauai!”544

The 2005 President’s Club retreat had taken place in Maui. The awards night was hosted

by Magic Johnson. An excerpt of the script from the evening gives a sense of the proceedings:

“VOICE-OVER ANNOUNCER

Good evening ladies and gentleman and welcome to your President’s Club 2005

Awards Night program!

Please welcome the host of President’s Club, the President of the Washington

Mutual Home Loans Group, Mr. David Schneider!

542 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62.

543 Prepared statement of David Schneider, April 13, 2010 Subcommittee Hearing.

544 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62.

146

WALK-UP MUSIC

FOR DAVID SCHNEIDER

DAVID SCHNEIDER

Thank you ladies and gentlemen, and welcome to this very special Awards

Evening.

Wow, could you feel the energy and excitement tonight out on the Red Carpet?!

Talk about star power!

And it was great fun to learn so much more about some of you during the

interviews … and at the bar.

But don’t worry. I’m told that the age-old tradition here at Washington Mutual is,

‘What happens at President’s Club stays at President’s Club.’ And who am I to

mess with tradition?

Tonight we are gathered together to pay the highest respects and honors to those

who deserve them the most, the President’s Club Class of 2005. …

And of course I want to pay special homage to all of you astonishing returning

champions of President’s Club. You multiple award-winning superstars clearly

lead our entire industry as the standard others can only attempt to match. You

folks really do make this feel like the academy awards tonight because

everywhere I turn I see another star of another box office sensation.”545

This 2005 awards ceremony was attended by WaMu loan officers Luis Fragoso and Thomas

Ramirez at the same time they were under investigation for fraud. Both were members of the

President’s Club in 2005 and 2006.

When asked about the sales culture at the bank, Mr. Vanasek testified at the hearing that

he tried in vain to counter it. He recalled one occasion at an annual management retreat in 2004,

in which the bank was promoting a new advertising slogan called, “The Power of Yes”:

“I stood in front of thousands of senior Washington Mutual managers and executives in

an annual management retreat in 2004 and countered the senior executive ahead of me on

the program who was rallying the troops with the company's advertising line, ‘The power

of yes.’ The implication of that statement was that Washington Mutual would find some

way to make a loan. The tag line symbolized the management attitude about mortgage

lending more clearly than anything I can tell you.

545 2005 “President’s Club 2005 - Maui, Awards Night Show Script,” Washington Mutual Home Loans Group,

Hearing Exhibit 4/13-63a.

147

“Because I believed this sent the wrong message to the loan originators, I felt compelled

to counter the prior speaker by saying to the thousands present that the power of yes

absolutely needed to be balanced by the wisdom of no. This was highly unusual for a

member of the management team to do, especially in such a forum. In fact, it was so far

out of the norm for meetings of this type that many considered my statement exceedingly

risky from a career perspective.”546

The President’s Club annual trip was the pinnacle of WaMu awards to its top producing

loan consultants. One loan consultant interviewed by the Subcommittee described it as an

incredible experience, with first class airfare, daily gifts, lavish food, and top entertainment for

both employees and their spouses.547 It was also an opportunity to meet WaMu’s top executives,

including Mr. Killinger, Mr. Rotella, and Mr. Schneider. It sent a powerful message about the

priority that WaMu placed on loan volume and sales of higher risk loans.

(2) Paying for Speed and Volume

The Long Beach and Washington Mutual compensation systems encouraged high

volumes of risky loans but provided little or no incentive to ensure high quality loans that

complied with the bank’s credit requirements. WaMu loan officers or their sales associates

typically interacted directly with customers interested in obtaining loans. Some also were

allowed to accept loans brought to them by third party lenders or mortgage brokers. Long Beach

account executives dealt only with third party lenders or mortgage brokers; they did not deal

directly with customers. After reaching agreement on a loan, the WaMu or Long Beach loan

officers or executives completed the loan application and sent it to a loan processing center

where the application was reviewed by an underwriter and, if approved, underwent further

processing and brought to a loan closing.

Long Beach and Washington Mutual loan officers received more money per loan for

originating higher risk loans and for exceeding established loan targets. Loan processing

personnel were compensated according to the speed and number of the loans they processed.

Loan officers and their sales associates received still more compensation if they charged

borrowers higher interest rates or points than required in bank rate sheets specifying loan prices,

or included prepayment penalties in the loan agreements. That added compensation created

incentives to increase loan profitability, but not loan quality. A 2008 OTS review elaborated:

“[T]he review defines an origination culture focused more heavily on production volume

rather than quality. An example of this was a finding that production personnel were

allowed to participate in aspects of the income, employment, or asset verification process,

a clear conflict of interest. … Prior OTS examinations have raised similar issues

546 April 13, 2010 Subcommittee Hearing at 16-17.

547 Subcommittee interview of Brian Minkow (2/16/2010).

148

including the need to implement incentive compensation programs to place greater

emphasis on loan quality.”548

(a) Long Beach Account Executives

Despite the years of internal and external audits that found a lack of internal controls at

Long Beach that led to some of the worst rates of loan delinquency in the subprime industry,

Long Beach continued to incentivize production volume over sound lending. The Subcommittee

obtained a presentation of the Long Beach 2004 Incentive Plan.549 The plan outlines four

compensation tiers based on volume, creating a system where the largest producers not only

make more money by issuing more loans, but rather, as producers climb more of the tiers, they

earn a higher rate of commission as well. Tier 1 Long Beach account executives, those who

closed 1-6 loans or funded up to $899,000 in loans per month, received 40 basis points (bps)

commission for each broker sourced loan.550 Tier 2 Long Beach account executives, those who

closed 7-12 loans or funded between $900,000 and $2,499,999 in loans per month, received 50

bps commission for each broker sourced loan plus $30 per loan in additional compensation. Tier

3 Long Beach account executives, those who closed 13-26 loans or funded between $2,500,000

and $4,999,999 in loans per month, received 55 bps commission for each broker sourced loan

plus $30 additional per loan. Tier 4 Long Beach account executives, those who closed more than

26 loans or funded more than $5,000,000 in loans per month, received 60 bps commission for

each broker sourced loan.551

The 2004 Long Beach Incentive Plan also introduced a contingent compensation program

called, “Long Term Cash Incentive Program,” which provided bonuses tied to the performance

of WaMu stock and could be converted to cash over a three-year period. Top producing Long

Beach account executives received the Long Term Cash Incentive bonus calculated as a small

percentage of overall volume. Like the tier system, as volume increased so did the percentage

used to calculate the bonus. Account executives ranked in the top 25% in volume received a five

bps bonus on their total production, account executives in the top 15% received a 7.5 bps bonus,

and account executives in the top 5% received a 10 bps bonus. These bonuses could add up to

tens of thousands, if not hundreds of thousands of dollars.552

In addition, in 2004, the top 40 Long Beach account executives were rewarded with a trip

to the President’s Club. Long Beach used a point system to calculate the top account executives

for this purpose. Three points were awarded for each loan funded for first mortgages, two points

548 6/19/2008 OTS Findings Memorandum, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13-

25.

549 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59a.

550 Id. The “units” referred to in the document are “loans.” Subcommittee interview of Brian Minkow (2/16/2010).

By awarding “basis points” the compensation system ensured that the account executives got a percentage of the

loan amounts that they successfully issued after receiving loan information from a broker, incentivizing them to

maximize the dollar amount of the loans they issued. Some were also paid a per loan fee, incentivizing them to sell

as many loans as possible.

551 Id.

552 Id.

149

were awarded for each purchase loan funded (as opposed to a refinance), and two points were

awarded for each $100,000 funded. The point system created a competition that focused

primarily on volume. The 2004 incentive plan makes no reference to loan quality.553

Long Beach regularly made changes to the compensation plan, but the basic volume

incentives remained. In the 2007 incentive plan, which took effect after the collapse of the

subprime market, the volume requirements were even greater than 2004 requirements. In 2007,

the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13

qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans

and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or

more funded.554

(b) WaMu Loan Consultants

Like Long Beach, at WaMu loan officers were compensated for the volume of loans

closed and loan processors were compensated for speed of loan closing rather than a more

balanced scorecard of timeliness and loan quality. According to the findings and

recommendations from an April 2008 internal investigation into allegations of loan fraud at

WaMu:

“A design weakness here is that the loan consultants are allowed to

communicate minimal loan requirements and obtain various verification

documents from the borrower that [are] need[ed] to prove income,

employment and assets. Since the loan consultant is also more intimately

familiar with our documentation requirements and approval criteria, the

temptation to advise the borrower on means and methods to game the

system may occur. Our compensation and reward structure is heavily

tilted for these employees toward production of closed loans.”555

An undated presentation obtained by the Subcommittee entitled, “Home Loans Product

Strategy, Strategy and Business Initiatives Update,” outlines WaMu’s 2007 Home Loans

Strategy and shows the decisive role that compensation played, while providing still more

evidence of WaMu’s efforts to execute its High Risk Lending Strategy:

“2007 Product Strategy

Product strategy designed to drive profitability and growth

-Driving growth in higher margin products (Option ARM, Alt A, Home

Equity, Subprime) …

553 Id.

554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b.

555 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name

redacted],” at 11, Hearing Exhibit 4/13-24.

150

-Recruit and leverage seasoned Option ARM sales force, refresh existing

training including top performer peer guidance

-Maintain a compensation structure that supports the high margin product

strategy”556

The presentation goes on to explain the Retail Loan Consultant incentive plan: “Incentive Tiers

reward high margin products … such as the Option ARM, Non-Prime referrals and Home Equity

Loans …. WaMu also provides a 15 bps ‘kicker’ for selling 3 year prepayment penalties.”557

In order to promote high risk, high margin products, WaMu paid its loan consultants

more to sell them. WaMu divided its products into four categories: “W,” “A,” “M,” and “U.”

WaMu paid the highest commissions for “W” category products, and in general, commissions

decreased though the other categories. “W” products included new Option ARMs, “Non-prime”

referrals, and home equity loans. “A” products included Option ARM refinancings, new hybrid

ARMs, new Alt A loans, and new fixed rate loans. Like Long Beach, WaMu also created four

compensation tiers with increasing commissions based on volume. The tiers were called:

“Bronze,” “Silver,” “Gold,” and “Platinum.”558 Even in 2007, WaMu’s compensation plan

continued to incentivize volume and high risk mortgage products.

In 2007, WaMu also adopted a plan to pay “overages,” essentially a payment to loan

officers who managed to sell mortgages to clients with higher rates of interest than the clients

qualified for or were called for in WaMu’s daily rate sheets. The plan stated:

“Overages … [give a] Loan Consultant [the] [a]bility to increase compensation [and]

[e]nhance compensation/incentive for Sales Management …. Major national competitors

have a similar plan in place in the market. ”559

Under the 2007 plan, if a loan officer sold a loan that charged a higher rate of interest than

WaMu would have accepted according to its rate sheet, WaMu would split the additional profit

with the loan officer.560 This compensation practice, often referred to as awarding “yield spread

premiums,” has been barred by the Dodd-Frank Act implementing financial reforms.561

556 2007 WaMu Home Loans Product Strategy, “Strategy and Business Initiatives Update,” JPM_WM03097217,

Hearing Exhibit 4/13-60a [emphasis in original].

557 Id.

558 Id.

559 12/6/2006 WaMu Home Loan Credit Risk F2F, JPM_WM02583396-98, Hearing Exhibit 4/13-60b (The proposal

to pay overages, adopted in 2007, increased compensation for loan officers who sold loans with a higher interest rate

or more points than required on WaMu’s daily rate sheet.)

560 Subcommittee interview of David Schneider (2/17/2010).

561 Section 1403 of the Dodd-Frank Act (prohibiting “steering incentives”).

151

(c) Loan Processors and Quality Assurance Controllers

At Long Beach and WaMu, volume incentives were not limited to the sales people. Back

office loan processors and quality control personnel were also compensated for volume. While

WaMu executives and senior managers told the Subcommittee that quality control was

emphasized and considered as part of employee compensation, the back office staff said

otherwise.562 Diane Kosch worked as a Quality Assurance Controller in a Long Beach Loan

Fulfillment Center (LFC) in Dublin, California, east of San Francisco Bay. She told the

Subcommittee that the pressure to keep up with the loan volume was enormous. Each month the

LFC would set volume goals, measured in dollar value and the number of loans funded. At the

end of each month the pressure to meet those goals intensified. Ms. Kosch said that at month’s

end, she sometimes worked from 6 a.m. until midnight reviewing loan files. Monthly rallies

were held, and prizes were awarded to the underwriters and loan processors who had funded the

most loans.563

Documents obtained by the Subcommittee confirm Ms. Kosch’s recollections. A

September 2004 email sent to all Dublin LFC employees with the subject line, “Daily

Productivity – Dublin,” by the area manager uses creative formatting to express enthusiasm:

“Less than 1 week and we have a long way to go to hit our 440M!

including today, we have 4 days of fundings to end the Quarter with a

bang! With all the new UW changes, we will be swamped next month, so

don’t hold any back!

4 days…..it’s time for the mad dash to the finish line! Who is in the

running……

Loan Set Up – Phuong is pulling away with another 18 files set up

yesterday for 275 MTD! 2nd place is held by Jean with 243…can you

catch Phuong? Get ready Set Up – come October, it’s going to get a little

crazy!

Underwriting – Michelle did it! She broke the 200 mark with 4 days left

to go! Nice job Michelle! 2nd place is held by Andre with 176 for the

month! Way to go Andre! Four other UW’s had solid performances for

the day as well including Mikhail with 15! Jason and Chioke with 11

and June with 10 – The double digit club!”564

562 Subcommittee interview of Mark Brown (2/19/2010). Mr. Brown, WaMu National Underwriting Director, told

the Subcommittee that incentives for loan processors were based on quality standards and monthly volume.

563 Subcommittee interview of Diane Kosch (2/18/2010).

564 9/2004 Long Beach processing center internal email, Hearing Exhibit 4/13-61. In the email, “UW” stands for

Underwriting or Underwriter, and “SLC” stands for Senior Loan Coordinator.

152

Ms. Kosch told the Subcommittee that from late 2005 until early 2007, loan volume

increased and loan quality remained very poor. She said that just about every loan she reviewed

was a stated income loan, sloppy, or appeared potentially fraudulent. Yet she was not given the

resources or support to properly review each loan. Ms. Kosch said that she was told by a Quality

Control manager that she should spend 15 minutes on each file, which she felt was insufficient.

Yet, because Quality Assurance Controllers received a bonus on the basis of the number of loans

they reviewed, she said some of her colleagues spent only ten minutes on each file.565

Ms. Kosch found that often, when she tried to stop the approval of a loan that did not

meet quality standards, it would be referred to management and approved anyway. She said

good Quality Assurance Controllers were treated like “black sheep,” and hated because they got

in the way of volume bonuses. She said certain brokers were identified as “elite,” and the Dublin

LFC employees were told to, “take care of them.” Ms. Kosch even suspected some underwriters

were getting kickbacks, in part, because of the clothes they wore and cars they drove, which she

believed would have been unaffordable to even the top back office employees. She reported her

suspicions to her supervisor, but she was not aware of any action taken as a result.

As it turns out, Ms. Kosch’s concerns about fraud were not unfounded. The September

2004 Daily Productivity email also lauds the work of a Senior Loan Coordinator (SLC) named

John Ngo:

SLC – This one is still tight with Sandy holding on to the first place slot! Sandy

funded 4 more on Friday for a MTD total of 46! 2nd place is John Ngo with 4 fundings

on Friday and 44 MTD – only 2 back!”

About a year after this email was sent, the FBI began to question Mr. Ngo about a scheme to buy

houses in Stockton, California with fake documents and stolen identities. According to court

records, the FBI had uncovered documents that showed Mr. Ngo had received more than

$100,000 in payments from a mortgage broker, allegedly bribes to approve bad loans. Mr. Ngo’s

estranged wife told the FBI that she didn’t know how he could afford their $1.4 million home for

which he made a down payment of $350,000. At the time, his salary at Long Beach was

$54,000. 566

Mr. Ngo later pled guilty to perjury and agreed to testify against his Long Beach sales

associate, Joel Blanford. Long Beach paid Mr. Blanford more than $1 million in commissions

each year from 2003-2005. According to the Department of Justice:

“NGO admitted in his plea agreement that most of the payments were to ensure that

fraudulent loan applications were processed and funded. NGO also admitted he received

payments from Long Beach Mortgage sales representatives to push applications through

the funding process. He knew many of these applications were fraudulent, and he and

565 Subcommittee interview of Diane Kosch (2/18/2010).

566 “At Top Subprime Mortgage Lender, Policies Were an Invitation to Fraud,” Huffington Post Investigative Fund

(12/21/2009), http://www.huffingtonpost.com/2009/12/21/at-long-beach-mortgage-a_n_399295.html.

153

others took steps to ‘fix’ applications by creating false documents or adding false

information to the applications or the loan file.”567

(3) WaMu Executive Compensation

Questionable compensation practices did not stop in the loan offices, but went all the way

to the top of the company. WaMu’s CEO received millions of dollars in pay, even when his high

risk loan strategy began unraveling, even when the bank began to falter, and even when he was

asked to leave his post. From 2003 to 2007, Mr. Killinger was paid between $11 million and $20

million each year in cash, stock, and stock options. In addition, WaMu provided him with four

retirement plans, a deferred bonus plan, and a separate deferred compensation plan. In 2008,

when he was asked to leave to leave the bank, Mr. Killinger was paid $25 million, including $15

million in severance pay. Altogether, from 2003 to 2008, Washington Mutual paid Mr. Killinger

nearly $100 million, on top of multi-million-dollar corporate retirement benefits.568

As WaMu began losing billions of dollars due to the declining value of its loans and

mortgage backed securities, top management paid significant attention to ensuring that they

would be well compensated despite the crisis. In January 2008, Mr. Killinger sent Mr. Rotella an

email with the subject “comp,” seeking input on formulating compensation recommendations for

the Board of Directors’ Human Resources Committee. The email discussed compensation for

WaMu’s top executives. Mr Killinger wrote: “Our current thinking is to recommend that equity

grants be in options this year. … I am considering an additional restricted stock grant which

would help a bit on retention and to help offset the low bonus for 2007.” 569

Mr. Rotella responded that he thought WaMu executives would want more of their

bonuses in cash:

“[T]he feeling people will have about this is tied to the level of pain on the cash bonus

side …. Unfortunately more than a few feel that our stock price will not easily recover,

that it is highly dependent on housing and credit and they can’t influence that at all. This

will come on the heels of what will be a terrible fourth qtr, and likely very poor results in

the first half along with continued bad news in the environment. So we will have some

people thinking, ‘this is nice but I don’t see the upside in a time frame that works.’ Also,

as you know folks feel very burned by the way their paper was tied to performance

targets that they now see as unrealistic and tied to housing and have a jaundiced view of

paper. … People want more certainty now with some leverage, not a high dose of

leverage with low cash.”570

567 6/19/2008 Department of Justice press release, “Federal Authorities Announce Significant Regional Federal

Mortgage Fraud Investigations and Prosecutions Coinciding with Nationwide ‘Operation Malicious Mortgage’

Takedown,” http://sacramento.fbi.gov/dojpressrel/pressrel08/sc061908a.htm.

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

Subcommittee, Hearing Exhibit 4/13-1h.

569 1/3/2008 email chain between Kerry Killinger and Steve Rotella, JPM_WM01335818, Hearing Exhibit 4/13-65.

570 Id.

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Mr. Killinger replied: “In short, the success of the comp program is up to you and me. I think

we are putting the right economics and opportunities on the table. But we have to convince our

folks that they will all make a lot of money by being with WaMu.”571

In February 2008, the Human Resources Committee approved a bonus plan for executive

officers that tried to shield the executive bonuses from any impact caused by WaMu’s mounting

mortgage losses. The Committee established a formula consisting of four weighted performance

measures, but took steps to exclude mortgage losses. The first performance measure, for

example, set a goal for WaMu’s 2008 net operating profit, but adjusted the profit calculation to

exclude: “(i) loan loss provisions other than related to our credit card business and (ii) expenses

related to foreclosed real estate assets.”572 The second performance measure set a target limiting

WaMu’s 2008 noninterest expense, but excluded expenses related to: “(i) business resizing or

restructuring and (ii) foreclosed real estate assets.”573

WaMu filed its executive compensation plan with the SEC, as required. The exclusion of

mortgage related losses and expenses in the plan attracted notice from shareholders and the

press. One March 5, 2008 article entitled, “WaMu Board Shields Executives’ Bonuses,”

reported: “The board of Washington Mutual Inc. has set compensation targets for top executives

that will exclude some costs tied to mortgage losses and foreclosures when cash bonuses are

calculated this year.”574 WaMu employees circulated the article through company email.575

Investors and analysts raised concerns.

Mr. Killinger sought to respond to the controversy in a way that would placate investors

without alienating executives. His solution was to eliminate bonuses for the top five executives,

and make cash payments to the other executives, without making that fact public. In July, Mr.

Killinger emailed Steve Frank, the Chairman of the Board of Directors, with his proposal:

“We would like to have the HR [Human Resources] committee approve excluding the

exec com [Executive Committee] from the 2008 bonus and to approve the cash retention

grants to the non NEOs [Named Executive Officers]. This would allow me to respond to

questions next week regarding the bonus plan on the analyst call. And it would help calm

down some of the EC [Executive Committee] members.”576

In other words, WaMu would announce publicly that none of the Executive Committee members

would receive bonuses in 2008, while quietly paying “retention grants” rather than “bonuses” to

the next tier of executives. Mr. Frank replied, “Sounds OK to me.” Mr. Killinger followed up

with the explanation: “We would disclose the exclusion of EC [Executive Committee] members

from the bonus plan. There would be no disclosure of the retention cash payments. Option

571 Id.

572 2/28/2008 email from David Schneider, “FW: 2008 Leadership Bonus,” JPM_WM02446549.

573 Id.

574 “WaMu Board Shields Executives’ Bonuses,” Wall Street Journal (3/5/2008), Hearing Exhibit 4/13-67.

575 Id.

576 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.

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grants would be held off until whenever other comp. actions were done.”577 At WaMu’s annual

meeting with shareholders, the Board indicated that it had “reversed” the decision to exclude

mortgage losses when calculating executive bonuses and made no mention of the cash retention

payments planned for some executives.578

When WaMu failed, shareholders lost all of their investments. Yet in the waning days of

the company, top executives were still well taken care of. On September 8, 2008, Mr. Killinger

walked away with $25 million, including $15 million in severance pay. His replacement, Allen

Fishman, received a $7.5 million signing bonus for taking over the reins from Mr. Killinger in

September 2008.579 Eighteen days later, WaMu failed, and Mr. Fishman was out of a job.

According to his contract, he was eligible for about $11 million in severance pay when the bank

failed.580 It is unclear how much of the severance he received.

G. Preventing High Risk Lending

Washington Mutual was a $300 billion, 120-year-old financial institution that was

destroyed by high risk lending practices. By 2007, stated income loans loans in which

Washington Mutual made no effort to verify the borrower’s income or assets made up 50% of

its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. Nearly half of

its loans were Option ARMs of which 95% of the borrowers were making minimum payments

and 84% were negatively amortizing. Numerous loans had loan-to-value ratios of over 80%, and

some provided 100% financing. Loans issued by two high volume loan offices in the Los

Angeles area were found to have loan fraud rates of 58, 62, and even 83%. Loan officer sales

assistants were manufacturing borrower documentation. The bank’s issuance of hundreds of

billions of dollars in high risk, poor quality loans not only destroyed confidence in the bank, but

also undermined the U.S. financial system.

The consequences of WaMu’s High Risk Lending Strategy and the proliferation of its

RMBS structured finance products incorporating high risk, poor quality loans provide critical

lessons that need to be learned to protect the U.S. financial system from similar financial

disasters. A number of developments over the past two years hold promise in helping to address

many of the problems identified in the Washington Mutual case history.

(1) New Developments

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),

P.L. 111-203, which the President signed into law on July 21, 2010, contains a number of

changes in law that will be implemented over the course of 2011. The Dodd-Frank Act changes

577 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.

578 See, e.g., “Shareholders Score at WaMu,” Bloomberg BusinessWeek (4/15/2008) (“And perhaps most notable:

WaMu reversed a much-criticized decision to leave out the company’s mortgage related losses when calculating

profits that determine executive bonuses for the year ahead.”).

579 “WaMu Creditors could Challenge Payments to Killinger, Others,” Seattle Times (10/1/2008), Hearing Exhibit

4/13-68.

580 “WaMu CEO: 3 Weeks Work, $18M,” CNNMoney.com (9/26/2008).

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include banning stated income loans; restricting negative amortization loans; requiring lenders to

retain an interest in high risk loan pools that they sell or securitize; prohibiting lenders from

steering borrowers to poor quality, high risk loans; and re-evaluating the role of high risk,

structured finance products in bank portfolios.

Ban on Stated Income Loans. Multiple witnesses at the Subcommittee’s April 16, 2010

hearing on the role of bank regulators expressed support for banning stated income loans. The

FDIC Chairman Sheila Bair testified: “We are opposed to stated income. … We think you

should document income.”581 When asked for his opinion of stated income loans, the FDIC

Inspector General Jon Rymer responded: “I do not think they should be allowed,”582 stressing

the fraud risk: “I really can see no practical reason from a banker’s perspective or a lender’s

perspective to encourage that. … That is just, to me, an opportunity to essentially encourage

fraud.” 583 Treasury Inspector General Eric Thorson also criticized stated income loans,

explaining: “[T]he problem is, you can’t assess the strength of the borrower and that has got to

be at the foundation of underwriting, risk assessment, risk management.”584 Even the former

head of OTS called stated income loans an “anathema” and expressed regret that OTS had

allowed them.585

The Dodd-Frank Act essentially bans stated income loans by establishing minimum

standards for residential mortgages in Title XIV of the law. Section 1411 establishes a new

Section 129C of the Truth in Lending Act (TILA) prohibiting lenders from issuing a residential

mortgage without first conducting a “good faith and reasonable” determination, based upon

“verified and documented information,” that a borrower has a “reasonable ability to repay the

loan” and all applicable taxes, insurance, and assessments. Subsection 129C(a)(4) states the

lender “shall verify” the borrower’s income and assets by reviewing the borrower’s W-2 tax

form, tax returns, payroll receipts, financial institution records, or “other third-party documents

that provide reasonably reliable evidence” of the borrower’s income or assets. In addition,

Section 1412 of the Dodd-Frank Act adds a new Subsection 129C(b) to TILA establishing a new

category of “qualified mortgages” eligible for more favorable treatment under federal law. It

states that, in all “qualified mortgages,” the “income and financial resources” of the borrower

must be “verified and documented.”

These statutory requirements, by prohibiting lenders from issuing a residential mortgage

without first verifying the borrower’s income and assets, essentially put an end to stated income

loans.586

581 April 16, 2010 Subcommittee Hearing at 88.

582 Id. at 27.

583 Id. at 15.

584 Id.

585 Id. at 42, 142.

586 The Federal Reserve is charged with issuing regulations to implement Section 1411. Federal Reserve regulations

issued in July 2008, under the authority of the Home Ownership and Equity Protection Act (HOEPA) of 1994,

which took effect in October 2009, already require lenders issuing certain high cost mortgages to verify a borrower’s

ability to repay the loan. 73 Fed. Reg. 147, at 44543 (7/30/2008). Since the Dodd-Frank Act applies to all types of

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Restrictions on Negative Amortization Loans. Witnesses at the Subcommittee’s April

16 hearing also criticized WaMu’s heavy reliance on Option ARM loans. These loans provided

borrowers with a low initial interest rate, which was followed at a later time by a higher variable

rate. Borrowers were generally qualified for the loans by assuming they would pay the lower

rather than the higher rate. In addition, borrowers were allowed to select one of four types of

monthly payments, including a “minimum payment” that was less than the interest and principal

owed on the loan. If the borrower selected the minimum payment, the unpaid interest was added

to the unpaid loan principal, which meant that the loan debt could increase rather than decrease

over time, resulting in negative amortization.

At the Subcommittee hearing, the FDIC Inspector General Jon Rymer warned that

negative amortization loans are “extraordinarily risky” for both borrowers and banks.587 The

FDIC Chairman Sheila Bair testified:

“We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed

rate. You should document the customer’s ability to repay, not just the initial

introductory rate, but if it is an adjustable product, when it resets, as well.”588

The Dodd-Frank Act does not ban negatively amortizing loans, but does impose new

restrictions on them. Section 1411 amends TILA by adding a new Section 129C(6) that requires,

for any residential mortgage that allows a borrower “to defer the repayment of any principal or

interest,” that the lender vet potential borrowers based upon the borrower’s ability to make

monthly loan payments on a fully amortizing schedule meaning a schedule in which the loan

would be fully repaid by the end of the loan period instead of evaluating the borrower’s ability

to make payments at an initial teaser rate or in some amount that is less than the amount required

at a fully amortized rate. The law also requires the lender, when qualifying a borrower, to “take

into consideration any balance increase that may accrue from any negative amortization

provision.” This provision essentially codifies the provisions in the 2006 Nontraditional

Mortgage Guidance regarding qualification of borrowers for negatively amortizing loans.

In addition, Section 1414 of the Dodd-Frank Act adds a new Section 129C(c) to TILA

prohibiting lenders from issuing a mortgage with negative amortization without providing certain

disclosures to the borrower prior to the loan. The lender is required to provide the borrower with

an explanation of negative amortization in a manner prescribed by regulation as well as describe

its impact, for example, how it can lead to an increase in the loan’s outstanding principal

balance. In the case of a first-time home buyer, the lender must also obtain documentation that

the home buyer received homeownership counseling from a HUD-certified organization or

counselor. Finally, Section 1412 of the Dodd-Frank Act, establishing the new favored category

of “qualified mortgages,” states those mortgages cannot negatively amortize.

mortgage loans, the Federal Reserve is expected to issue revised regulations during 2011, expanding the verification

requirement to all mortgage loans.

587 April 16, 2010 Subcommittee Hearing at 16.

588 Id. at 88.

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Together, these borrower qualification and disclosure requirements, if well implemented,

should reduce, although not eliminate, the issuance of negative amortization mortgages.

Risk Retention. One of the root causes of the financial crisis was the ability of lenders

like Washington Mutual to securitize billions of dollars in high risk, poor quality loans, sell the

resulting securities to investors, and then walk away from the risky loans it created. At the April

16 Subcommittee hearing, the FDIC Chairman Bair testified:

“[W]e support legislation to require that issuers of mortgage securitizations retain some

‘skin in the game’ to provide added discipline for underwriting quality. In fact, the FDIC

Board will consider … a proposal to require insured banks to retain a portion of the credit

risk of any securitizations that they sponsor.”589

Section 941(b) of the Dodd-Frank Act adds a new section 15G to the Securities Exchange

Act of 1934 to require the federal banking agencies, SEC, Department of Housing and Urban

Development, and Federal Housing Finance Agency jointly to prescribe regulations to “require

any securitizer to retain an economic interest in a portion of the credit risk for any residential

mortgage asset that the securitizer, through the issuance of an asset-backed security, transfers,

sells, or conveys to a third party.”590 The retained economic interest must be “not less than 5

percent of the credit risk” of the assets backing the security, with an exception made for

“qualified residential mortgages,” to be further defined by the regulators. The regulators issued a

proposed rule early in 2011, which is currently the subject of a public comment period.

In the meantime, the FDIC has issued a new regulation, effective September 30, 2010,

that imposes a range of disclosure, risk retention, and other obligations on all insured banks that

issue asset backed securitizations.591 One of the provisions imposes a 5% risk retention

requirement on all asset backed securitizations issued by an insured bank, whether backed by

mortgages or other assets. The provision states that the bank sponsoring the securitization must:

“retain an economic interest in a material portion, defined as not less than five (5)

percent, of the credit risk of the financial assets. This retained interest may be either in

the form of an interest of not less than five (5) percent in each of the credit tranches sold

or transferred to the investors or in a representative sample of the securitized financial

assets equal to not less than five (5) percent of the principal amount of the financial assets

at transfer. This retained interest may not be sold or pledged or hedged, except for the

hedging of interest rate or currency risk, during the term of the securitization.”592

The provision also states that this risk retention requirement applies only until the “effective

date” of the regulations to be issued under Section 941 of the Dodd-Frank Act.

589 Id. at 81.

590 Section 941(b) also imposes risk retention requirements on other types of asset backed securities and

collateralized debt obligations.

591 12 CFR § 360.6.

592 12 CFR § 360.6(b)(5)(i).

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The FDIC risk retention requirement, followed by the risk retention requirement to be

developed under the Dodd-Frank Act, should, if well implemented, end the ability of banks to

magnify risk through issuing asset backed securities and then walking away from that risk.

Instead, banks will be required to keep “skin in the game” until each securitization concludes.

Ban on Steering. The Washington Mutual case history also exposed another problem:

compensation incentives that encouraged loan officers and mortgage brokers to steer borrowers

to higher risk loans. Compensation incentives called “overages” at WaMu and “yield spread

premiums” at other financial institutions also encouraged loan officers and mortgage brokers to

charge borrowers higher interest rates and points than the bank would accept, so that the loan

officer or mortgage banker could split the extra money taken from the borrower with the bank.

To ban these compensation incentives, Section 1403 of the Dodd-Frank Act creates a new

Section 129B(c) in TILA prohibiting the payment of any steering incentives, including yield

spread premiums. It states: “no mortgage originator shall receive from any person and no person

shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the

terms of loan (other than the amount of the principal).” It also states explicitly that no provision

of the section should be construed as “permitting any yield spread premium or other similar

compensation.” In addition, it directs the Federal Reserve to issue regulations to prohibit a range

of abusive and unfair mortgage related practices, including prohibiting lenders and brokers from

steering borrowers to mortgages for which they lack a reasonable ability to repay.

The Dodd-Frank provisions were enacted into law shortly before the Federal Reserve, in

September 2010, promulgated new regulations prohibiting a number of unfair or abusive lending

practices, including certain payments to mortgage originators.593 In its notice, the Federal

Reserve noted that its new regulations prohibit many of the same practices banned in Section

1403 of the Dodd Frank Act, but that it will fully implement the new Dodd-Frank measures in a

future rulemaking.594

High Risk Loans. Still another problem exposed by the Washington Mutual case history

is the fact that, in the years leading up to the financial crisis, many U.S. insured banks held

highly risky loans and securities in their investment and sale portfolios. When those loans and

securities lost value in 2007, many banks had to declare multi-billion-dollar losses that triggered

shareholder flight and liquidity runs.

Section 620 of the Dodd-Frank Act requires the federal banking regulators, within 18

months, to prepare a report identifying the activities and investments that insured banks and their

affiliates are allowed to engage in under federal and state law, regulation, order, and guidance,

and analyzing the risks associated with those activities and investments. The federal banking

agencies are also asked to make recommendations on whether each allowed activity or

investment is appropriate, could negatively affect the safety and soundness of the banking entity

or the U.S. financial system, and should be restricted to reduce risk.

593 75 Fed. Reg. 185 (9/24/2010).

594 Id. at 58509.

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(2) Recommendations

To further strengthen standards and controls needed to prevent high risk lending and

safeguard the Deposit Insurance Fund, this Report makes the following recommendations.

1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their

regulatory authority to ensure that all mortgages deemed to be “qualified residential

mortgages” have a low risk of delinquency or default.

2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk

retention requirement under Section 941 by requiring the retention of not less than a

5% credit risk in each, or a representative sample of, an asset backed securitization’s

tranches, and by barring a hedging offset for a reasonable but limited period of time.

3. Safeguard Against High Risk Products. Federal banking regulators should

safeguard taxpayer dollars by requiring banks with high risk structured finance

products, including complex products with little or no reliable performance data, to

meet conservative loss reserve, liquidity, and capital requirements.

4. Require Greater Reserves for Negative Amortization Loans. Federal banking

regulators should use their regulatory authority to require banks issuing negatively

amortizing loans that allow borrowers to defer payments of interest and principal, to

maintain more conservative loss, liquidity, and capital reserves.

5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the

Section 620 banking activities study to identify high risk structured finance products

and impose a reasonable limit on the amount of such high risk products that can be

included in a bank’s investment portfolio.

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IV. REGULATORY FAILURE:

CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION

Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in

deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest

thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight

largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The

bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing,

accelerating the unraveling of the financial markets. WaMu’s collapse marked one of the most

spectacular failures of federal bank regulators in recent history.

In 2007, many of WaMu’s home loans, especially those with the highest risk profile,

began experiencing increased rates of delinquency, default, and loss. After the subprime

mortgage backed securities market collapsed in September 2007, Washington Mutual was unable

to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth

quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu

lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and

a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of

Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac,

Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG,

and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From

2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank,

triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into

receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion.

Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s

entire $45 billion Deposit Insurance Fund.

OTS records show that, during the five years prior to its collapse, OTS examiners

repeatedly identified significant problems with Washington Mutual’s lending practices, risk

management, and asset quality, and requested corrective action. Year after year, WaMu

promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond

with meaningful enforcement action, choosing instead to continue giving the bank inflated

ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly

gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators

that WaMu was fundamentally sound.

Federal bank regulators are charged with ensuring that U.S. financial institutions operate

in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed

to prevent Washington Mutual’s increasing use of high risk lending practices and its origination

and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to

adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS

regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems

identified by OTS with minimal regulatory intervention, and expressed reluctance to interfere

with even unsound lending and securitization practices. OTS displayed an unusual amount of

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deference to WaMu’s management, choosing to rely on the bank to police itself. The reasoning

appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then

rely on WaMu’s assurances that problems were corrected, with little need for tough enforcement

actions. It was a regulatory approach with disastrous results.

Over the five-year period reviewed by the Subcommittee, OTS examiners identified over

500 serious deficiencies in WaMu operations. Yet OTS did not once, from 2004 to 2008, take a

public enforcement action against Washington Mutual, even when the bank failed to correct

major problems. Only in late 2008, as the bank incurred mounting losses, did OTS finally take

two informal, nonpublic enforcement actions, requiring WaMu to agree to a Board Resolution in

March and a Memorandum of Understanding in September, but neither action was sufficient to

prevent the bank’s failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator,

for stronger measures and even impeded FDIC oversight efforts at the bank. Hindered by a

culture of deference to management, demoralized examiners, and agency infighting, OTS

officials allowed the bank’s short term profits to excuse its risky practices and failed to evaluate

the bank’s actions in the context of the U.S. financial system as a whole.

OTS not only failed to prevent Washington Mutual from engaging in unsafe and unsound

lending practices, it gave its tacit approval and allowed high risk loans to proliferate. As long as

Washington Mutual was able to sell off its risky loans, neither OTS nor the FDIC expressed

concerns about the impact of those loans elsewhere. By not sounding the alarm, OTS and the

FDIC enabled WaMu to construct a multi-billion-dollar investment portfolio of high risk

mortgage assets, and also permitted WaMu to sell hundreds of billions of dollars in high risk,

poor quality loans and securities to other financial institutions and investors in the United States

and around the world. Similar regulatory failings by OTS, the FDIC, and other agencies

involving other lenders repeated these problems on a broad scale. The result was a mortgage

market saturated with risky loans, and financial institutions that were supposed to hold

predominantly safe investments but instead held portfolios rife with high risk, poor quality

mortgages. When those loans began defaulting in record numbers and mortgage related

securities plummeted in value, financial institutions around the globe suffered hundreds of

billions of dollars in losses, triggering an economic disaster. The regulatory failures that set the

stage for these losses were a proximate cause of the financial crisis.

A. Subcommittee Investigation and Findings of Fact

To analyze regulatory oversight of Washington Mutual, the Subcommittee subpoenaed

documents from OTS, the FDIC, and WaMu, including bank examination reports, legal

pleadings, reports, internal memoranda, correspondence, and email. The Subcommittee also

conducted over two dozen interviews with OTS, FDIC, and WaMu personnel, including the

FDIC Chairman, OTS Director, OTS and the FDIC senior examiners assigned to Washington

Mutual, and senior WaMu executives. The Subcommittee also spoke with personnel from the

Offices of the Inspector General (IG) at the FDIC and the Department of Treasury, who were

engaged in a joint review of WaMu’s failure. In addition, the Subcommittee spoke with nearly a

dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 16,

2010, the Subcommittee held a hearing at which OTS, the FDIC, and IG officials provided

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testimony; released 92 hearing exhibits; and released the FDIC and Treasury IGs’ joint report on

Washington Mutual.595

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

Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the

role of the regulators overseeing WaMu. That memorandum stated:

“Federal bank regulators are supposed to ensure the safety and soundness of individual

U.S. financial institutions and, by extension, the U.S. banking system. Washington

Mutual was just one of many financial institutions that federal banking regulators allowed

to engage in such high risk home loan lending practices that they resulted in bank failure

and damage to financial markets. The ineffective role of bank regulators was a major

contributor to the 2008 financial crisis that continues to afflict the U.S. and world

economy today.”

On March 16, 2011, the FDIC sued the three top former executives of Washington

Mutual for pursuing a high risk lending strategy without sufficient risk management practices

and despite their knowledge of a weakening housing market.596

“Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating

The FDIC complaint stated:

Officer Stephen J. Rotella (“Rotella”), and Home Loans President David C. Schneider

(“Schneider”) caused Washington Mutual Bank (“WaMu” or “the Bank”) to take extreme

and historically unprecedented risks with WaMu’s held-for-investment home loans

portfolio. They focused on short term gains to increase their own compensation, with

reckless disregard for WaMu’s longer term safety and soundness. Their negligence, gross

negligence and breaches of fiduciary duty caused WaMu to lose billions of dollars. The

FDIC brings this Complaint to hold these three highly paid senior executives, who were

chiefly responsible for WaMu’s higher risk home lending program, accountable for the

resulting losses.”

595 See “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent

Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee

Hearing”).

596 The Federal Deposit Insurance Corporation v. Kerry K. Killinger, Stephen J. Rotella, David C. Schneider, et al.,

Case No. 2:11-CV-00459 (W.D. Wash.), Complaint (March 16, 2011), at

http://graphics8.nytimes.com/packages/pdf/business/conformedcomplaint.pdf (hereinafter “FDIC Complaint

Against WaMu Executives”).

164

The Levin-Coburn memorandum contained joint findings of fact regarding the role of

federal regulators in the Washington Mutual case history. Those findings of fact, which this

Report reaffirms, are as follows.

1. Largest U.S. Bank Failure. From 2003 to 2008, OTS repeatedly identified

significant problems with Washington Mutual’s lending practices, risk management,

and asset quality, but failed to force adequate corrective action, resulting in the largest

bank failure in U.S. history.

2. Shoddy Lending and Securitization Practices. OTS allowed Washington Mutual

and its affiliate Long Beach Mortgage Company to engage year after year in shoddy

lending and securitization practices, failing to take enforcement action to stop its

origination and sale of loans with fraudulent borrower information, appraisal

problems, errors, and notoriously high rates of delinquency and loss.

3. Unsafe Option ARM Loans. OTS allowed Washington Mutual to originate

hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages,

knowing that the bank used unsafe and unsound teaser rates, qualified borrowers

using unrealistically low loan payments, permitted borrowers to make minimum

payments resulting in negatively amortizing loans (i.e., loans with increasing

principal), relied on rising house prices and refinancing to avoid payment shock and

loan defaults, and had no realistic data to calculate loan losses in markets with flat or

declining house prices.

4. Short Term Profits Over Long Term Fundamentals. OTS abdicated its

responsibility to ensure the long term safety and soundness of Washington Mutual by

concluding that short term profits obtained by the bank precluded enforcement action

to stop the bank’s use of shoddy lending and securitization practices and unsafe and

unsound loans.

5. Impeding FDIC Oversight. OTS impeded FDIC oversight of Washington Mutual

by blocking its access to bank data, refusing to allow it to participate in bank

examinations, rejecting requests to review bank loan files, and resisting the FDIC

recommendations for stronger enforcement action.

6. FDIC Shortfalls. The FDIC, the backup regulator of Washington Mutual, was

unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the

Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to

limit its examination authority, and did not initiate its own enforcement action against

the bank in light of ongoing opposition by the primary federal bank regulators to

FDIC enforcement authority.

7. Recommendations Over Enforceable Requirements. Federal bank regulators

undermined efforts to end unsafe and unsound mortgage practices at U.S. banks by

issuing guidance instead of enforceable regulations limiting those practices, failing to

165

prohibit many high risk mortgage practices, and failing to set clear deadlines for bank

compliance.

8. Failure to Recognize Systemic Risk. OTS and the FDIC allowed Washington

Mutual and Long Beach to reduce their own risk by selling hundreds of billions of

dollars of high risk mortgage backed securities that polluted the financial system with

poorly performing loans, undermined investor confidence in the secondary mortgage

market, and contributed to massive credit rating downgrades, investor losses,

disrupted markets, and the U.S. financial crisis.

9. Ineffective and Demoralized Regulatory Culture. The Washington Mutual case

history exposes the regulatory culture at OTS in which bank examiners are frustrated

and demoralized by their inability to stop unsafe and unsound practices, in which

their supervisors are reluctant to use formal enforcement actions even after years of

serious bank deficiencies, and in which regulators treat the banks they oversee as

constituents rather than arms-length regulated entities.

B. Background

At the time of its collapse, Washington Mutual Savings Bank was a federally chartered thrift

with over $188 billion in federal insured deposits. Its primary federal regulator was OTS. Due

to its status as an insured depository institution, it was also overseen by the FDIC.

(1) Office of Thrift Supervision

The Office of Thrift Supervision was created in 1989, in response to the savings and loan

crisis, to charter and regulate the thrift industry.597 Thrifts are required by their charters to hold

most of their assets in mortgage lending, and have traditionally focused on the issuance of home

loans.598 OTS was part of the U.S. Department of the Treasury and headed by a presidentially

appointed director. Like other bank regulators, OTS was charged with ensuring the safety and

soundness of the financial institutions it oversaw. Its operations were funded through

semiannual fees assessed on the institutions it regulated, with the fee amount based on the size,

condition, and complexity of each institution’s portfolio. Washington Mutual was the largest

thrift overseen by OTS and, from 2003 to 2008, paid at least $30 million in fees annually to the

agency, which comprised 12-15% of all OTS revenue.599

597 Twenty years after its establishment, OTS was abolished by the Dodd-Frank Wall Street Reform and Consumer

Protection Act, P.L. 111-203, (Dodd-Frank Act) which has transferred the agency’s responsibilities to the Office of

the Comptroller of the Currency (OCC), and directed the agency to cease all operations by 2012. This Report

focuses on OTS during the time period 2004 through 2008.

598 6/19/2002 OTS Regulatory Bulletin, “Thrift Activities Regulatory Handbook Update” (some educational loans,

SBLs, and credit card loans also count towards qualifying as a thrift), http://files.ots.treas.gov/74081.pdf.

599 See April 16, 2010 Subcommittee Hearing at 11 (testimony of Treasury IG Eric Thorson).

166

In 2009, OTS oversaw about 765 thrift-chartered institutions.600

During the years reviewed by the Subcommittee, the OTS Executive Director was John

Reich; the Deputy Director was Scott Polakoff; the Western Region Office Director was Michael

Finn and later Darrel Dochow; and the Examiners-in-Charge at WaMu were Lawrence Carter

and later Benjamin Franklin.

OTS supervised its

thrifts through four regional offices, each led by a Regional Director, Deputy Director, and

Assistant Director. Regional offices assigned an Examiner-in-Charge to each thrift in its

jurisdiction, along with other supporting examination personnel. Approximately three-quarters

of the OTS workforce reported to its four regional offices, while the remaining quarter worked at

OTS headquarters in Washington, D.C. Washington Mutual, whose headquarters were located in

Seattle, was supervised by the Western Region Office which, through the end of 2008, was based

in Daly City, California.

(2) Federal Deposit Insurance Corporation

WaMu’s secondary federal regulator was the FDIC. The FDIC’s mission is to maintain

stability and public confidence in the nation’s financial system by insuring deposits, examining

and supervising financial institutions for safety and soundness and consumer protection, and

managing failed institutions placed into receivership.601

To minimize withdrawals from the Deposit Insurance Fund, the FDIC is assigned backup

supervisory authority over approximately 3,000 federally insured depository institutions whose

primary regulators are the Federal Reserve, OCC, and, until recently, OTS. Among other

measures, the FDIC is authorized to conduct a “special examination” of any insured institution

“to determine the condition of such depository institution for insurance purposes.”

The FDIC administers the Deposit

Insurance Fund, which is the primary mechanism used to protect covered deposits at U.S.

financial institutions from loss. The Deposit Insurance Fund is financed through fees assessed

on the insured institutions, with assessments based on the amount of deposits requiring

insurance, the amount of assets at each institution, and the degree of risk posed by each

institution to the insurance fund.

602 To

facilitate and coordinate its oversight obligations with those of the primary bank regulators and

ensure it is able to protect the Deposit Insurance Fund, the FDIC has entered into an inter-agency

agreement with the primary bank regulators.603

600 2009 OTS Annual Report, “Agency Profile,”

The 2002 version of that agreement, which was

in effect until 2010, stated that the FDIC was authorized to request to participate in examinations

of large institutions or higher risk financial institutions, recommend enforcement actions to be

taken by the primary regulator, and if the primary regulator failed to act, take its own

enforcement action with respect to an insured institution.

http://www.ots.treas.gov/_files/482096.pdf.

601 See “FDIC Mission, Vision, and Values,” http://www.fdic.gov/about/mission/index.html.

602 12 U.S.C. § 1820(b)(3).

603 The interagency agreement is entitled, “Coordination of Expanded Supervisory Information Sharing and Special

Examinations.” During the time period of the Subcommittee’s investigation, the 2002 version of the interagency

agreement, signed by the FDIC, Federal Reserve, OCC, and OTS, was in effect. In July 2010, the federal financial

regulators agreed to adopt a stronger version, discussed later in this Report.

167

For the eight largest insured institutions at the time, the FDIC assigned at least one

Dedicated Examiner to work on-site at the institution. The examiner’s obligation is to evaluate

the institution’s risk to the Deposit Insurance Fund and work with the primary regulator to lower

that risk. During the period covered by this Report, Washington Mutual was one of the eight and

had an FDIC-assigned Dedicated Examiner who worked with OTS examiners to oversee the

bank.

During the years examined by the Subcommittee, the FDIC Chairman was Sheila Bair;

the Acting Deputy Director for the FDIC’s Division of Supervision and Consumer Protection’s

Complex Financial Institution Branch was John Corston; in the San Francisco Region, the

Director was John Carter and later Stan Ivie, and the Assistant Director was George Doerr. At

WaMu, the FDIC’s Dedicated Examiner was Stephen Funaro.

(3) Examination Process

The stated mission of OTS was “[t]o supervise savings associations and their holding

companies in order to maintain their safety and soundness and compliance with consumer laws,

and to encourage a competitive industry that meets America’s financial services needs.” The

OTS Examination Handbook required “[p]roactive regulatory supervision” with a focus on

evaluation of “future needs and potential risks to ensure the success of the thrift system in the

long term.”604

To carry out its mission, OTS traditionally conducted an examination of each of the

thrifts within its jurisdiction every 12 to 18 months and provided the results in a Report of

Examination (ROE). In 2006, OTS initiated a “continuous exam” program for its largest thrifts,

requiring its examiners to conduct a series of specialized examinations during the year with the

results from all of those examinations included in an annual ROE. The Examiner-in-Charge led

the examination activities which were organized around the CAMELS rating system used by all

federal bank regulators. The CAMELS rating system evaluates a bank’s: (C) capital adequacy,

(A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.

A CAMELS rating of 1 is the best rating, while 5 is the worst. In the annual ROE, OTS

provided its thrifts with an evaluation and rating for each CAMELS component, as well as an

overall composite rating on the bank’s safety and soundness.

OTS, like other bank regulators, had special access to the financial information of

the thrifts under its regulation, which was otherwise kept confidential from the market and other

parties.

605

At Washington Mutual, OTS examiners conducted both on-site and off-site activities to

review bank operations, and maintained frequent communication with bank management through

emails, telephone conferences, and meetings. During certain periods of the year, OTS examiners

604 2004 OTS Examination Handbook, Section 010.2, OTSWMEF-0000031969, Hearing Exhibit 4/16-2.

605 A 1 composite rating in the CAMELS system means “sound in every respect”; a 2 rating means “fundamentally

sound”; a 3 rating means “exhibits some degree of supervisory concern in one or more of the component areas”; a 4

rating means “generally exhibits unsafe and unsound practices or conditions”; and a 5 rating means “exhibits

extremely unsafe and unsound practices or conditions” and is of “greatest supervisory concern.” See chart in the

prepared statement of Treasury IG Eric Thorson at 7, reprinted in April 16, 2010 Subcommittee Hearing at 107.

168

had temporary offices at Washington Mutual for accessing bank information, collecting data

from bank employees, performing analyses, and conducting other exam activities. Washington

Mutual formed a Regulatory Relations office charged with overseeing its interactions and

managing its relationships with personnel at OTS, the FDIC, and other regulators.

During the year, OTS examiners issued “findings memoranda,” which set forth particular

examination findings, and required a written response and corrective action plan from WaMu

management. The memoranda contained three types of findings. The least severe was an

“observation,” defined as a “weakness identified that is not of regulatory concern, but which may

improve the bank’s operating effectiveness if addressed. … Observations may or may not be

reviewed during subsequent examinations.” The next level of finding was a “recommendation,”

defined as a “secondary concern requiring corrective action. … They may be included in the

Report of Examination … Management’s actions to address Recommendations are reviewed at

subsequent or follow-up examinations.” The most severe type of finding was a “criticism,”

defined as a “primary concern requiring corrective action … often summarized in the ‘Matters

Requiring Board Attention’ … section of the Report of Examination. … They are subject to

formal follow-up by examiners and, if left uncorrected, may result in stronger action.”606

The most serious OTS examination findings were elevated to Washington Mutual Bank’s

Board of Directors by designating them as a “Matter Requiring Board Attention” (MRBA).

MRBAs were set forth in the ROE and presented to the Board in an annual meeting attended by

OTS and FDIC personnel. Washington Mutual tracked OTS findings, along with its own

responses, through an internal system called Enterprise Risk Issue Control System (ERICS).

ERICS was intended to help WaMu manage its relationship with its regulators by storing the

regulators’ findings in one central location. In one of its more unusual discoveries, the

Subcommittee learned that OTS also came to rely largely on ERICS to track its dealings with

WaMu. OTS’ reliance on WaMu’s tracking system was a unique departure from its usual

practice of separately tracking the status of its past examination findings and a bank’s

responses.607

The FDIC also participated in the examinations of Washington Mutual. Because WaMu

was one of the eight largest insured banks in the country, the FDIC assigned a full-time

Dedicated Examiner to oversee its operations. Typically, the FDIC examiners worked with the

primary regulator and participated in or relied upon the examinations scheduled by that regulator,

rather than initiating separate FDIC examinations. At least once per year, the FDIC examiner

performed an evaluation of the institution’s risk to the Deposit Insurance Fund, typically relying

primarily on the annual Report on Examination (ROE) issued by the primary regulator and the

ROE’s individual and composite CAMELS ratings for the institution. After reviewing the ROE

as well as other examination and financial information, the FDIC examiner reviewed the

CAMELS ratings for WaMu to ensure they were appropriate.

606 Descriptions of these terms appeared in OTS findings memoranda. See, e.g., 6/19/2008 OTS Findings

Memorandum of Washington Mutual Bank, at Bisset_John-00046124_002, Hearing Exhibit 4/16-12a.

607 See April 16, 2010 Subcommittee Hearing at 21 (information supplied by Treasury IG Thorson for the record).

169

In addition, for institutions with assets of $10 billion or more, the FDIC had established a

Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that

may pose a threat to the Deposit Insurance Fund. Under that program, the FDIC Dedicated

Examiner and other FDIC regional case managers performed ongoing analysis of emerging risks

within each covered institution and assigned it a quarterly risk rating, using a scale of A to E,

with A being the best rating and E the worst. In addition, senior FDIC analysts within the

Complex Financial Institutions Branch analyzed specific bank risks and developed supervisory

strategies. If the FDIC viewed an institution as imposing an increasing risk to the Deposit

Insurance Fund, it could perform one or more “special examinations” to take a closer look.

C. Washington Mutual Examination History

For the five-year period, from 2004 to 2008, OTS repeatedly identified significant

problems with Washington Mutual’s lending practices, risk management, appraisal procedures,

and issued securities, and requested corrective action. WaMu promised to correct the identified

deficiencies, but failed to do so. OTS failed, in turn, to take enforcement action to ensure the

corrections were made, until the bank began losing billions of dollars. OTS also resisted and at

times impeded FDIC examination efforts at Washington Mutual.

(1) Regulatory Challenges Related to Washington Mutual

Washington Mutual was a larger and more complex financial institution than any other

thrift overseen by OTS, and presented numerous regulatory challenges. By 2007, Washington

Mutual had over $300 billion in assets, 43,000 employees, and over 2,300 branches in 15 states,

including a securitization office on Wall Street, a massive loan portfolio, and several lines of

business, including home loans, credit cards, and commercial real estate.

Integration Issues. During the 1990s, as described in the prior chapter, WaMu

embarked upon a strategy of growth through acquisition of smaller institutions, and over time

became one of the largest mortgage lenders in the United States. One consequence of its

acquisition strategy was that WaMu struggled with the logistical and managerial challenges of

integrating a variety of lending platforms, information technology systems, staff, and policies

into one system.

OTS was concerned about and critical of WaMu’s integration efforts. In a 2004 Report

on Examination (ROE), OTS wrote:

“Our review disclosed that past rapid growth through acquisition and unprecedented

mortgage refinance activity placed significant operational strain on [Washington Mutual]

during the early part of the review period. Beginning in the second half of 2003, market

conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past

mortgage banking acquisitions, address operational issues, and realize expectations from

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certain major IT initiatives exposed the institution’s infrastructure weaknesses and began

to negatively impact operating results.”608

Long Beach. One of WaMu’s acquisitions, in 1999, was Long Beach Mortgage

Company (Long Beach), a subprime lender that became a source of significant management,

asset quality, and risk problems. Long Beach’s headquarters were located in Long Beach,

California, but as a subsidiary of Washington Mutual Inc., the parent holding company of

Washington Mutual Bank, it was subject to regulation by the State of Washington Department of

Financial Institutions and the FDIC. Long Beach’s business model was to purchase subprime

loans from third party mortgage brokers and lenders and then sell or securitize the loans for sale

to investors.

For the first seven years, from 1999 to 2006, OTS had no direct jurisdiction over Long

Beach, since it was a subsidiary of WaMu’s parent holding company, but not a subsidiary of the

bank itself. OTS was limited to reviewing Long Beach indirectly by examining its effect on the

holding company and WaMu. In late 2003, OTS examiners took greater notice of Long Beach

after WaMu’s legal department halted Long Beach’s securitizations while it helped the company

strengthen its internal controls. As many as 4,000 Long Beach loans were of such poor quality

that three quarters of them could not be sold to investors. In 2005, Long Beach experienced a

surge in early payment defaults, was forced to repurchase a significant number of loans, lost over

$107 million, and overwhelmed its loss reserves. Washington Mutual requested permission to

make Long Beach a division of the bank, so that it could assert greater control over Long

Beach’s operations, and in March 2006, OTS approved the purchase with conditions. In 2006,

Long Beach experienced another surge of early payment defaults and was forced to repurchase

additional loans. When Long Beach loans continued to have problems in 2007, Washington

Mutual eliminated Long Beach as a separate operation and rebranded it as a Washington Mutual

“Wholesale Specialty Lending” division. In August 2007, after the collapse of the subprime

secondary market, WaMu stopped offering subprime loans and discontinued the last vestiges of

the Long Beach operation.

High Risk Lending. In 2004, Washington Mutual shifted its strategy toward the

issuance and purchase of higher risk home loans. OTS took note of the strategic shift in WaMu’s

2004 ROE:

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

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

increasing to near $500 billion by 2009.”609

608 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed

Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share

to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity

issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been

exceedingly patient.”).

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

Exhibit].

171

OTS recommended, and the bank agreed, to spell out its new lending strategy in a written

document that had to be approved by the WaMu Board of Directors.610

The result was the bank’s January 2005 High Risk Lending Strategy, discussed in the

prior chapter, in which WaMu management obtained the approval of its Board to shift its focus

from originating lower risk fixed rate and government backed loans to higher risk subprime,

home equity, and Option ARM loans.611 The High Risk Lending Strategy also outlined WaMu’s

plans to increase its issuance of higher risk loans to borrowers with a higher risk profile. The

purpose of the shift was to maximize profits by originating loans with the highest profit margins,

which were usually the highest risk loans. According to actual loan data analyzed by WaMu,

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, 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.

requiring each WaMu

employee to oversee more than 2,400 third party brokers.

(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:

“[S]ubprime 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.

184

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.

187

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.

191

(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.

203

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.

204

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.

205

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

review WaMu loan files, insisting that the FDIC instead rely on the findings and conclusions of

OTS examiners who conducted the loan file reviews.

In September 2006, when OTS first refused to give the FDIC direct access to WaMu loan

files, an FDIC senior official commented: “The OTS must really be afraid of what we might

come across, but bottom line is we need access to the information.”786

782 11/10/2006 letter from OTS senior official Michael Finn to FDIC Regional Director John Carter, OTSWMS06-

008 0001827, Hearing Exhibit 4/16-52b.

The FDIC explained to

the Subcommittee that it needed direct access to the loan files to assess the higher risk loans

WaMu was issuing, both to evaluate what insurance fees should be imposed on Washington

Mutual and to assess the extent of any threat to the Deposit Insurance Fund.

783 Id.

784 See, e.g., 1/22/2007 letter from Michael Finn to John Carter, Hearing Exhibit 4/16-52d.

785 See, e.g., April 16, 2010 Subcommittee Hearing at 73-74.

786 9/7/2006 email from FDIC senior official John Carter to George Doerr, FDIC-EM_00252239, Hearing Exhibit

4/16-51c.

206

In February 2007, OTS refused an FDIC request to review WaMu loan files to evaluate

the bank’s compliance with recently issued federal guidance on how to handle nontraditional

mortgages, such as subprime, stated income, and negatively amortizing loans. Even though

Washington Mutual was issuing exactly those types of loans under its High Risk Lending

Strategy, OTS indicated that it did not plan to evaluate WaMu’s compliance with the guidance

and did not want the FDIC to perform that evaluation either. In a February email, the FDIC

Dedicated Examiner at WaMu informed the FDIC Assistant Regional Director: “OTS is

restricting FDIC on the current examination in the SFR [single family residential loan] review

segment. OTS will not allow us to review SFR loan files.”787 The Assistant Regional Director

relayed the development to the Regional Director: “John, here we go again. … OTS wants to

draw a distinction between loan file review as an examination activity (that they object to) vs.

risk assessment (which they do not object to). I don’t fathom the distinction.”788

Two months later, in April 2007, the FDIC continued to press for permission to review

WaMu loan files. The FDIC Assistant Regional Deputy wrote in an email to a colleague:

“[OTS Regional Director] Finn pushed back on his previous approval of our participation

in the 2007 exam targets, specifically as to our ability to work loan files alongside OTS

examiner, and we were particularly interested in WAMU’s compliance with

nontraditional mortgage guidance. ... Mr. Finn and his examiner, Ben Franklin, stated that

OTS did not intend to look at files for purposes of testing nontraditional mortgage

guidance until after the bank made a few changes they had agreed to. I asked if we could

then join the file review whenever ots did look at this, and he said, ‘No.’”789

At the Subcommittee hearing, when asked about these incidents, the FDIC Chairman

Sheila Bair testified:

“[I]n 2005 … OTS management determined that FDIC should not actively participate in

OTS examinations at WaMu, citing the 2002 interagency agreement. In subsequent

years, FDIC faced repeated resistance to its efforts to fully participate in examinations of

WaMu. Even as late as 2008, as problems at WaMu were becoming more apparent, OTS

management sought to limit the number of FDIC examiners involved in the examination

and did not permit the FDIC to review loan files.”790

Both the Treasury and the FDIC Inspectors General were critical of OTS’ actions. In response to

a question about “[w]hether or not OTS should have allowed the FDIC to help” with the

examinations of WaMu, FDIC IG Rymer responded:

“[I]t is clear to me that they [OTS] should have. … [T]hey [the FDIC] had concerns and

those concerns were principally driven by its own LIDI analysis. … [T]here is no

question in my mind that the FDIC’s request for back-up authority, simply given the

787 2/6/2007 email from Stephen Funaro to George Doerr, Hearing Exhibit 4/16-55.

788 2/6/2007 email from George Doerr to John Carter and others, Hearing Exhibit 4/16-55.

789 4/30/2007 email from George Doerr to David Collins, FDIC_WAMU 000014457, Hearing Exhibit 4/16-57.

790 April 16, 2010 Subcommittee Hearing at 80-81 (testimony of Sheila Bair).

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sheer size of WaMu, was, to me, enough reason for FDIC to ask for back-up

authority.”791

Treasury IG Thorson agreed:

“I agree with Mr. Rymer. … [T]he sheer size of the bank would say that there should be

a maximum of cooperation, not to mention the fact that it is dictated by statute, as well.

… [A]s a matter of policy, I think they [OTS] should have allowed that. No matter what

their reasoning was, as a matter of policy, they should have, yes.”792

OTS Turf War. At the Subcommittee hearing, John Reich, the OTS Director, was asked

about the friction between the two agencies. In response to a question about the August 2008

email in which he wrote that the FDIC had “no role” at WaMu until OTS “rules on solvency,”793

Mr. Reich: I think basically and fundamentally it was who was the primary Federal

regulator.

Mr. Reich stressed that the key point he was trying to convey was that OTS was WaMu’s

primary federal regulator:

Senator Levin: It was turf, in a word.

Mr. Reich: I think OTS had the responsibility as the primary Federal regulator.

Senator Levin: Turf.

Mr. Reich: We had the statutory responsibility.

Senator Levin: Instead of going at this as partners –

Mr. Reich: I have more than most – an understanding of the role of the FDIC and their

need to participate. I have been there.794

The evidence shows that OTS senior officials not only resisted, but resented the FDIC

participation in the oversight of Washington Mutual Bank and deliberately took actions that

limited the FDIC oversight, even in the face of a deteriorating $300 billion institution whose

failure could have exhausted the entire Deposit Insurance Fund. After contrasting OTS’ hardedged

treatment of the FDIC with the collaborative approach it took towards WaMu, Senator

Levin observed:

“About the only time OTS showed backbone was against another agency’s moving, in

your view, into your turf. Boy, that really got your dander up. That got your blood

pressure up. I do not see your blood pressure getting up against a bank which is engaged

791 April 16, 2010 Subcommittee Hearing at 34.

792 Id. at 35.

793 See 8/6/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, “Re: W,” FDICEM_

00110089, Hearing Exhibit 4/16-66 (“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.”).

794 April 16, 2010 Subcommittee Hearing at 64.

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in the kind of dangerous practices that the bank engaged in, dangerous to their solvency,

dangerous to their investors, dangerous to their depositors, dangerous to this

economy.”795

Because OTS has been abolished, its turf war with the FDIC is over. But witnesses from

the FDIC told the Subcommittee that the remaining banking regulators also sometimes resist its

participation in bank oversight. In particular, a senior FDIC official told the Subcommittee that,

although the FDIC has the statutory authority to take an enforcement action against a bank, the

FDIC has never used that authority because the other regulators would view it as “an act of war.”

The WaMu case history demonstrates how important it is for our federal regulators to view each

other as partners rather than adversaries in the effort to ensure the safety and soundness of U.S.

financial institutions.

D. Regulatory Failures

In a market economy, the purpose of regulation within the financial markets is to provide

a level playing field that works for everyone involved, from the financial institutions, to the

investors, to the consumers and businesses that rely on well functioning financial systems. When

financial regulators fail to enforce the rules in an effective and even handed manner, they not

only tilt the playing field in favor of some and not others, but also risk creating systemic

problems that can damage the markets and even the entire economy.

At the April 16, 2010 hearing of the Subcommittee, Senator Coburn had the following

exchange with Inspectors General Thorson and Rymer, which explains in part why OTS failed as

a regulator to address WaMu’s harmful lending policies:

Senator Coburn: As I sat here and listened to both the opening statement of the Chairman

and to your statements, I come to the conclusion that actually investors would have been

better off had there been no OTS because, in essence, the investors could not get behind

the scene to see what was essentially misled by OTS because they had faith the regulators

were not finding any problems, when, in fact, the record shows there are tons of

problems, just there was no action taken on it. ... I mean, we had people continually

investing in this business on the basis—as a matter of fact, they raised an additional $7

billion before they collapsed, on the basis that OTS said everything was fine, when, in

fact, OTS knew everything was not fine and was not getting it changed. Would you

agree with that statement or not?

Mr. Thorson: Yes, sir. I think ... basically assigning a ‘satisfactory’ rating when

conditions are not is contradictory to the very purpose for which regulators use a rating

system. I think that is what you are saying.

Senator Coburn: Any comments on that Mr. Rymer?

Mr. Rymer: I would agree with Mr. Thorson. ...

795 Id. at 66.

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Senator Coburn: [To Mr. Thorson] By your statement, it would imply almost that OTS is

an enabler of this effort rather than an enabler of making sure that the American people’s

taxpayer dollars and the trust in institutions that are supposed to be regulated by an

agency of the Federal Government can be trusted.

Mr. Thorson: Right.

In trying to understand why OTS failed to make use of its enforcement tools to compel

WaMu to operate in a safe and sound manner, the Subcommittee investigation has identified

factors that have resonance not only in the recent financial crisis, but are critical for regulators

and policymakers to address in order to avoid future financial disasters as well.

(1) OTS’ Failed Oversight of WaMu

During the five-year period of the Subcommittee’s inquiry, from 2004 to 2008, OTS

identified over 500 serious operational deficiencies at WaMu and Long Beach. At WaMu, the

problems included weak lending standards, high loan exception and error rates, noncompliance

with bank loan policy, weak risk management, poor appraisal practices, and poor quality loans.

At Long Beach, OTS identified many of the same problems and added on top of those, weak

management, poor quality mortgage backed securities, and inadequate repurchase reserves. The

problems are described in examination report after examination report, and OTS raised many of

the same concerns, in writing and in person, with WaMu’s Board of Directors.

But for all those years, OTS did little beyond describing the problems and asking bank

executives to make improvements. When the reforms failed to materialize, the problems

continued, and the risk increased, OTS stood on the sidelines. Subcommittee interviews found

that, until 2008, OTS regulators never even held internal discussions about taking an

enforcement action against the bank. In 2008, in the face of mounting losses, OTS took two

informal, nonpublic enforcement actions, which contained few mandatory measures or deadlines

and were together insufficient to save the bank.

In trying to understand the agency’s years of inaction, the Subcommittee’s investigation

concluded that the lack of enforcement reflected an OTS culture of deference to bank

management, demoralized examiners whose oversight efforts were unsupported by their

supervisors, and a narrow regulatory focus that allowed short term profits to excuse high risk

activities and disregarded systemic risk. Inflated CAMELS ratings may have further reduced the

pressure to act, while conflicts of interest may have also tempered OTS’ willingness to take

tough enforcement action against WaMu.

(a) Deference to Management

Part of the reason that OTS declined to take enforcement action against Washington

Mutual was a posture of deference to the management of the institutions it regulated. Ronald

Cathcart, WaMu’s chief enterprise risk officer from 2006-2008, described OTS as essentially

believing in “self-regulation”:

210

“I … have actually operated in banks under three regulators, in Canada under the Office

of the Supervisor of Financial Institutions, at Bank One under the OCC, and then at

Washington Mutual under the OTS[.] … [T]he approach that the OTS took was much

more light-handed than I was used to. It seemed as if the regulator was prepared to allow

the bank to work through its problems and had a higher degree of tolerance that I had …

seen with the other two regulators. … I would say that the OTS did believe in selfregulation.”

796

A former OTS regulator who later took a job with WaMu, was quoted in a press report as saying

that OTS provided “by far the softest” oversight of any federal bank regulator.797

Evidence of OTS’ unusually deferential approach can be found in its internal documents,

starting at the top. In a May 2007 email, for example, cancelling lunch with a colleague so he

could instead have lunch with WaMu’s CEO, Kerry Killinger, OTS Director, John Reich,

described the bank as “my largest constituent.”798 At the Subcommittee hearing, Mr. Reich

defended using the term, testifying that referring to others as constituents was a “habit” he had

picked up while working on Capitol Hill.799 One Senator pointed out that OTS’ true constituents

were not the banks it regulated, but “the American people it was supposed to protect from unsafe

and unsound banking practices.”800

On another occasion in July 2008, Mr. Reich sent an email to Mr. Killinger informing

him that OTS had decided to issue a Memorandum of Understanding (MOU) to address issues of

concern at the bank. In the email, the OTS Director apologized twice for his method of

communication, but also sounded a note of regret for his decision to take a tougher approach:

“Kerry,

I’m sorry to communicate by email – I’ve left a couple of messages on your office phone,

but I’m guessing you may be off for a long weekend.

I’ve been wrestling with the issue of an MOU versus a Board Resolution as a result of

our conversation in my office last week. And I’ve decided that an MOU is the right

approach for OTS to do in this situation ….

We almost always do an MOU for 3-rated institutions, and if someone were looking over

our shoulders, they would probably be surprised we don’t already have one in place. …

So as much as I would like to be able to say a Board Resolution is the appropriate

regulatory response, I don’t really believe it is. I do believe we need to do an MOU. We

796 April 13, 2010 Subcommittee Hearing, at 39-40 (Testimony of Ronald J. Cathcart, former WaMu Chief

Enterprise Risk Officer, 2006-2008).

797 “Lax Regulators Helped Doom Washington Mutual,” Associated Press (4/16/2010).

798 5/2/2007 email from OTS Director John Reich to Shelley Hymes, “Re: Lunch Friday,” Reich_John-

00025837_001, Hearing Exhibit 4/16-78.

799 April 16, 2010 Subcommittee Hearing at 36.

800 Id. at 5 (opening statement of Senator Levin).

211

don’t consider it a disclosable event, and we also think the investment community won’t

be surprised if they learn of it, and would probably only be surprised to learn one didn’t

already exist.

Again, I’m sorry to communicate this decision by email, but I’m scheduled to be out of

the office next week myself and wanted you to have this information.

Best regard, Kerry,

John”801

The email does not convey a message from an arms-length regulator concerned about a

failing bank. To the contrary, the email conveys a sense of familiarity and discloses that the

head of OTS knew his agency had already been providing preferential treatment to the bank by

failing to impose an MOU after its downgrade to a 3 rating five months earlier, in February

2008. Mr. Reich stated that others “looking over our shoulders … would probably be surprised”

an MOU was not already in place at WaMu.

When asked about this email at the Subcommittee hearing, the Treasury and the FDIC

Inspectors General both expressed discomfort with its language and tone:

Mr. Thorson: Again, he sort of apologizes in the previous document that this could

become known. This gets right to the heart of what you were talking about, the culture.

… [T]here is not an acceptance of the fact that a strong regulatory control helps them.

Senator Levin: This is far too cozy?

Mr. Thorson: Absolutely, as far as I am concerned, yes.

Senator Levin: Mr. Rymer, do you have any reaction to this?

Mr. Rymer: It does indicate a level of familiarity that makes me uncomfortable.802

Equally telling is the fact that, even after sending the email, OTS delayed imposing the MOU on

WaMu for another two months, waiting until September 2008, just three weeks before the bank’s

failure.803

Like the head of the agency, OTS examiners also took a deferential approach to WaMu.

In a January 2006 email discussing WaMu’s desire to purchase Long Beach, for example, the

OTS Examiner-in-Charge indicated that, rather than insist the bank clean up Long Beach

801 7/3/2008 email from OTS Director John Reich to WaMu CEO Kerry Killinger, OTSWMS08-014 0000912-13,

Hearing Exhibit 4/16-44.

802 April 16, 2010 Subcommittee Hearing at 34.

803 See also id. at 46 (When asked why OTS took so long to complete the MOU, former OTS Director John Reich

testified: “I don’t know, to tell you the truth. I do not know why it took so long to implement the MOU. … I regret

[the] … delay.”).

212

problems before the purchase, OTS would have to rely on its “relationship” with WaMu to get

the job done:

“The letter [from WaMu] seems okay. They obviously want to leave it a little squishy, of

course, on the growth plans, but at least they make a firm commitment to clean up the

underwriting issues. At some level, it seems we have to rely on our relationship and their

understanding that we are not comfortable with current underwriting practices and don’t

want them [Long Beach] to grow significantly without having the practices cleaned up

first.”804

On another occasion in June 2006, the same OTS Examiner-in-Charge sent a lengthy

email to his Regional Director discussing plans for the annual WaMu Report on Examination

(ROE). His email expressed concern about losing credibility with the bank if OTS pressed too

hard on certain reforms, twice noted the bank’s size and complexity, and stressed that the bank

was making progress in fixing identified problems:

“[W]e still have some strong feelings on some items that I’d like to ‘push back’ … some

on. Generally we feel that we are quite balanced and do not have any gloves on in our

approach to our findings and conclusions at WAMU. We have some concern that if we

press forward with some things … we may run the risk of losing some credibility in

terms of understanding the size and complexity of their business and looking as though

we do not have a balanced perspective. My own fear is that we may not have done

enough to communicate to you [the Regional Director] why we feel that the few negative

things we have brought up through findings memos and meetings, while important to

keep in front of management, are not so serious they wipe out all the right things the

institution is doing in all those areas we reviewed and did not have any issues, nor should

they negate the ongoing good progress in making improvements in a manner that seems

reasonable given the size, complexity, and status of the institution.”805

The Examiner-in-Charge then listed three areas of concern, problems at Long Beach

which he seemed to downplay, the need to limit the number of corrective actions listed in the

ROE, and the need to review how OTS cited the bank for compliance violations. In the Long

Beach discussion, he wrote that improvements “will take time because of size and complexity

…. We don’t feel demanding more than providing us with an acceptable action plan with

realistic timelines is appropriate or necessary at this time.” On the corrective actions, he wrote

that the list had to be limited or “more important findings will get lost. … We feel strongly that

we should not cite all findings and corrective actions within the body of the ROE … [which] is

already not getting read I believe.” He also expressed concern that OTS was “starting to ‘overmeeting’

the institution” and suggested that “the exit meeting” with the bank to discuss the ROE

findings had “become almost unnecessary.”

804 1/27/2006 email from Lawrence Carter to Darrel Dochow, OTSWMS06-008 0001082, Hearing Exhibit 4/16-32.

805 6/15/2006 email from Lawrence Carter to Darrel Dochow, Dochow_Darrel-00022908_001, Hearing Exhibit

4/16-7.

213

After urging patience on WaMu reforms, suggesting a limit on the corrective actions

listed in the ROE, and recommending fewer meetings with WaMu management, the curious final

line in the email is: “My management class this week has made me feel empowered! Can you

tell? Please don’t fire me!”

Additional evidence of OTS deference is its reliance on WaMu to track its own

compliance with OTS findings calling for corrective action. At all other thrifts, OTS tracked the

extent to which the thrift implemented OTS findings, using its own systems. But at WaMu, OTS

did not keep its own records, but relied on WaMu’s Enterprise Risk Issue Control System

(ERICS). The Treasury and the FDIC Inspectors General criticized this arrangement, noting that

they were unable to use WaMu’s system to determine the status of multiple OTS findings.806 In

addition, they noted that, in 2006, ERICS discontinued its practice of identifying “repeat

findings,” making it difficult to identify and track those findings.807

Finally, the actual language used by OTS in its reports and memoranda that described

deficiencies demonstrated a passive approach to dealing with management. Common phrases

noted that the bank’s practices were “less than satisfactory,” error rates were at “higher than

acceptable levels,” and “management’s actions did not improve underwriting to a satisfactory

level.” OTS reports rarely used more assertive language that, for example, called the bank’s

efforts unsatisfactory, inadequate, or ineffective. An exchange at the Subcommittee hearing

between Senator Levin and the OTS Examiner-in-Charge at WaMu from 2004 to 2006,

Lawrence Carter, captured the issue:

Their report explicitly

recommends against OTS’ relying on a bank’s systems in the future to track compliance.

Mr. Carter: I think that what I said here is that we could not conclude that their progress

was wholly inadequate, because they did make some progress.

Senator Levin: … Can you use the words, ‘Folks, your progress was inadequate?’ Are

you able to tell them that?

Mr. Carter: For their progress on this specific action plan, I did not conclude we could

tell them that.

Senator Levin: That it was inadequate?

Mr. Carter: That is right.

Senator Levin: You could tell them it was not wholly adequate.

Mr. Car